Hedging Shows Growth

Chris Mumford, Keith Kefgen | GENERAL COMMENTARY

Picture the scene. You are a director of a publicly traded company and you know that your company’s stock price has topped out. Keen to cash out before the share price falls, you are also concerned about the negative impact. After all, your move could easily be construed as lack of confidence in the company. So what do you do? One option that has been gaining in popularity during the past few ‘down’ years of the stock market is known as ‘hedging’.

Hedging is a legal arrangement whereby corporate insiders cash out their stock without officially selling it. The stockholder enters into a transaction called a ‘variable prepaid forward’ with a third party, such as a bank, which pays him cash for the shares which he has agreed to sell over a period of time. In many cases, the shareholder can still vote the shares and can also take a certain percentage of the gain if the shares go up in value. There are also additional tax benefits as the tax payment on the sale can be deferred until all of the shares are officially sold.

Such transactions must be disclosed on SEC document Form 4 but in reality they are rarely noticed by the average investor and seldom reported by financial web sites and trading terminals. There are however a large number of corporate insiders who are making similar transactions but not disclosing them, which is an illegal act. Conversely, some high profile investors have issued press releases when hedging in order to explain the reasons why. In some cases, where transactions are structured so that the insider still gains when the stock rises, the market has actually regarded those transactions in a more favourable light than an outright sale.

The increased practice of hedging has raised concerns however in the investor community. The University of Washington conducted a recent study on hedging and found evidence that corporate insiders employ hedging, “when an outright sale of equity would be most likely to attract attention.” The study also reported evidence that some stockholders were clearly using hedging to ensure their gains before expected downturns in company performance. Such activity could be interpreted as insider trading.

In its article ‘Getting what you pay for with stock options’ The McKinsey Quarterly 2002, Number 4, listed five principles to help boards more closely align the role of stock options as executive pay incentives with the interests of shareholders. The fifth principle, ‘Limit the potential for hedging strategies’, warns that, “hedging poses a real danger because it can, without the shareholders’ knowledge, limit the real exposure of these executives to the consequences of their own decision making.” The article goes on to recommend that company boards ask their executives to disclose on a regular basis their shareholdings as a deterrent to devious hedging.

As executive pay comes under ever more intense scrutiny so too will practices such as hedging. Investors are sniffing around for any hint of insider trading and corporations insiders would be well advised to make full and open disclosures of any hedging transactions involving their stock in the future.