Executives and Hedging: The Fragile Legal Foundation of Incentive Compatibility

Abstract:     
In the capital markets, the 1990s have been the decade of executive stock options and the derivatives market. Legal scholars and economists have begun to realize that, in combination, these two trends raise a serious concern. Options are supposed to inspire better performance by tying pay to the stock price. Yet, what if an executive could use the derivatives market to simulate a sale of her option -- a practice known as "hedging" -- without violating her contract with the firm? The incentive justification for option grants would no longer hold.

This Article demonstrates that the tax law helps avert this consequence in the United States; this phenomenon, in turn, shows that the U.S. tax law performs an important corporate governance function, not previously recognized in the academic literature. The tax law discourages executives from hedging options (but not necessarily from hedging stock holdings, although such hedging raises somewhat different concerns). Whereas shareholders and executives should contract to ban options hedging, the existing tax barrier is a plausible substitute. Indeed, since the tax law already has reason to monitor and penalize hedging, it can perform this corporate governance function without significant new administrative costs. Yet the tax barrier is overbroad and potentially unstable. Indeed, it could unravel due to relatively minor changes in the tax law that seem far removed from corporate governance. Moreover, the tax barrier does not govern foreign executives who are not subject to U.S. tax. Accordingly, this Article recommends strengthening contractual and securities law constraints on hedging. It concludes with reflections about the capacity of tax to influence corporate governance, not only for the worse, as has widely been observed, but also sometimes for the better.

JEL Classification: G34

Accepted Paper Series