Is it Wrong to Hedge Your Own Company’s Shares?

Last year I wrote a somewhat controversial article on how to sell call options against your underlying company stock option grants or restricted stock grants in order to hedge against a potential decline while forfeiting massive upside should the shares take off (see How Options Work if this is Greek to you).  The comments ranged from cries of conflict of interest to “that’s what our company specializes in – it’s normal”.  My personal opinion was, and still is, that for a mid-level employee like myself, this is a rather moderate/conservative method of preserving income/asset values from my hard-earned work rather than seeing annual option grant after grant disappear into thin air as the company stock followed the rest of the economy in what was the “lost decade” where stocks basically went nowhere from 2001-2010.

I basically take in several hundred dollars per year in option premiums which works out optimally for a flat or moderate rise in company stock.

Where it becomes a bit more questionable is when an executive or CEO who is clearly in possession of insider knowledge (future earnings outlook, strategic direction, impending risks/upsides that will inevitably impact share prices) starts embarking on much more elaborate, and financially significant hedges to the tune of several million dollars per year.  This week’s BusinessWeek did an article on more elaborate hedges with some disturbing statistics attached to the hedging timing.  In essence, in companies where the executives embarked on major hedges of their own company stock (and rightly publicized in company filings), the shares tended to greatly under-perform in the period following versus both their peer group and the market at large.

What this chart is showing is that executives somehow tend to perfectly time the peak when they sell hedges against their underlying shares and then share performance suffers following.  Inevitably, this leaves a bad taste in the mouths of investors, who didn’t enjoy the same market timing “luck”.

While the article doesn’t outline a similar strategy to the one I outlined where I sell calls against company stock outright, two variants that executives are keen on are the following from the same BusinessWeek article:

SCENARIO ONE: ZERO-COST COLLARS

This hedge puts a “collar,” i.e., a floor and ceiling, around the price an executive gets paid for stock

1. An executive wants to protect 2 million shares, currently worth $100 each, against a big drop in the stock.

2. He buys a put option on the stock from a broker, which gives him the right to sell his shares at a given price, say $95. If the stock drops below $95, he sells at that price and suffers no further losses.

3. To pay for the put, the executive simultaneously has his broker sell a call option on his stock. The call gives a buyer the right to acquire the shares at a set price if they rise, say to 110.

4. If the stock goes above $110 while the call option is in effect, the executive must sell his shares to the buyer; if the shares remain between $95 and $110 during the life of the two options, he holds on to all his stock. And during the life of the collar, he can borrow funds—generally up to 50% of the value of his shares.

SCENARIO TWO: PREPAID VARIABLE FORWARD CONTRACT (PVF)

This is the more popular—and complex—hedge strategy.

A PVF sale revolves around a contract established between a senior executive and an investment bank, and it frees up more cash without initially requiring that the executive sell his stock or pay capital-gains tax.

1. Now the executive hedges those 2 million shares worth $100 apiece with a three-year PVF. He agrees on a floor and a ceiling price with the bank—again, say $95 and $110.

2. In the meantime, to protect itself from a loss if the shares fall below $95, the investment bank will generally short the company’s shares. It also collects fees on the contract.

3. At the end of three years, if the shares fall below $95, the executive simply turns over his 2 million shares. He keeps the cash he received in advance and has limited his downside.

4. If, on the other hand, the shares have risen, he can settle up with the bank in cash. He hangs onto the shares and profits from any further rise in the stock.

5. Or he can pay the bank back in stock; the exact number of shares will depend on how the stock performs. The better the stock does during the life of the hedge, the fewer shares he’ll owe.

6. The executive receives a cash advance from the bank that generally equals up to 85% of the value of his stock at the time of the hedge, or in this case, $170 million.

While these strategies are slightly more complex than the one I initially outlined and have followed myself, and all 3 of these are legal, don’t violate securities laws or company policies, apparently, the concept of hedging against your own company stock (some would call this “betting” on your company’s shares to decline) rubs many people the wrong way.  Personally, I am a bit alarmed by what the data shows about the executive moves who clearly are aware of impending stock moves, but I still stand behind offloading some risk of underlying options for lower level employees that have no insider information, are making peanuts-type trades once per year and have a routine/recurring strategy for doing this annually, so there’s no “market timing” going on.

What Are Your Thoughts?

Is It Wrong For Executives to Hedge Shares?

Is It Wrong for Worker Bee Employees to Hedge Shares?

Tagged as: Employee Stock Options