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Fiduciary’s Duty to Explain and Encourage Risk Reduction                              To Employees Holding                ...
A fiduciary is held to a standard of conduct and trust above that of a stranger or of acasual business person. He/she/it m...
Let us assume that the stock is trading $75 with the ESOs having a “fairvalue” of about $350,000 (i.e. $250,000 of intrins...
So the loss when the stock is $75 equals the $100,000 of “time value”and the loss when the stock is $115 equals the $50,00...
“fair value” is $350,000 when the stock was $75 and the “fair value”was $700,000 when the stock was $115.So it is easy to ...
The strategy of early exercise sell and diversify has very large penaltiesfrom forfeiture of the remaining “time value” an...
However, if the client is prohibited from selling calls and/or buying putsby the options contract, which is rare, or the c...
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Employee stock options and Fiduciary Duties

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Illustrates that Wealth Managers have a duty to understand the risks of holding employee stock options and give advise on how to efficiently reduce that risk. If they promote a strategy which benefits themselves and the company/employer to the disadvantage of their clients, they are violating their duty and are subject to a cause of action.

If wealth managers promote early exercises, sell and "diversify", they are violating their duty in most cases unless their client has emergency needs for the early cash.

olagues@gmail.com
www.truthinoptions.net
504-875-4825

http://www.wiley.com/WileyCDA/WileyTitle/productCd-0470471921.html

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Transcript of "Employee stock options and Fiduciary Duties"

  1. 1. Fiduciary’s Duty to Explain and Encourage Risk Reduction To Employees Holding Employee Stock Options (or SARs)This article is an examination of a fiduciary’s duty to understand therisks that are inherent in a client holding Employee Stock Options (orSARs). Must the fiduciary alert his/her clients to those risks and proposean efficient way to manage those risks? This paper also examines howto efficiently lower the risks of such holdings.Definition of FiduciaryFirst we define what a fiduciary is:A fiduciary obligation exists whenever the relationship with the client involves aspecial trust, confidence, and reliance on the fiduciary to exercise his discretion orexpertise in acting for the client. The fiduciary must knowingly accept that trust andconfidence to exercise his expertise and discretion to act on the clients behalf.When one person does agree to act for another in a fiduciary relationship, the lawforbids the fiduciary from acting in any manner adverse or contrary to the interestsof the client, or from acting for his own benefit in relation to the subject matter.The client is entitled to the best efforts of the fiduciary on his behalf and thefiduciary must exercise all of the skill, care and diligence at his disposal when actingon behalf of the client. A person acting in a fiduciary capacity is held to a highstandard of honesty and full disclosure in regard to the client and must not obtain apersonal benefit at the expense of the client.From US Legal.comhttp://definitions.uslegal.com/b/breach-of-fiduciary-duty 1
  2. 2. A fiduciary is held to a standard of conduct and trust above that of a stranger or of acasual business person. He/she/it must avoid "self-dealing" or "conflicts of interests" inwhich the potential benefit to the fiduciary is in conflict with what is best for the personwho trusts him/her/it. For example, a stockbroker must consider the best investment forthe client and not buy or sell on the basis of what brings him/her the highestcommission.From LAW.comhttp://dictionary.law.com/Default.aspx?selected=744So it is clear that Wealth Managers must put the interests of theirclients holding Employee Stock Options above their own and above theinterests of the employer shareholders when advising the managementof their employee stock options holdings. If they make decisions basedon their objective to get assets under management or because theemployer wants lower compensation costs that result from inefficientmanagement of employee ESOs, they violate their duty.To explain how a fiduciary should understand the inherent risks of aclient holding ESOs, we consider an example:AssumptionsAssume that an employee is granted ESOs to purchase 10,000 shares ofABC stock for $50.00 per share. There are no dividends expected andthe volatility is between .30 and .40. The ESOs are vested and there are4.5 expected years to expiration with the risk free interest rate at 2%.We will compare the risks associated with holding the positions toexpiration after the stock has advanced to higher prices. 2
  3. 3. Let us assume that the stock is trading $75 with the ESOs having a “fairvalue” of about $350,000 (i.e. $250,000 of intrinsic value and $100,000of “time value”) and then we will assume that the stock is trading at$115 with the same expected time to expiration of the ESOs, whose“fair value” is about $700,000 (i.e. $650,000 of intrinsic value and$50,000 of “time value”).Assume the stock drops 20%We will assume that a drop of 20% from $75 has the same probabilityas a drop of 20% from $115. This is what most theoretical pricingmodels assume.In the case of a 20% drop of the stock from$75 to $60 at expiration, theemployee will lose about 70% of the “fair value” that the options hadwhen the stock was $75.In the case of the stock dropping 20% from $115 to $92 at expiration,the loss is about 40% of the options value when the stock was $115.Assume the stock is unchanged at expirationIf the stock remained the same or near the same at expiration, the lossis greater when the stock is trading at $75 than when the stock istrading at $115 because the “time value” eroded completely and the“time value” was larger for the options when the stock was at $75. 3
  4. 4. So the loss when the stock is $75 equals the $100,000 of “time value”and the loss when the stock is $115 equals the $50,000 of “time value”.Assume that the stock dropped 35%In the first case the stock goes from $75 to $48.75 making the loss onthe ESOs 100% at expiration. Or if we took the higher price of the stockat $115, the stock would go from $115 to $74.75 making the loss on theoptions about 65% of its “fair value” when trading at $115. In everycase, the possible percentage loss is greater for the stock trading at $75if held to expiration.Stock increasing substantially.Of course if the stock increased substantially, the percentage gain ofoptions with the stock moving up from $75 will be greater than if thestock moved the same percentage upward starting at $115.If we examined the losses in absolute terms, the results are somewhatdifferent. Assume the stock goes below $50 at expirationIf the stock went to or below $50 on expiration in each case, the resultsin each case is a 100% loss. But the probability of the stock moving from$115 to below $50 (i.e. about 1 chance in 15with a .35 volatility) ismuch less than the probability of the stock going from $75 to below$50(i.e. about 1 chance in 4). However, the absolute loss on theESOswith the stock starting from $115 and going to or below $50 isgreater than the absolute loss with the stock starting at $75 becausethe 4
  5. 5. “fair value” is $350,000 when the stock was $75 and the “fair value”was $700,000 when the stock was $115.So it is easy to see that the risk of substantial loss in percentagetermsismuch greater when the stock is trading $75 than at $115.Although in absolute terms, if there are low probabilitylarge drops(i.e.less than 1 chance in 4 of drops greater than 30%), the absolute valueof “fair value” lost will be greater starting from $115. Even in absoluteterms most of the times any loss is nearly equal to or greater for thestock starting with a price of $75. If we wished to do a more extensivecomparison of absolute losses, we would have started with each of theoptions’ “fair value” equal, which would have required using 20,000ESOs with the stock at $75 and 10,000 ESOs with the stock at $115 inthe comparison.Therefore, can anyone reasonably hold the view that fiduciaries have alesser duty to reduce risk when the stock is $75 than the duty thefiduciary has when the stock is $115? The answer is no.Since the fiduciary’s duty to reduce risk is greater in percentage andabsolute terms when the stock is $75 than when the stock is $115, isthere anyefficient risk reducing strategy available? Under theassumptions made about the volatility and expected time to expiration,the only efficient strategy is to sell calls and/or buy puts, because thatstrategy reduces the delta and the theta risk. 5
  6. 6. The strategy of early exercise sell and diversify has very large penaltiesfrom forfeiture of the remaining “time value” and paying a penalty forearly tax payments which preclude it from having any use when thestock is trading at $75.And the early exercise sell and diversify strategydoes not reduce general market risk.Even if the stock is trading at $115, the high penalties again make theearly exercise strategy highly inefficient when compared to selling callsand buying puts.On another point, the chance of the stock trading for near $75 after thevesting period of three years,when the stock was trading at $50 ongrant day is four times as great as the stock trading for near $115 aftervesting.So the probability of the early exercise, sell stock and diversifythe net residual amounts strategy having any use is very low.It cannot be denied that the risk of loss, when the stock is 50% abovethe exercise price, is greater than when the stock is 130% above theexercise price. The wealth advisers who do not at least advise partiallyreduction of risk at 50% above the exercise price by selling calls and/orbuying puts are violating their duty to their clients. Their clientstherefore, have a cause of action under SEC Rules if the adviser failed toadvise selling calls or buying puts.So what does all this mean? It means that if a client, holding ESOs orSARs, is not advised by the wealth manager to efficiently reduce riskwhen the stock has gone up 50% from the exercise price and the stocksubsequently goes down over time, the client can sue the wealthmanager for negligence. 6
  7. 7. However, if the client is prohibited from selling calls and/or buying putsby the options contract, which is rare, or the client has no assets toinitiate the selling of calls or buying of puts, the adviser certainly cannotbe liable. But most promoters of the early exercise strategy willexaggerate any alleged restraints of selling calls and/or buying puts.John Olaguesolagues@gmail.comwww.optionsforemployees.com/articles504-428-9912 7

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