With a little help from their bankers, corporate insiders can enter transactions, such as zero-cost collars and prepaid variable forward contracts, to limit their exposure to movements in their firmâ€™s stock price. These transactions might be even nastier than plain vanilla insider selling activity.
At BlueTrader, we are always on the hunt for new ways to shield investors from being the ones holding the bag when things go sour. We are currently working on updating our platform to flag insider transactions that could signal adverse developments for firms, the nastiest type of which may be executive hedging. In this piece, we present a primer on executive hedging. We begin by touching briefly on agency theory and how it applies to executive hedging. Then we discuss what executive hedging is, why itâ€™s nasty, and what that could mean for you as an outside investor.
Agency theory revisited
In 1976, Jensen and Meckling posited that the best way to align the incentives of management and shareholders, assuming a separation of ownership and control in a firm, was to pay management in stock (for more on agency theory, click here). It is now standard practice among most large publicly-traded companies that a large portion of executive compensation be paid in equity-related compensation, with restricted share awards and option grants being the most commonly-used vehicles. By making managers have â€œskin in the gameâ€, their interests should be in line with outside shareholders, right? The short answer is generally â€œyesâ€, although management, with a little help from their friends at financial institutions, have devised ways around this through â€œhedgingâ€ mechanisms.
What is executive hedging?
Executives can enter into contracts with external entities in order to limit their downside exposure inherent in holding company stock in several ways. First, they can use a â€œcollarâ€ option strategy to buy a put and sell a call on the firmâ€™s stock, which limits both the upside and downside in changes in wealth. The second (and sneakier) way is for an executive to enter into a Prepaid Variable Forward contract. While the nuances surrounding these transactions are quite complicated, the crux of what happens is that the executive will enter into a contract with an investment bank to deliver stock in the future in exchange for cash upfront today (usually between 75-85% of notional value). Because the bank is implicitly long shares eventually, it offsets its exposure by shorting the companyâ€™s shares. In essence, the bank acts as an intermediary, selling the shares on behalf of the executive (for more on â€œHow Hedges Workâ€, click here). To boot, the executive has a deferred tax benefit because although they receive cash, they have not yet sold the stock. Sidebar: The IRS has delved into this issue and is examining cases in the hope of closing the loophole on this matter.
Why is executive hedging nasty?
Theoretically, if unusual selling activity is generally regarded as â€œbadâ€, then efforts made to disguise stock sales by insiders should be â€œworseâ€. BusinessWeek recently published a piece on executive hedging titled â€œSome CEOs Are Selling their Companies Shortâ€, and presented results of an event study conducted by Gradient Analytics, which showed that once executives hedge their holdings via prepaid variable forward contract, their companiesâ€™ stocks, on average, significantly underperformed those of their peers and the market (see chart).
Put another way, the initiation of prepaid variable forward contracts can be considered a signal that something bad may about to go down at a company. It must be noted that while there may be legitimate reasons for entering into these agreements, such as needs for liquidity, again, on average, share performance often suffers. Outside investors who hold onto the stock run the risk of holding onto relative losers, while management will have already effectively cashed out at a premium.
To conclude, while there are good companies with solid management teams abound, there are always bad apples. Executive hedging activities are but one of many possible red flags that should be watched to make sure that, as a diligent investor, your lunch is not being eaten. Stay tuned to more from BlueTrader, to help protect yourself from financial predators.
Jason F. Moschella