Executives and hedging: The fragile legal foundation of incentive compatibility

Options are granted to executives to inspire better performance by tying pay to the employer's stock price. Yet this incentive rationale no longer holds if executives can use the derivatives market to simulate a sale of their options, a practice known as hedging. This Article evaluates the effectiveness of existing legal constraints on hedging by executives, including limits derived from contract, securities and tax law. Although investment bankers have been searching for ways around these constraints, the bottom line is that, at least for now, executives are unable to hedge option grants: While contractual limits are rare, the securities law blocks the most straightforward options hedges by the most senior executives and the tax law blocks the rest (including "basket" hedges by the most senior executives and all hedges by less senior ones). In contrast, executives are relatively free to hedge stock. Whereas this distinction between stock and options can be justified, these legal constraints should be reformed because the relevant tax rules were not meant to pursue corporate governance goals. As a result, tax constraints on options hedging are unstable, as well as over- and under-inclusive. They should be replaced with more effective contractual and securities law hedging limits.