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.

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