SCOTT PATTERSON and
New research suggests complex stock-sale
arrangements designed to protect executives from declines in their company
share holdings often are struck not long before such declines occur.
The deals have long been criticized as
opaque and hard for investors to understand. Now, a new study, which jibes
with other recent research, shows that after executives strike these
favorable deals, share prices tend to decline disproportionately.
The contracts "appear to be used
opportunistically because they are followed on average by a share decline
and unusual levels of negative corporate events," said Carr Bettis,
chairman of Scottsdale, Ariz., research firm Gradient Analytics and
co-author of a recent report on the subject.
Known as prepaid variable forward
contracts, the arrangements are usually made between an executive and a
brokerage firm. The executive typically agrees to deliver to the brokerage
a number of shares at a date several years in the future in exchange for
upfront cash often equal to between 75% and 90% of the shares' value at
the time of the agreement.
If the share price falls in the contractual
period, the brokerage absorbs the loss. If it rises, the executive shares
in the gains up to a point.
In any case, the executive locks in some
value, minimizes losses and retains a shot at some gains, all while
maintaining voting rights for a time.
Researchers say they have no specific
evidence that executives who use such deals are motivated by knowledge
that isn't public.
The New York attorney general last year
sought information from some companies that permit the arrangements and
looked at how they were disclosed. To date, investigators haven't brought
any charges or given any public indications of suspected securities fraud
at any of those companies.
One trend that could help explain the
results: Executives often enter such deals when their company's stock has
been rising, research suggests, and so may be due for a fall. But
researchers say they accounted for that phenomenon and concluded the price
declines in these cases were statistically significant.
A report by Gradient, released to clients
in April and reviewed by The Wall Street Journal, showed that shares of
companies whose executives entered into these hedging contracts fell about
8% more than a peer group of similar companies about a year after the
contracts were entered into. The report covers 474 contracts spread over
363 firms from 1996 and 2006.
Gradient's Mr. Bettis, a professor at
Arizona State University, has pursued the research for years with
colleagues at Portland State University and Southern Methodist University.
A 2007 study of about 100 contracts by
Stanford University finance professor Alan Jagolinzer and two colleagues
also found correlations between weakness in companies' shares and the
Some companies, such as
Pitney Bowes Inc., have banned the arrangements. "We think it is
inappropriate for senior employees to, in effect, bet against the
company," said Johnna Torsone, Pitney's chief human-resources officer. The
company instituted the ban about three years ago.
The contracts have been used by roughly 400
publicly traded companies, according to Gradient, and aren't as common as
share sales as a way for executives to reduce their exposure to their
Supporters of the contracts say they help
executives with concentrated exposure to company stock diversify while
retaining voting rights for the shares until the contract ends.
Another way for executives to diversify
share holdings is to sell shares on the open market. It is transparent,
but can draw the attention of shareholders, and also costs executives
The tax treatment of the contracts has also
come under scrutiny from the Internal Revenue Service, since executives
are allowed to cash out their share holdings, but defer capital-gains
taxes for years on that cash.
Several years ago, the SEC looked into
disclosure issues surrounding the contracts. The IRS didn't comment and
the SEC didn't respond to a request for comment.
One company that saw a steep decline after
its chief executive entered into one of the contracts is shipping company
Horizon Lines Inc. In November 2006, Chief Executive Charles Raymond
entered forward contracts in which he committed shares at a price of about
$27, according to regulatory filings. In exchange, he was given $5.3
million. By the time the contracts matured in early 2009, the stock had
fallen to below $5 a share.
A company spokesman said he wanted to
diversify "holdings without losing out in the anticipated growth of the
Write to Scott Patterson
email@example.com and Serena Ng at
Printed in The
Wall Street Journal, page C1