Buyer should beware in structured product deals

Recently published in the Denver Business Journal, Volume 58, Number 48, May 25, 2007-May 31, 2007, 56 pages (Denver Business Journal), by Rich Todd. A reprint of the article can be found at the Innovest Website (Reprint)

In every weekly Denver Business Journal, you will read of closely held companies being sold and often the buyers are public companies.  The transaction is often structured with the seller receiving a substantial stake in the stock of the public company.  This can be beneficial from a tax point of view as an actual taxable event may not occur until shares of the public company are sold.  The seller therefore trades the illiquid, closely held company to a public company receiving the benefit of the liquidity (common stock) of the acquirer.  However, the seller still has a concentrated position in a single stock.

The risks of a concentrated position, whether in a closely held or publicly traded company, are substantial.  One of the benefits of holding shares of a public company may be the ability to hedge that position, but buyers should be cautious.  A seemingly sound structure and strategy may be a commodity in the real world and the prices that are charged and the commissions levied by brokers and banks can vary significantly.

A prepaid variable forward contract (PVF) is one such strategy.  A PVF is typically a guarantee of limited downside risk in a stock position, with some participation in the upside, and a substantial amount of cash be paid upfront to that closely held stock owner.  If structured properly, a taxable event may not be created until the end of the term (can be for many years) and the stockholder has significant liquidity to make other investments and diversify much of the risk that accompanies a single position.  The structure can be very complicated from a tax point of view.  Legal advice should be utilized.

Many banks and brokers will compete for the contract and the terms will be fairly comparable between most high quality institutions.  The problem is that commission rates vary hugely and the client may never know it. 

Case in point – (some of the details have been changed to protect the identity of the investor but general circumstances are accurate). A business seller received $25 million in common stock from the sale of a business and was presented a PVF from his long time securities broker.  The stock would be hedged to limit all downside risk, would receive up to a 40 or 35 percent gain on the stock, and receive the current dividend rate plus 1/3 of any dividend increase, and would have a $15 million loan against the $25 million wired to his bank account to invest in other areas, spend, or leave in the account.  The term was 5 years and at the end of the term the client repays the loan with the shares needed to cover the loan.  They could receive substantially more at the end of the contract, a long term capital gain would be triggered, and Uncle Sam would finally get his due.

The broker “scoured” the universe for the best deal for the client – only going to the best banks and settled on an AAA, high rated institution to guarantee the transaction.  What was not disclosed to the client was that the broker carved out a piece of the deal for himself and was receiving a healthy $1 million in commission.  Luckily for the client, their CPA wanted objective and independent advice on the structure and the deal itself and asked us to re-bid the contract. Many of the same banks were involved in the new bidding process and not surprising; the client was able to put well over $1 million more into his pocket.

We see cases like this time and again – especially when the broker/advisor has a “captive” client.  Relationships are always important with your advisor but be careful to not get too cozy. Commissions corrupt advice and at times it is difficult to know when a commission is paid – let alone the amount of the commission.