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Collaring - Escrow's get out of jail card.

By Marc Phillips

American investors are starting to worry about the practice of `collaring'. It's a clever financial trick used by senior executives in the US to unlock the wealth tied up in stock options that are under escrow. The fear is that by using collars, CEOs can unravel the reward-for-performance relationship that is implicit when senior managers are paid in equity.

Collaring is a form of hedging using derivatives. The most popular version is known as `zero-cost' collaring, because it doesn't involve spending any money. Suppose you are the CEO of a dotcom company that pays you in stock options at $20 and the shares are currently trading at $50. If you sell a call option at, say, $40, you'll raise enough money to buy an equal number of put options at, say, $70.

This allows the executive to manage the risk involved with the options. Both the downside and the upside are restricted to a limited band. This can be worth huge sums. For example, late last year, Microsoft founder Paul Allen hedged his shares in the company in a series of transactions that saved him almost a billion dollars.

Few hedges equal Allen's in magnitude and the man is no longer a Microsoft executive, but, while the practice still isn't exactly widespread among dotcom CEOs, it is gaining momentum.

Because collaring transactions don't involve the underlying assets, they don't need to be included in official company filings. Under US rules, they are officially recorded elsewhere, but most company investors are unlikely to learn of the transaction. And this is what has them worried.

The whole point of paying senior managers in stock options is that their personal wealth becomes tied to that of the company they are running. Apart from anything else, investors like to know when managers are bailing out of their stock.

For more information contact APT Strategies at info@aptstrategies.com.au