Executives use hedging and pledging to convert share into cash, often undermining the incentive effects of equity-based compensation
Executive compensation is at the forefront of the current governance debate. A considerable portion of the newly enacted legislation centers on how executives should be paid, and what restrictions, if any, might be applied. Central to the discussion is improving the way executive compensation is linked to corporate performance, both in the medium and long term.
The prevailing wisdom is that paying executives in stock and/or options helps align the interests of the individual to those of the company and the larger share-owner community. Most companies agree with this concept and, looking at the largest companies in the US, a significant proportion of executive compensation – 37 percent, on average – is paid in the form of equity.
Often bonuses and incentive schemes are based on the issuance of stock or options. Thus it makes sense that executives who remain at the same company for an extended time and those who are particularly successful will accumulate substantial ownership positions, especially if they retain exercised options and vested restricted stock. In fact, according to research by Stanford Law School, the median value for stock and options owned by CEOs at the 100 largest companies is approximately $11 million. Looking at the largest 1,000 companies, the figure becomes about $5 million.
Investors and analysts take great interest in the amount of stock CEOs and other senior executives own in the companies they serve. Generally speaking, it is considered favorable for executives to hold high levels of stock and to accumulate it on a consistent basis. It is even better if they spend their own money doing so.
The problem is that simply looking at the amount of stock an executive owns does not give you the full story. There are many ways that an executive can legally own stock without actually having any economic interest in the company .
Types of hedging and pledging
• Pledged shares: shares that are used as collateral for a loan.
• Prepaid variable forward (PVF): contract that allows the original owner to obtain immediate cash in exchange for a commitment to surrender shares or cash value at a predetermined future date.
• Zero-cost collar: series of trades involving the simultaneous purchase of a put option that is bought using the proceeds from the sale of a call option with a lower strike price.
• Exchange-traded funds: allow an investor to exchange his or her large holding of a single stock for units in a pooled (diversified) portfolio.
• Equity swap: an agreement between two parties to exchange cash flows associated with the performance of their specific holdings. The arrangement allows each party to diversify its income while still holding the original assets.
Studies like An analysis of insiders’ use of prepaid variable forward transactions by Alan Jagolinzer, Eric Yeung and Steven Matsunaga have shown that executives hedge approximately 30 percent of their ownership positions. These transactions allow holders of shares to effectively dispose of them and receive cash in return. There are many good reasons for allowing and also restricting executives from conducting such transactions, but even with rules in place, it can be very difficult for investors to discover if shares have been hedged or pledged, and therefore to get a real understanding of the actual holdings of an executive.
SEC rules implemented in 2006 require that companies disclose whether executive shares are pledged to a brokerage account or used as collateral for a loan. The disclosure is included in the annual proxy (DEF 14A).Hedges of company stock, on the other hand, are not in the proxy statement but are found by going through Form 4s filed by the executive after each transaction. These filings can be difficult to search, and the sheer number of Form 4s per company can make them burdensome to go through manually.
To gain greater clarity on these practices and to determine whether companies permit executives to make such transactions, Stanford Law School and Corporate Secretary conducted a survey of publicly listed US firms in August.
In general, most companies have some form of restrictions on the most common hedging and pledging transactions. Only a quarter of companies surveyed actually permit such transactions. Rules or restrictions are usually found in the insider trading policies (ITPs) of the company laws.
Summary of results
1. Hedging and pledging is not done in the majority of firms
• 34 firms out of 135 allow some type of hedging or pledging (about 25 percent).
• 27 of these 34 firms allow pledging (three do not allow, four responded ‘don’t know’).
• 10 firms allow prepaid variable forwards.
• Seven firms allow zero-cost collars.
• Six firms allow exchange-traded funds.
• Seven firms allow equity swaps.
• Six firms allow all of these hedging devices.
Pledging is much more common than hedging (if either is allowed).
2. General counsel (or similar corporate officer) monitors these pledging and hedging transactions
• 18 firms out of 34 require approval before executing the transaction (six do not require approval, 10 responded ‘don’t know’).
• Four of the six firms that allow all types of hedging require general counsel approval (two do not require approval).
3. These transactions are governed by the company’s ITP
• ITPs have been in place for an average of 8.3 years; all firms have such a policy, and the same policy is in place for a long period of time.
• Despite the general lack of proprietary content in the ITP, it is publicly disclosed by only 42 firms (30 percent; 89 firms do not disclose, four responded ‘don’t know’). This compares to the vast majority of firms that publicly disclose their governance documents – board charter, committee charters, and other similar governance information.
An interesting question to ask: why wouldn’t companies disclose their insider trading policies?
4. The Dodd-Frank Act has increased concern about pledging and hedging disclosures, but firms are waiting to revise
• 22 firms (16 percent) are either revisiting or revising their pledging and hedging policies (37 are not, 76 responded ‘don’t know’). The extent of revision is related to how the rules are enforced and what becomes best practice.
5. 10b5-1 plans are commonly allowed, regardless of whether firms allow pledging and hedging
• 108 firms (80 percent) allow 10b5-1 plans (21 do not, six responded ‘don’t know’).
Perhaps not surprisingly, firms that do not allow 10b5-1 plans also do not allow hedging (i.e., hedging is seen as the more ‘risky’ practice).
6. General counsel approval is typically required to execute a 10b5-1 trade
• 98 firms (73 percent) require general counsel approval (10 do not, six responded ‘don’t know’).
• 79 firms (59 percent) require general counsel approval to cancel or modify an existing 10b5-1 plan (24 do not, 11 responded ‘don’t know’).
Similar to hedging, general counsel is closely involved in monitoring executive equity portfolio trading.
Hedging and pledging of equity ownership is a serious concern for boards, shareholders and general counsel, and must be explicitly discussed by the compensation committee and the entire board. It would be highly desirable for shareholders to know about the board’s view of hedging and pledging. Can the board actually explain why it allows executives to pledge and hedge and at the same time continues to provide equity grants to executives? If executives are doing this for diversification, we would expect to see less equity grants and more cash payments. Current practices suggest that boards have not made an explicit determination of how hedging changes the incentive value of executive compensation.
Pros and cons of hedging and pledging
Pros:
• Hedging/pledging allows the executive to diversify and consume some of the wealth that he or she has accumulated, and can be a more tax efficient way of doing so than an outright sale.
• Concentrated ownership in company stock may encourage risk aversion. The executive will shy away from making risky, net-present-value-positive investments (that may be necessary for the firm to grow) and favor safe, low-risk projects in order to protect personal wealth.
Cons:
• Hedging/pledging unwinds the incentives imposed on the manager by the board of directors. If the executive is allowed to hedge or pledge a significant portion of these incentives, the board might as well have paid in cash.
• Hedging/pledging is inefficient. The manager is paid a risk premium, but he or she captures the value of the premium through hedging. For example, assume that the CEO needs to be paid $1 million in expected compensation. The board can pay him or her $1 million in (riskless) cash, or $1.2 million in (risky) stock options. The CEO is indifferent between these two payments. However, if the CEO immediately hedges the stock options, he or she converts the risky payment into $1.2 million (less transaction costs). So, the board and shareholders actually overpay the CEO – they could have satisfied the CEO with $1 million in cash, not $1.2 million.
• Hedging/pledging can be a sophisticated form of insider trading. Jagolinzer, Matsunaga and Yeung (2007) find that executives who hedge their positions tend to do so before a decline in the stock (generally after a period of strong outperformance) – that is, executives seem to have an information advantage when putting on the hedge.
• Hedges fundamentally require executives to short their own stock using puts. This is difficult to explain to shareholders (and the board of directors).
• Sales through 10b5-1 plans may also be a sophisticated form of insider trading. In his report entitled Sec Rule 10b5-1 and insiders’ strategic trade, Jagolinzer finds that executives who trade through 10b5-1 plans outperform the market.
• Hedges allow executives to escape scrutiny. If an executive sold 30 percent of his position in one transaction, the sale would receive significant public attention from the media. By using a hedge, executives can avoid potential negative publicity.
