Table Of ContentWhy Do Insiders Hedge Their Ownership? An Empirical Examination*
Carr Bettis
Arizona State University and Gradient Analytics
John Bizjak
Texas Christian University
Swaminathan Kalpathy
Southern Methodist University
This Draft: May 2011
* The authors thank participants at the 2010 FMA European Conference in Hamburg, Germany, participants at the
2010 American Law and Economic Association meetings in Princeton, participants at the 2010 FMA meetings in
New York, seminar participants at Arizona State University, Southern Methodist University, Texas Christian
University, Texas Tech University, and University of Oregon for helpful comments. The authors thank Lucian
Bebchuk, Jeff Coles, Huasheng Gao, Mike Lemmon, Ebru Reis, and David Yermack for their helpful comments and
suggestions. The authors are thankful to Emmelin Cardella for her excellent research assistance.
Electronic copy available at: http://ssrn.com/abstract=1364810
Why Do Insiders Hedge Their Ownership? An Empirical Examination
Abstract
We analyze four different instruments – collars, forwards, exchange funds and equity swaps –
used by corporate insiders to hedge or diversify their ownership in order to better understand
why these instruments are used and how they impact managerial incentives and behavior.
Insiders hedge over a third of their ownership with collars, forwards and equity swaps which
significantly reduces pay-performance-sensitivity, but they hedge much less ownership with
exchange funds. The use of collars and forwards, but not exchange funds, precedes poor stock
performance and adverse corporate events indicating opportunistic timing by insiders. Our
analysis also indicates that insiders use these securities to reduce personal taxes and to maintain
voting rights prior to certain corporate events. Finally, most corporate boards do not restrict the
use of these derivative instruments. Understanding these strategies and how they are used has
important implications for both insider trading and incentive contracting.
Electronic copy available at: http://ssrn.com/abstract=1364810
1. Introduction
We provide the most comprehensive analysis to date of how corporate insiders
use different types of derivative securities to hedge or diversify their equity holdings of
stock and options in their firm. According to SEC filings the most common derivative
instruments used by insiders are: pre-paid variable forwards (forwards), zero-cost collars
(collars), exchange trusts, and equity swaps. Forwards and collars are similar instruments
that allow insiders to protect themselves from downside movement in the firm’s stock
price while retaining the opportunity to benefit from stock price appreciation, deferring
income taxes, and maintaining voting rights. Exchange trusts, also known as exchange
funds, are portfolios of securities formed when insiders from different companies
contribute their own shares into a portfolio. Equity swaps allow the insider to trade the
return on the stock for the return on another security.1
Because these instruments can allow insiders to trade opportunistically ahead of
adverse firm-specific events without the transparency or litigation risk that is typically
associated with open market sales the use of these securities has attracted significant
scrutiny from shareholders and proxy advisors (e.g., Institutional Shareholder Services
and Council of Institutional Investors), regulators (e.g., the Securities and Exchange
Commission) along with legislators (e.g., the Dodd-Frank Act) and academics (Bebchuk
and Fried (2010) and Larcker and Tayan (2010)).2 Another concern with these
instruments is they reduce the sensitivity of an executive’s wealth to firm performance
1 We provide more details about the structure of these instruments in Section 2 and in Appendix A.
2 We discuss below how these contracts are reported and the reasons they are harder to identify than an
insider sale.
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which affects the incentives of executives to increase shareholder value and can
exacerbate agency problems in the firm.
While the potential use of these securities to exploit private information raises
concerns, there are rational economic reasons for why insiders would use these
instruments. Insiders often have significant holdings of stock and options and can use
these securities to reduce personal portfolio risk associated with concentrated holdings of
one asset. The other advantages of these securities relative to an open market sale
include deferring personal income taxes, maintaining some of the upside gain in share
price, and maintaining voting and dividend rights on the underlying shares.
Diversification at the personal level could also prevent costly hedging and investment
distortions at the firm level (Amihud and Lev (1981), Stulz (1984)). In addition,
derivative securities might allow an otherwise risk-averse executive to bear more firm-
specific risk and thereby take on risky, yet value-enhancing projects for shareholders.
Beginning in 1996 Primark/Disclosure (now part of Thomson Reuters) began
collecting all of the hedging and diversification transactions that appear in Table II of
forms 3, 4, and 5 (most of which are revealed in footnotes to the tables). We gather
information on these transactions reported by corporate insiders over a ten-year period
starting in January of 1996 through December of 2006 from the Thomson Reuters
database and augment this with hand-collected data from our own keyword searches of
SEC filings. We compile a sample of over 2,000 hedging transactions initiated by over
1,000 insiders at almost 600 unique firms. To our knowledge this is the most
comprehensive data set gathered on these types of transactions.
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Given a lack of comprehensive information about the different types of derivative
strategies available to insiders, our first objective is to provide some basic facts about the
types of hedging and diversification strategies that are used, their fundamental
characteristics, the frequency of their use, their evolution over time, and the amount of
ownership covered. Our second objective is to provide an understanding of what
motivates insiders to hedge, if there are reasons to use one instrument versus another
(e.g., forward versus exchange funds) and the implications of the use of these securities
for insiders, shareholders, and the firm.
With regard to our first objective, we document a recurrent use of three particular
types of transactions - collars (481), pre-paid variable forwards (983), and exchange
funds (442). Equity swaps (136) are less frequently used. The data reveal that a diverse
group of corporate insiders engage in these transactions and include CEOs and Chairmen
of the Board (380), other senior officers (363), non-officer directors (239) and 10%
beneficial owners (158). We find that CEOs tend to use exchange funds more frequently
while upper level managers tend to use collars and forwards more often. Equity swaps
appear to be more prevalent among 10% beneficial owners. In our sample the average
level of ownership hedged with collars (31%), forwards (28%), and swaps (33%) are
quite similar and significantly larger than the average open-market insider sale
(Lakonishok and Lee (2001)). In contrast, we find significantly lower levels of
ownership placed in exchange funds (9% on average).
In terms of our second goal of understanding the motivation behind the use of
these different instruments the results of our empirical analysis suggest that insiders time
their use collars and forwards based on inside information. For collars (forwards) we
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find cumulative abnormal returns of 43% (22%) in the year prior to the transaction
compared to an industry-size matched control firm which is then followed by an
abnormal return of –19% (–7%) the year following the transaction. These abnormal
returns are larger than what has been documented in prior research for insider sales
(Seyhun (1992) and Lakonishok and Lee (2001)). We also find evidence of poor
performance following equity swaps but we are cautious about interpreting this finding
due to the small sample size.
Further bolstering the timing story is our evidence that collars and forwards are
followed by shareholder securities-based litigation, earnings restatements, and negative
earnings surprises (for collars) in the year subsequent to the transaction – activities that
are traditional associated with poor firm performance. We also find that forwards are
frequently used by insiders in an acquiring firm prior to the announcement of an M&A
transaction. A potential explanation for this latter finding is that insiders want to keep
voting rights to influence the deal but protect themselves from any downside risk.
In contrast, the use of exchange funds by insiders does not appear to be
information based. We do find a run-up in stock price prior to the transaction but find no
evidence of poor performance subsequently. In fact, we find a positive 9% abnormal
return post transaction. We also do not find evidence that the use of exchange funds is
related to shareholder litigation, earnings restatements, or negative earnings surprises the
year after the transaction.
Another motivation for the use of these various instruments is as a diversification
strategy when insiders are concerned about changes in firm risk. To test this idea we
examine if the frequency of these transactions is associated with corporate events that
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could change the firm’s risk profile such as a change in CEO, changes in R&D, book
leverage, total investments or with increases in stock return volatility. We find no
relation between the use of derivative transactions and these events or changes in firm
characteristics. An alternative interpretation of these findings is that these instruments do
not provide incentives for managers to initiate riskier investment strategies.
Another rational for the use of these securities, with the exception of equity
swaps, is to allow insiders to defer income taxes over the contract life which effectively
reduces the present value of personal tax liability. Consistent with this idea, we find some
evidence that insiders are more likely to use these securities to reduce taxes.
To better understand how these instruments might affect incentives we measure
the impact of hedging on pay-for-performance sensitivity of CEOs, and report on related
governance characteristics at hedging versus non-hedging firms. To be clear, these
experiments lack a theoretical framework to explain why it is optimal to allow insiders to
hedge at the personal level to adjust the pay-for-performance sensitivity when boards can
structure compensation contracts that would nullify the need for any hedging on the part
of the insiders. Similarly, our investigation of firm governance characteristics may be
viewed as merely descriptive. What we do find, however, raises some concerns. Collars
and forwards reduce the sensitivity of changes in CEO wealth to changes in stock price
by about 22% and boards do not appear to reinstate the weakened incentives by making
ex-post adjustments to compensation. Indeed boards can mandate and enforce corporate
policies that ban or restrict the use of these instruments, but seldom do. In addition, we
find that these instruments tend to be used in firms that have characteristics that are
traditionally associated with weaker corporate governance. Firms where insiders use
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these derivatives tend to have fewer independent directors and for forwards lower levels
of ownership by 5% institutional investors.
Our analyses suggest that not all derivative instruments are created equal and that
there are important differences in the use of these securities. One reason why the size of
collars, forwards and swaps transactions tend to be larger in magnitude compared to
exchange trusts is because these instruments can be tailored to the individual needs of the
insiders. Moreover, since these three securities provide full protection from any drop in
share price they are more conducive to being used when insiders anticipate poor
performance. In contrast, exchange funds are primarily designed by investment banks as
a diversification strategy for insiders, which suggest that banks have the incentive to limit
the amount that any particular insider can contribute into the fund and to monitor the
quality of stocks selected for inclusion into the fund.
There are three notable papers that precede our work. Bolster, Chance and Rich
(1996) provide a case study on a single equity swap transaction by the CEO of Autotote
in 1994. Bettis, Bizjak and Lemmon (2001) examine 85 zero-cost collars initiated
between 1996 and 1998. Jagolinzer, Matsunaga, and Yeung (2007) study a sample of
200 forward contracts spanning 100 individuals between 1996 and 2004. While this
previous work has addressed some of the issues surrounding the use of some of these
instruments the size and comprehensive nature of our data allow us to provide insight into
a number of issues left unexplored in prior studies. These issues include: the use of these
instruments around material corporate events; whether the use of these instruments affect
managerial behavior; how hedging affects incentive contracting; to what extent personal
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taxes and voting rights influence the motivation to use these instruments; and to what
extent firms ban insiders from using these instruments.
The paper is organized as follows. Section 2 provides a description of these
securities and the data. Section 3 provides a background for the different motivations
insiders would have to use these securities. Section 4 contains the examination of stock
price performance and corporate events surrounding hedging transactions. Section 5, 6
and 7 provide evidence on the determinants of the use of hedging contracts. Section 8
concludes.
2. Sample Collection and Summary Statistics
2.1 Common Hedging and Diversification Instruments
There are four types of securities reported in SEC filings that insiders can use to
hedge or diversify their equity holdings in the firm. Each type is described briefly here
with more detailed discussion in Appendix A. In a collar transaction the proceeds from
the sale of a call option on the stock are used to buy a put option on the stock. Forwards
represent a forward sale of the firm’s stock. While collars and forwards are different
instruments they share some of the same fundamental characteristics. They both provide
downside protection in stock price (floor), while sacrificing some of the upside return
(ceiling). Also each has a fixed maturity that determines the contract length and both are
private over-the-counter transactions between the individual and the investment bank. A
major difference between these two instruments is forwards are much easier to monetize
than collars (i.e. to receive a cash advance against the shares). In an exchange fund a
group of insiders from different firms individually place their shares in a limited
partnership or limited liability company. By pooling shares into a single entity the
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participants receive a return based on the performance of the diversified portfolio. These
funds are organized by financial institutions such as investment banks. Equity swaps
allow investors to exchange the future returns on their stock for the cash flows of another
financial instrument such as a debt instrument (e.g., the cash flows associated with the
return of the LIBOR), or any other financial instrument such as the S&P 500.
2.2 Identifying Hedges.
Beginning in 1996 Primark/Disclosure (now part of Thomson Reuters) via its
Lancer Analytics strategic partnership with Gradient Analytics began collecting all of the
hedging transactions that appear in Table II of Forms 4 and 5.3 Our dataset is comprised
of transactions collected by Thomson Reuters, supplemented by additional filings
identified by Verus Research, LLC, and by our own investigation of identified filings.
The quality of reporting for hedging transactions varies widely. Some filings contain the
contract details (e.g., contract ceiling and floor values for collars and forwards) but many
merely include generic references to the hedging instruments. When details are presented
most of them are contained in the footnotes to the filings. When available we collect the
type of instrument reported, name of the insider who enters into the transaction, title of
the insider, transaction date, number of shares hedged in the transaction, and the length of
the contract. For collars and forwards when reported we also gather information on the
3 Prior to 1994 the SEC viewed hedging transaction, at the time mainly swaps and collars, as private deals
and not open-market transactions, and therefore did not require insiders to report these transactions (Norris,
1994). In 1996 the SEC formalized their position regarding hedging transactions in release No. 34-347260
(1996) and mandated that these instruments be reported in Forms 4 or 5. Details of these transactions are
primarily reported in Table II of those forms.
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Description:There are three notable papers that precede our work. Bolster, Chance and Rich.
(1996) provide a case study on a single equity swap transaction by the CEO of
