Many high net worth individuals and family trusts have a significant portion of their wealth allocated to portfolios consisting of marketable equities and fixed income securities. This may be either in the form of a single concentrated stock position or a diversified portfolio of various securities. These securities may have been acquired through the sale of a family business, through years of accumulating assets through disciplined investing, acquired through the exercise of employee stock options, or by out-right inheritance. Given recent market volatility, many have seen their investment portfolios decrease significantly in value. Traditionally, there were few options available to protect against such declines in the overall value of an individual’s investment portfolio or concentrated stock position. One option is to hedge against downside risk by purchasing “puts”. However, this is a sub-optimal mechanism since options pricing during volatile markets can be very costly, and moreover, it can be difficult to administer on a diversified portfolio. Another option available to investors is to “collar” their existing position by buying a put and simultaneously selling a call option with identical maturity dates to off-set the cost of purchasing the put option. However, this is also a sub-optimal strategy in that it limits the upside potential in the future appreciation of the underlying equity, it is difficult to administer on a diversified investment portfolio, due to the “straddle rules” results in the dividends paid being taxed at ordinary income tax rates rather than the capital gain tax rate applied to qualified dividends, and it is coming under increased scrutiny by the Internal Revenue Service under the “constructive sales” rules. Finally, an investor could enter into a derivative trade by shorting an index (e.g. S&P 500). However, this too requires a significant out-of-pocket expense on the part of the investor, and it may not directly correlate to the price fluctuation of the investor’s underlying stock portfolio.
As an alternative to the protective strategies listed above, an investor could enter into a “pledge agreement” with a re-insurance company, whereby the investor would pledge their securities to the reinsurer in exchange for a non-recourse loan. Based on the trading volume and volatility of the underlying stock portfolio, the investor would receive a non-recourse loan in the amount of 75%-85% of the portfolio’s present value. Since the agreement is structured as a traditional loan, it is not considered a sale or transfer of beneficial ownership for either IRS or SEC purposes. The loan is also designed to be non-purpose so that the cash proceeds may be used by the investor for any means he or she desires. Since the loan is structured to be non-recourse, it has the additional benefit of creating a “synthetic put” without the investor incurring the cost of purchasing a put option in the market. Furthermore, as the transaction is structured as a pledge of the underlying shares, no change in beneficial ownership occurs. The investor retains all voting rights, dividends, and unlimited future appreciation of the underlying stock portfolio.
To best understand how the mechanics of this transaction works, it is essential to understand how various financial institutions earn profits. Traditionally, there are four forms of financial institutions; banks, trust companies, broker-dealers and insurance companies. The first group, banks, earns money by making business and consumer loans. In order to make such loans, they need to have sufficient capital reserves in the form of deposits which are strictly regulated by the Federal Government. The bank then makes a profit based on the spread between what it charges in interest on the loans it makes to consumers and businesses and the interest it pays out on its deposit accounts. Secondly there are trust companies that essentially act similar to bank, however they also earn fees by being named as trustee over potentially multi-generational family trusts. They then oversee the investment of these trust assets according to terms of the trust document and in accordance with their own conservative investment philosophies. The third form of financial institution, the broker-dealer, essentially matches buyers and sellers in the market. The broker-dealer then makes a commission on the transaction based on the size or value of the trade. This commission can either take the form of a one-time fee or an on-going charge based on the total assets under management. Broker-dealers therefore typically have “use” of the shares of stock held in accounts at their institutions to facilitate such transactions. Few investors realize that broker-dealers are constantly using the shares of stock the investor has on deposit in their account to make markets for the underlying securities. The final group, insurance companies, or in this case re-insurance companies, earns money by underwriting policies and collecting premiums based on the value of the policies they underwrite. Much like banks, in order to write new policies, insurance companies must have the statutory capital to support the underlying risk associated with those policies. This statutory capital requirement is also strictly regulated by the Federal Government with ongoing review by the insurance company’s actuaries and analysts. Much like a broker-dealer, when an investor “pledges” their marketable securities to the insurance company, the investor essentially allows the insurance company the use, not ownership, of their securities for the term of the pledge agreement. The insurance company can then leverage the use of those securities, now considered statutory capital for purposes of writing new policies. Since the agreement is deemed a pledge, and not a sale or transfer, the investor’s securities are not deemed assets of the insurance company and are not subject to the creditors of the company.
Although each transaction is unique and is designed to be a private transaction between two parties (that is to say, it is not a mass market product, rather a negotiated agreement between two independent parties), it might prove helpful to discuss a typical transaction. The first step in the transaction is for the investor to enter into a pledge agreement with the re-insurance company. This agreement essentially grants the re-insurance company dominion and control over the collateral, which is a “perfected interest” for regulatory purposes, but not a transfer of ownership. Thus, the reinsurance company derives the benefit of the use of the underlying securities. This is the “bookable event” to which the regulators look to in order to establish the asset’s value for purposes of the re-insurance company’s statutory capital requirement. Much like leasing a commercial office building, the leassor has use of the office space during the term of the agreement, but does not have an ownership interest in the underlying building. Therefore, although the re-insurance company derives the benefit of the underlying securities as statutory capital during the term of the pledge agreement, all incidents of ownership remain with the investor.
The second step (done simultaneously with the first) is for the re-insurance company to loan the investor an amount in cash today equal to 75% to 85% of the current fair-market value based on the trading price of the underlying securities. This loan is structured as a non-recourse interest-only note typically for a period of three or more years. The interest rate charged on the loan is based on the 3-month LIBOR rate (currently about 1.25%), plus a spread of between 50 and 100 basis points. Although this is a “floating” interest rate, the agreement provides that at no point will the interest rate charged on the outstanding principal exceed 100 basis points above the initial contract amount. Thus, there is a cap in the amount the rate can increase pursuant to the agreement. Since re-insurance companies are not in the business of making loans, rather writing new policies, the re-insurance company is merely passing along its cost of capital to the investor. Thus, the investor is getting the added benefit of being availed the opportunity to borrow at institutional rates rather than individual rates, which traditionally are much higher. Going back to the point of non-purpose, the investor now has the cash proceeds from the loan to do with as he or she pleases. This includes paying down other debt, making other investments, or even personal spending. So long as the investor makes the quarterly interest payments in a timely manner, the re-insurance company will not foreclose on the loan and sell the underlying collateral. Furthermore, on dividend or interest paying securities, the annual yield is usually sufficient to cover the cost of the quarterly interest payments.
At expiration, the investor has three options. First, the investor may simply pay off the principal balance of the loan and receive their securities back in kind. The second option is to re-document the pledge and loan agreement based on the new value of the underlying equity portfolio. Essentially, the investor has the right to “refinance” the loan and pledge agreements. Assuming the value of the portfolio has increased, the investor can then drawdown more money based on the portfolio’s appreciated value and lock-in a higher non-recourse loan.
Finally, if the investment portfolio or concentrated stock position has decreased in value below the level of the initial loan principal, the investor has the option to just keep the non-recourse loan proceeds and “put” the stock to the re-insurance company. It should be pointed out that this alternative may have significant income tax, and in the case of a company insider, potential SEC filing consequences, and therefore should be carefully considered with the investor’s legal and tax advisors. However, since the loan is non-recourse, the re-insurance company only has the underlying securities to look to as collateral for the loan. It cannot hold the investor liable for any shortfall between the portfolio’s value and the principal outstanding on the non-recourse loan. In this aspect, this structure is far superior to a traditional margin account in that margin balances are still “recourse” to the investor. If the stock drops significantly in value, the bank or broker-dealer retains the right to look to the investor personally for making good on the loan as a whole. Also, in the instance of a margin call, the investor is required to infuse additional capital from other sources, or required to sell a portion of the underlying securities at depressed market values. An additional benefit of this structure is that unlike a collar, pre-paid forward contract, or interest rate swap, there is no off-setting derivative trade in this structure. Therefore, each of these options is also available to the investor at anytime during the term of the agreement and there is no pre-payment penalty for unwinding the contract early.
There are several situations where this structure is the ideal transaction for the individual high net worth investor. Initially, it is well suited for the entrepreneurial business owner who has just sold his/her private company to a publically traded company in exchange for stock. Since the entrepreneur is no-longer in control of the company and most likely had much of their net-worth tied up in their business, he or she would want to protect against the potential downside risk in their newly acquired stock. This is especially true if there is a “lock-up” period associated with the transaction whereby the individual is precluded from selling shares for a certain period. Another situation is the individual investor who has a significant margin position against their marketable portfolio and is now perhaps receiving margin calls. This structure would allow the investor to convert their margin balance to a non-recourse loan with a higher LTV and at a lower interest rate. A third situation is a significant shareholder in a non-dividend paying stock that could use this strategy to create a “synthetic dividend”. This could be accomplished by taking advantage of the interest rate arbitrage between the 3-month LIBOR rate plus the spread charged on the loan principal, and the interest that can be earned on other investments currently available in the market. The final situation is any investor who is concerned with the potential downside risk currently associated with their investment portfolio. This investor can use this structure to create a “synthetic put”, below which value he or she is guaranteed their investment portfolio will not decrease. The investor is also able to accomplish this without having to incur the out-of-pocket cost typically associated with purchasing such insurance in the open market.
In summary, a privately structured stock pledge and loan agreement has many benefits to investors over the traditional structures used to protect the investor against the downside risk in their equity and fixed income portfolios or monetize the securities in their portfolio. First, it allows the investor to borrow money today on a non-recourse basis, thus creating a synthetic put value on the investor’s total portfolio without having to incur the cost of purchasing a put in the open market. Second, it allows the investor to limit their downside risk in their portfolio without giving up any of the upside potential appreciation of the underlying securities. Third, the investor is able to monetize their portfolio on a non-recourse basis at a much higher loan-to-value level than traditional margin accounts and at significantly lower interest rates. Also, since the loan is non-recourse, there will never be a margin call requirement to infuse more capital into the account, so long as the investor continues to make the timely interest payments. Fourth, the transaction is structured as a loan with sufficient downside exposure and unlimited upside potential so as not to fall under the constructive sales rules of the IRS. Next, since beneficial ownership of the stock does not change, all incidents of ownership remain with the investor and the stock is merely pledged to the re-insurance company. As a result, there is no Form 4 filing requirement for SEC purposes. Lastly, as there is no off-setting counter position, the investor retains the right to unwind the transaction at any point during the term of the pledge agreement without incurring a pre-payment penalty.
A Privately Structured Stock Pledge & Loan Agreement Benefits the Investor
1. By protecting the current value of an investor’s portfolio of concentrated stock position.
2. By creating liquidity without having to sell the investor’s underlying portfolio.
3. By creating a “synthetic” cash dividend on a non-dividend paying security.
4. By increasing the current dividend yield on an annual basis.
5. By enabling an investor to diversify their overall investment portfolio.
6. By reducing interest expense on other loans.
7. By preventing distressed sales due to margin call requirements.
8. By deferring capital gains taxes.
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