Protecting Wealth Accumulated in a Concentrated Equity Position

Transcription

1 Protecting Wealth Accumulated in a Concentrated Equity Position Introduction As part of your overall investment strategy, it is important to determine whether you have a concentrated equity position in your portfolio and, if you do, to evaluate the potential risks associated with holding this position. A concentrated equity position occurs when a single security or industry represents a substantial portion of your total assets. Holding a concentrated equity position is often intended to increase your profit potential, but it can greatly increase your investment risk as well. If you have a concentrated position, a decline in the position could seriously impact your financial health. In fact, if the assets comprising the position are particularly volatile, such as small-cap stocks, a concentrated position can carry even greater portfolio risk. Different types of investors may find themselves in a situation where they have accumulated a concentrated equity position: > Corporate Executives, who receive a significant portion of their compensation in the form of company stock or stock options > Business Owners, who sell their company and receive a sizeable portion of the proceeds in stock > Individuals who receive an inheritance that includes a large position in a single security > Aggressive investors who seek high returns through a concentrated position > A resident of a part of the country where one industry has a significant presence and who amasses stock in several area companies in that industry This paper explores various strategies to mitigate the risks associated with concentrated positions, including: > Wealth Protection > Wealth Diversification The First Decision: What Are Your Strategic Objectives? Before identifying specific solutions or deciding whether any action should be taken, you will have to define your strategic objectives. They may include: > Creating liquidity > Hedging your risk > Diversifying your concentrated position > Accepting the risk of a concentrated position Morgan Stanley does not render advice on tax and tax accounting matters to clients. This material was not intended or written to be used, and it cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed on the taxpayer under U.S. federal tax laws.

2 In addition to these primary goals, you may have secondary considerations, such as transitioning all or part of the wealth you have accumulated in the position to your heirs or charities. In identifying your goals, important considerations include: (1) your risk tolerance, (2) your need for cash, (3) your time horizon, which may be based on a holding period requirement, (4) certain life events such as retirement, (5) your tax situation, and (6) the outlook for the stock and the markets overall. In addition, if your securities are restricted or you are a controlling shareholder, there may be securities laws and other issues you need to consider. Each of the strategies discussed in this paper can be used to achieve one or more of these strategic objectives. The following table summarizes some of the strategies: SUMMARY OF OBJECTIVES AND SOLUTIONS FOR MANAGING CONCENTRATED EQUITY POSITIONS Create Liquidity Hedge Diversify Variable prepaid forward contract Variable prepaid forward contract Variable prepaid forward contract Sell the position Protective put and put spread options Sell the position Covered call Zero-premium collar Exchange Fund Premium Sales Stop Loss Orders Net Unrealized Appreciation (NUA) Preset Diversification Program SM (PDP) (10b5-1 plans) Preset Diversification Program SM (PDP) (10b5-1 plans) Borrow against the position We have categorized the strategies according to a primary objective, but in many cases they can be used to achieve more than one goal. Keep in mind that not all of the strategies are appropriate for every investor. Also, the price of the underlying stock will change, and your objectives may change too, so that you will probably need to reevaluate the strategies you choose in the future. Many of the strategies involve the use of options that are either listed on an exchange or are customized by an investment firm. Certain characteristics of those strategies will differ depending on whether the options are listed or not. Create Liquidity Sell the position The simplest of all strategies is to sell your position to create liquidity. This eliminates stock price risk and allows you to reinvest proceeds into a diverse portfolio of investments. Although selling typically generates a taxable event, it may be a viable option given today s low capital gains tax rates. However, selling the position also prevents you from participating in further stock price appreciation. For many holders of concentrated positions, selling shares outright or even over time is a complicated matter. For example, if you are a company executive or other insider, corporate policies related to open window periods and regulatory restrictions must be considered before sales can occur. Stock sales, including those of restricted and control stock, can be accomplished in various ways, including open market sales, private placements, registered offerings, and resales to the issuer. For executives or insiders of public companies, a Preset Diversification Program SM (PDP) may help facilitate open market sales of your stock according to Rule 10b5-1. Here s how: Typically, there are only short windows of time during which executives and other insiders can sell stock. In the example on the next page, these periods are represented by the dark orange areas. A preset diversification program establishes a schedule for sales to occur at preset intervals, automatically, over a period of time. Executives are able to create liquidity and diversify their holdings without worrying about timing sales of company stock during open window periods. In addition, a PDP can offer an affirmative defense against allegations of federal insider trading. 2

3 PRESET DIVERSIFICATION PROGRAMS In this example, you can see how an executive s stock sales could be restricted by blackouts and corporate events. The PDP establishes a schedule for sales to occur at regular intervals. Earnings Released 1/1 4/1 9/1 10/1 Typical Corporate Blackout Schedule (Trading permitted only during open trading window) Events May Close Windows (such as possession of inside information) Preset Diversification Program (Trading pursuant to terms of plan regardless of blackout) Blackout Events Open Trading Window PDP Implemented Litigation settlement negotiations Insider receives clinical trial results Acquisition negotiations Source: Morgan Stanley Covered call options Writing a covered call option establishes an upside selling price for the stock (the strike price). You receive an upfront payment the premium for the sale of the option, that can enhance your return on the stock or partially offset a decline in the stock price. With this strategy, you might become obligated to sell the underlying stock at the strike price anytime during the life of the option contract. You participate in stock price appreciation only up to the strike price; downside risk is reduced only by the amount of the premium received. You might use this strategy if you believe the stock has only moderate upside potential or you are interested in selling the stock at the strike price. With this strategy, you can derive income from the premium payment. You are still exposed to any depreciation to the security; however, the income from the premium can help offset potential losses. In addition, covered call options are usually exchange-traded so dividends (if any) continue to accrue to the shareholder until the stock gets called away or the option expires (dividends will still accrue if there is no option position). Call options can be sold through public securities markets or can be created in over-the-counter markets. Variable prepaid forward contracts With the prepaid forward strategy you receive a cash payment of typically 70 90% of the current value of your stock position. In exchange, you are obligated to deliver a variable amount of shares or cash in the future. Similar to a collar (see below), the prepaid forward is a customized strategy that lets you lock in a stock value range for the shares by establishing ceiling and floor values. The strategy can generate significant liquidity and, if appropriately structured, may defer capital gains taxes until maturity. You are protected below a floor price, and you forego price appreciation above an established cap. Depending on certain contract terms, you could continue to receive current dividends, avoid the tax implications of an outright sale and, in almost all cases, even retain your voting rights. Variable prepaid forward contracts are usually executed in the over-the-counter market and require the completion of the ISDA (International Swap Dealers Agreement). Borrowing against the position Borrowing against the stock provides a way to generate liquidity, but the risk of a decline in the value of your collateral must be carefully weighed. You pledge the securities as collateral for a loan, giving you access to cash that you can use for any number of reasons, such as investing in a business, second home or art; meeting education expenses; or funding a trust or foundation. Since you do not sell the stock, you continue to participate in any upside, or downside, in the stock price. In certain circumstances, it is also possible to borrow against a restricted stock position. 3

4 There are limitations on the amount you can borrow as well as interest expenses to consider. Importantly, if the value of the stock declines, you may be required to post additional securities or cash to maintain the value of the collateral, reduce the amount of the loan, or sell the stock. Combining a loan with the zero-premium collar strategy may help mitigate this risk. This strategy allows for limited upside participation should the stock rise in value and at the same time creates liquidity while minimizing risk. Hedge Protective put options Purchasing a put option may be useful if you want to hedge the price risk of the underlying equity. With the protective put strategy, you have no downside risk below the put strike price until the put option expires. The strike price is usually below the current market price, thereby establishing a floor for the value of the stock. You participate fully in future stock price appreciation but your return is reduced by the cost of the option its premium, which you pay up front. Downside protection also is reduced by the amount of the put premium. Protective put options are generally listed options, which means you typically retain voting rights and maintain dividend income throughout the life of the contract term. Be aware, however, that premiums on put options can be very costly. Zero-premium collars The zero-premium collar is established when you purchase a put and sell a call on the same underlying stock. Strike prices may be set at levels that result in a net zero premium outlay. With the collar, you have no downside risk below the put strike price (the floor) and no upside potential beyond the call strike price (the ceiling) until the options expire. The collar, typically a customized contract, is a way to achieve downside price protection at little or no upfront cost. For many investors, the limited upside potential is a substantial consideration. Other hedging strategies include the prepaid forward contract (see Create Liquidity category on page 2). Stop Loss Orders Stop loss orders involve setting a sell price for a stock that is below its current market price. By establishing a stop loss order, you can protect profits that have already been made or prevent further losses if the stock price drops. However, a stop loss order may not be practical if you hold a large block of shares in a particular stock or if you own restricted stock. In addition, some investors have concerns about stop loss orders because of the potential effect of a volatile market on their position. For clients who closely monitor their stock prices, a stop loss order is usually unnecessary. IDENTIFY THE RISK TO BE HEDGED The hedging strategy you choose is determined by the risk to be hedged. In general, the more narrow the risk, the more important it is that the hedging instrument matches the risk specifically. Market Risk Stock-specific Risk Industry Risk (such as hardware or semiconductor) Sector Risk (such as technology or retail) Risk Rate Hedging Instrument Options on the stock itself Industry Indexes Sector Indexes Broad-based index products Source: Morgan Stanley 4

5 Diversify Exchange funds Exchange funds can be a tax-efficient way to diversify a concentrated position without being subjected to immediate capital gains taxes. You exchange your position for a diversified portfolio made up of stock contributed by other investors in similar situations. After a period of years (typically at least seven), you can redeem your limited partnership interests for a diversified basket of securities chosen by the portfolio manager. Upon exiting the fund (after at least seven years), you have in essence transferred your original cost basis from a single stock to a portfolio of stocks. A sale of any appreciated stock out of this portfolio would trigger a capital gain. A typical exchange fund, though not all, is professionally constructed but unmanaged; no additions or sales take place within the term of the fund. During that time, you significantly reduce your exposure to the single stock position and achieve immediate diversification. There may be size restrictions and other considerations, including SEC filings. You also have the ability to opt out of the fund if you do not like the other securities being contributed to the fund. If you withdraw from the fund before the time period necessary to receive a diversified basket of securities, you will receive back all or a portion of the securities that you initially contributed, depending on the specific withdrawal rights provided by the exchange fund in which you have invested. Exchange fund participants must generally be accredited investors and in some cases must qualify as 3(c)7 qualified purchasers, with net investments of at least $5 million. There are risks involved with investments in exchange funds, which include: the investment may be illiquid for several years; and any situation that requires the fund to sell or distribute a contributed security prior to the end of the minimum lock up period will trigger a taxable event. It should also be noted that there is always the possibility that the tax code can change disallowing the favorable tax treatment of exchange funds and the changes could be retroactive. EXCHANGE FUND STRATEGY An exchange fund facilitates diversification. Your concentrated position preexchange Fund during investment phase: includes your shares and those of other contributors Your portfolio postexchange BA FDX LUV LUV IBM XYZ XYZ PEG IBM AES PEG GE AES MSFT This chart is for illustrative purposes only and does not represent an actual transaction or portfolio. Source: Morgan Stanley Net unrealized appreciation (NUA) If you have amassed a large position in your employer s stock within a 401(k) or other qualified retirement plan, net unrealized appreciation (NUA) may enable you to sell and diversify that position in a tax efficient manner. In order to take advantage of NUA, you must be at least 55 years old and separated from service. Here s a brief overview of how NUA works: When you separate from the service of your employer, you may take the company stock portion of your retirement plan as a lump sum distribution in certificate form. At that time, you pay ordinary income tax based on the cost basis of the stock to the plan. When you sell the stock, you would pay capital gains taxes on the appreciated value (the difference between the cost basis of the stock and the market value at the time of the sale). If you had not utilized NUA but rolled the stock portion of your distribution over to an IRA, you would have to pay ordinary income tax on the appreciated value as you make plan withdrawals, although deferred until ultimate distribution from the IRA plan. To determine whether NUA will work for you, speak with your tax and legal advisors. Other strategies that can help diversify a concentrated position include selling the position or using the prepaid forward contract (see Create Liquidity category on page 2). 5

6 Transitioning Wealth to Charities and Heirs When your goals also include gifting a portion of the wealth accumulated in a concentrated position to charities, a charitable remainder trust may be an appropriate solution. Charitable remainder trusts (CRT) A CRT makes annual payments to beneficiaries (usually the donor and/or family members) for a set period of time or for the donor s lifetime. At the end of the period, the assets remaining in the trust pass to the charitable organizations designated by the donor, which can include a family foundation. You can gift a highly appreciated concentrated position to a CRT and, since the trust is income tax exempt, it can sell the shares and diversify the position without incurring any immediate capital gains taxes. Instead, gains on the investments in the trust are subject to capital gains tax as they are paid out to the income beneficiaries. You select the trustee who will make all investment decisions for the trust. In addition, you receive a charitable contribution income tax deduction. Keep in mind that there may be gift tax consequences if anyone other than the donor or spouse is designated as an income beneficiary. Utilizing Structured Investments Structured investments are designed to meet specific investor needs by incorporating special, nonstandard features, including capital protection, leverage, and exposure to a variety of underlying assets like stocks, bonds, currencies and commodities. They are essentially debt instruments linked to an underlying market index or basket of stocks through the use of options. An issuer backs the debt, so the credit quality of the issuing firm is an important consideration. Structured investments typically have intermediate term maturities of between one and six years. Structured investments are generally linked to a specific industry sector or index. If your consolidated position is aligned with that sector or index, the structured investment could provide a targeted hedge. For example, an investment could be structured with a principal protected note (designed to pay back principal in full at maturity) plus an additional payout linked to any decline in the housing market. Such an investment could provide a hedge against a concentrated position in housing stocks. Likewise, a security featuring a payoff linked to the decline in gold prices could be used to offset a concentrated position in gold stocks. In certain cases (investments in excess of $3 5 million), structured investments can be customized to meet a specific investor need. Conclusion This paper has presented a number of strategies for managing concentrated stock positions. Each solution has advantages and disadvantages that you should carefully consider before taking any actions. Morgan Stanley has in-depth knowledge and experience in each of the strategies discussed here, along with dedicated professionals to support our Financial Advisors in these sophisticated areas of investing. This includes futures and options strategists, a Preset Diversification Program (PDP) team, and wealth planning professionals (with detailed knowledge of estate planning and personal trusts). In addition, we are an industry leader and innovator in structured investments with dedicated support for our Financial Advisors and clients. Morgan Stanley can discuss the pros and cons of each strategy, helping you to choose what is best for your personal financial needs. In addition, we can help you navigate the complexities of securities laws and restrictions governing insider transactions. These transactions can have additional risks that need to be addressed. Furthermore, we will work with you to reassess your financial objectives over time and help you explore different strategies should something change in your portfolio or personal life. Reducing concentration risk can be a vital step in protecting the wealth you have worked hard to accumulate. Ask a Morgan Stanley Financial Advisor for help identifying your objectives and determining solutions that may help you achieve your financial goals. 6

7 Appendix A Commission Costs and Tax Considerations Commissions and taxes are important considerations when investing in options or structured investments. > Commissions or bid-ask spreads are incurred for the purchase, sale and exercise of options > Transactions that offset a stock position, including qualified covered calls, may be considered constructive sales if settled for cash, and would, therefore, result in a tax recognition event > Hedging transactions, including protective puts, covered calls, and zero premium collars, may be subject to straddle tax rules. Resulting gains may be treated as short-term gains for tax purposes and any resulting losses may be deferred > Transaction costs/commissions are especially significant in options strategies calling for multiple purchases and sales of options, such as multiple leg strategies, including spreads, straddles and collars Appendix B Affiliates and Insiders Under Section 16(a) of the Securities and Exchange Act, every officer or director of an issuer that has a class of equity security registered with the SEC under the Act, and every beneficial owner of more than 10% of such equity interest in the issuer (Affiliates) must file reports with the SEC disclosing any equity interest in the issuer (including options and derivative securities), as well as any changes in such ownership interest. The Act further states that any profit by an Affiliate from any purchase and sale of an equity security of the issuer (including options and other derivative securities) within a six-month period, is recoverable by the issuer. However, Rule 16(b)-3 provides an exception for transactions occurring under employee and direct benefit plans. Furthermore, the Act prohibits an Affiliate from selling short any equity security of the issuer. This does not prohibit selling calls or buying puts. 7

8 Options are not suitable for all investors. Before engaging in the purchase or sale of options, potential clients should understand the nature of and extent of their rights and obligations and be aware of the risks involved, including, without limitation, the risks pertaining to the business and financial condition of the issuer of the underlying security or instrument. Options investing, like other forms of investing, involves tax considerations, transaction costs and margin requirements that can significantly affect the profit and loss of buying and writing options. The transaction costs of options investing consist primarily of commissions (which are imposed in opening, closing, exercise and assignment transactions), but may also include margin and interest costs in particular transactions. Transaction costs are especially significant in options strategies calling for multiple purchases and sales of options, such as multiple leg strategies, including spreads, straddles and collars. If you are considering options as part of your investment plan, your Morgan Stanley Financial Advisor or Investment Representative is required to provide you with the Characteristics and Risks of Standardized Options booklet from the Options Clearing Corporation. Clients should not enter into options transactions until they have read and understood the Disclosure Document, as options are not suitable for everyone, and discuss transactions costs with their Financial Advisor or Investment Representative. Please ask your Morgan Stanley Financial Advisor, Investment Representative or call Morgan Stanley s Options Help Desk at for a copy of the booklet. This report does not provide individually tailored investment advice or offer tax, regulatory, accounting or legal advice. It has been prepared without regard to the individual financial circumstances and objectives of persons who receive it. The securities/investments discussed in this report may not be suitable for all investors. Morgan Stanley recommends that investors independently evaluate particular investments and strategies, and encourages investors to seek the advice of a Financial Advisor. The appropriateness of a particular investment or strategy will depend on an investor s individual circumstances and objectives. This report is not an offer to buy or sell any security or to participate in any trading strategy. Morgan Stanley does not render advice on tax and tax accounting matters to clients. This material was not intended or written to be used, and it cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed on the taxpayer under U.S. federal tax laws. Morgan Stanley and its Financial Advisors do not provide tax or legal advice. Consult our personal tax advisor regarding taxation and tax planning, and your attorney for personal trusts and estate planning. An investment in Morgan Stanley Structured Investments may not be suitable for all investors. These investments involve risks, which include but are not limited to: fluctuations in the price, level or yield of underlying instruments, interest rates, currency values and credit quality, substantial loss of principal, limits on participation in appreciation of underlying instrument, limited liquidity, Morgan Stanley credit risk and conflicts of interest. Clients should carefully read the detailed explanation of risks, together with other information in the relevant offering materials, including but not limited to information concerning the tax treatment of the investment, before investing in any Morgan Stanley Structured Investments. Margin can be very risky, and its use may not be suitable for all investors. Before opening an account, the clients should fully understand the risks involved in trading securities on margin, which include but are not limited to the following: > You can lose more funds than you deposit in the margin account > The Firm can force the sale of securities or other assets in your Accounts > The Firm can sell your securities or other assets without contacting you > You are not entitled to choose which securities or other assets in your Account are to be liquidated or sold to meet a margin call > The Firm can increase its house margin maintenance requirements at any time and is not required to provide you advance written notice > You are not entitled to an extension of time on a margin call If you have any questions or concerns, please contact your Financial Advisor. Investments and services are offered through Morgan Stanley & Co. Incorporated, member SIPC. Investment banking, underwriting and research are through Morgan Stanley & Co. Incorporated. Preset Diversification Program is a registered service mark of Morgan Stanley & Co. Incorporated, protected in the United States and other countries Morgan Stanley. All rights reserved. NY CS /07 CLF#37430