NEW DEVELOPMENTS IN EQUITY DERIVATIVES

NEW DEVELOPMENTS IN EQUITY DERIVATIVES William M. Paul June 6, 2001

STOCK FUTURES

BACKGROUND Shad-Johnson Accord limited equity-related futures contracts to futures on broad-based indexes Commodity Futures Modernization Act of 2000 authorizes trading of security futures, including: Single stock futures Narrow-based index futures Options on those futures

KEY DATES August 21, 2001 Principal-to-Principal Trading December 21, 2001 Retail Trading December 21, 2003 Trading in Options on Stock Futures

REGULATORY FRAMEWORK Joint regulation by SEC/CFTC Product can trade on securities exchange, commodities exchange or alternative trading system Down tick rule does not apply

TAXES What model should apply? Futures model Options model Stock model Policy decision: treat single stock futures comparably to listed equity options Not like other futures contracts Generally not 1256 contracts Level playing field 60/40 treatment limited to dealers in stock futures Perform functions similar to options market-makers Treasury to define by 7/1/01

NON-DEALER TAX TREATMENT Comparable to listed equity options Not treated as a commodities future, but as a security Character Gain or loss from sale or exchange is capital if gain or loss on underlying would be capital. 1234B. Gain or loss from cancellation, lapse, expiration or other termination is capital if the securities future is a capital asset in hands of the taxpayer. 1234A. Gain or loss from short security future will be short-term regardless of holding period Compare options: gain/loss on long call or long put can be longterm; gain/loss on short call or short put is short-term regardless of holding period

NON-DEALER TAX TREATMENT Holding Period: Because not treated as commodities future, holding period for long-term gain/loss is 12 months, not 6 months. See 1222 (flush language) If long security future is physically settled, purchaser tacks holding period More favorable than no tacking rule applicable to options

NON-DEALER TAX TREATMENT Timing: No gain or loss on entering into stock futures contract No gain or loss to purchaser on exercise if physically settled Gain or loss to seller if physically settled, and to both parties if cash settled

ANTI-ABUSE RULES Short-Sale Rule of 1233 Long security future treated like long stock position So if have long security future and enter short sale of underlying, 1233(b) will apply Because not a commodity future, the rule that commodity futures are not substantially identical if they call for delivery in different months does not apply Wash Sale Rule Expanded to include options or contracts to acquire stock that can be settled in cash (or property other than the underlying stock) Straddle Rules 1092(d) amended to include stock offset by stock future

DEALER ISSUES Who should be treated as stock futures dealer? Must perform functions similar to options marketmaker Making two-sided markets v. providing liquidity Headed Toward Very Odd System Dealers governed by 1256 mark-to-market, 60/40 treatment Active traders will likely elect 475 to avoid straddle and wash sale headaches But they get marked to market at ordinary income rates

WILL THE PRODUCT SUCCEED? Constructive Sale rules limit utility as hedge of appreciated stock Push for the product has come from the supply side, not the demand side Lots of interest from the exchanges CME, CBT and CBOE have announced joint venture Will trade on electronic platform

NARROW-BASED INDEXES

BACKGROUND Before CFMA, equity-related futures limited to broad-based indexes (e.g., S&P 500) These futures, like all other futures before CFMA, are 1256 contracts Mark to market, 60/40 treatment Options on broad-based indexes are classified as nonequity options and are also 1256 contracts Tax parity with competing futures contracts Options on narrow-based indexes not 1256 contracts Definition of broad-based index for options tied to whether CFTC had authorized a futures contract on the index or if the requirements for such authorization were met

CFMA CFMA now authorizes trading in futures on narrowbased indexes CFMA also includes an objective definition of narrow-based index E.g., 9 or fewer stocks Futures on narrow-based indexes are not 1256 contracts,while futures on broad-based indexes remain 1256 contracts Same rule for index options traded on exchange Tax rules for determining if index option is a 1256 contract can no longer look to whether CFTC has authorized trading in a futures contract on the index

NEW TAX DEFINITION 1256(g)(6) incorporates definition of narrowbased index enacted in CFMA 3(a)(55) of Securities Exchange Act of 1934 This new definition became effective December 21, 2000 Immediate impact on tax status of certain index options Some index options that were narrow-based under Shad Johnson became broad-based over night Became 1256 contracts

UNCERTAINTIES AND HEADACHES Status of index can change as a result of change in market capitalization or average trading volume of component stocks More of a problem for options than futures Unclear how IRS will administer from perspective of 1256 Application of Reg. 1.246-5(c) where individual stock offset by broad-based index consisting of fewer than 20 stocks

QUALIFIED COVERED CALLS

Qualified Covered Calls What is a Qualified Covered Call ( QCC )? Written call option on stock held or acquired Traded on exchange At least 30-day term Not deep-in-the-money

Qualified Covered Calls Benefits of QCC Status Not subject to general straddle rules of Section 1092 Subject to modified straddle rules Year-end rule If in-the-money when written: Suspend holding period in stock Loss on call will be long-term if stock held long-term

Qualified Covered Calls Proposed QCC Regulations Expanders Extend QCC status to FLEX options Prop. Reg. 1.1092(c)-1 Deep-in-the-money determination based on standardized strike price intervals Extend QCC treatment to OTC options Prop. Reg. 1.1092(c)-3 Tight definition of qualifying options The only payments permitted with respect to the option are a single fixed premium paid not later than 5 business days after the day on which the option is granted, and a single fixed strike price stated as a dollar amount that is payable at (or within 5 business days of) exercise.

Qualified Covered Calls Proposed QCC Regulations Tightener No QCC status if option has term longer than one year Applies to LEAPS, FLEX and OTC options Larger premiums possible even if not deep-in-themoney

Qualified Covered Calls Example 1 Stock price $50, volatility 50% Premium for at-the-money call 90-day option = $4.80 2-year option = $14.56 Example 2 Stock price = $50, volatility = 50% Premium for 6-month, $45 option = $9.55 Premium for 1½ year, $60 option = $9.07

Qualified Covered Calls Over-reaction? Additional risks of using long-dated calls Option price may move independently of stock price Greater risk of loss on stock Possible modifications to limit potential for increased risk reduction Limit premium to specified percentage of stock price Forward pricing approach

PROPOSED REGULATIONS UNDER SECTIONS 263(g) AND 1092(d)

BACKGROUND Section 1092 defers losses to extent of unrealized gains in offsetting positions with respect to actively traded personal property Reg. 1.1092(b)-5T(d) defines loss as a loss under 165(a) Does not apply to interest expense or expenses deductible under 162 or 212 Section 263(g) requires capitalization of interest and carrying charges properly allocable to personal property that is part of a straddle Includes interest on indebtedness incurred or continued to purchase or carry personal property Similar language in 265(a)(2), Rev. Proc. 72-18 Also includes all other amounts paid or incurred to carry personal property that is part of a straddle

THE PROBLEM (from Treasury s Perspective) Taxpayers began issuing debt-like instruments that (may) exploit gaps in coverage of existing law DECS Interest-bearing deposit plus kinky forward on portfolio stock held by issuer Debt used for general corporate purposes, not to purchase or carry the portfolio stock

THE PROBLEM (from Treasury s Perspective) PHONES Contingent payment debt instrument with embedded position in portfolio stock held by issuer Accrue OID based on comparable yield, pay only small coupon Issuer (arguably) does not have position in personal property with respect to its own debt OID accruals not losses under 165 Debt used for general corporate purposes Uncertainty over treatment of payments on equity swap offset by stock Periodic payments on the swap not losses under 165

THE (PROPOSED) SOLUTION Prop. Reg. 1.1092(d)-1(d): Issuer has position in personal property if one or more payments under the debt instrument are linked to the value of personal property (or a position with respect to personal property) Proposed regulations under 263(g) would require capitalization of periodic payments on instruments such as DECS, PHONES and equity swaps

PROBLEMS WITH THE (PROPOSED) SOLUTION 263(g) approach technically cumbersome 263(g) linked to personal property that is part of a straddle 1092 applies to positions with respect to actively traded personal property IRS felt constrained to say that debt (PHONES) is not personal property of the issuer, even though it is a position under 1092 Therefore cannot allocate interest cost to the PHONES Leads to strained reading of carry and Byzantine logic to get to result IRS wants Alternative would be to expand definition of loss under 1092