Intent on fixing a banking system that contributed heavily to the recent financial crisis, lawmakers and regulators pushed Wall Street to overhaul its pay practices. Big banks responded by shifting more compensation into stock, a move intended to align employees’ interests more closely with those of investors and discourage excessive risk-taking.
But it turns out that executives have a way to get around those best-laid plans. Using complex investment transactions, they can limit the downside on their holdings, or even profit, as other shareholders are suffering.
More than a quarter of Goldman Sachs’s partners, a highly influential group of around 475 top executives, used these hedging strategies from July 2007 through November 2010, according to a New York Times analysis of regulatory filings. The arrangements were intended to protect their personal portfolios when the firm’s stock was highly volatile, especially at the height of the crisis.
In some cases, executives saved millions of dollars by using these tactics. One prominent Goldman investment banker avoided more than $7 million in losses over a four-month period.
Such transactions are at the center of a debate over whether Wall Street executives should be allowed to hedge their stock holdings. The concern with hedging is that executives can easily break the ties between compensation and company performance. Employees who hedge their holdings are less concerned about a falling share price. That’s why the government barred top executives at banks that received multiple bailouts from using the strategies until they paid back the funds.
“Many of these hedging activities can create situations when the executives’ interests run counter to the company,” said Patrick McGurn, a governance adviser at RiskMetrics, which advises investors. “I think a lot of people feel this doesn’t have a place in a compensation structure.”
“Many of these hedging activities can create situations when the executives’ interests run counter to the company,” said Patrick McGurn, a governance adviser at RiskMetrics, which advises investors. “I think a lot of people feel this doesn’t have a place in a compensation structure.”
More broadly, critics say, the practice of hedging represents another end run around financial reform.
Article Tools
For example, new rules that cracked down on debit card fees have led several big banks to eliminate free checking. Firms also plan to make up missing revenue by adapting their businesses to the tougher new regulations on derivatives and trading with the banks’ own capital.
“Wall Street is saying it is reforming itself by granting stock to executives and exposing them to the long-term risk of that investment,” said Lynn E. Turner, a former chief accountant at the Securities and Exchange Commission. “Hedging the risk can substantially undo that reform.”
Most public companies, including Wall Street firms, have policies that ban the practice for only their most senior executives, though the number of executives affected varies by company.
At The New York Times, executive officers and other employees who have access to material nonpublic information about the company may not engage in hedging without written approval — a group that includes more than 100 people, as well as anyone they supervise.
Shareholders can figure out the investment practices of the highest-ranking officers of a public company, who are required by law to report. Even those disclosures are buried deep in the footnotes of regulatory filings. Whether lower-level executives are hedging is nearly impossible to determine.
But the unusual structure of the Goldman partnership requires the company to disclose the investment activities of partners in filings. The documents provide a window into what a broad range of senior executives were doing with their own shares.
Hedging — a commonly used tactic for years, especially during times of weakness or volatility — makes sense for executives at public companies who have amassed a large concentration of stock. They allow employees to limit losses, raise cash, or diversify their portfolios without selling the underlying holdings. Any individual investor can use hedging tactics for the same reasons, but few do because the transactions are complicated and make more sense for those who own a large amount of stock.
“Goldman Sachs shares represent the largest component of the wealth for many of our employees,” said Michael Duvally, a Goldman spokesman. “Hedging or outright sales, when allowed, can be a prudent part of a portfolio diversification strategy.”
By maintaining their stake, executives can continue to vote on shareholder proposals that influence the direction of the business. Hedging also helps investors to avoid the tax obligations associated with offloading stock.
There are various types of hedging strategies, many of which involve stock options. In one transaction, known as a covered call, a long-term shareholder can make income off a stock for a few months, provided it stays below a certain level. But if the price soars, the investor will not benefit from most of the rise.
In another hedge, known as a collar, an investor uses options to lock in the potential profits and losses on a stock. Although the move caps the potential upside, it also limits the risk.
Institutional hedging policies vary across Wall Street. Bank of America bans all employees from hedging their company stock, although management can make exceptions for “legitimate, nonspeculative purposes.”
But most big banks — including JPMorgan Chase, Morgan Stanley and Goldman Sachs — prohibit only their highest-ranking executives from such transactions. At Goldman, the chief executive, Lloyd C. Blankfein, and nine other top officers are not permitted to hedge their holdings, Mr. Duvally said.
The rest of Goldman’s employees can hedge shares they own outright. But they can’t make such moves with restricted stock. The partners, some of whom shape the firm’s strategy as heads of major business units, are required to hold 25 percent of their equity awards and are not allowed to hedge that portion of their holdings.
“Our equity awards vest over a multi-year period, are subject to clawbacks and cannot be hedged until they are delivered to our employees,” Mr. Duvally said. “These policies align equity compensation with the firm’s performance.”
The filings illustrate how routinely Goldman’s executives used the strategies. From July 2007 through November 2010, at least 135 partners used options to protect themselves from stock drops or to profit if shares held steady.
Several used such transactions routinely. Among them: David J. Greenwald, Goldman’s deputy general counsel overseeing its international businesses; Peter C. Aberg, a senior executive in the mortgage group; and Jack Levy, co-chairman of mergers and acquisitions. Howard Wietschner, the co-head of a hedge fund advisory group, had at least 32 such arrangements.
Shareholders over the same period endured roller coaster volatility. Goldman shares peaked at $248 in fall 2007 before dropping to $52 a year later after Lehman Brothers failed. At $164.83 on Friday, the stock still has not reached its former highs.
Regulators are taking a hard look at the practices. The Financial Stability Board, a group of global banking supervisors, wants firms to restrict employees from using the strategies. The Federal Reserve is examining hedging in its review of bank compensation.
And the Federal Deposit Insurance Corporation is expected to propose on Monday a new rule requiring big banks to defer at least 50 percent of annual stock and cash bonuses. That compensation would be released over the course of three years, so that executives don’t reap big, short-term windfalls even if their bets don’t pan out.
As part of the Dodd-Frank financial reform bill, the S.E.C. is hashing out regulations that would require all public companies to disclose their policies. Congress inserted the rule in the bill to discourage executives from hedging. The final S.E.C. proposal is anticipated during the second half of 2011.
For Goldman partners, the most popular hedging strategy was covered calls. Take Christopher Cole, chairman of Goldman’s investment bank and a member of the management committee. From 2007 to 2009, he made at least 11 such transactions, earning more than $675,000, according to the filings.
Not all strategies proved successful. With the stock around $98 in early February 2009, Milton R. Berlinski, who oversees a group that caters to private equity firms, made a risky bet called a short strangle. The maneuver would pay off if the stock stayed between $60 and $110 over the next six months. By mid-July 2009, Goldman shares were trading north of $156, meaning Mr. Berlinski took a loss.
Byron D. Trott, a Goldman partner best known as Warren E. Buffett’s investment banker, fared much better on one deal. In October 2008, Mr. Trott hedged 175,000 shares, using a collar to limit his profit potential but insulate him should the stock plummet over the next four months.
The transactions, set up months before, were executed just a few weeks after Mr. Buffett agreed to hand over $5 billion to Goldman in exchange for a potentially lucrative stake — a transaction Goldman hailed as a “strong validation of our client franchise and future prospects.” Mr. Trott, who did not return calls for comment, helped facilitate the investment. Goldman’s stock, which was trading around $128 that October, dropped to $73 by January. With the hedge, Mr. Trott lost roughly $2 million on the stake, less than a quarter of what he would have otherwise.
Two months later, Mr. Trott departed Goldman to start his own advisory firm.
READERS' COMMENTS
More than a quarter of Goldman Sachs's partners hedged their stock from 2007 to 2010, fueling concerns that executives have broken the ties between compensation and company performance.
Share your thoughts.
