After the financial crisis, it was clear that Wall Street's pay incentives had to be reformed to better align executive compensation with the interests of shareholders. One way was to award more compensation in stock, which would allow executives to enjoy gains along with shareholders and share the economic pain if the firm's investment practices proved too risky. But Wall Street has a way of turning every constraint into a "heads I win, tails you lose" opportunity. Investment bank executives are insulating themselves from potential stock losses by employing complicated financial transactions to hedge their holdings. Just as there are rules against insider trading, there should be regulations against Wall Street insiders hedging their company stock. There's too much opportunity for mischief.
According to an analysis of regulatory filings, the New York Times found that more than a quarter of Goldman Sachs' partners used hedging strategies from July 2007 through November 2010 to reduce their portfolio's risk of exposure to their company's stock volatility. In some cases the techniques saved them millions of dollars, with one executive avoiding $7 million in losses over a four-month period.
The tactics vary, but one hedge that is used frequently is known as a covered call. It allows a long-term shareholder to make profits on a stock by essentially selling off any stock gains over a certain price for a short period of time. The shareholder is betting that the share price will either remain fairly steady or fall within a set time period. And there are similar techniques that pay off when the stock underperforms.
By definition, this kind of hedging divorces the financial interests of shareholders from the people running the firm. It also allows insiders to benefit from their knowledge of a firm's immediate prospects. Holding information that the company's stock may soon dip, employees can move to limit their losses, a kind of insider trading that might prove difficult to police.
Some big banks already take precautions from having their employees hedge company stock. Bank of America bars its employees from doing it. But, according to the New York Times, most Wall Street banks — including JPMorgan Chase, Morgan Stanley and Goldman Sachs — limit hedging only for a handful of executives, such as the CEOs and other top officers.
This system needs to be fixed, and regulators are getting involved. The Federal Reserve is looking at the issue as it examines executive compensation practices. The SEC also is in the process of developing regulations to implement a new rule in the Dodd-Frank financial reform law that requires public companies to disclose their policies on hedging. But the practice should be banned outright. If Wall Street executives are given any loophole, they'll be sure to drive on through.