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