By John Thackray

In recent months many derivatives financial engineers have been busy studying new product possibilities based on the Taxpayer Relief Act of 1997, enacted August 5. The Republican-sponsored bill was most notable for reducing taxes on capital gains and granting other goodies to taxpayers in high-income brackets.

The bill, however, has significant consequence for derivatives transactions. One section of the bill is directed at certain types of short sales of the same or identical property as a taxpayer already owns, an offsetting notional principal contract such as a swap, or a hedge using futures and forward contracts.

Among several popular tax strategies blunted or banned by the new law are equity shorts-against-the-box, in which an investor with significant gains from a long-term equity position deposits stock in a custodial account with a broker-dealer, who then executes a short sale for the same number of shares. Being simultaneously long and short, changes in the stock have zero effect. Proceeds of the short can become collateral for a margin loan of up to 95 percent, while the investor maintains voting rights. As long as stock is available to borrow for the shorting, the transaction could be left open indefinitely, and no tax is involved.

In recent years tax gurus in the Treasury Department have argued that short-against-the-box is tantamount to sale and should incur tax liability. They did not move for a reform, however, until the use of this technique by members of the Estee Lauder family was recently given unfavorable media exposure. In Congress the suspicion grew that many high-net-worth founders of businesses were using short-against-the-box strategies to monetize their gains without incurring a dime of tax. The result is a law that creates a major shift in the environment of tax-based derivatives plays. "People are attempting to develop a product that does not trigger tax liability, and yet give the taxpayer some protection and some upside opportunity,” notes Richard Shapiro of Ernst and Young. "Both are key points in terms of development of transactions.”

The law, which grandfathers transactions entered into before June of this year, says that classic forms of shorting against the box are a "constructive sale,” triggering a tax treatment identical to a sale and repurchase of the asset. There is one significant exception, however. There will be no constructive sale if, 30 days after the close of the taxable year, the taxpayer goes naked for two months then goes back into the short. Some sources feel that this alternative will be attractive to investors. Erika Nijenhuis of Cleary Gottlieb believes that "we shall see a lot more short-term hedges in consequence. Some investors will be satisfied with being fully-hedged 10 months of the year.”

Nor does the taxpayer have to be entirely naked during that 60-day time frame. Though the more effective hedges such as puts or collars are disallowed, swaps against an equity basket of similar securities are permitted. For example, someone like Bill Gates might use a basket of technology stocks as the short for the period of exposure.

Because they require no money down, collars are the most likely replacement strategy for short-against-the-box strategies, provided they aren't "abusive”—that is, with strike prices on the call and the put that are so close that there is no downside risk or upward potential—though the official determination of this term remains to be determined at some future date by Treasury experts. "With this provision Congress and the IRS want to make sure that the investor has not synthetically written a short by having a de minimus spread, which would be the functional equivalent of a sale,” notes Shapiro. Among Wall Street tax lawyers, the consensus seems to be that the collar has to be at minimum out-of-the-money, and probably 10 percent to 20 percent of the stock price, to avoid the abusive label.

Many experts believe that collars will very likely be preferred over the 10-month short-against-the-box. However, Robert Gordon, president of Twenty-First Securities, believes that collars have some fairly unattractive features that create serious challenges for financial engineers. "One of the things that was good about short-against-the-box is that it was not considered to be part of a straddle,” he explains. "That is a negative attribute that the derivatives manufacturer is going to have to work around.” He also points out that under Federal Reserve rules, a broker could lend the taxpayer 95 percent of the value of the stock. With collars a broker is theoretically limited to a 50 percent loan.

Another headache: the short-against-the-box could be of unlimited duration, while options and swaps have continual rollovers, resulting sometimes in the "whipsaw” effect. Consider an investor who puts on a collar with the stock at $100 and the price subsequently goes up to $120. He buys back the call at a $20 loss, which for tax purposes has to be capitalized because it is part of a straddle. At $120 the investor puts on another collar and the stock declines to $100, so he gets out of the put with a $20 gain. This profit is taxable, even though the investor is back where he started. He's been whipsawed. "This problem was one of the reasons collars were not the tool of choice in the past,” notes Gordon.

Pro Market: RIP The dream of futures legislative reform died last summer. Although in early August the Treasury Department was still claiming the Commodity Exchange Amendments Act was alive, Washington insiders knew that the corpse had begun to smell. The post-mortem turned out to be an easy job. Blame for the fiasco lay squarely with the two giant exchanges, the Chicago Board of Trade (CBOT) and the Chicago Mercantile Exchange (CME), who had teamed up to twist arms in Washington to seek new freedoms and major relief from regulation by the Commodities Futures Trading Commission (CFTC) only to become bitter antagonists at the end. Sen. Richard Lugar (R-Ind.), chief sponsor of the legislation, decided he'd squandered enough political capital on this issue and consequently "has gone on to other things,” says a Washington source. Insiders believe nothing more will be done about the bill's various agendas until new champions are found in the capital, but that won't happen any time soon. In spring, the omens were good. Despite intense public opposition by CFTC chairwoman Brooksley Born, it appeared that the exchanges had a good shot at getting a substantial portion of the relief that they sought—in particular, an unregulated listed professionals-only market in futures. But in July, the CBOT made a side-deal with a breakaway group from the International Swaps Dealers Association (ISDA)—eight powerful financial institutions that lent their support to a new and more radical proposal for deregulation of government securities futures. Angered that its foreign currency futures would not be given the same freedoms by this proposal, the CME cried foul. Both sides met once to try to patch up their bitter public quarrel but failed to do so. There are rumors that other attempts at reconciliation may be tried, "but this is not on a fast track,” says a source close to the situation. The moral of this story is not easy to find. On the surface it looks as if the old internecine rivalries between the two giant exchanges blew out of control and they ended up shooting themselves in the foot. But in fact both of them worked hand in hand, coordinating their goals, structuring what they wanted out of the new law for well over a year. How did this considerable capacity for self-control, diplomacy and self-interest suddenly evaporate? The CME clearly felt it got too little out of the alliance with the eight big banks—notably no support for its ambitions for individual stock futures. The CBOT gambled that the CME could be made to swallow its unhappiness by pressure from the U.S. Treasury, Federal Reserve and legislators. It lost that bet, and with it chances for industry reform in general. In light of the industry's monumentally self-destructive behavior, the old complaints about the loss of global market share from CFTC red tape may never again carry the same weight.