Wednesday, February 03, 2010

Selling Out

From the Wall Street Journal last week:

Investment bankers in the U.S. have begun using equity derivatives to convert restricted shares paid as bonuses into cash, side-stepping new guidelines on remuneration which were designed to prevent bankers cashing out for at least three years, according to a headhunter.

The bankers are using over-the-counter equity derivatives strategies such as call options, put options and collars to monetise their shares now, albeit at a discount to what they would receive if they waited for the restrictions to lift.

The revelation comes as global regulators seek to put an end to large cash bonuses in favour of deferred awards which tie bankers' compensation to long-term performance.

Gustavo Dolfino, senior managing director of U.S. business services firm Accretive Solutions, said some top earners at investment banks have negotiated to receive the shares component of their bonuses in restricted stock that is already vested or soon to vest. The stock is still subject to restrictions, for example on when it can be sold in the open market. However, because it is vested, they are able to turn it into cash by trading derivatives.

It is not clear how many bankers have used this mechanism, but Dolfino said: "The vesting provision allows these executives to take advantage of a financially engineered legal loophole which lets corporate insiders with concentrated equity positions and holders of control, restricted and M&A stock to monetise that stock.

"Rather than wait three or five years for the restrictions to pass, bankers would rather take a discount of up to 50% now just to get out and do something else."

Okay, first of all, ignore that last line. There AIN'T NO bankers taking *50% discounts* on their bonuses in order to reap them today. That's ludicrous on its face.

Now, getting to the crux of this story...

It's obviously meant as a swipe at *fat cats*, at those high level executives who are making an *end around* the attempts to align their compensation with long-term stock performance. Fair enough.

But there are thousands of mid-level employees who are forced to take substantial amounts of their annual pay in the form of vesting, restricted stock.

For those of you unaware, restricted stock is usually given at the current market price. So every tick upward leading up to your bonus day is bad - it results in you getting fewer shares of stock.

And then once you get the stock, you are theoretically powerless to do anything until it vests - usually over 3-5 years, I believe 7 used to be more common. In other words, one whole year after getting the *bonus*, you can only sell, say, one-third of your allotment. Obviously, the stock can be much, much lower by the time all the shares have vested. Imagine getting 50-100k restricted stock awards every year in say Bank of America? Only to see it plumb $2.50 a share last March?

or, even worse, in Citigroup?!

What about Fannie Mae, AIG, Bear Stearns, or Lehman????!!!! All equity stakes in those have been reduced to ZERO. For wound-salt...people paid income tax (even possibly capital gains) on shares as they vested to boot!

But here's the deal....

In general, most companies would never allow an employee (esp. a high level one) to short their own company stock; they see it as a red flag for possible insider trading. But there is, I believe, a special case. Workers ARE PERMITTED to short up to an amount equal to their unvested, restricted stock. Let's just say I've executed the trade for people before.

I don't know about you Morons, but if I was a Goldman crook, and I was handed $5,000,000 in restricted stock as part of my compensation, at today's elevated price of $157(!)....I'd sure as heck try to *hedge* the risk of my vesting period!

I'd short directly against the unvested shares if possible; I'd find some OTC bookie to collar (short call, long put) my stake; or I'd try to lay off some of the risk through ETFs or other index products.

Very rarely is there *nothing one can do* in these situations. Everything can somehow be hedged. Behold the alchemy of this parlor game!

1 comment:

Anonymous said...

The derivative in question is a simple equity swap, I believe.