Commentary by David F. Larcker, James Irvin Miller Professor of Accounting & Director, Stanford GSB Corporate Governance Research Program; and Brian Tayan, Stanford GSB Case Writer, MBA ’03.
A recent article in BusinessWeek (“Some CEOs Are Selling Their Companies Short,” February 25, 2010), explains how CEOs and other insiders use hedging strategies to lock in the value of equity compensation (either restricted shares or options). The example cited in the article is Keith Olsen, CEO of Switch & Data Facilities, who entered into a prepaid variable forward contract with an investment bank to hedge the value of 150,000 shares—a quarter of his holdings—following a rally in the company stock price.
Hedging of equity ownership is not illegal. However, it can still be a significant concern for shareholders. When an executive insulates himself from declines in the stock price, the incentive value of equity ownership goes away. Shareholders have to ask: why provide compensation in the form of equity if the value of that equity can be converted to a cash equivalent at the CEO’s discretion. More worrisome, academic literature suggests that the practice of hedging is rife with abuse: CEOs that hedge, either through a prepaid variable forward or 10b5-1 plan, tend to outperform the market. If true, such behavior may constitute a sophisticated form of insider trading.
There are several solutions to the problem, and they are relatively easy to implement. The board should have strict guidelines on the timing and percentage of total ownership that executives are allowed to hedge. The justification for these guidelines should be explained to shareholders. The board should also require that hedged transactions be disclosed through public filings. When such information is disclosed to investors, they are better positioned to evaluate whether hedging behavior is justified.
Related Stanford GSB Research:
Stanford University-Graduate School of Business Teaching Case: 10b5-1 Plans: Mortgaging a Defense Against Insider Trading (CG-10) Authors: David F. Larcker and Brian Tayan
Stanford Business School Research Underpins SEC Scrutiny of Scheduled Insider Trades
Stanford GSB News, July 2009
In the wake of alleged misconduct by executives at Countrywide Savings, Novatel, and Qwest, research by Stanford accounting professor Alan Jagolinzer may be prompting the Securities and Exchange Commission to rethink rules that permit scheduled trading by insiders.
Jagolinzer, Alan D., Yeung, Eric and Matsunaga, Steven R., An Analysis of Insiders’ Use of Prepaid Variable Forward Transactions (May 2007). Available at SSRN: http://ssrn.com/abstract=816945