On 30 June 2003, the Australian Securities and Investments Commission (ASIC) released guidelines on valuing share options which listed companies issue to directors and senior executives. Listed companies with financial year-end on 30 June 2003 will need to become familiar with ASIC’s guidelines relatively quickly, as they apply to directors’ reports for the 2003 financial year.
The practice of issuing share options to managers has become increasingly popular among listed companies in recent years. This enthusiasm however, has not been shared by the investing public. Reports of directors and senior executives of listed companies cashing in lucrative options packages have led to share options being depicted as an overgenerous perk given to those in charge of listed companies.
According to ASIC there is a problem of keeping investors informed - companies do not expense share options in their financial reports, and do not include the value of share options in their directors’ reports. As a result, there is an information gap for investors seeking to compare the remuneration packages granted by a listed company with its performance, or with the packages of competitors. A contrary argument is that an option does not cost a company anything at the time it is granted, and valuing an option may be a meaningless task if it is never exercised.
The issue of valuing share options as emoluments received by directors and senior executives in a company’s directors’ report has recently resurfaced with the release of ASIC guidelines on 30 June 2003.
The directors of listed companies have been required to include the value of share options granted to directors and senior executives in their directors’ reports since 1998. The requirement stems from section 300A of the Corporations Act, which provides that directors' reports must include:
- a discussion of board policy for determining the nature and amount of directors’ and senior executives’ "emoluments" (which is defined as the value of any money, consideration or benefit given to a director in connection with the management of the company, or a parent or subsidiary, excluding out-of-pocket expenses);
- a discussion of the relationship between such policy and the company’s performance; and
- details of the nature and amount of each element of the emolument of each director and each of the five named officers receiving the highest emolument.
In Practice Note 68 – Emoluments of directors and five named officers (PN 68), issued in 1998, ASIC confirmed its view that the concept of "emoluments" includes the value of options granted to directors and senior executives. ASIC declined to prescribe a method for valuing options in PN 68 however, and many boards of listed companies simply took the view that they had no value. With the release of its guidelines, ASIC has now prescribed a method for valuing options, which will apply to directors’ reports for the 2003 financial year on.
Although in one sense ASIC's guidelines signal its frustration with the refusal of many listed companies to value options in their directors' reports, its actual impetus for adopting a method for doing so appears to stem from a draft document released by the International Accounting Standards Board (IASB) on 7 November 2002 entitled ED 2 – Share-based Payment. The document focuses on the issue of expensing share options in a company's financial reports, and provides guidelines on how entities should account for share-based payments. ASIC states in its guidelines that ED 2 – Share-based Payment "provides a basis for valuing options and allocating those values over time". In other words, in ASIC’s view listed companies should now value share options consistently with ED 2 – Share-based Payment.
The target of ED 2 – Share-based Payment is different from that of ASIC’s, as it sets out a method for measuring the value of services received by a company in return for equity instruments of the company. However, ED 2 – Share-based Payment provides that the value of an equity interest granted, such as an option, is more readily determinable than the value of the services received, and it is on this analysis that ASIC is focusing.
In short, ED 2 – Share-based Payment requires a listed company to value its options at grant date, and then apportion that value over the vesting period. Listed companies that already address options in their directors’ reports are encouraged by ASIC to ensure that their valuation principles reflect those in ED 2 – Share-based Payment.
For options that cannot be measured at the market price, ED 2 – Share-based Payment stops short of identifying a particular option pricing model. It simply provides that the value is estimated by applying "an" option pricing model, and gives as examples the Black-Scholes model and the binomial model. No further guidance is given, and it is implicit that a listed company choose the model that is most suited to its circumstances and the terms and conditions which attach to its options.
The ASX notes on its website that the most common model used is probably the binomial model, and most texts on the subject begin with the binomial and Black-Scholes models. Whichever option pricing model is chosen, ED 2 – Share-based Payment requires that it take into account the following factors:
- the exercise price of the option;
- the life of the option;
- the current price of the underlying shares;
- the expected volatility of the share price;
- the expected dividends on the shares;
- the risk-free interest rate for the life of the option; and
- the vesting period, if the company uses a model that values options that can be exercised at any time during the life of the options.
Further, if the options are subject to vesting conditions, such as performance conditions, these must be taken into account either by incorporating them into the model, or by making an adjustment to the value produced by the model.
Several of the above factors involve the directors of a listed company making predictions, such as the expected volatility of the company’s share price, and the probability of the options not being exercised. Although guidance is available on these factors (including on the ASX’s website), a board’s judgment will invariably affect the reliability of the valuation produced. When this is considered with the fact that different option pricing models may produce different results for the same inputs, it becomes less clear that ASIC’s guidelines will achieve one of its aims - namely, consistent valuations across the market.
On the other hand, it should be borne in mind that section 300A(1)(a) of the Corporations Act requires not only that a board disclose the valuation arrived at, but also the board’s policy for determining the valuation. ASIC notes in its guidelines that boards are encouraged to disclose, amongst other things, information on how option values have been determined, including the model used and its inputs. This requirement will go some way to equipping an investor with useful information with which to compare the remuneration of a particular company with its industry.
ED 2 – Share-based Payment also provides a method for allocating the value of options over the course of the vesting period. However, ASIC takes the view that this method is more suited to large employee share and option plans, and accordingly recommends that valuations for options granted to directors and senior executives be equally apportioned from grant date to vesting date. (This has proven to be a fortunate deviation - the IASB stated shortly after the release of a draft of ASIC’s guidelines that it had "tentatively agreed" to abandon its proposed allocation method).
A change in the value of options during the vesting period will be triggered only by a modification to the terms on which the options were granted. Although seemingly illogical a change in value is not made if the options are forfeited during the vesting period.
Consistent with the approach that the value of options be apportioned over their vesting period, ASIC’s guidelines capture all options that have not already vested prior to the start of the first financial year to which the guidelines apply.
Finally, it is worth noting that ASIC’s guidelines do not have the force of law. Essentially, companies are required to comply with section 300A of the Corporations Act, and, theoretically at least, may do so outside of ASIC’s guidelines. However, ASIC states that it will pursue listed companies that fail to disclose the value of emoluments relating to options, and it will be a brave board that disregards ASIC’s guidelines and the option valuation methods set out in ED 2 – Share-based Payment.
Kieren Parker is an associate in Coudert Brothers' Sydney office Corporate Advisory Group. He works with clients in a variety of commercial transactions, including mergers and acquisitions, debt offerings and cross-border securities transactions, and has experience in advising with respect to both Australian and international corporate, securities and contract law.
The content of this article does not constitute legal advice and should not be relied on in that way. Specific advice should be sought about your specific circumstances.