Avoid Turning $1,000,000 into $12,000

Good to Know

Imagine an individual investor passionate about a specific stock (it happens more often than you might think). Assume the investor's portfolio is worth $2 million, but $1 million is in just one stock. How could that $1,000,000 concentration hemorrhage into only $12,000 in just over one year?

Sadly, that's precisely what happened to one of the top 5 investment banks in the United States(Bear Stearns). The stock price plummeted by a heart-arresting 99% during 14 months in 2007-2008.

Concentrated wealth risk is painfully real but ultimately manageable most of the time. This article continues our series with Variable Prepaid Forward Contracts. Here's our game plan:

  • Your Call to Action,
  • Client Perspective,
  • Purpose and Definition,
  • Flexibility, and
  • Tax Deferral.

Your Call to Action

As an advisor, your call to action is to raise awareness of this potentially catastrophic risk. Help your clients avoid or manage concentrated wealth risk through strategies such as:

  • Swap Funds,
  • Variable Prepaid Forward Contracts,
  • Performance Exchange Funds, and
  • Zero Premium Collars.

Swap funds were discussed in a previous article. Before illustrating variable prepaid forward contracts in this article, the advisor should understand this strategy's appropriate and inappropriate uses from a client's perspective.

Client Perspective

Why would your client be attracted to a variable prepaid forward contract (VPFC)? First and arguably foremost, the client is bullish on the stock. In addition, clients who place a high value on the following may be appropriate candidates for VPFCs:

  • Continued stock ownership,
  • Liquidity,
  • Protection against market value decline,
  • Participation in appreciation, and
  • Deferral of capital gains.

However, this strategy is not for every client with a concentration. Specifically, VPFCs may not be appropriate for:

  • Clients bearish on the stock,
  • Less-sophisticated investors (these transactions are complex),
  • Clients with less than $5 million,
  • Stocks with a relatively low market capitalization, thinly traded stocks, or stocks severely depressed in price.

Purpose and Definition

A Variable Prepaid Forward (VPF) contract is an agreement to sell shares at a future point in time ("to sell forward"). They are commonly executed by company insiders looking to protect concentrated positions while retaining upside potential.

There are two parties to the contract, the client, and a counterparty. The party buying the securities from the client, the counterparty, provides an advance payment (from 75% to 90% of the shares' value) to the client upon execution of the contract; hence it is "prepaid." There are no restrictions on the prepayment, so the seller can use the funds to purchase other securities or for any other purpose.

Flexibility

There is the advantage that the owner is not generally locked into a sell decision but could ultimately settle the contract with cash. There is a great deal of flexibility regarding the settlement date of the contract, three to five years being most common. When the time comes to close the contract, the amount of the settlement with the counterparty will depend upon the market value of the stock at the time of settlement; hence it is "variable."

Tax Deferral

The number of shares required to settle the contract is not known until the settlement date. The uncertainty regarding the number of shares to be delivered and their exact cash value when the contract is closed out generally keeps this arrangement from being treated as a constructive sale and allows the seller to receive the "prepayment" on a tax-deferred basis. Capital gain or loss will be realized upon settlement. Consultation with a professional tax advisor is strongly recommended before structuring a Variable Prepaid Forward Contract.

Summary

A VPFC may appeal to a client owning many shares in a single company (whether an insider or not) with a desire to raise cash and simultaneously defer taxes. This strategy may resonate strongly with the client who wants to own the stock but is concerned about concentrated position risk. Unlike the swap (exchange) fund in our previous article, your client keeps their concentrated stock position in the VPFC strategy while simultaneously hedging downside investment risk. Caveat—the use of a VPFC may raise IRS audit flags; this potential should not intimidate the client who is willing to use tax counsel and follow counsel's advice to the letter!

Coming Attraction—Stay tuned for our next article! We'll review how the zero-premium collar can be yet another arrow in your quiver.