Executive Financial Planning

Diversification Strategies for Public Company Executives

Public company executives who receive equity may face concentration risk. Discover seven ways they may be able to diversify.

Public company executives who receive equity compensation often face a dilemma. While the link between company performance and share price may drive their personal wealth, many executives often find their investment portfolios overly concentrated in a single stock.  

 

To complicate matters, as the SEC prohibits transacting under material non-public information provisions, many companies limit executive stock sales and restrict the use of hedging (e.g., derivatives), preventing corporate executives from relying on traditional diversification strategies to reduce their concentration risk.  

 

So, how can you help your executives who might be interested in diversifying? Fortunately, a range of alternative strategies exist that may enable them to better balance their portfolios. Here, we take a look at some of those approaches. We recommend that executives seek legal and tax advice before implementing any of the strategies described below.  

  1. 1
    Direct Indexing

    Executives who have assets outside of company equity could use a direct indexing strategy to counterbalance their exposure to their company’s stock. In a nutshell, direct indexing involves setting up a separately managed taxable account that allows for the direct ownership of the individual holdings that make up an existing stock index. Using this strategy, executives could build a portfolio that avoids exposure to their company stock—or even to its sector. Executives may even choose to avoid equities altogether. The key is to consider a range of factors when using this approach, such as the relative weights of corporate equity and other assets, expected volatility of corporate equity positions and individual risk tolerance and target asset allocation.

  2. 2
    10b5-1 Plans

    Under SEC Rule 10b5-1, company insiders can establish preset trading plans that allow them to sell company stock under predetermined conditions that could help provide an affirmative defense to insider trading. Keep in mind, however, that recent regulatory changes now require a minimum 90-day period for directors and officers between plan adoption and plan execution, among other new limitations. 

  3. 3
    Exchange Funds

    Structured as limited partnerships, exchange funds allow investors with concentrated positions to swap them for a diversified stock portfolio, typically after a seven-year holding period. This strategy may be beneficial to executives with highly appreciated shares because they would not recognize their tax gains. That said, some executive stock agreements disallow the use of exchange funds or limit the number of shares executives may contribute. Additionally, the seven-year lockup period may deter executives seeking liquidity.

  4. 4
    Estate Planning

    A popular estate planning vehicle, called a grantor retained annuity trust (GRAT), may allow corporate executives to reduce their concentration risk by transferring company shares to a trust and then receiving those assets, plus interest, via annuity payments over time. A particular benefit of a GRAT is that any trust assets that remain once annuity payments end, flow directly to the trust’s beneficiaries free of estate and gift taxes. Before implementing any estate planning strategy, however, executives should seek legal and tax advice—especially as gifts may be subject to scrutiny by the SEC under insider trading laws.

  5. 5
    Charitable Gifting

    Executives who gift publicly traded and restricted shares to a Donor Advised Fund (DAF) or other charity may be eligible to receive charitable tax deductions (subject to limitations). However, SEC rules suggest insiders should avoid making such gifts if they possess material non-public information. To avoid missteps, it’s important to seek legal and tax advice before implementing this type of strategy.

  1. 6
    Leveraging Public Market Liquidity

    Corporate executives who hold thinly traded stock may be able to gain liquidity by arranging a transaction away from the public markets. With a block trade, for instance, the buyer (typically a brokerage house) will break up a larger trade into many smaller orders and may use private exchanges to sell those shares outside of public view. Alternatively, the broker could find an institutional buyer willing to privately buy all the shares at a discount. Both these types of transactions, however, may be prohibited under company stock agreements or prevailing securities laws, be sure to seek legal and tax advice.

  2. 7
    Pledging Corporate Stock

    A somewhat riskier strategy for obtaining liquidity involves using company shares as collateral for a loan, and then applying the proceeds of that loan to cover liquidity needs or invest in a diversified portfolio. As a downside, if the pledged stock’s share price drops considerably, executives could face a margin call—requiring them to sell shares, pledge additional shares or cover the margin balance with cash. Some companies do not allow insiders to pledge shares, so executives interested in this strategy should confirm it is allowed before exploring further. 

Arming Executives With Education 

The financial needs of corporate executives can be nuanced—and may be best addressed with tailored insights and support. If you’d like to learn more about the resources available through Morgan Stanley at Work, explore our Executive Services offering.   

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Diversification does not guarantee a profit or protect against loss in a declining financial market.

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Individuals executing a 10b5-1 trading plan should keep the following important considerations in mind: (1) 10b5-1 trading plans should be reviewed and approved by the legal and compliance department of the individual’s company. (2) Recent rule changes will require a mandatory cooling-off period between the execution of a 10b5-1 trading plan (or a material modification) and the first sale pursuant to the plan (or the first sale following such material modification). (3) 10b5-1 trading plans do not alter the nature of restricted and/or control stock or regulatory requirements that may otherwise be applicable (e.g., Rule 144, Section 16, Section 13). (4) 10b5-1 trading plans that are modified or terminated early may require new cooling-off periods and may weaken or cause the individual to lose the benefit of the affirmative defense. (5) 10b5-1 trading plans may require a cessation of trading activities at times when the company engages in securities offerings or when lockups may be required at the company (e.g., secondary offerings). (6) Recent rule changes will require companies to publicly disclose material terms of Section 16 director and officer 10b5-1 trading plans, and the adoption, material modification or early termination of such plans.

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