We’re hiding our sales from you. Got a problem with that?

Posted by Marc Hodak on June 3, 2009 under Executive compensation | Read the First Comment

Recent research finds a significant correlation between something called prepaid variable forward contracts and negative relative returns to shareholders.

In layman’s terms, the executives are selling their firms short (after a fashion), and their stockholders are suffering afterward.

Now, executives can’t actually sell their firm’s shares short.  That has been illegal since the Erie Railroad scandal in the late 1800s.  But executives are allowed to sell their company’s shares that they own, and they are allowed to sell those shares in forward contracts, i.e., an agreement to sell them in the future.  Why would an executive do this?

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.

The problem is that shareholders don’t want their managers to diversify.  They like having the pilot in the front of the plane without a parachute. 

So, executives have found ways to hide their sales using prepaid variable forward contracts, which have the added attraction of allowing the executive to retain voting rights of the shares until they are actually sold at some point in the future.  Many boards believe this is OK because they are not spooking the market with sales of their executives’ shares.  No harm, no foul.

Except that now it seems that even when shareholders don’t know that the executives are selling their firm’s shares, the stock underperforms anyway.  Why?  The most likely explanation is that the executives had a bad vibe about their firm’s future, and they’re looking to bail in advance of the turmoil.

I’m not looking forward to what Barney Frank will have to say about this one, but I know what my pal Berk will say, and that it will kill him to agree with Barney.