Journal of Business Ethics

, Volume 111, Issue 2, pp 157–164

The Ethics of Hedging by Executives

Authors

    • Department of Finance and EconomicsCollege of Business
  • Ken Washer
    • Department of Finance and EconomicsCollege of Business
Article

DOI: 10.1007/s10551-011-1198-x

Cite this article as:
Dunham, L.M. & Washer, K. J Bus Ethics (2012) 111: 157. doi:10.1007/s10551-011-1198-x

Abstract

Executives of many publicly held firms agree to compensation packages that create immense exposure to their employer’s stock. Corporate boards, aspiring to motivate executives to make value-maximizing decisions, often tie an executive’s earnings to stock price performance through stock or option awards. However, this engenders a significant ethical dilemma for many executives who are uncomfortable with sizable, firm-specific risk and desire to reduce it through hedging activities. Recent research has shown that executive hedging has become more prevalent. In essence, managers are unwinding the acute economic incentive to act in the best interest of the owners. This appears to violate the spirit of the compensation contract and from a normative standpoint, is not how executives should act. In this article, we describe how some executives are acting in regard to this issue (descriptive ethics), how they should act (normative ethics) and how they can be helped to get from what they are doing, to what they should be doing (prescriptive ethics).

Keywords

Executive CompensationManagerial HedgingEthicsBusiness Ethics

Introduction

The principal-agent problem that exist in corporations when the manager holds less than a 100% ownership interest has a long history in the agency theory literature (Berle and Means 1932; Jensen and Meckling 1976). To mitigate this problem, the compensation contracts for senior executives of most U.S. publicly-traded corporations typically include an equity-based component to link firm performance directly to remuneration. While stock-based compensation is generally successful in providing a direct link between compensation and performance, it typically results in the executive holding an undiversified portfolio of the firm’s stock. Bryant (1997) documents that a significant portion of senior executives’ personal wealth consists of their employer’s stock. Furthermore, a significant fraction of these shares may be labeled “restricted”, indicating that they cannot be sold until vesting occurs. So, in addition to holding a concentrated portfolio of firm stock, the liquidity of restricted shares serves as a secondary obstacle in reallocating the portfolio to achieve a more optimal balance between risk and return.

Modern portfolio theory suggests that rational executives would diversify their concentrated portfolios if the opportunity to do so were available. While U.S. securities laws prevent executives from short selling their firm’s stock, they are not prohibited from engaging in hedging activity outside the firm. Interestingly, Schizer (2000) finds that contractual prohibitions on executive hedge transactions are quite rare, and Bebchuk et al. (2002) and Bebchuk and Fried (2003) document that many firms do not restrict or regulate the financial market activity of their executives. Recent studies in the hedging literature suggests that hedging by executives is more prevalent today than in past years, mostly due to innovations in financial markets that have led to greater hedging and diversification instruments becoming available to firms and their executives. As such, these studies, coupled with earlier work, have documented a number of techniques that executives use to hedge their stock positions. These techniques include the use of low-cost equity collars, equity swaps, secured loans, prepaid variable forward (PVF) contracts, exchange trusts, and even shorting a competitor’s stock.1

In this article, we address the ethical considerations that executives confront when engaging in hedging activity. One can argue that executives who engage in hedging violate the spirit of compensation agreements that are intended to connect their wealth to company performance. Senior managers confront an ethical dilemma, as they must choose between honoring the essence of the agreement and protecting their family’s wealth. One can rationalize either course of action. In this article, we evaluate the merits of the decision to hedge by executives within the ethical framework of Kohlberg (1983), De Mott (2001) and Oberlechner (2007). Kohlberg’s (1983) three-stage model of ethics outlines how people’s ethical decision making changes as they mature psychologically. De Mott (2001) defines ethics as “rules of behavior based on beliefs about how things should be.” Artificially removing incentives from a compensation contract is not how things are meant to be. Oberlechner (2007) characterizes ethics in the finance and investment industry where decisions fall into one of three categories of ethics: normative ethics, descriptive ethics, and prescriptive ethics. Normative ethics focuses on what professionals such as board members and executives should do, while descriptive ethics details what these board members and executives actually do. When there is disconnect between normative ethics and descriptive ethics, prescriptive ethics offers solutions to encourage individuals to act appropriately.

The remainder of the article is organized as follows. Section II provides a discussion of the principal-agent conflict within a corporation, and Section III provides a synthesis of the executive hedging literature. Section IV provides some discussion of how ethics have evolved in business and finance. In Section V, we outline a typical scenario of an executive facing the decision to hedge, and in Section VI we discuss and recommend a course of action for the executive within our ethical framework. Section VII provides conclusions and topics for future research.

Agency Conflicts in a Corporation

The principal-agent problem arises in a corporation when managers fail to act in the best interest of shareholders. This conflict is well documented in the agency literature Berle (1932), Jensen and Meckling (1976). When owners delegate the responsibility of operating a company to managers, it may result in suboptimal performance since the costs and benefits of operating decisions do not accrue symmetrically to the manager holding only a fraction of the firm’s shares. For example, a manager who holds a 1% ownership stake will absorb only one penny of every dollar of corporate resources spent on personal perquisites, but will receive 100% of the benefit. To illustrate this point, suppose a chief executive officer (CEO) with a 1% ownership stake is in need of a new office chair. There are two chairs available; a budget-priced chair for $100 and a lavish chair for $300. From the firm’s perspective, the cost difference is a nontrivial $200; however, from the CEO’s perspective, the cost difference is a mere $2. If the CEO were the sole proprietor, then the cost difference as owner and as CEO would be the same $200. However, in this case, the CEO will receive the full benefit of a much nicer chair for a mere $2 personal cost. One implication here is that a manager who owns a larger fraction of the firm will have a greater incentive to pursue value-creating activities and will be less motivated to shirk or consume perquisites. A second implication is that the agency problem between management and shareholders decreases as the level of stock ownership held by management increases.

While the example of a chair purchase to illustrate the principal-agent problem is rather trivial, there are plenty of examples where the consequences of managers failing to act in the best interest of shareholders are severe. First, Cai and Vijh (2007) find that executives of target firms in merger and acquisition deals may be influenced by their undiversified firm stock and option holdings to sell the firm as a means of cashing out, even if the transaction is not in the best interest of shareholders. Second, there are cases where management is accused of overpaying to acquire another company just to increase the size of the business, in an effort to run a larger corporate empire or demand a higher salary (Jensen and Meckling (1976), Jensen (1986), Roll (1986)). For example, in 1994, despite warnings from Wall Street that the company was paying about $1 billion too much, Quaker Oats acquired Snapple for a purchase price of $1.7 billion. In just 27 months, Quaker Oats sold Snapple to a holding company for a mere $300 million, sustaining a loss of $1.6 million for each day that the company owned Snapple.2 Furthermore, former Tyco CEO Dennis Kozlowski was convicted in 2005 of crimes relating to the unauthorized purchase of personal items costing millions of dollars with company funds. In short, the principal-agent problem can lead to a conflict between managers and shareholders that could prove to be costly to shareholders.

As might be expected, this disconnect in incentives between shareholders and management can lead to executives ultimately making decisions that maximize their personal interests and not the interests of all shareholders. To mitigate this incentive problem, most optimal contracting models typically recommend that a component of managers’ compensation packages can be linked to company performance through equity-based incentives. However, one major consequence of such equity-based compensation for a firm’s executives is that it typically results in executives holding large, undiversified portfolios. The use of equity-based compensation diminishes the traditional agency problem within the firm and is preferred by non-management shareholders; however, it may create sleepless nights for executives who are uncomfortable having their financial future tied to the performance of a particular stock. Unsurprisingly, there is ample evidence confirming that some managers hedge away weighty exposure to their company’s stock, which is the topic of the next section.

Executive Hedging Literature

Amihud and Lev (1981) and Smith and Stulz (1985) show that risk-averse executives, who are unable to hedge their exposure to the company’s stock, focus harder on managing firm risk in an effort to protect their own financial wealth and human capital. May (1995) also finds supporting evidence of CEOs considering risk of personal wealth when making decisions that affect firm risk. Bettis et al. (2001) postulate that executive hedging actually benefits shareholders, as managers, who have less wealth at stake, are not as likely to engage in costly hedging at the corporate level. Executives with wealth moored to company stock may be able to reduce risk at the firm level in a number of ways, such as allocating investment dollars toward tangible assets in lieu of research and development expenditures, increasing the level of firm diversification, increasing the payout ratio, and reducing the firm’s debt ratio.3 This is consistent with Coles et al. (2006) who document a strong causal relationship between managerial compensation and firm risk, investment policy and debt policy. More recently, Dunham (2010) documents a negative relationship between firm risk and the composition of a CEO’s shareholdings between restricted and unrestricted shares following the notion that executives are only able to use unrestricted shares in hedging transactions.

While it is possible for executives to hedge their undiversified portfolio inside the firm by influencing the firm level of risk, it is generally easier for executives to hedge their shares outside the firm. Numerous studies have documented the extensive use of hedging by executives in an effort to manage the risk of holding a risky, undiversified portfolio. Executives may prefer to hedge their portfolios rather than selling shares outright for a number of reasons. First, in some cases, the low cost basis of executive stock holdings may result in these executives opting to engage in a lower cost hedge of the position rather than trigger massive capital gains taxes that would result from an outright sale of shares. Second, an outright sale of shares by an executive can be interpreted as a negative signal to market participants, including existing shareholders, and may trigger downside pressure on the stock price. Third, executives may be prohibited from selling shares due to implicit and explicit firm ownership requirements that dictate that managers hold a minimum fraction of firm stock Core and Larcker (2002), Cai and Vijh (2007).

Over the past two decades, there has been a trend toward securities dealers developing products that permit managers to capture value from their firm shareholdings without actually selling any shares (Ofek and Yermack 2000). As Bettis et al. (2001) point out, “there has been a dramatic increase in the development, sophistication and use of strategies that enable individual investors, institutional investors, and corporate insiders to hedge their stock ownership positions in a firm.” These hedging instruments include equity swaps, put options, zero-cost collars, exchange trusts, prepaid variable forward contracts, sector-specific inverse exchange traded funds (ETFs), and even secured lending arrangements, where firm shares are used as collateral. Bolster et al. (1996) document the use of equity swaps by executives as a means of hedging. In an equity swap, the executive pays the return of the underlying firm stock and receives a fixed-rate payoff or even a payoff tied to a diversified equity index such as the S&P 500. By doing so, the executive has effectively exchanged the risk of a single stock for a diversified portfolio (or a known fixed-rate payoff) and has also retained the voting rights, and dividends if any, of the underlying stock. O’Brian (1997) documents the significant use of insiders using secured lending arrangements with their firm’s stock as collateral in margin loans and products like Mortgage 100 formerly offered by Merrill Lynch that permit executives to use firm equity as a substitute for a mortgage down payment.

Bettis et al. (2001) scrutinize SEC filings and find that executives do engage in hedging activity through the use of equity collars. In a typical collar transaction, the executive sells a call option and uses the proceeds to buy a put option (at a lower strike price than the call) on the firm’s stock to effectively hedge a portion of the manager’s undiversified firm ownership at minimal cost. In fact, the collar strategy can be designed by choosing option strike prices such that the premium received by the executive from selling the call option can offset the cost of purchasing the put option, resulting in a near zero-cost collar. With this collar transaction, the executive significantly reduces return volatility by locking in a range of stock price outcomes between the put and call strike prices until expiration. Investment banks, perhaps, looking to secure new business either from the executive or the firm, typically take the other side of this transaction. Interestingly, the investment bank can simply take a short position in the firm’s stock to hedge its collar position. While the bank usually requires that shares tied to a collar transaction be held in escrow until expiration, it typically relaxes the rules for executives and thus allows them to monetize by borrowing against the escrowed shares. So, the executive benefits twofold; he or she is able to fully or partially protect an undiversified equity position while at the same time create liquidity with the loan proceeds, which may then be used to diversify his or her personal wealth. For example, the executive could conceivably use the proceeds to buy a diversified index portfolio such as the S&P 500.

Recently, Kelly (2007) documents the emerging trend of investment banks providing executives, who are mulling initial public offerings (IPOs) of their firm’s stock, with an opportunity to hedge against potential share price declines post-IPO. Also, a relatively new hedging product that has been developed is the prepaid variable forward contract (PVF). A PVF is essentially a forward contract that allows the executive to sell shares at a certain price at a date in the future for an upfront payment. Attractive features of the typical PVF contract are that the executive gets full downside protection while also retaining the ability to participate in price appreciation in the range of 20–30%. Jagolinzer et al. (2007) document that insiders, on average, contract approximately 30% of their stockholdings in a single PVF transaction and receive an average upfront cash payment of $22 million. Last, there has been a surge in recent years in the availability of ETFs and inverse ETFs. These ETF products provide executives with an easy way to cross-hedge their undiversified portfolios without alerting directors or other market participants and without the need for risky short-selling. These inverse ETFs create synthetic portfolios through the use of future contracts that allow the investor to profit from downside movements in stock indices, sectors, and commodities by purchasing shares without unlimited loss potential that comes with short selling. To summarize, there are numerous hedging instruments available to executives that can be employed to hedge all or some of their firm shareholdings, and many of these transactions do not appear in the firm’s insider reporting documents.4 We now turn our attention to the ethical considerations of hedging by executives.

Ethics in Business and Finance

Oberlechner (2007) states “the field of ethics in the investment industry is the study of situations and decisions in the industry that address moral issues of right and wrong.” Ethical behavior often goes considerably beyond obeying the law. As an example, a broker breaks no statute when he or she recommends a costly mutual fund to a client when a much cheaper alternative is available. In this instance, the broker has placed his or her self-interest (as well as the company’s) ahead of the client’s interest. At the very least, the client should be made aware that the broker’s primary interest is with his or her company. If this is not disclosed plainly and directly, one may easily view this as an unethical act.

In his 1989 book entitled “Liar’s Poker,” Michael Lewis openly discusses his activities as a financial advisor/salesman employed by Salomon Brothers. He describes how he and others “pushed” clients into investments that the firm’s traders wanted to unload. Traders had significant input into how much of a bonus the advisor received, so it was in the advisor’s interest to follow instructions. Again, it is likely that most individuals would find such behavior unethical.

Oberlechner (2007) distinguishes between normative, descriptive, and prescriptive ethics. Normative ethics formulates a narrative of how things should be. For example, the Chartered Financial Analyst (CFA) Institute’s Code of Ethics and Standards of Professional Conduct instructs the professional to “place the integrity of the profession and the interests of clients above your own interests. “Undoubtedly, financial executives should look beyond their own self-interest and beyond simply adhering to the letter of the law when making choices. From a normative viewpoint, society desires executives to display the utmost ethical development, in essence to position social welfare above all else.

Alternatively, descriptive ethics centers on what actually occurs in practice. Currently, Registered Investment Advisors (RIAs) are required by law to act in the best interest of their clients. However, non-RIA brokers have no fiduciary duty and thus, do not always act in the client’s best interest. There is an obvious disconnect between what some in the industry are doing, and what the leading organizations in the profession want them to be doing. In a recent Businessweek article on the topic of executive hedging, Sasseen (2010) refers to the work of Bettis et al. (2010) and points out that hedging transactions reported to the SEC were up significantly in 2009 from a decade low in 2007. This evidence that executives are engaging in more hedging activity in the midst of turbulent markets is consistent with the risk-averse behavior of most investors. The important implication here is that shareholders would prefer that the firm’s executives feel the pain of loss along with the shareholders, but that is clearly not what happens when executives hedge. Sasseen (2010) provides some detail in the case of Switch and Data Facilities. Shareholders of Switch and Data Facilities witnessed the company’s share price rocket from $8.60 in March 2008 to $18.17 in late July. But then, the financial crisis hit and the shares fell all the way to $4.21 by November. One shareholder who did not experience the full extent of that loss was the firm’s CEO, Keith Olsen. Interestingly, at the time when the shares were trading above $18, Olsen used a PVF contract to hedge 25% of his shareholdings against losses below $18. Other recent examples of hedging involve executives at Krispy Kreme, Hasbro and Chattem (before being recently acquired by Sanofi-Aventis).

The key challenge for corporate boards is getting executives to “behave” in an ethical manner as it relates to engaging in hedging activities. Prescriptive ethics helps bridge gaps between normative and descriptive ethics. It prescribes tools that can be implemented to assist people in choosing the best course of action. One tool is disciplinary action. As an example, if a CFA Charterholder violates the CFA Code of Ethics and Standards of Professional Conduct, he or she will face disciplinary action, which could result in revoking the use of the CFA Charter. One other possible solution would be for more companies to ban their executives from engaging in hedging transactions. For example, Proctor and Gamble and Kellogg are two of the few companies that ban executive hedging.

In the next section, we focus on an ethical dilemma a hypothetical executive faces when her compensation package and wealth are strongly aligned with her employer’s stock performance. Our executive meets with an investment banker who offers hedging strategies. Depending on her stage of ethical development, she may or may not elect to engage in a hedging arrangement. We argue that extricating herself from inducements built into her employment contract is unethical at higher levels of ethical development and that the board of directors shares blame for this act by burdening her with an over abundance of company specific risk.

Hypothetical Case

Marge Schmidt, a hypothetical professional, has been the CEO for Developmental Drug Company (DDC), a small capitalization pharmaceutical company that went public 5 years ago. The company’s stock price was at $10 when she took over and now trades for $24.88. The company’s sales and profits are heavily dependent on a single drug that has been successful in helping people lose weight. The company’s stock returns are about twice as volatile as market returns as evidenced by a high stock beta.

When Marge accepted the position 5 years ago, DDC had limited cash resources and thus agreed to pay her a salary of $200,000 per year plus restricted stock, which is now fully vested and has a current value of $1 million. A new five-year contract was signed recently that provides her with an annual cash salary of $300,000 and also provides her with stock options. The options vest incrementally over the next 5 years and have a strike price of $20.00. An investment banker has conservatively estimated the value of the options at $1,500,000. The compensation committee for DDC believes that much of the company’s success has been driven by forces that tie the stock price performance to key employees’ wealth and feels strongly about continuing this practice even though DDC could provide more cash-based compensation.

Marge has been very satisfied at DDC and believes the company has a bright future. Her husband stays home with their two children who are both in high school. Recently, the couple met with a financial planner who strongly advises that they diversify their portfolio as 75% of their financial wealth is tied to DDC’s stock price. They have amassed enough wealth to accomplish their primary goals, which include sending their kids to college and retiring when they are 60. At this point in their lives, they are far more interested in protecting wealth than trying to grow it with significant exposure to risky investments.

Their current portfolio has two primary flaws. First, both their accumulated wealth and Marge’s monthly income are aligned tightly with the success of the firm. If a new and better drug were to be developed by a competitor, the couple could be financially devastated. Second, the beta of the portfolio is very high. A market decline of only 10% would be expected to produce a 20% decline in their stock portfolio. Also, a 20% decline in DDC’s stock price would hit the options even harder, perhaps decreasing their value by as much as 70%. So even if the company performs on keel with the market, the couple’s wealth will significantly decline in a very modest bear market. For these reasons, the planner is recommending that Marge diversify her family’s wealth to better secure her financial future.

Marge is comfortable selling the stock she currently owns as she has fulfilled the obligations of that contract. She is, however, concerned with the reaction of the company’s board and shareholders, as it may appear to them that she lacks confidence in DDC’s future. Also, she is very conflicted about the stock options. She has been in contact with an investment banker who has made the following proposals:
  1. 1.

    Immediately sell a significant stake in DDC stock to reduce the concentration of the stock in her portfolio.

     
  2. 2.

    Hedge a large stake of DDC stock by entering into a PVF contract with an investment bank. The proceeds received from the PVF contract would also be used to purchase a diversified portfolio of other securities.

     
  3. 3.

    Use an equity collar to protect the concentrated position in DDC stock. This involves selling some call options and using the proceeds to purchase put options on DDC stock.

     

Marge is conflicted. She would like to protect her family’s wealth by implementing one of the proposals recommended by the investment banker. However, she does feel like she is violating the employment contract that was signed. As a practical example of what can go wrong if an executive like Marge fails to hedge, one can look to Chesapeake Energy Corporation’s CEO, Aubrey McClendon.5 In September 2008, McClendon owned 33.5 million shares of the company’s stock. He was the company’s third largest shareholder and like our hypothetical CEO had much of his wealth tied directly to the company’s performance. Seventy-five percent of his annual compensation was in the form of Chesapeake stock. The company’s earnings are directly linked to a signal product, natural gas. The stock performed very poorly during the Financial Crisis in 2008, and McClendon was forced to sell substantially all of his stock because of loans he had taken against it. The 33.5 million shares of stock he owned was worth about $2.2 billion pre-crisis and his forced sales netted him around $0.6 billion. Thus, his wealth decreased by about $1.6 billion in just a few months. He undoubtedly could have avoided this severe pain if he had hedged his stock position and is what our hypothetical CEO is concerned about.

More recently, the CEO of Netflix, Reed Hastings, has seen his net worth drop considerably due a significant decrease in the company’s stock price. The shares hit a high of just over $300 in July of 2011. By November they were trading at $74.25. According to Forbes, in 2010, 90% of Reed’s $5.5 million compensation package was in the form of stock options.6 Much of his wealth is tied to the company’s performance and he has undoubtedly seen a significant reduction in his net worth. Another example of what can happen when an executive fails to reduce risk is Sanjiv Sidhu. He founded i2 Technologies and in 2000 had a net worth of over $10 billion. However, when the technology bubble burst in 2001, his wealth decreased by over 90%.7

Clearly, in light of these examples of catastrophic losses incurred by executives, the decision to hedge, and related ethical considerations, is important for executives. In the next section, we focus on how the hedging decision of our hypothetical CEO, Marge, ultimately pivots on her level of ethical development.

Discussion

Psychologist Lawrence Kohlberg’s (1983) stage model of ethics shows how people’s ethical decision making changes as they mature psychologically. There are three levels in this model. At the pre-conditional level, self-interest determines how one acts. If Marge is at this level, she will undoubtedly hedge for two reasons. First, there is little chance this activity will be discovered by the company in a timely manner, and thus her actions will probably go unpunished. Furthermore, even if the actions are uncovered, a significant punishment is unlikely. Second, she will be rewarded from the hedge with a more desirable portfolio. The hedging activity reduces risk substantially and essentially helps her sleep better. In her mind, and in the mind of others at the pre-conditional stage, she is behaving ethically.

The second gradation of Kohlberg’s model is the conditional level. Here, one is concerned not so much with punishments and/or rewards, but with what others deem acceptable. Marge might converse with other CEOs to glean a consensus opinion on this issue. If peers frown on it, she will not hedge even though substantial rewards emanate from it. If, however, hedging is acceptable among her peer group, she will feel ethical about implementing the hedge. Marge may also investigate whether or not hedging breaks any laws, as being a dutiful citizen is very important.

The highest degree of ethical development and the final level in Kohlberg’s model is the post-conventional level. One is not just intent on following the law, but is concerned with social welfare. Breaking what one deems an unjust law is morally acceptable and perhaps is best exemplified by Dr. Martin Luther King’s civil disobedience (Crain 1985). If Marge is at the pinnacle of ethical development, she will examine the best course of action for all concerned. She won’t focus solely on what is best for her family or base her decision on what others are doing. She will put herself in the position of shareholders and the board of directors. Perhaps she will decide that a hedging arrangement violates the intent of the option grant and thus forgo it. A preferred course of action may be to simply communicate with the board of directors her concern of having an abundance of wealth tied directly to the company’s stock price. The board may be willing to re-work her contract to reduce the incentives without making them inconsequential. They may decide to repurchase much of her stock in a pre-announced, transparent transaction.

Another aspect to this case involves the board of directors. Board members should reconsider approving compensation packages brimming with firm specific risk that creates ethical tension for executives like Marge. The board is attempting to motive the executive to work hard for the shareholders, and the executive is trying to better manage his or her finances. Financial executives may find themselves torn between two ideals: displaying confidence in the company’s future and responsibly managing their wealth. In an ideal world, executives always act in the best interest of shareholders and have their personal wealth properly diversified.

In the final section of this article, we recommend that hedging activity be more transparent. The SEC has the power to require this. We also believe that the vast majority of top-level executives have high ethical development and that hedging is not a concern. However, there are subsets of executives that are focused too intently on personal welfare. Boards should develop and share policies on hedging with executives.

Conclusions

Recent studies suggest that managerial hedging is more prevalent than in years past mostly as a result of innovations in financial markets that have led to greater hedging and diversification instruments available to firms and their executives. Investment bankers are often eager to assist top-level managers to profit from the deal or in hopes of securing more lucrative business from the company in the future.

Unfortunately, hedging activity by executives has been associated with subsequent poor stock price performance relative to market returns (see Bettis et al. 2010). This suggests that some executives initiate hedges when they become concerned about their firms’ future performance and are not using them simply to diversify, but instead to effectively liquidate shares at a high price. This action is reflective of someone with a very low level of ethical development and must be discouraged. It is definitely not good for market integrity when a company like Krispy Kreme sees its share price fall significantly, and later it is disclosed that executives hedged millions of shares at significantly higher prices.

We believe that executives should be allowed to protect and diversify wealth and that hedging is an efficient means to this end. However, executives should first communicate their desire to reduce exposure to company stock with the board of directors. Boards of directors should also develop policies in regards to executive hedging activity. With an open and honest line of communication established, an appropriate agreement can be negotiated that both satisfies the executive’s need to diversify and the board’s need to sufficiently incentivize the executive to maximize shareholder wealth. With the board’s approval and perhaps oversight, hedging may be the most efficient way for executives to transfer firm specific risk.

We are also convinced that transparency needs to be improved when it comes to executives engaging in hedging activity. Currently, firms must report hedging activity to the SEC on Form 4 within two business days of the transaction date. However, there is empirical evidence to suggest that some firms do not obey this rule, and there appears to be little enforcement by the SEC. In addition, there is no real standard for how the information is presented. Some companies minimally report this activity and may also bury it in footnotes. Others are less evasive in their reporting. Regardless, full, timely, and public disclosure should be made whenever an insider essentially buys or sells stock in order to protect market integrity. A person with a high level of ethical development does this, as it is the right thing to do.

Footnotes
1

These studies include: Bolster et al. (1996), who discuss the use of equity swaps; Bettis et al. (2001) provide empirical evidence of the use of equity collars by executives; O’Brian (1997) outlines the use of secured lending arrangements as a hedging instrument. Bettis et al. (2010) provide evidence of the use of prepaid variable forward contracts and exchange trusts as hedging instruments.

 
2

Facts for the Quaker Oats acquisition of Snapple were taken from case study number 1-0041 from the Tuck School of Business at Dartmouth.

 
3

Bhagat and Welch (1995) and Kothari et al. (2002 find that R&D expenditures are more risky than investment dollars allocated to property, plant and equipment. Crutchley et al. (1989) suggest that R&D expense is an uncertain, intangible asset that inherently increases firm risk.

 
4

Ownership of firm securities by executives and other insiders as well as transactions in firm securities by insiders are subject to mandatory reporting through the SEC Forms 3, 4, and 5. Changes in ownership of firm securities by insiders are reported on the SEC Form 4 and must be reported within 2 business days after the transaction date.

 
5

Bodzin, Steven, and Dan Lonkevich. "Chesapeake CEO Sold `All' Stock to Meet Margin Calls." Bloomberg. 10 Oct. 2008.

 
6

Data taken from compensation profile available at Forbes.com.

 
7

Greenberg, Duncan. "Riches-to-rags Stories: Fallen Billionaires." Forbes. 18 June 2007.

 

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