SEC Chairman Sees Potential in Cisco’s Options Derivative Plan

Securities and Exchange Commission Chairman William H. Donaldson on Thursday welcomed a Cisco Systems Inc. plan to create a financial device for valuing employee stock options, saying it has “a lot of potential.”

For the last decade, Cisco and other technology companies fought a losing battle against rules requiring employee stock options to be treated as an expense. Cisco is seeking permission from the SEC to set a market value on its options by selling a derivative with the same terms.

Silicon Valley must “get over the issue of should options be expensed, which I believe is a foregone conclusion and the right conclusion, and direct its attention on how to do that, how to price,” Donaldson said after a speech in Washington. “And they have tremendous talent that can do that.”

The Financial Accounting Standards Board passed the expensing rule in December and encouraged companies to value employee options using one of several mathematical models or an “observable market price.” No market exists for the options, which by their design can’t be traded.

Donaldson pushed to have employee options treated as an expense, saying they represent a quantifiable cost to shareholders. Cisco, in opposing the rule, said the real cost of an option depended on the company’s stock price and often could not be known for years.

Lynn Turner, a former SEC chief accountant, said he was concerned that Cisco and other companies were turning to the market approach as a way to evade the expensing requirement.

“If the value ascribed to the options turns out to be pennies on the dollar compared to well-established models, then it certainly raises the question of how much financial engineering and gamesmanship investors are being subjected to,” said Turner, managing director of research at proxy advisor Glass, Lewis & Co.

Employee options, which companies use to attract and retain talent, let workers make future purchases of stock at a set price.

Once an option vests, or matures, the employee can buy the underlying share at that exercise price, pocketing any gain in the stock since the grant date.

The proposed security, designed by investment bank Morgan Stanley, would function under the same terms as Cisco’s employee stock options, including the same exercise prices and five-year vesting schedule. They would be sold once and couldn’t be traded or hedged. Settlement of any gains would be with Cisco shares.

Cisco shares rose 15 cents to $18.70 on Nasdaq.