CFO: Magazine for Senior Financial Executives: Gambling with buybacks - Stock Option Hedging

GIVEN THE TROUBLE EDS Corp. has incurred from its equity-based hedging program, it's little wonder such techniques are under fire. In late September, the Plano, Tex.-based company announced that it had to issue $225 million in commercial paper to buy back 3.7 million of its own shares, thanks to put options it had sold on them through June. The price was $60.61 a share, when EDS stock was selling on the open market for $17. The announcement, coming on the heels of a surprise profit warning, sent the stock down 66 percent in the week following.

"The mistake that EDS made was waiting in the hope that the stock price would go back up to the $60 level," says Bane of America Securities LLC analyst Prakash Parthasarathy. It should have closed out the contracts earlier, he says, although "even if all the stars are aligned right, it shouldn't be done when there is so much unpredictability in the market."

But EDS wasn't alone. When stock prices were soaring, many companies, including Dell, Microsoft, and McDonald's, sold put options against their own stocks to help pay for the cost of stock option cash-outs. "The whole point was to offset the dilutive effect that stock options have on shares," says Dell spokesperson Mike Maher. Dell stopped issuing the puts in 2000, when it saw the economy softening, but said it was liable for up to $1 billion to settle options that will expire this year.

Still, some say this type of equity-based hedging is a valid strategy. "When you know you're going to need some shares, I think you [can] argue that some policies around puts and calls are a good idea," says analyst Mark Specker of SoundView Technology Group. Explains Joe Elmlinger, a managing director in Salomon Smith Barney's equity derivatives group, "It wasn't the derivative that caused the loss, it was the decision to buy back shares."

But even if the market comes back, companies may stay wary. By the end of this year, the Financial Accounting Standards Board is slated to issue new accounting rules on equities and liabilities related to company stock, including a requirement that will force transactions, including some types of equity forwards, to be considered as liabilities and marked-to-market on income statements.

Meanwhile, the repercussions for EDS are only intensifying. The company received notice of an "informal inquiry" from the Securities and Exchange Commission in early October.