Illustration by Mark Kseniak
Like many people, if you or your clients held a concentrated equity position prior to June 1997, there is a good chance that the topic of "going short against the box" came up. If your clients hold such positions, a new application of a popular hedging strategy can help them lose that "boxed in" feeling with respect to their concentrated equity positions - and protect their heirs at the same time.
"Short against the box," or SATB, is an elegant hedging strategy that allowed investors to protect the value of their shares and borrow (i.e., "monetize") between 90 percent and 95 percent of the market value of that protected position at a low rate of interest. This borrowing could then be used to reinvest into a more diversified portfolio. So your client ended up with roughly the same economic result as selling the shares, but faced no taxable event.
While this is a somewhat common strategy, it proved too much of a good thing for Representative Barbara Kennelly, D-Conn., when she met cosmetics mogul Estee Lauder. By borrowing each other's shares and going short against the box, members of the Lauder family effectively shielded (forever) approximately $100 million in capital gains they realized when the Estee Lauder Company went public. Kennelly, who at the time was serving on the Congressional Finance Committee, orchestrated the insertion into the Taxpayer Relief Act of 1997 (TRA '97) language that defined several existing methods of hedging and monetization concentrated equity positions as constructive sales, and therefore subject to capital gains tax as if the shares had been sold outright.
Strategies that were specifically identified in the TRA '97 as constructive sales included:
o "Short against the box" (a short sale of securities when an identical long position is owned but will not be delivered until a later date);
o A total return equity swap transaction;
o A forward or futures contract that delivers a "substantially fixed amount" of the appreciated asset for a "substantially fixed price"; and
o Any other similar transaction proscribed in IRS regulations.
Several strategies currently exist that allow investors to hedge and monetize concentrated equity positions without triggering a constructive sale, and these were discussed in a previous article (see "Spread the Wealth," Dow Jones Investment Advisor, November 1999).
This article, however, focuses on investors who entered into short against the box (SATB) positions prior to June 1997 in order to be grandfathered under TRA '97. These investors may believe they are sitting pretty, but they can improve their situation by unwinding their existing position and rehedging using a different structure - a variable pre-paid forward.
Short Against the Box
Consider an investor who held a long position in a highly appreciated stock (XYZ Inc.) prior to June 1997. In order to lock in the value of those shares without triggering a taxable event, the investor entered into a SATB transaction. In summary, going SATB means borrowing shares in the marketplace and selling these shares short, creating a net offsetting position that locks in the value of the shares at the short price. The investor then borrowed, say, 90% of the value of the protected shares at a very low rate of interest and used this to diversify his or her investment portfolio. The net result is that the investor locked in a price for their stock (as if they sold it) at the SATB price and diversified their investment portfolio without paying the taxes associated with a sale.
| Current SATB Position | |||||
|---|---|---|---|---|---|
| Issue | Shares | SATB Px | Basis |
Current Price |
Total Value |
| SATB Shares | |||||
| XYZ, Inc. | 250,000 | $25.00 | $0.10 | $40.00 | $10,000,000 |
|
| |||||
| Additional Long (Unencumbered) Shares | |||||
| XYZ, Inc. | 250,000 | $0.10 | $40.00 | $10,000,000 | |
| SATB Transaction Date | January 1, 1997 | ||||
| Current Date | December 31, 1999 | ||||
Neat deal, but it can be even better. Aside from the economics, one problem with investors who went SATB is that the investor's heirs lose the ability to gain a step-up in basis when the SATB is inherited. So, while the investor has deferred paying the capital gains tax on the sale of the shares, the heirs will have to pay this tax when they ultimately close out the position.
Unwinding and Rehedging the SATB
Consider an investor who holds the position illustrated in the table at left. Not atypically, this investor hedged only one-half of the original long position with a SATB in order to keep upside potential on the unhedged half. This investor is completely hedged at $25.00 per share on one-half of the overall position, and completely unhedged on the remaining half.
A variable pre-paid forward (VPPF) is a hedging strategy in which the investor receives a cash advance today in exchange for an agreement to deliver shares to the counterparty bank at some point in the future. How many shares the investor needs to deliver is dependent on the market price of the underlying stock at the maturity of the trade. Properly structured and documented, a VPPF does not constitute a constructive sale under the language of TRA '97. In a typical VPPF, the investor has full protection on the shares below the current market price, keeps any upside price movement up to a certain level, and then keeps a percentage of any additional price increase above that. For example, the investor with the SATB position on XYZ might see a VPPF structure as follows:
| Stock: | XYZ Inc. |
| Term: | 5 years |
| "Put Strike": | 100% of current market price |
| "Call Strike": | 125% of current market price |
| Participation Rate: | 20% of any price increase above 125% of the current market price |
| Cash Advance Rate: | 75% of the current market value of the hedged shares |
Given the current market price of $40 per share, this structure gives the investor full protection on the hedged shares below $40, allows the investor to keep any price increase up to 125% of $40, or $50, and allows the investor to keep 20% of any price increase above $50. In exchange for entering into this strategy, the counterparty bank will advance the investor 75% of the current market value of the shares.
The investor can unwind the existing SATB by simply delivering the hedged long shares. Doing so, however, creates a taxable event since the investor has now closed down the position and effectively sold the shares. A better alternative is to refinance the position using a VPPF. Here's how it works. The investor will borrow enough money from the counterparty bank to buy clean shares in the marketplace and use these shares to close out the SATB. This leaves the investor unhedged on the original shares, but no taxable event has occurred (other than a realized capital loss on the short position if XYZ has appreciated since the trade was put on). The investor then rehedges the original long shares by entering into a VPPF and uses the proceeds from the cash advance to repay the loan taken out to close out the SATB. The investor will need to hedge more shares with the VPPF than were originally hedged with the SATB. The table at the top of the page summarizes the economics of the transaction.
| |||||||||||||||||||||||||||||||||||||
| |||||||||||||||||||||||||||||||||||||
By hedging 333,333 shares with a VPPF, the investor will receive a cash advance of 333,333 shares x $40.00 x 0.75 = $10,000,000, sufficient to repay the loan taken out to buy 250,000 new shares in order to close out the SATB.
What has the investor accomplished by doing this? In essence, the investor has hedged more shares at a higher price compared to the existing SATB position. In addition, the investor gets to keep some of the upside price movement on the hedged shares, whereas the shares hedged with the SATB were locked in at a price of $25 per share.
The graph on this page illustrates the results for different prices of XYZ at the maturity of the trade. Note that as long as the price of XYZ moves either up or down, the investor is better off with the VPPF than with the SATB. Here's why. If the price of XYZ moves down, the investor is better off because more shares are protected at a higher price (333,333 shares protected below $40) compared to the SATB (250,000 shares protected below $25).
On the other hand, if the price of XYZ goes up, under the SATB the investor is completely locked out of any participation in the price increase on one-half of the shares. But under the VPPF, the investor effectively participates in all of the price increase on 100% of his/her shares up to a price of $50. Above $50, the investor keeps all of the upside on 33% of the shares (166,667) and 20% of the upside on the remainder of the shares.
There is an additional benefit to rehedging the SATB if the price of XYZ has appreciated since the SATB was put on. When the SATB is unwound, the investor will realize a capital loss (because he/she went short on a stock that went up). This loss can be used in a variety of ways: (1) to offset other capital gains in his/her investment portfolio; (2) to offset the unrealized gain on XYZ when the investor ultimately sells (the investor should wait 31 days after rehedging XYZ before selling any of the original long shares in order to avoid any question of a wash sale); or (3) carry the loss forward and use it in future years.
Rehedging and refinancing the position using a VPPF gives the investor more protection, more upside participation, and perhaps the ability to harvest some tax losses. In addition, the investor's heirs can regain the ability to get a step-up in basis when they inherit the position. A good deal all around.
