Current Options
Disclosure Document
(PDF Format) 

May 1999, Volume II, Issue 3    

Protection for Restricted Holdings

  Proposed Regs Could Makes Swaps Less Attractive (February 2004).

Restricted securities may appear to present problems for investors who wish to hedge their holdings. Since Rule 144 requires an investor to hold restricted stock for one year from acquisition, brokers generally refuse to accept such stock as collateral until the one-year holding period has lapsed. As a result, many investors believe that, unless they have other collateral, they cannot hedge "new" restricted stock. This perception is wrong. Several techniques are usually available for protecting restricted positions.

Swaps, collars and forwards are all efficient hedging strategies. In a typical swap, the investor exchanges the return on a securities position for an approximate money market rate of return on the market value of the position. At the end of the term, one party is required to make a payment to the other equal to the difference in the return on the securities and the money market rate of return for the term. (Alternatively, one could swap the return on the restricted securities for the return on other publicly traded securities). With this strategy, the collateral issue can be managed directly as long as the swap is contractually structured to terminate after the one-year holding period expires. If the swap is properly structured and the stockholder's credit quality is acceptable, the stockholder can usually borrow a significant portion of the value of the stock.

A variable forward contract also can be used to hedge a restricted stock position. With a typical contract the investor will sell the stock forward and can currently receive up to 100% of the forward sale proceeds. As with swaps, the contract must be structured to terminate after the one-year holding period expires.

A third hedging strategy involves options - i.e., puts, calls or combinations thereof (collars).  Standardized listed options are not viable since they can be exercised at any time (American style).  As a result, brokers generally will not accept as collateral any restricted stock that has not been held for one year.  To resolve this problem, the investor should select OTC or E-flex options, which allow the investor to choose European-style settlement (the options can only be exercised on the expiration date).  Generally, if the expiration date occurs after the Rule 144 one-year holding period expires, the investor can use the restricted stock as collateral and can even borrow against the long stock.

Finally, an investor who wishes to sell restricted stock prior to the expiration of the one-year holding period can usually do so at a discount in a private transaction.  The stock’s price is based on the amount of time left in the holding period and the buyer's ability to hedge the long shares.  Due to the somewhat complicated mechanics of the sale, the entire sale process can take up to two weeks to complete.

Investors considering these strategies should be aware of some potential pitfalls.  First, even if these instruments are structured to expire after the one-year holding period lapses, large positions may be limited by the Rule 144 volume limitations.  In addition, swaps generally will be deemed to be constructive sales that could trigger a capital gains tax, although collars and forwards can be structured to avoid constructive sale treatment. Finally, in the past few years, the SEC staff has raised the possibility of placing limitations on investors’ ability to hedge restricted securities.

For an interactive overview of hedging and monetizing possibilities for different types of appreciated securities, investors can consult Twenty-First Securities' hedging low-basis stock decision tree.

This article and other articles are provided for information purposes only.  They are not intended to be an offer to engage in any securities transactions or to provide specific financial, legal or tax advice. Articles may have been rendered partly inaccurate by events that have occurred since publication.  Investors should consult their advisers before acting on any topics discussed herein.   

Options involve risk and are not suitable for all investors.  Before engaging in an options transaction, investors must review the booklet "Characteristics and Risks of Standardized Options".  


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