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 the risks that are inherent in a client holding Employee Stock Options (or SARs). Must the fiduciary alert his/her clients to those risks and propose an efficient way to manage those risks? This paper also examines how to efficiently lower the risks of such holdings.

Definition of Fiduciary

First we define what a fiduciary is:

A fiduciary obligation exists whenever the relationship with the client involves a special trust, confidence, and reliance on the fiduciary to exercise his discretion or expertise in acting for the client. The fiduciary must knowingly accept that trust and confidence to exercise his expertise and discretion to act on the client's behalf.

When one person does agree to act for another in a fiduciary relationship, the law forbids the fiduciary from acting in any manner adverse or contrary to the interests of 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 the fiduciary must exercise all of the skill, care and diligence at his disposal when acting on behalf of the client. A person acting in a fiduciary capacity is held to a high standard of honesty and full disclosure in regard to the client and must not obtain a personal benefit at the expense of the client.

From US Legal.com http://definitions.uslegal.com/b/breach-of-fiduciary-duty

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 A fiduciary is held to a standard of conduct and trust above that of a stranger or of a casual business person. He/she/it must avoid "self-dealing" or "conflicts of interests" in which the potential 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 or sell on the basis of what brings him/her the highest commission.

From LAW.com http://dictionary.law.com/Default.aspx?selected=744

So it is clear that Wealth Managers must put the interests of their clients holding Employee Stock Options above their own and above the interests of the employer shareholders when advising the management of their employee stock options holdings. If they make decisions based on their objective to get assets under management or because the employer wants lower compensation costs that result from inefficient management of employee ESOs, they violate their duty.

To explain how a fiduciary should understand the inherent risks of a client holding ESOs, we consider an example:

Assumptions

Assume that an employee is granted ESOs to purchase 10,000 shares of ABC stock for $50.00 per share. There are no dividends expected and the volatility is between .30 and .40. The ESOs are vested and there are 4.5 expected years to expiration with the risk free interest rate at 2%.

We will compare the risks associated with holding the positions to expiration after the stock has advanced to higher prices.

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Let us assume that the stock is trading $75 with the ESOs having a “fair value” of about $350,000 (i.e. $250,000 of intrinsic value and $100,000 of “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 probability as a drop of 20% from $115. This is what most theoretical pricing models assume.

In the case of a 20% drop of the stock from $75 to $60 at expiration, 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 at expiration, the loss is about 40% of the options value when the stock was $115.

Assume the stock is unchanged at expiration

If the stock remained the same or near the same at expiration, the loss is greater when the stock is trading at $75 than when the stock is trading at $115 because the “time value” eroded completely and the “time value” was larger for the options when the stock was at $75.

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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 on the ESOs 100% at expiration. Or if we took the higher price of the stock at $115, the stock would go from $115 to $74.75 making the loss on the options about 65% of its “fair value” when trading at $115. In every case, the possible percentage loss is greater for the stock trading at $75 if held to expiration.

Stock increasing substantially.

Of course if the stock increased substantially, the percentage gain of options with the stock moving up from $75 will be greater than if the stock moved the same percentage upward starting at $115.

If we examined the losses in absolute terms, the results are somewhat different. Assume the stock goes below $50 at expiration

If the stock went to or below $50 on expiration in each case, the results in each case is a 100% loss. But the probability of the stock moving from $115 to below $50 (i.e. about 1 chance in 15 with a .35 volatility) is much 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 the ESOs with the stock starting from $115 and going to or below $50 is greater than the absolute loss with the stock starting at $75 because the

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“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 percentage terms is much greater when the stock is trading $75 than at $115. Although in absolute terms, if there are low probability large drops (i.e. less than 1 chance in 4 of drops greater than 30%), the absolute value of “fair value” lost will be greater starting from $115. Even in absolute terms most of the times any loss is nearly equal to or greater for the stock starting with a price of $75. If we wished to do a more extensive comparison of absolute losses, we would have started with each of the options’ “fair value” equal, which would have required using 20,000 ESOs with the stock at $75 and 10,000 ESOs with the stock at $115 in the comparison.

Therefore, can anyone reasonably hold the view that fiduciaries have a lesser duty to reduce risk when the stock is $75 than the duty the fiduciary has when the stock is $115? The answer is no.

Since the fiduciary’s duty to reduce risk is greater in percentage and absolute terms when the stock is $75 than when the stock is $115, is there any efficient risk reducing strategy available? Under the assumptions made about the volatility and expected time to expiration, the only efficient strategy is to sell calls and/or buy puts, because that strategy reduces the delta and the theta risk.

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The strategy of early exercise sell and diversify has very large penalties from forfeiture of the remaining “time value” and paying a penalty for early tax payments which preclude it from having any use when the stock is trading at $75. And the early exercise sell and diversify strategy does not reduce general market risk.

Even if the stock is trading at $115, the high penalties again make the early exercise strategy highly inefficient when compared to selling calls and buying puts.

On another point, the chance of the stock trading for near $75 after the vesting period of three years, when the stock was trading at $50 on grant day is four times as great as the stock trading for near $115 after vesting. So the probability of the early exercise, sell stock and diversify the net residual amounts strategy having any use 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 least advise partially reduction of risk at 50% above the exercise price by selling calls and/or buying puts are violating their duty to their clients. Their clients therefore, have a cause of action under SEC Rules if the adviser failed to advise selling calls or buying puts.

So what does all this mean? It means that if a client, holding ESOs or SARs, is not advised by the wealth manager to efficiently reduce risk when the stock has gone up 50% from the exercise price and the stock subsequently goes down over time, the client can sue the wealth manager for negligence.

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However, if the client is prohibited from selling calls and/or buying puts by the options contract, which is rare, or the client has no assets to initiate the selling of calls or buying of puts, the adviser certainly cannot be liable. But most promoters of the early exercise strategy will exaggerate any alleged restraints of selling calls and/or buying puts.

John Olagues

olagues@gmail.com

www.optionsforemployees.com/articles

504-428-9912

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