April
1, 2002
Bettin' It All on Jack?
By David A. Gaffen
Registered Rep.
The case of the former Salomon Smith
Barney brokers who are suing their erstwhile
firm is a perfect example of why financial
advisors need to educate clients about complicated
options hedging strategies.
Last month, Registered Rep. broke the story about the
fired brokers, Phil Spartis and Amy Elias, who filed
claims against Smith Barney, as well as high-profile
telecom analyst Jack Grubman. The two were among those
responsible for supervising stock option plans for
WorldCom employees, a number of whom, after losing
a bundle, filed arbitration claims seeking millions
in damages from the brokers and the firm.
The suit is the first known instance where brokers
have sued a former analyst. Even the New York Stock
Exchange has gotten involved. The NYSE is investigating
the complaints against the firm and the brokers, which,
according to attorneys familiar with the matter, is
focused on the advice the clients were given. According
to documents obtained by Registered Rep., the recommended
strategy was to have the clients exercise and hold
the stock, rather than exercise and sell, or employ
a few basic hedging strategies that would have capped
their clients' downside.
"There were elementary strategies that could have
been employed," says Lawrence Klayman of Klayman & Toskes,
one of the lawyers suing Smith Barney for negligence: "They're
trying to point the finger at the analyst, where I
don't think the analyst knows preferred stock from
livestock," he says. "If Grubman loved
the stock," hedging strategies could still have
been employed, he says.
During the raging bull market, options holders were
so convinced of the market's invincibility they took
foolish risks. They exercised big option grants and
went long company stock to reap an assumed future tax
savings. When WorldCom's share price dropped -- from
highs of around $60 to its recent lows in the $7 range
-- some were left with big margin debt and the bill
from the IRS. Smith Barney's exercise analysis package,
provided to WorldCom clients, did not always address
hedging options, although Spartis says hedging was
discussed.
Selling, paying the taxes, and then reinvesting is
the most prudent strategy, but wasn't done in these
cases. If a client is intent on holding the stock,
as many top execs are, then there are other ways to
protect one's money. But there are hurdles: Not every
company allows employees to hedge. "Companies
often oppose hedging strategies," says Bruce Brumberg,
CEO of Mystockoptions.com, a Web site that provides
education content and tools on employee stock options. "It's
counter to the reasons they may have granted the stock,
and they get concerned it could result in inadvertent
insider trading violations."
For those top executives who can hedge, there are a
couple of newer strategies that can offset risk. First
Federated Financial of Brownsburg, Ind., is offering
something called an "equity collateralized loan
agreement," essentially a loan against your stock
holdings. It helps clients avoid selling large blocks
of stock or taking out a margin loan.
Meanwhile, Credit Suisse First Boston has a new product
called a premium forward execution. A client will sell
shares forward every day the stock trades above a predetermined
level. This strategy monetizes one's stock position
at a premium to the current market price, but the upside
is capped if the stock rallies sharply. Other hedging
strategies include variable prepaid forward hedges,
which involve hedging one's upside but allow a client
to reinvest money that would have otherwise been in
a long position.
Often these strategies, because of hefty investment
limits, won't work for rank-and-file employees. For
the bourgeoisie, there are simpler protection methods.
Zero-cost collars, through the purchase of put options
and sale of call options, offset the risk of taking
a long position and help protect clients from massive
calamity. Simply buying puts can help hedge risk, and
stop orders or sell limits will limit one's downside,
although these carry risk in a volatile market.
At the very least, brokers should know to tell their
clients that it's a good idea to diversify all of their
capital, to prevent them from tying their own wealth
to the company that pays their salary too directly.
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