April 1, 2002
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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