Monetization trades can turn illiquid stock holdings into cold cash. But what do shareholders and the SEC need to know?

By Nina Mehta

So iBathroomTissue.com, the company you started with begged and borrowed money, has just gone public. The IPO tore through the roof and you're worth $59 million. On paper. But you owe $41,000 for college loans, your VISA debt has swelled to $77,000, and your brother has just called in his $130,000 loan. The fact is, you're cash poor. What do you do?

Or maybe your name is Dick Cheney. You have options on 400,000 shares of Halliburton Co. stock (including 140,000 resricted shares). Ignoring the political liability of having a chunk of equity in an oil services company when you may soon be kingpin of U.S. energy policy, how do your protect your holdings from a decline in the stock price and diversify into, say, U.S. Treasuries?

From Wall Street to Silicon Valley, the answer lies in two golden words: monetization trades.

Monetization trades allow you to pull cash out of illiquid positions or positions you can't climb out of easily (or don't want to exit). You may have oodles of restricted stock or a large position that has simply appreciated over the years, or perhaps you're the CEO of a startup who doesn't want to spook investors by selling the baby because the bathwater is looking dicey. Even if selling out of a position is feasible, you may find the capital-gains tax hit unconscionable. Structured monetization trades enable investors to protect their wealth from a slide in stock price and to diversify into other positions. The cost: investors gives away some upside to fund the protection.

Sounds simple. And the fact that there are many tens of billions of dollars worth of underlying stock hedged this way each year by individuals in the United States indicates that these trades are not simply for family offices and sky-high-net-worth individuals. (Merrill Lynch, for example, will put on trades for concentrated positions of $1 million, although the minimums at most dealers are three times that.) Business is also up significantly from this time last year-anywhere from a 20 percent rise in the notional value of the stocks being hedged to double the number of trades getting executed by individual dealers. These structured transactions, however, take place at a crossroads of thundering tax-law complexity and wildly ominous speculation about disclosure rules. Figuring out what's allowable when and by whom, and what must be disclosed to the Securities and Exchange Commission, requires great forbearance. And a gold-plated tax attorney.

31 FLAVORS

Like stockholders, structured monetization trades come in different shapes and sizes. One versatile, popular product is the zero-cost, or costless, collar plus loan. If a stock is trading at $100, for instance, a client could buy a put at, say, $90, and sell a call at $112 or whatever strike price will generate enough premium to cover the cost of the call-perhaps $110 or $115. By locking in the value of the position to the range between the put and the call, the client will have effectively secured his wealth and can then borrow against 90 percent of the put strike times the number of shares being hedged.

The monetization product that has surged ahead of collars in the popularity stakes this year, however, is the prepaid variable forward contract. In this case, a client enters into a contract to sell forward a number of shares that varies based on the price of the stock at the contract's expiry, and gets an advance of, usually, 80-85 percent of the market value on the trade date. There are also other instruments that can be used, such as exchange funds (pools of restricted stock), and variations on collars and forwards, involving put straddles or call straddles, as well as differing degrees of upside participation and risk that can be laid into a transaction based on the client's expectations about the stock being hedged. There are also, of course, regulatory restrictions on the use of proceeds in certain transactions and layers of delicate tax-arbitrage issues to weigh before making a move.

Needless to say, these intensely tricky products come at a price. Not only do clients generally lose their ability to gain on the upside above the strike price, but they could lose big-time if they decide they want out of a position too early. "One problem is that quite a few insiders change their minds after they've entered into a hedging transaction," points out Peter Romeo, former chief counsel of the SEC's Division of Corporation Finance and now a partner and securities specialist at Hogan & Hartson LLP, a Washington, D.C.-based law firm. People need to be clear about their reasons for hedging, he notes. If an equity collar is unwound within six months after it's entered into by a corporate insider and a profit is booked, for instance, that person must disgorge the profit to the corporation, according to federal securities law. "This happens more often than I care to say-that insiders change their minds," adds Romeo, co-author of the standard treatise on U.S. corporate-insider reports used by statutory insiders and their lawyers.

WHO'S USING WHAT

By and large, people put on collars and monetization trades to protect against declines in stock price. The first such trade, an equity swap, was structured in 1994 by Michael Dweck, then at Bankers Trust, for the CEO of Autotote Corp., a New York-based company that provides pari-mutuel wagering equipment and services to racetracks and off-track betting facilities. After the CEO bought what amounted to an insurance policy on his personal chips, the price of the high-flying, volatile stock jackknifed. The effect was twofold: the deal kickstarted what is now a multibillion-dollar industry, and it launched what has turned out to be a resurgent anxiety about what needs to be disclosed and how the hedging activities of corporate insiders might affect the marketplace.

"People are pitched products that may not be right for their needs. It's like telling everybody they have to wear a mouse suit.” Bob Gordon, Twenty-First Securities

While wealth protection is the primary hedging motivation, investors generally want to spoon money out of concentrated positions in order to diversify. People are not afraid of market risk, say dealers, but they don't want to be sitting on powderkeg positions. Monetization trades therefore tend to take place after there's been a run-up in stock price, prompting investors to try to lock in their gains.

Another crucial (and continually replenished) source of hedging activity is mergers and acquisitions. Many executives and entrepreneurs, particularly those who founded businesses, are content to hold unhedged stock when it's their company, but after a stock-for-stock merger or acquisition, in which they wind up with a large portfolio of the new stock, they become leery. At Morgan Stanley, the hands-down market-share leader in monetization trades, approximately 90 percent of transactions come off the back of M&A activity. Marie Mole, managing director and head of the firm's equity structured products group, points out that entrepreneurs and executives are "generally not as well-versed in the stock they end up receiving as they were in the original company," which leads them to consider hedging initiatives.

There are other significant trends among people who put on hedges nowadays. Although many people assume the Nasdaq-fueled bull market has encouraged a lot of newbie high-rollers to seek out wealth-preservation schemes, about 50 percent of monetization trades are done on stocks of Old Economy companies. In the first half of this year, "there was a pretty heavy concentration in the hedging of New Economy stocks," says Jeff Sparks, executive director in the equities division at UBS Warburg in Stamford, Conn. "But since the decline in Nasdaq in the spring, the weighting has probably become a bit more balanced." A trader at a European investment bank notes that people with $50 million or $75 million were the ones putting on these transactions in the past. Now, it's high-net-worth individuals who are considerably younger and worth $10 million or $20 million instead.

The products clients use to monetize concentrated positions have also changed over the years, primarily because of the Taxpayer's Relief Act of 1997. Until then, equity swaps (in which the cash flows of different instruments or baskets of stock are exchanged) and shorts against the box (in which a client borrows from a dealer shares of a stock already owned and sells them short) eliminated the risk of stock-price slippage and allowed investors to diversify their exposure without paying capital gains tax on the position being monetized. But these no-risk trades were coldcocked when the Taxpayer's Relief Act deemed such strategies "constructive sales"-and therefore subject to capital gains tax, even though the positions were not actually sold.

But no tax law change can truly stifle hope and dealer activism, and this change in the tax code resulted, unwittingly, in an efflorescence of new monetization strategies. And that, coupled with a roaring equity market and the creation of many tens of thousands of paper millionaires in the United States, led to greater demand for these products. Options-based strategies and trades that were not deemed "abusive" were allowed as long as investors retained a significant ability to win or lose from their transactions. So the dealing community, thrown back to square one, "turned to options to replicate the payoff patterns clients wanted," explains Robert Gordon, president of Twenty-First Securities, a New York-based tax arbitrage firm, and a former chairman of the Securities Industry Association's tax policy committee. The tax and regulatory consequences of these products are their most critical component, he adds, and are typically the deciding factor between trades that are otherwise economically equivalent.

"Over the last year, securities lawyers have tried to find more creative end-runs around the standard language of lockup agreements.” Keith Styrcula, Credit Suisse First Boston

In addition to wealth preservation and tax deferral, another reason for the increased use of monetization trades is intensive marketing. Although standard hedging transactions are becoming more commoditized, spreads in these trades haven't suffered. The deals, after all, must be structured individually and often need to be executed over-the-counter since liquidity in the listed options market isn't always adequate. "There's good money to be made on the investment banking side by selling monetization trades, especially in illiquid Internet companies that just went public," admits one industry maven. Since dealers can usually pocket half the bid/ask spread, "the worst deal for the client turns out to be the best place to sell for the dealer in terms of getting good margins," he says.

One drawback for clients is that these products are so complicated, with so many legalistic alleyways and switchbacks, that individuals can get easily confused. "These products are sold, they're not purchased by informed investors," argues Gordon. "People are pitched products that may not be right for their needs, by whichever desk gets to them first. That's obviously not good, because they have different needs. It's like telling everybody they have to wear a mouse suit." Mouse suit or no, a number of dealers have opened offices in Silicon Valley, where many in apparent need of hedging live, and some traders are leaving more traditional desks to sign up for active wealth-preservation duty on behalf of newly minted i-millionaires.

REPORTING CONCERNS

The boom in monetization trades, however, also brings to the fore a number of reporting and shareholder issues.

One striking aspect of the monetization phenomenon is that it thrives despite an enormous number of mistaken assumptions about market disclosure rules and hedging activity. Dealers and tax lawyers, as a group, see no wiggle room about what needs to be reported. Many otherwise knowledgeable experts, however, argue that the SEC's regulations are not black and white, but streaked with a deleterious gray. One mistaken assumption is that the disclosure rules are less stringent for derivatives transactions than they are for outright sales. "The disclosure requirements are very vague in this area and they're subject to interpretation," says one person who follows the hedging activities of corporate insiders. "There's a real need for the SEC to clarify them."

Another mistaken assumption is that it's more difficult to locate information about collars and other hedging activity than it is to track stock sales. "You just don't read in the Wall Street Journal about people who have put on costless collars, but you do read about people owning more than 5 percent [of a company's stock] selling the stakes," argues one market participant who suggests that SEC reporting allows varying degrees of latitude based on the type of transaction executed.

There are also other wrong-headed assumptions making the rounds: that restricted stock is illegally being hedged; that lockup covenants are casually being abrogated by investors putting on collars after they've agreed not to pledge, loan, hypothecate or hedge their positions directly or indirectly; that deadlines for filings are flexible; and, simply, that there are ways to avoid disclosure by setting up an offshore trust or some other entity.

"Perhaps 80 percent of the time, corporate insiders are just hedging, but 20 percent of the time they're getting out ahead of the women and children.” Neil Chriss, ICor Brokerage

In fact, there is nothing vague about the SEC's regulations. People who simply have a lot of stock, but who are not affiliates of the public company whose stock they own, and who are not statutory corporate insiders or large stockholders, do not need to disclose their hedging activity. Or, indeed, their sales. So a twenty-something entrepreneur who sells his company to Microsoft and winds up with a million shares of the Seattle-based tech tycoon-but no executive managerial role in Microsoft's affairs-can hedge his position without so much as a nod in the SEC's direction.

Those who need to report their hedging activities are those in specific relationships with the corporation whose stock they own. Affiliates need to file a Form 144 when they execute a sale (Rule 144 provides a safe harbor for the transfer and sale of restricted and control securities). Statutory corporate insiders-that is, officers of a company, directors and 10 percent stockholders-fall under Section 16 of the Securities Exchange Act of 1934 and must file a Form 4 whenever there's a change in their beneficial-ownership holdings. And 5 percent stockholders have to file other forms specified in Section 13. These are the sum total of the reports the SEC has at its disposal for purposes of the disclosure of hedging transactions (and all the deadlines are writ in stone).

Misinformation also runs rampant about whether hedging is permitted on restricted stock and during lockup periods, such as after an IPO or at the time of a merger or acquisition. Restricted stock can be hedged just like unrestricted stock, although for collateral purposes the contract generally has to mature after the stock is no longer restricted. Lockup agreements, meanwhile, are contractual agreements between underwriters and the people who receive restricted stock. "Over the last year, securities lawyers representing the holders of restricted stock have tried to find more creative end-runs around the standard language of lockup agreements," notes Keith Styrcula, equity derivatives product manager at Credit Suisse First Boston's e-commerce initiative in New York. Because of the legal risk to the corporation under Rule 144, however, "the first order of business in a restricted-stock hedging transaction is to get the lockup agreement and have seasoned legal counsel review the restrictive covenants for what can and can't be done," he adds. Not surprisingly, attorneys respresenting companies issuing restricted stock have recently made a concerted effort to bullet-proof the restrictive language of lockups, since restricted-stock holders and some Wall Street firms have taken more aggressive and creative approaches to monetizing that stock.

While the law is clear about what statutory corporate insiders need to disclose when a hedge is transacted, the business of disclosure is fraught with anxiety for many executives. The bogey of disclosure is that hedging is seen as a no-confidence vote on the company's stock. After all is said and done, notes one trader, "hedging is a way of cashing out of a position. It is not good PR." So CEOs, CFOs and the like have for years fretted over-and often shied away from-transactions that could sound alarms in the marketplace and send their stock price tumbling.

This worry is grave enough to have affected the actions of corporate insiders, says Bill Quinlan, a partner and securities lawyer in the Chicago office of McDermott Will & Emery, a national law firm. In the past year, every one of the dozen-plus CEOs of publicly traded companies who inquired at his firm about collars and other hedging transactions wound up walking away from the deals. "They got cold feet and decided that this was not something they were interested in doing because of all the reporting requirements-especially since they had huge blocks of stock," he points out.

Quinlan's firm gets involved in monetization trades regularly, but not for statutory corporate insiders who have to report their positions. The ideal people for these trades, he suggests, are individuals who have a lot of stock or people whose companies have merged into or been acquired by another company whose stock they now own-and who are no longer corporate executives and therefore don't need to file disclosure forms chronicling their transactions. Indeed, he adds, many executives in merged companies wind up turning down executive-officer or director positions in order to have the freedom to not report their hedging transactions.

But not everyone agrees that corporate insiders are wary about hedging concentrated positions. Broker-dealers and investment banks insist they are putting on dozens upon dozens of what could be called comfort trades for CEOs, CFOs, men and women serving on boards, and affiliates. "Hedging a position is much more palatable than selling the stock," argues Morgan Stanley's Mole, "because collars and forward contracts don't send a signal to the market that you think the stock has no upside. You believe it has some upside, which is why you are not selling out of your position." UBS's Sparks adds that corporate insiders and affiliates who have done well in the market over the last few years are not reluctant to hedge, "but might be hedging 10 percent or 20 percent of their position, not 100 percent, because of concern about the potential market impact of disclosure."

Increasing sophistication about derivatives also has an impact on how comfortable people are with these transactions. Corporate insiders have more concentrated wealth than they did a half-dozen years ago, and make no bones about the need to diversify. At the same time, shareholders recognize that executives don't want to hold concentrated positions any more than they do-and are less likely to see a skull-and-crossbones warning hovering over a ticker symbol when an executive lightens his or her load by hedging a position.

HIDDEN VIEW

Yet while Section 16 filers must disclose their hedging activities, the practical effect sometimes is that less information about what an executive is doing gets disseminated to the public. Form 144 filings of market sales by affiliates of a company are regularly reported on Yahoo and other web sites that track the activities of corporate bigwigs. News of collars and other derivatives hedges occasionally shows up in the Wall Street Journal, Business Week and other financial publication-but not often and not as a matter of course.

There are a few reasons for this. First, while information about hedging activity is automatically public, members of the public must seek out that information. Second, bus fare to the SEC is required. So far, the SEC has not mandated that Form 4 be filed electronically (as is required with many other forms), because it is so complex. Therefore, interested parties must traipse to Washington, D.C., for a look-see at the relevant paper filings. In addition, derivatives transactions are reported in Table II of Form 4, while sales are recorded in Table I-and Table II is on the reverse side of Table I. Romeo, the former SEC counsel who's now at the law firm Hogan & Hartson, suggests that people looking for this information may simply not be flipping over the form. The information, he points out, is public and is as accessible as Form 144 filings (which are also not electronic), and it is not incumbent on corporate insiders to make an announcement every time they do a transaction.

There are companies, however, that are now tracking exactly these sorts of derivatives transactions put on by corporate insiders. Lancer Analytics, a joint venture by Primark Corp. and Scottsdale, Ariz.-based Camelback Research Alliance, will collect corporate-insider-trading data from SEC forms, analyze and model the data, and sell customized reports of relevant information to institutional investors. The company will also grade statutory insiders who seem to have a sixth sense about when their stock will go up or down, based on their transactional disclosures. InsiderTrading.com, owned by Individual Investor Group Inc., also offers information about insider-trading activities on its premium service.

SHAREHOLDER CONCERNS

In the meantime, there is a different area of disclosure that relates directly to shareholders.

What shareholders know about the hedging activities of corporate insiders and when they know it is an area of growing concern, if only because the hedging activity of insiders seems to be on the rise. More than half the hedges executed and the preponderance of increased dealer activity come not from insiders but simply from those with large positions and no reporting requirements. But hedging among Section 16 filers also seems to be kicking up. And for shareholders, the hedging gambits of statutory insiders are not insignificant.

One drawback to monetization trades for shareholders is that once corporate insiders at publicly traded companies protect themselves from the risk of stock-price declines, their interests are no longer automatically aligned with shareholder interests. There is nothing illegal about this, but it flies in the face of the not-unreasonable expectations of shareholders. "It clearly diverges from shareholder interests for corporate insiders to have [these kinds of] transactions on, because they can take risks that may not be in the interest of shareholders, while they are indifferent to some of those risks since they're protected on the downside," says one dealer. "To a certain extent, what this means is that the executives are getting out of the game," adds another market participant. "And shareholders in a company usually want their senior executives to be in the game."

The first study tracking the hedging activity of statutory insiders is primed to be released soon. Michael Lemmon, an assistant professor of finance at the University of Utah's business school and one of the authors of "Insider Trading in Derivative Securities" (currently a working paper), argues that the ability for derivatives transactions to be slightly more hidden than direct sales makes it possible for people to use collars and monetization trades "more opportunistically" and in ways that shareholders cannot readily fathom. (For more on the study, see "Does More Monetization Mean More Risk for Shareholders?".)

The presence of monetization trades in the market also raises questions, or at least complicates, the issue of executive compensation. "The reason companies give option-based compensation or stock-based compensation to executives is to make sure their incentives are aligned with those of shareholders, and one of the premises is that they can't go out and simply undo those incentives," says Lemmon. "Yet monetization trades give executives at least the potential to do exactly that."

David Yermack, an associate professor of finance at the Stern School of Business at New York University, and an authority on executive-compensation structures at public companies, agrees. "When executives take those options and effectively sell them through equity swaps or other transactions, what they're doing is basically removing the incentive contract that the firm put in place. This means managers will have lower and less powerful incentives than it appears to shareholders." To the extent that those incentives were causing them to do things like raise the stock price, make dividend payments or not make dividend payments, he adds, "all the effects of the incentive contract are going to be diminished."

This can also be framed as a matter of transparency. Equity investors try to make investment decisions based on every available nugget of information. "Therefore, anytime there's a differential in information, someone is liable to make an inferior decision," suggests Neil Chriss, president and COO of ICor Brokerage, a global on-line interdealer-broker of derivatives. No one, of course, can know why an executive wants to extract cash from a concentrated position. The executive may be using the equity to generate cash to purchase a home or may be hedging a portfolio, but the person may also be hedging because he knows a competitor is coming out with a better product. "You would definitely consider it a negative signal if an insider in a company, especially a young and growing company, were using his or her equity to generate a lot of cash," says Chriss. "Perhaps 80 percent of the time they're just hedging, but 20 percent of the time they're getting out ahead of the women and children. In that case, if you own a portfolio, you might want to lower your portfolio allocation to that particular piece of equity."

Another broad concern is that those who wind up riding volatile stocks down tend to be the ordinary shareholders, not the company executives. A company executive with low-basis stock that shoots up from its $12 initial offering to $120 after the IPO lockup period ends, for example, can collar a transaction at that upper level. If the stock price is then hacked down to a stump, the executive will have captured his economics at the upside, while shareholders are left with fistfuls of stock now worth 5 percent of its initial value. This, say some, is unfair. But it is also, point out others, how the market works. People pay for their insurance policies, and an insider who caps his upside in order to fund his floor will not share in the winnings if the stock appreciates to the moon.

No one, of course, is about to argue that hedging stock holdings isn't defensible, or that it does not have widespread market utility. People who have built companies and holders of large concentrated positions should be able to hedge their positions, just as farmers and copper smelters are able to protect themselves against changes in market prices. The IRS, however, has not taken its eye off collars and other monetization trades that defer taxes to a later date, although it's not considered likely that the tax authority will revisit these trades in a major way. Ultimately, though, the SEC, the great purveyor of transparency and shareholder education, may decide step up to the plate and issue new rulings to add more transparency to the market. But even if this doesn't happen, there will be enterprising companies that will fill the existing information breach with new layers of detail about what corporate executives are doing and what it might mean. And that, probably, that won't be such a bad thing.

Does more monetization mean more risk for shareholders?

Until now, there have been no hard-and-fast statistics about what tends to happen to the stock price of companies whose corporate insiders hedge their stock holdings. A working paper by three academics west of the Mississippi, however, replaces a lot of speculation with actual findings. "Insider Trading in Derivatives Securities: An Empirical Examination of the Use of Zero-Cost Collars and Equity Swaps by Corporate Insiders" by Michael Lemmon, J. Carr Bettis and John Bizjak, is based on the SEC-mandated Form 4 filings of statutory insiders. The data in the study was gathered by Primark Data Co., and the study analyzed the hedging activities of corporate insiders from the beginning of 1996 through the end of 1998. (The paper is currently under review at a finance journal.) According to the study, statutory insiders who engage in hedging activities such as equity collars and prepaid variable forwards tend to be relatively undiversified, tend to put on hedges after big increases in their firms' stock prices, and are typically looking for ways to diversify their portfolios. "In that respect," says Lemmon, an assistant professor of finance at the University of Utah's business school and one of the authors of the paper, "there's nothing evil about what they're doing. The thing that's a bit tricky is that I don't think the average shareholder has a good feel for how often these products are used or even what they do." Corporate insiders generally end up hedging their positions at high stock-price levels. Subsequently, returns on the stocks tend to revert to more normal levels-they don't fall but they don't continue to go up, at least not nearly as quickly. "Corporate insiders are certainly not taking advantage of shareholders in the sense that stock prices fall significantly after they do this," says Lemmon. "At the same time, they're not leaving any money on the table." The study found that stock-price volatility usually increases after hedges are transacted. One explanation is that executives put on these transactions because they anticipate increased stock-price volatility. The other explanation, notes Lemmon, "is that [after hedging] they're more willing to take on greater risks because their wealth is less influenced by changes in the stock price." Companies whose insiders hedge their positions, for instance, tend to have more M&A activity or other restructuring after executives put on collars or similar transactions than companies whose executives are not protecting their positions. So is this good or bad? "Increased volatility can actually be good for shareholders because managers who are undiversified don't want to take on as much risk as shareholders would often like," notes the Utah professor. "On the other hand, it can be bad for shareholders if they take risks that shareholders would rather they not take. And the fact that we don't find any stock-price increases associated with increased volatility does suggest that it's not beneficial to shareholders." But is it actually disadvantageous? Well, yes. Companies that display the biggest stock-price volatility increases after executives hedge their holdings tend to be the ones whose stock prices rise the least. The study also found that young companies, defined as those that have been listed for a year or less, are more likely to have insiders insuring their positions. The findings did not suggest that insiders were instigating collars or other hedges in defiance of lockup covenants, but the study concluded that younger firms were three times more likely than more established firms to have executives throwing protective blankets over their gains. Needless to say, that's not a great sign for shareholders and investors who don't want executives to have the effective equivalent of a tag sale the moment the lockup comes off.