CEOs Living on the Hedge

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Story by Margie Peterson
Image by iStock/Santima.Studio

Researchers study the effectiveness of anti-hedging policies on managers’ decision-making.

Are managers of companies with anti-hedge policies for executives more likely to align their decisions with the interests of their firm’s shareholders?

That was the question Raluca Chiorean, assistant professor of accounting, and her Lehigh College of Business coworkers, Paul Brockman‚ Perella Department of Finance professor and senior associate dean for faculty and research and Jae B. Kim‚ associate professor of accounting sought to answer in a study of the effects of anti-hedge policies on the choices managers make. If the managers can hedge—reduce the risk of financial loss in their compensation—will they make more risky investments for the firm?

“The main concern with executives hedging their risk is they no longer have a large exposure to the company’s stock‚” says Chiorean. “The whole reason that they have equity-based compensation is because the board and investors want them to have a large exposure so when the firm is doing well‚ they’re doing well and they personally profit.

“If managers are allowed to hedge‚ then they can undo some of those incentives‚” she says.

The Dodd-Frank Act of 2010 mandated disclosure of whether companies have anti-hedge policies for executives. But it wasn’t until 2018 that the SEC implemented the final rule: requiring‚ as of 2020‚ that firms disclose whether they have anti-hedge policies for executives. Prior to that‚ disclosure of anti-hedge policies was voluntary.

The team examined firm disclosures regarding anti-hedge policies in proxy statements between 2010 and 2017.

“Even though the SEC didn’t require disclosure in 2010‚ firms knew the requirement would be coming. They started changing their policies to disclose. We saw a sharp increase in the number of firms making this disclosure‚” Chiorean says.

The study found that firms with stronger governance—based on such attributes as board size and independence‚ analyst coverage and auditor quality—were more likely to adopt anti-hedge policies. The team also saw evidence that companies that adopted anti-hedge polices revised their managers’ compensation contracts.

“When the board adjusted the managers’ abilities to hedge‚ they also adjusted the compensation contract‚” she said. “The two were related.”

Overall‚ firms ended up investing less after they adopted an anti-hedge policy and used that would-be investment cash to improve the health of the company.

“What we observed was that instead of seeing an excess of cash in these firms that disclosed‚ there was a change in their cash holding‚” Chiorean says. “They used the cash to reduce risky debt‚ paying off debt and repurchasing equity.”

Companies that were prone to under-investing actually increased investments after the adoption of an anti-hedge policy. 

“Firms that should have taken on more investments‚ more risk‚ were doing so‚” Chiorean says. “But those that over-invested tended to take on fewer investments once the anti-hedge policy was adopted.”

Why it Matters

Anti-hedge policies lead to more efficient investments and use of excess cash. The policies prove to be an effective means of maintaining the originally-intended incentive alignment between managers and shareholders.