Fiduciary duty and Employee Stock Options

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Wealth Managers are fiduciaries to clients who have concentrated positions in employee stock options.It's impossible to efficiently manage those positions for risk averse employee/executives without using sales of exchange traded calls or buys of puts
http://www.wiley.com/WileyCDA/WileyTitle/productCd-0470471921.html

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Fiduciary duty and Employee Stock Options

  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 understandthe risks that are inherent in a client holding Employee StockOptions (or SARs). Must the fiduciary alert his/her clients to thoserisks and propose an efficient way to manage those risks? Thispaper also examines how to efficiently lower the risks of suchholdings.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, thelaw forbids the fiduciary from acting in any manner adverse or contrary to theinterests of the client, or from acting for his own benefit in relation to the subjectmatter. The client is entitled to the best efforts of the fiduciary on his behalf andthe fiduciary must exercise all of the skill, care and diligence at his disposal whenacting on behalf of the client. A person acting in a fiduciary capacity is held to ahigh standard of honesty and full disclosure in regard to the client and must notobtain a personal benefit at the expense of the client.From US Legal.com http://definitions.uslegal.com/b/breach-of-fiduciary-duty 1 A fiduciary is held to a standard of conduct and trust above that of a stranger or of a casualbusiness person. He/she/it must avoid "self-dealing" or "conflicts of interests" in which thepotential benefit to the fiduciary is in conflict with what is best for the person who trusts him/her/it. For example, a stockbroker must consider the best investment for the client and not buy orsell on the basis of what brings him/her the highest commission.From LAW.com http://dictionary.law.com/Default.aspx?selected=744
  2. 2. So 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 ofa client holding ESOs, we consider an example:AssumptionsAssume that an employee is granted ESOs to purchase 10,000shares of ABC stock for $50.00 per share. There are no dividendsexpected and the volatility is between .30 and .40. The ESOs arevested and there are 4.5 expected years to expiration with the riskfree interest rate at 2%.We will compare the risks associated with holding the positions toexpiration after the stock has advanced to higher prices. 2Let us assume that the stock is trading $75 with the ESOs havinga “fair value” of about $350,000 (i.e. $250,000 of intrinsic valueand $100,000 of “time value”) and then we will assume that thestock is trading at $115 with the same expected time to expirationof the ESOs, whose “fair value” is about $700,000 (i.e. $650,000of 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 sameprobability as a drop of 20% from $115. This is what mosttheoretical pricing models assume.
  3. 3. In the case of a 20% drop of the stock from $75 to $60 atexpiration, the employee will lose about 70% of the “fair value”that the options had when the stock was $75.In the case of the stock dropping 20% from $115 to $92 atexpiration, the loss is about 40% of the options value when thestock was $115.Assume the stock is unchanged at expirationIf the stock remained the same or near the same at expiration,the loss is greater when the stock is trading at $75 than whenthe stock is trading at $115 because the “time value” erodedcompletely and the “time value” was larger for the options whenthe stock was at $75. 3 So the loss when the stock is $75 equals the $100,000 of “timevalue” and the loss when the stock is $115 equals the $50,000of “time value”.Assume that the stock dropped 35%In the first case the stock goes from $75 to $48.75 making theloss on the ESOs 100% at expiration. Or if we took the higherprice of the stock at $115, the stock would go from $115 to $74.75making the loss on the options about 65% of its “fair value” whentrading at $115. In every case, the possible percentage loss isgreater for the stock trading at $75 if held to expiration.Stock increasing substantially.Of course if the stock increased substantially, the percentage gainof options with the stock moving up from $75 will be greater thanif the stock moved the same percentage upward starting at $115.If we examined the losses in absolute terms, the results are
  4. 4. somewhat different. Assume the stock goes below $50 atexpirationIf the stock went to or below $50 on expiration in each case, theresults in each case is a 100% loss. But the probability of thestock moving from $115 to below $50 (i.e. about 1 chance in 15with a .35 volatility) is much less than the probability of the stockgoing from $75 to below $50 (i.e. about 1 chance in 4). However,the absolute loss on the ESOs with the stock starting from $115and going to or below $50 is greater than the absolute loss withthe stock starting at $75 because the 4“fair value” is $350,000 when the stock was $75 and the “fairvalue” was $700,000 when the stock was $115.So it is easy to see that the risk of substantial loss, in percentageterms, is much 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 than30%), the absolute value of “fair value” lost will be greater startingfrom $115. Even in absolute terms most of the times any loss isnearly equal to or greater for the stock starting with a price of $75.Absolute Risk ComparisonIf we wished to do a more extensive comparison of absolutelosses, we would have started with each of the options’ “fairvalue” equal, which would have required using 20,000 ESOs withthe stock at $75 and 10,000 ESOs with the stock at $115 in thecomparison.Therefore, can anyone reasonably hold the view that fiduciarieshave a lesser duty to reduce risk when the stock is $75 than theduty the fiduciary has when the stock is $115? The answer is no.Since the fiduciary’s duty to reduce risk is greater in percentage
  5. 5. and absolute terms when the stock is $75 than when the stock is$115, is there any efficient risk reducing strategy available? Underthe assumptions made about the volatility and expected time toexpiration, the only efficient strategy is to sell calls and/or buyputs, because that strategy reduces the delta and the theta risk. 5The strategy of early exercise sell and diversify has very largepenalties from forfeiture of the remaining “time value” and payinga penalty for early tax payments which preclude it from havingany use when the stock is trading at $75. And the early exercisesell and diversify strategy does not reduce general market risk.Even if the stock is trading at $115, the high penalties again makethe early exercise strategy highly inefficient when compared toselling calls and buying puts.On another point, the chance of the stock trading for near $75after the vesting period of three years, when the stock was tradingat $50 on grant day is four times as great as the stock trading fornear $115 after vesting. So the probability of the early exercise,sell stock and diversify the net residual amounts strategy havingany usefulness is very low.It cannot be denied that the risk of loss, when the stock is 50%above the exercise price, is greater than when the stock is 130%above the exercise price. The wealth advisers who do not at leastadvise partially reduction of risk at 50% above the exercise priceby selling calls and/or buying puts are violating their duty to theirclients.Their clients therefore, have a cause of action under SEC Rules ifthe adviser failed to advise selling calls or buying puts. 6
  6. 6. So what does all this mean? It means that if a client, holdingESOs or SARs, is not advised by the wealth manager to efficientlyreduce risk when the stock has gone up 50% from the exerciseprice and the stock subsequently goes down over time or evenjust erodes away the time premium, the client can sue the wealthmanager for negligence.However, if the client is prohibited from selling calls and/orbuying puts by the options contract, which is rare, or the clienthas no assets to initiate the selling of calls or buying of puts, theadviser certainly cannot be liable. But most promoters of the earlyexercise strategy will exaggerate any alleged restraints of sellingcalls and/or buying puts.John Olaguesolagues@gmail.comwww.optionsforemployees.com/articles504-428-9912 7

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