Wednesday, January 27, 2010

Catching Up With Innovation

Where management has a significant portion of its net worth invested along with shareholders, agency costs are likely to be at a minimum. Shareholders can easily determine how invested management is in a company by looking in the same place that a company's executive compensation can be found. Unfortunately, the use of equity swaps, becoming more common in the financial world, can render the information on management's stake in the company essentially useless.

Equity swaps are a financial innovation that allows one party to swap the returns of one asset for the returns of another asset. Consider an example of how this might be useful:

Andre Preneur started a company from scratch, and recently took it public. His net worth is now several hundred million, but all of his wealth is invested in just this one company, a risky portfolio no matter how strong the company. Andre has family commitments and wants to lock in some of this gains, however, and this undiversified portfolio could result in a significant loss of capital should something go wrong. Selling 20% of his holdings in order to diversify would drag down the stock price, hurting all investors in the process. But a swap in which he trades the returns on a portion of his holdings to a dealer that pays him the return on the S&P 500 (minus a fee) allows him to achieve some diversification without high transaction costs.

Clearly, this type of swap serves a useful purpose. Unfortunately, regulators must constantly play catch-up to avoid unforeseen problematic consequences. For one thing, Mr. Preneur would owe a substantial sum of taxes if he actually sold his shares, so when this product first came out, it would have saved him a tidy sum (regulators have since closed this loophole). Furthermore, an insider could effectively sell his shares in a company - without having to report any insider sales, which shareholders often count on as a clue towards management's outlook! (This loophole has been closed as well.)

Unfortunately, one loop hole that has not (yet?) been closed has to do with the fact that management may show ownership of a number of shares, but may have swapped the returns away. Shareholders wouldn't know unless they pieced together disclosures of insider sales, insider buys, restricted stock issuances, stock option issuances, and stock option exercises - and even then, these particular disclosures are not likely to form a complete picture of exactly how much a manager owns. In an extreme case, this could lead to a problematic situation where a manager has voting control, but suffers no consequences as a result of his actions (for he has swapped the returns away), while shareholders believe that the manager has a full stake in the company!

Innovation in the banking and financial industry has benefited us all. Of course, if unchecked, things can go awry in a hurry, as evidenced by the bank-induced recession that took the world by storm last year. This doesn't mean innovation should be stifled, but it does mean investors and regulators must stay abreast of what's going on, and take corrective action when publicly disclosed information is unintentionally suppressed as a collateral result.

This article was written by Saj Karsan of Barel Karsan. If you enjoyed this article, please vote for it by clicking the Buzz Up! button below.

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