Two varieties of restricted securities are flowering, aiding executives, business owners-and now investors.
So you're chatting restricted stock with a client,
and suddenly the discussion takes an unexpected turn. He's going off
about shares of a public company that never have been registered with
the Securities and Exchange Commission. You thought the topic was stock
with vesting restrictions received as compensation.
Sound familiar? Restricted stock, like so many
financial terms, has multiple connotations. The trouble for advisors is
that these two are on the rise. So even if you've never had a
tete-a-tete about restricted stock, let alone a confused one, soon you
may.
In executive compensation, for instance, grants of
restricted stock and restricted stock units are gaining currency now
that accounting rules require employers to expense options. The trend
has the attention of John Nersesian, the Nuveen Investments managing
director who trains the Chicago investment house's advisor consultants.
He's hammering home restricted stock right now. "We want them to have a
better understanding of its impact on the client's financial plan and
to be more fluent in counseling about it," Nersesian says.
Meanwhile, unregistered public company shares, which
have restricted salability to the public, are now easier for insiders
and others to liquidate thanks to a new private marketplace. Launched
in October, the Restricted Securities Trading Network also has widened
access to this obscure alternative asset for eager institutional and
accredited investors. (See sidebar.)
How to help clients who hold restricted stock? Start
by ascertaining which genus the client has. Then explain what can, and
cannot, be done with the securities, along with the attendant financial
planning challenges and possible solutions. "It's the advisor's job to
let the client know what the options are," says William Fuhs, president
and chief executive officer of New York Private Bank & Trust in New
York City.
You'll need to bring in an attorney experienced in
tax, benefits, securities and employment law. Plan to work with the
company's human resources department too, because the organization may
impose its own restrictions that you have to take into account, says
Larry Macklin, a wealth strategist and senior vice president at the
Private Bank of Bank of America in Baltimore. Some companies don't
allow their executives to sell any stock. "Others will allow only a
certain amount," Macklin says.
The types of restricted stock are presented below as
distinct categories. In actual practice, there could be some overlap.
Unregistered Shares Of Public Corporations
SEC Rule 144 prohibits unregistered shares from being sold in the
public market for one year from date of issue. There also are limits on
how much may be sold within any three-month period-for instance, no
more than 1% of the outstanding shares-a restriction that can be
burdensome for clients at thinly traded companies. Wealth concentration
frequently exacerbates the planning challenge.
Consider a case from Fuhs' file. The client had built a successful
private business that he took public after several years. Through the
IPO process, the man received unregistered shares in the recapitalized
corporation that represented a significant percentage of his net worth.
But how to diversify without waiting a full year? (Fuhs' solution
later.)
Besides business owners, executives at the very highest echelons of
management sometimes receive unregistered shares as compensation.
However, they can bargain for registered shares when coming on board
and avoid Rule 144 altogether, says Peter Marathas, an executive
compensation attorney and partner at Kirkpatrick & Lockhart
Nicholson Graham LLP in Boston. "For somebody coming into an
organization at that level, there's a lot of negotiation surrounding
the terms of the employment agreement," Marathas says. But be sure the
client's attorney is knowledgeable about securities law, he adds.
Otherwise, the lawyer may not think to demand registered stock.
Clients stuck with unregistered shares shouldn't get cute with the
rules that restrict public sale, warns attorney Burton Wiand, a partner
and leader of the financial-services practice group at Fowler White
Boggs Banker, in Tampa. "People get into trouble looking for creative
ways around the rules. Entering into a transaction to avoid a
securities regulation could cost you an exemption that might otherwise
be available," Wiand says.
The Search For Liquidity
So, how to achieve liquidity? When wealth concentration is not an
overriding concern, you could recommend riding out the one-year holding
requirement. Then the shares can be sold to the public under Rule 144's
safe-harbor provisions, with any appreciation since the client received
the shares taxed at capital gains rates. (The stock grant is taxed as
ordinary income upon receipt.) An SEC filing is required whenever
selling more than 500 shares or $10,000 in stock within a 90-day period.
Complying with Rule 144 doesn't preclude illiquidity due to
blackouts-time windows during which individuals with access to inside
information can't trade because they possess it, such as when quarterly
earnings are being compiled. To overcome that, insider clients need a
10b5-1 plan, allowed since 2000.
These plans let an insider prearrange future sales of stock at a time
when she has no nonpublic data, ideally when first starting with the
company. Because the sales are scheduled in advance, they're permitted
to take place even on dates that fall within blackout periods, and the
client is insulated from insider-trading claims, Wiand says. Selling
plans are usually integrated with the Rule 144 sales limitations when
those are an issue, according to Marathas. "You can set up the 10b5-1
plan so that every three months the client sells the maximum allowed,"
Marathas says.
Individuals who are not in a position to wait a full year to divest must seek a private transaction. One possibility is to hedge or monetize the restricted-stock position by going to a large financial institution for a customizable derivative transaction, such as a prepaid forward or collar. These sophisticated techniques, which often carry high minimums and have come under IRS attack recently, enable the client to borrow against the stock by putting it up as collateral. The loan proceeds, which in a good deal might equal 80% of the value of the restricted-stock position, can buy diversified assets or meet other objectives.
Another alternative, and the one Fuhs recommended to his client, is to sell the shares privately. But because the restriction stays with the stock, a seller will have to accept a discount from current market price. For example, if the client has held his stock for two months, a buyer would not be able to resell them in a public transaction for ten months, to finish out Rule 144's one-year restriction on the shares' sale to the public. Liquidating restricted stock at a discount isn't a new option, says Fuhs. "Trying to locate buyers has always been the difficult part."
Sell To Whom?
Enter the Restricted Securities Trading Network, brainchild of former
investment banker Barry Silbert, now chief executive officer of
Restricted Stock Partners, the broker that runs the network in lower
Manhattan. Silbert and his cohorts have gathered more than 200
professional and accredited individual investors who covet restricted
stock for the diversification benefit that buying at a discount affords.
"Finding buyers was a lot easier than I thought it would be," Silbert
says, attributing the interest to competition among money managers for
unique opportunities. The network does about a deal a day, with an
average transaction size close to $1 million, he reports.
Here's how it works: At no cost or obligation, would-be sellers contact
the network's trading desk. After going over the details of the
security's restriction, the desk typically offers guidance on an
appropriate discount. That can range from 2% to 50%, depending on
factors including the time remaining on the restriction, the security's
volatility and the liquidity of the public market for the security. "We
may have several phone calls just about valuation before the position
is listed," Silbert says.
Once listed, buyers and sellers negotiate between themselves. "It's not
unusual for (the client) to have a better feel for the security than
the marketplace," says Fuhs, adding that the advisor's role is to help
the client decide whether the best price negotiable is acceptable. Do
that by focusing on the outlook for the security and the proportion of
the client's net worth that it represents. "When it's a key component
and you're not comfortable with it, you're probably willing to take a
slightly larger discount," Fuhs says.
Completed transactions owe a commission of about 1% to 6%, split
between buyer and seller, to pay the brokerage for transferring
ownership-a hideously laborious process with unregistered certificates.
Vesting Restrictions
Talk about restricted stock's second iteration-share grants in which
the employee vests over time-can be heard in both public- and
private-company hallways. Executive comp types hail it as a retention
tool. Advisors hate the uncertainty it brings to retirement planning.
How do you factor in an asset the client doesn't truly own yet? The
total lack of liquidity is another peeve. Until the executive's risk of
forfeiture lapses, says Nuveen's Nersesian, the shares can't be sold or
pledged, which precludes hedging. Meanwhile, the value could drop
precipitously.
Where the advisor can help is with tax planning. Nersesian explains the
usual treatment: "The executive has no tax bill until the shares vest,
when they are taxed at ordinary rates based on their value at that
time." Stated another way, the tax hit is unknowable.
The I.R.C. Section 83(b) election, which must be made within 30 days of
the stock grant, removes that uncertainty. Taking the election allows
the client to pay tax immediately, based on the shares' worth when
awarded, rather than wait until vesting, when who knows what their
value or the tax rate will be. Further, the election establishes the
stock's basis and starts the capital gains clock ticking. Once the
stock vests, say three years later, if it's immediately sold any
appreciation would be taxed as long-term capital gains, Nersesian says.
Without the election, the client would have paid ordinary tax on the
full value of the stock at vesting.
What if the stock drops? There's the rub. "The risk with 83(b) is that
you could pay more in taxes up front than the stock might ultimately be
worth," Nersesian says.
Of course, that's not much of a concern when the shares are cheap to
begin with, such as with a startup. "The election is more likely to
make sense when it causes only a small amount of current income," says
Bank of America's Macklin. The same is true when the stock has homerun
potential.