Prof. Jayanth R. Varma's Financial Markets Blog

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Prof. Jayanth R. Varma's Financial Markets Blog, A Blog on Financial Markets and Their Regulation

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Wed, 13 Dec 2006

Google Transferable Employee Stock Options

Google has introduced another financial innovation in relation to its own stock by allowing its employee stock options to be transferred after they have vested. Details on the transferable stock options (TSO) are available on its blog and several links in that blog entry. Google says:

When the options are sold to a bidder under the TSO program, three changes occur:

  1. The remaining life is shortened to two years unless the remaining life is less than two years. If the remaining life is less than two years, then the transferable life is further reduced from two years in six-month increments (e.g., 18 months, 12 months, six months) until the remaining transferable life is zero. For example, an option with a remaining life of 23 months will, upon sale in the TSO program, have an 18-month life.
  2. The forfeiture provisions related to the employee's employment with Google are removed.
  3. We anticipate the anti-dilution provisions will be changed to conform to market-standard provisions.

Some conclusions are obvious. Any employee who is leaving Google should sell all long maturity options since that allows them to realize at least the value of two year options. If they do not sell, they would have to exercise the options within three months of quitting so as to avoid forfeiting the options. Employees should also sell options that have residual maturity of around two years or less to diversify their portfolios. They should ideally sell the options on dates when the residual life of the options is a few days more than an integral multiple of six months.

The hard part is those who do not intend to leave Google soon and who have options with much more than two years to maturity. Finance theory would suggest that they are better off delta hedging those options rather than shortening the lives of the options. If they are really sure that they will stay with Google for a long time they might also want to hedge the gamma and vega of their stock options with exchange traded options. But in practice, shorting stocks is not very easy for individuals and many might choose to sell the options rather than hold on to them. Probably, only the most financially sophisticated employees will hold on to the options and most others will sell. Incidentally, the possibly most sophisticated employees (the executive management group) is excluded from TSOs altogether.

All in all, Google has added value to its stock option programme and created a model that many other companies will try to emulate. There is an accounting charge as the existence of the TSO increases the expected life of the employee stock options and therefore their fair value. But this is I think a small price to pay for the added benefits. Perhaps, this effect might also be offset by issuing less number of options.

The most interesting question is whether this can be done with unlisted companies. I am sure some hedge funds would be quite willing to bid for even these options if there is reasonable assurance of a liquidity event in the not too distant future. That would add a lot of value to the employees.

Posted at 13:25 on Wed, 13 Dec 2006     View/Post Comments (1)     permanent link

Sat, 09 Dec 2006

US court rules that IPO market is inherently inefficient

The ruling of the US Court of Appeal in Miles et al v Merrill Lynch et al (In Re: Initial Public Offering Securities Litigation is a sweeping judgement on the inherent inefficiency of the IPO market that effectively makes it impossible to use private litigation to deal with IPO fraud. The court not only tightened the legal standard for class action but then went on to decide the matter itself rather than remand it to the District Court. In the process it presented a dim view of the IPO market that effectively puts many kinds of wrong doing in this market beyond the purview of a class action law suit. This effectively rules out private litigation and makes the market dependent entirely on timely action by the regulator. This is extremely unfortunate.

The court’s views on the IPO market are as follows:

In the first place, the market for IPO shares is not efficient. As the late Judge Timbers of our Court has said, sitting with the Sixth Circuit, “[A] primary market for newly issued [securities] is not efficient or developed under any definition of these terms.” Freeman v. Laventhol & Horwath, 915 F.2d 193, 199 (6th Cir. 1990) (internal quotation marks omitted); accord Berwecky v. Bear, Stearns & Co., 197 F.R.D. 65, 68 n.5 (S.D.N.Y. 2000) (The fraud-on-the-market “presumption can not logically apply when plaintiffs allege fraud in connection with an IPO, because in an IPO there is no well-developed market in offered securities.”). As just one example of why an efficient market, necessary for the Basic presumption to apply, cannot be established with an IPO, we note that during the 25-day “quiet period,” analysts cannot report concerning securities in an IPO, see 17 C.F.R. 230.174(d), 242.101(b)(1), thereby precluding the contemporaneous “significant number of reports by securities analysts” that are a characteristic of an efficient market. See Freeman, 915 F.2d at 199.

Some good might still come out of it if these strong words induce the SEC to drop the unwarranted quiet period during IPOs.

Posted at 05:11 on Sat, 09 Dec 2006     View/Post Comments (1)     permanent link

Sun, 03 Dec 2006

US Capital Market Regulation

I was reading The Social Construction of Sarbanes Oxley by Langevoort when the Committee on Capital Markets Regulation published its interim report The interim report, the National Venture Capital Association Statement on this report, and the Statement of the Council of Institutional Investors on this report conform quite nicely to the social construction proposed by Langevoort.

Posted at 12:54 on Sun, 03 Dec 2006     View/Post Comments (0)     permanent link

Fri, 01 Dec 2006

UK Bill about Light Touch Regulation of Exchanges

I have been reading the bill that the UK has introduced to ensure that a foreign acquisition of the London Stock Exchange does not endanger the “light touch regulation” of UK exchanges. When I blogged about this idea three months back, I was mildly in favour of it, but when I see the actual law, my reaction is quite negative.

First of all, the law is far too wide. It says

A requirement is excessive if –

  1. it is not required under Community law or any enactment or rule of law in the United Kingdom, and
  2. either–
    1. it is not justified as pursuing a reasonable regulatory objective, or
    2. it is disproportionate to the end to be achieved.

Second, the law requires any exchange that proposes to make any regulatory provision to give written notice of the proposal to the FSA. The provision can be introduced only if the FSA does not veto it during a 30 day period. The only saving grace is that the FSA has been empowered to limit the applicability of this clause to “specified descriptions of regulatory provision or in specified circumstances”.

It appears to me that in the name of preserving a light touch regulation, the law is introducing a whole new layer of regulation that is not light touch at all. The motivation for the law was to deal with certain extreme situations and it would have been better to limit the law to such situations. As it stands, the law only illustrates the general principle that knee jerk legislative responses end up as disasters.

Posted at 17:05 on Fri, 01 Dec 2006     View/Post Comments (0)     permanent link