Backdate-Proof Options Pricing?

After years of haggling, the Securities and Exchange Commission has approved a new, derivative-based method of setting market values for stock options. The new method was devised by Zions Bancorporation and uses an online, modified Dutch auction to set market-based prices for options. The model could replace several academic methods of pricing options and is the first market-based model among several attempts to win approval.

Called Employee Stock Option Appreciation Rights Securities (ESOARS), the product is an options-based derivative, says Evan Hill, a Zions vice president. (Options are themselves derivatives.) ESOARS price options grants according to the exercise price of a pool of such grants. Their market value is set by an online auction—a modified version of the Dutch auction routinely used by the U.S. Treasury Dept.—held near or on the grant dates. Anyone may invest in ESOARS; holders receive payment when employees exercise their options.

The Zions approach removes any incentive to backdate option strike dates, since the instrument’s value depends on a pool with numerous players bidding at auction. That will lessen the chances of the kinds of scandals now ravaging more than 175 companies. Hill also notes that using ESOARS is cheaper than some of the academic pricing models. Since the SEC’s positive response, he says, Zions has been inundated with requests for information from firms wanting to use the new model.