| BUSINESSWEEK ONLINE : JANUARY 15, 2001 ISSUE | |||||
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| FINANCE
Commentary: Undermining Pay for Performance This summer was a good one for Wylie Plummer. The Semtech Corp. (SMTC) vice-president's 170,000 company shares were worth $10 million on Aug. 31--up from $3.8 million three months earlier. But as the outlook worsened for the cell-phone market, the stock took a hit. By Dec. 22, Semtech had slumped from $59 to less than $18. So Plummer's holdings were worth just $3 million, right? Well, no. They were actually worth $5.3 million. That's still a big drop from $10 million, but a far cry from the one most shareholders saw. Call it the new math. In September, Plummer hedged his bets by using an increasingly popular device called a zero-cost collar. While other investors cried in their beer, perhaps taking solace in the belief that company bigwigs were in the same boat, 100,000 of Plummer's shares never fell below $41. Plummer, a Semtech director, declined comment through a spokesman. You can't blame Plummer and other executives for wanting to cut their risk a little. Many are underdiversified, with most of their wealth tied up in a single stock. Some are company founders and some hold restricted shares that can't be sold for months, sometimes years. Hedging lets them protect shares they can't sell or prefer to keep, and by borrowing against the hedge, they can diversify their portfolios. Says Jeff Sparks, executive director of UBS Warburg's equities division, which markets hedging products: ''They're prudently addressing financial planning.'' The problem is that many executives who hedge do so with shares they were awarded as a way to tie their pay to the performance of the companies they manage. Such performance-based pay now accounts for more than half of all compensation for top executives and directors. But hedging can undermine the purpose of performance-based pay, since it cuts the risk of ownership. And unlike an outright sale of stock, investors rarely learn of hedging transactions. Says Charles M. Elson, director of the University of Delaware's Center for Corporate Governance: ''It's like a baseball player betting on the other team. If the executive is collaring, shareholders should be aware of it.'' But most are not. When top managers sell stock, the transaction is widely reported and can send a powerful signal to investors. Hedging transactions, on the other hand, while reported to the Securities & Exchange Commission on Form 4, rarely appear on EDGAR--because few executives file them electronically. They're not included in other company filings, such as the proxy or 10-K reports. And they're ignored by most services that provide insider-trading data to investors. When hedging was rare, that was understandable. But it's getting less so every year. Last year, at least 31 insiders reported hedging, up from 15 in 1996, according to Camelback Research Alliance Inc., an investment research firm in Scottsdale, Ariz. Among them were some of the biggest names in the tech sector, including Microsoft Corp. (MSFT) co-founder Paul G. Allen and CNET Networks Inc. (CNET) founder Halsey M. Minor. What's more, executives are protecting more wealth than ever. Even without Allen's collar of more than 76 million shares, the other 30 executives hedged an average of more than 300,000 shares each last year, up 66% from 1999. For three out of four, the transactions were a smart move. If their hedges were to expire now, the executives' shares would fetch millions more than the market price. For Allen the decision to collar was particularly timely. Preceding a recent slump in Microsoft shares by weeks, the series of 36 transactions in October and November allowed Allen, who could not be reached for comment, to avoid nearly $1 billion in losses. Kevin Walsh, derivatives manager at Mellon Financial Corp., says the volatility of tech stocks sent many executives scurrying for cover. ''We had many customers who did transactions in the past year who are very, very happy,'' says Walsh. ''They bought insurance, and a tornado came.'' Insurance is a good word to describe the appeal of the most popular hedge, the zero-cost collar, which limits future losses and gains. For executives with boatloads of suddenly valuable shares in one company--shares they may be prohibited from selling--the collar safeguards wealth and allows it to grow. Since the transactions are not widely watched, the chance of triggering a sell-off is small. And because ownership does not change hands, executives retain voting rights and defer taxes until they sell. Michael L. Lemmon, assistant finance professor at the University of Utah and co-author of a study on executive hedging, expects the practice to grow in popularity. ''These instruments provide executives another way of limiting their exposure,'' says Lemmon. Executives say hedging isn't always a bet against the company. Minor, for example, says his hedge was a way to raise cash. Unwilling to sell his CNET founders' shares for $35 apiece in May, when he needed cash to start another business, he made a deal. He set up a collar with a floor of $29 a share and a ceiling of $49 a share, and got the $29 up front. If the stock falls below $29, he's protected. If it rises before the collar expires, he can get up to an additional $20 per share. The hedge, he says, is a bet on CNET's success, not its failure. Says Halsey: ''If I thought it was going down and staying down, I would have done an outright sale. I'm taking an educated gamble that it will be back above 35 by May 15.'' Whatever the motivation, when top managers hedge, shareholders deserve to know. In the past decade, equity has become the chief way of aligning executives' interest with that of shareholders. Pay-for-performance is built on it. But when an executive hedges part of his stake, that link is diminished. By hedging, an executive can take out insurance on his shares while appearing to have an unadulterated interest in the company's fate. Says Lenny Mendonca, a McKinsey & Co. director: ''If they have perceived self-interest but have no self-interest, that's not right.'' An executive who hedges is a little bit like the captain of a ship who sees an iceberg up ahead and heads for his lifeboat without waking the sleeping passengers. Nobody's suggesting the captain should go down with the ship, but if a top executive has lost confidence in his company to the point where he's safeguarding his shares, investors should be told. Clearly, better disclosure is needed, preferably by the companies, and preferably where it would do the most good--in the annual proxy. That way, all investors, not just the supersleuths, will be able to see which executives are putting their money where their mouths are and which ones aren't taking any chances. By Louis Lavelle Lavelle covers management and executive compensation from New York. _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ BACK TO TOP |
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