Senators Urge SEC to Prohibit Executive Hedging as Part of Dodd-Frank Incentive Compensation Regulations

Three U.S. senators urged the SEC prohibit highly-paid corporate executives from hedging in any way on their own incentive-based compensation arrangements as part of the regulations to implement the Dodd-Frank Act. Senators Robert Menendez (D-NJ), Frank Lautenberg (D-NJ) and Jeff Merkley (D-OR) said the use of hedging by corporate executives of their own compensation arrangements takes the incentive out of incentive-based compensation and undermines the accountability of the executives who engage in these tactics. It also significantly undermines the legislative intent of the Act in dealing with incentive-based compensation. Executives should benefit when their company does well, according to the senators. If they are allowed to hedge, it takes the company out of the equation and permits them to profit regardless of the company’s performance and encourages excessive risk-taking.

Section 956(b) of the Dodd-Frank Act requires the SEC and other federal regulators to adopt regulations to prohibit any type of incentive-based payment arrangement which they determine may encourage inappropriate risks by covered financial institutions. Covered institutions include SEC-registered broker-dealers and investment advisers.

During the debate of the Dodd-Frank Act, the senators offered an amendment to prohibit executives and other highly-compensated employees—those making more than $1 million—from engaging in trades that would bet against their own company's stock. While the amendment was never voted on, the senators said it was supported by the Americans for Financial Reform, the Council of Institutional Investors and former SEC Chief Accountant Lynn Turner.

When offering the amendment, Menendez said that executives and highly-compensated employees should never have financial incentives to act against the best interests of their companies. He cited a study which found that in 2,000 cases at over 900 firms, executives tried to profit by betting against their own company. Menendez said that if the executives can hedge their stock it does not matter how well the company does because either way the executive makes money. Not only is this fundamentally wrong, in his view, but it may in some cases give executives an incentive to use their status to take a position that may not be in the company’s best interest and make a profit by selling the company stock short.

In their letter to the SEC, the senators noted that the SEC and the other regulators on the joint proposal recognized in the proposing release that the use of personal hedging strategies, such as financial derivatives, on incentive-based compensation arrangements for highly-paid executives would make many of the provisions prescribed by the agencies less effective. The senators said there is ample evidence suggesting that this type of hedging is a widespread problem that has serious implications for investors and for the health of their companies.

The senators cited other federal officials who have taken exception to the hedging tactic. For example, the Treasury’s special master for TARP executive compensation, who was responsible for overseeing the distribution of compensation to top executives at companies that received federal bailout assistance, banned executives under his jurisdiction from this practice because he wanted to make sure that they could not undercut the links that Treasury created between compensation and long-term performance.