Anschutz as Icarus: Flying too Close to the Sun

The variable prepaid forward contract, without question one of the most popular transactions on corporate and high net worth derivatives desks on Wall Street. Every firm has their own brand name for it, but the bottom line is always the same: helping a company or a wealthy individual protect the value of a concentrated stock position and generate liquidity from the position without paying taxes currently. In essence, getting all the benefits of a sale without the costs associated with a sale. An article in today's Wall Street Journal highlighted the structure and provided an example of its being pushed to the limit, so much so that the favorable tax treatment generally associated with the strategy is being challenged by the IRS. These strategies in other forms have not drawn the IRS's ire, but why?

First some historical perspective. In a perfect world, derivatives professionals and their clients would like to figure out how to sell an appreciated asset and not pay taxes - ever. Historically there has only been one foolproof way to accomplish this feat - by dying (with your heirs getting a stepped-up basis in the appreciated stock to fair market value at the time of death, enabling a sale without ever paying capital gains taxes on the position). Most clients and their advisers prefer a somewhat less draconian vehicle for accomplishing this, and the easy answer used to be the "short-against-the-box" trade. This involved simply borrowing stock against an appreciated stock position and selling it, posting the sale proceeds as collateral against the short position and perfectly hedging the value of the appreciated shares. This deal worked for a long time, until the IRS determined that if a transaction looked like a sale and smelled like a sale then it probably was a sale, and eliminated the tax deferral associated with the strategy. So smart derivatives practitioners then asked themselves the question - if a "short-against-the-box" transaction eliminated too much risk to warrant a tax deferral, then exactly how much risk needed to be taken in order to secure the more favorable treatment?

Financial engineering then gave us the variable prepaid forward and its variants (collectively 'VPF"). Essentially, you can think of a VPF as a kind of private mandatory convertible, similar to the instruments sold to raise capital for banks and corporations. Put another way, a client using a VPF to hedge a stock position is:

• Selling their stock forward (agreeing to sell at a future date for a pre-agreed upon price, generally 3 to 7 years foward);
• Buying a call option struck at the current stock price; and
• Selling a call option (or in some structures .833 of a call option) at 120% or more of the current stock price.

And once the hedge is put in place, the client can receive the present value of the future cash flows upfront, which is generally in the range of 80-85% of the current fair market value of the hedged position.The net effect of all this is to give the client significant liquidity, protect the full downside of the hedged position at the current stock price and to defer payment of capital gains taxes until the expiration of the hedge.

• Question: why does the IRS deem this not to be a constructive sale for tax purposes while the short-against-the-box is treated as a sale?
• Answer: because of the variability of future outcomes associated with the hedged position, the measure of which is the spread between the call option bought and the call option sold (in the above example a 100% call bought and a 120% call sold for a 20% spread) as well as the length of the hedge.

What are two ways to make the above hedge more "sale-like" and therefore blowing the tax deferral in the eyes of the IRS?

1. Make the call strikes closer, e.g., a 100% bought call and a 110% sold call; or
2. Make the maturity longer, e.g., 10 or more years.

The best measure of "stock-likeness" is embodied by the concept of delta. Per Wikipedia:

The delta measures the sensitivity to changes in the price of the underlying asset. The Δ of an instrument is the mathematical derivative of the option value V with respect to the underlyer's price.

Think of it this way: owning stock has a delta of +1. Selling stock has a delta of -1.  The hedge is the synthetic selling of stock. So if the delta of the hedge is too high (meaning the call spread is too tight or the maturity is too long), there won't be enough retained risk or variability of potential outcomes to cause the IRS to allow tax deferral. And while Congress hasn't enacted concrete rules that govern these strategies, the IRS has issued "private letter rulings" to law firms and banks on the topic that pretty much support what I've written above (or at least they did when I was in the business). But what was always an issue, a niggling little issue that sometimes found its way into certain of these hedging contracts, concerned the issue of stock borrow. And this is where the wealthy and generally fortunate Mr. Anschutz might be in a bit of trouble.

In order to execute one of these VPF deals, stock needs to be borrowed and sold to establish the short position. The Wall Street bank is the one who does this. But in the hedging contract, it has to be stated who bears the risk of a stock borrow being "called in" (meaning you've got to give the shares back to the stock lender and the transaction gets unwound). While there are lots of shades of gray (e.g., the stock can go "on special" and the borrow simply gets more expensive but doesn't go away, but someone has to incur the higher borrowing costs), someone is taking the borrow risk. So far we're ok as far as the IRS is concerned.

But where it used to be fuzzy prior to 2006 (but now is not) was when the Wall Street firm had the ability to borrow the shares held by the client in the event of a short squeeze or if there was not sufficient borrow available to get the hedge off in the first place. I looked at this feature many, many times and spent countless hours with counsel trying to get comfortable with this but never could. In the late 1990s/early 2000s during the Internet bubble, it was often very difficult to source enough borrow to execute a big hedge on a recently IPO-ed stock, and borrowing the client's shares would have been the ticket to millions in fees. But sadly, a prudent man's view of the facts and circumstances left these deals to be done by others or none at all. Don't shed too many tears, however: there were plenty of liquid stocks to hedge where this issue never came up, but in some cases it did and some decided to roll the dice.

Enter Mr. Anschutz. Now, according to the WSJ article, these transactions were entered into during 2000 and 2001. But they provided the counterparty, DLJ, with the ability to borrow the shares held by Mr. Anschutz. So think about this. Mr. A has shares. He posts them as collateral to DFJ for the hedging transaction. They sell those exact same shares as part of the hedge. Seems like a sale, right? This is the IRS position. The IRS formally shut the door on this type of deal back in 2006, a full 5-6 years after Mr. Anschutz put his hedges in place. Clearly his counsel will argue that such transactions should be grandfathered as they were entered into before the rules were clarified. But some of us saw these deals during the same time period and concluded that they were simply too dangerous. The benefit of an 8-year tax deferral like the one contemplated by Mr. Anschutz's hedges are very valuable. But the terms of his particular agreements are yet another example of something we see on Wall Street time and time again: flying too close to the sun.

 

Comments

[Ashish]

This doesn't seem fair to Mr. Anschutz, who had no say into whether DLJ could borrow and sell his shares .. poor Mr. Anschutz!! .. oh wait ..

[BL]

Great post - issues with hybrid and equity derivatives have been overshadowed by coverage of fixed income structured products. While I appreciate blogs for their alternative interpretations of mainstream media, what I truly appreciate about blogs is their potential for unearthing topics that mainstream media overlooks.