Corporate executives typically receive compensation in company stock as a means of aligning their incentives with those of shareholders. If they desire to reduce the firm-specific risk associated with these sizeable positions in their companies, they face an ethical dilemma. The authors explore popular hedging techniques used by executives and offer recommendations for how executives can act in their companies’ best interests while protecting their own financial situations.
What’s Inside?
The authors examine the ethical dilemmas faced by corporate executives who want to hedge sizeable positions in their company stock. To begin, they discuss the use of equity-based compensation by boards and give an overview of the most commonly used hedging techniques of risk-averse executives. The authors then provide an overview of the ethical considerations of hedging by executives and real-world hedging examples. They conclude with a hypothetical case study and subsequent discussion of how executives facing this dilemma can act in the interest of their companies’ shareholders while also protecting their own financial well-being.
How Is This Research Useful to Practitioners?
Equity-based compensation has become standard for corporate executives as a solution to the principal–agent problem that arises when managers fail to act in the best interest of shareholders. A major consequence of equity-based compensation is that it often results in a firm’s executives holding large, undiversified portfolios.
The authors cite a number of previous studies on executive hedging. Executives often prefer to hedge their positions (rather than sell shares) to defer triggering capital gains taxes, to avoid sending a negative signal to investors, or to avoid restrictions on outright sales. The authors discuss a number of hedging instruments, such as equity swaps, put options, zero-cost collars, exchange trusts, prepaid variable forward contracts, and sector-specific inverse exchange-traded funds, and provide a brief overview of each of these strategies.
The authors summarize Oberlechner’s (Research Foundation of CFA® Institute 2007) ethical framework, which distinguishes between normative ethics (how things should be) and descriptive ethics (what actually occurs in practice). They provide examples of CEOs hedging significant exposure prior to significant stock price declines. The authors also use Kohlberg’s model of ethics to illustrate how hedging motivations change with psychological maturity.
The authors recommend that hedging driven by concerns about future stock performance be discouraged, but they also believe that executives should be allowed to protect and diversify wealth and that hedging is an efficient tool for doing so. They suggest that executives be more transparent in discussing their hedging intentions with the board.
This article will be of the most interest to equity investors, corporate governance analysts, board compensation committees, and corporate executives. The overview of hedging techniques may also be of interest to financial planning professionals who work with executives with concentrated equity positions.
How Did the Authors Conduct This Research?
The authors provide a qualitative discussion of the ethical challenges associated with corporate executives engaging in hedging transactions. They begin by summarizing the existing literature to create a framework for how ethical decisions are made.
A significant portion of the article is devoted to a hypothetical case study involving a CEO of a developmental drug company. Although she believes the company has a bright future, 75% of the CEO’s wealth is tied to the stock price. Examples of significant losses by real world CEOs are provided for context. The authors use this hypothetical case study to analyze different potential hedging options and the ethical considerations involved when balancing the goals of aligned interests with financial risk aversion.
Because of the qualitative approach the authors take, more of the observations and conclusions are based on their subjective interpretation than would be the case if they had relied more heavily on empirical data.
Abstractor’s Viewpoint
The authors provide an interesting overview of the ethical considerations involved with executive stock hedging. A hypothetical case study and discussion provokes thought on how to achieve balance between the interests of shareholders and those of risk-averse executives. The authors achieve a balanced approach to the issue. Although examples of insiders apparently acting in self-interest are provided, executives are not vilified for their desire to manage risk. The authors provide some general suggestions for improvement, but it would be helpful if more specific proposals were offered that could be adopted by compensation committees and/or regulators.