What do top executives from Starbucks, Costco, Tyson Foods and 400 other publicly traded companies have in common? They all engaged in complex stock sales know as variable prepaid forward contracts. And they aren't alone. In addition to highly paid corporate employees, billionaire businessmen and investors routinely use variable prepaid forward contracts to lock in their gains and defer their taxes.
Proponents of these contracts view them as valuable wealth preservation tools. Detractors see them as a way for rich people to make themselves richer even if shares of the companies they work for fall in value and shareholders take a hit. (Learn more in Tax Effects On Capital Gains.)
How the Contracts Work
A wealthy stockholder agrees to give a pre-determined number of shares of stock to a brokerage firm or investment bank to hold, with the understanding that ownership of the shares will be officially given to the brokerage firm or bank at a future date. In exchange for this agreement, the brokerage firm or bank pays the stockholder somewhere between 75% and 90% of the value of the stock. The payment is made the day the deal is struck, even if the deal isn't due to be officially completed for years.
If the stock has risen in value by the time ownership of the stock is due to be officially transferred from the former owner to the new owner, the executive gets a portion of the gains. If the stock declines, the brokerage firm or bank absorbs the loss.
Why They Do It
Locking in the cash is the biggest reason executives enter into these agreements. They get a huge payment upfront, turning their holdings into liquid cash all the while maintaining the ability to make even more money if the shares rise in value. They also retain voting rights, which keeps them in control of the portion of the company that they own. For investors, this means that they profit from the stock while maintaining the leverage of ownership and voting power. (Shareholders are getting a bigger say in how companies are run. Find out how you can be heard, see How Your Vote Can Change Corporate Policy.)
For employees, this means that they take home the cash while staying in the good graces of their employer and their employer's other shareholders, as nobody likes to see highly-placed corporate leaders selling vast quantities of the firm's shares. From a public relations perspective, it looks bad to see the top executives bailing out. From a securities analysis perspective, it could raise questions about the firm's future profitability if an insider is selling. Once again, variable prepaid forward contracts provide an attractive solution. The complex nature of the transaction, long lead times before share ownership is given up, and limited disclosure requirements enable executives to eliminate the risk of owning the shares without attracting the ire of shareholders or other members of the management team. (Predated trades at regular intervals can instill confidence, not fear, for investors Insider Selling Isn't Always A Bad Sign.)
Some executives also use this transaction as a way to defer taxes. The argument being that the transaction isn't complete until the shares have been handed over, so taxes on all that cash that was handed out when the deal was stuck aren't due for years. The IRS may frown on this aspect of the transaction, but that hasn't stopped some executives from engaging in the behavior.
Pros and Cons
From the standpoint of a wealthy executive or investor, variable prepaid forward contracts are a good deal. Potential tax deferral aside, the contracts provide downside protection, upside potential, instant access to cash and ongoing ownership. They are also an excellent estate planning tool for senior executives. Since these executives often have a significant portion of their wealth tied up in share of their employer's stock, and may have contracts that forbid them from selling some or all of their shares, variable prepaid forward contracts provide a way to reduce the risk of having such a concentrated position of single stock. For the person looking to enter into the contract, the only downside is the possible loss of a small percentage of gains if the stock price continues to climb.
On the other hand, research has shown that companies where executives make use of these contracts tend to see significant declines in their share prices after the deals are stuck. Research firm Gradient released a report in April of 2009 showing that companies where these deals are struck tend to see, on average, an 8% greater decline in their share prices in the year after the deals are done than companies where executives don't engage in these types of arrangements. This difference is compared to similar companies in the same peer group from 1996 to 2006. (Calculate returns frequently and accurately to ensure that you're meeting your investing goals, check out Gauge Portfolio Performance By Measuring Returns.)
Adding that 8% on top of any other declines seen by peer group companies results in a hefty drop. While Joe and Jane shareholder suffered the full brunt of those declines in their brokerage accounts and 401(K) plans, the richest people in the companies that use these contracts locked in gains. While this arrangement doesn't seem too fair to the vast majority of investors, the practice is legal and quite common.
Like many complex investment transactions, perspective plays a big role in how you view the issue. If you benefit from the arrangement, you probably view it as a positive. If you come out on the short end of the deal, you're unlikely to view the arrangement as ethical. (For similar strategies and to guard your finances in uncertain times, see Don't Forget Your Protective Collar.)