Using Forward Sale Agreements to Capitalize on Market Conditions
Spencer Johnson, Keith Townsend, Tony Rothermel, Kathryn Furman, Jeff Stein, Jennifer Morgan, Wayne Pressgrove, Mark Thigpen
A forward sale of common shares is an offering that is agreed upon today with a settlement date in the future. Forward sale agreements allow companies to capitalize on current trading prices by locking in a price at which it can sell shares to a forward purchaser – typically an investment bank – in the future. The delayed issuance provides flexibility to the issuer without a “drag on” performance measures (e.g., funds from operations) or shareholders incurring immediate economic dilution (i.e., dividends and earnings per share). These agreements are typically used to fund transactions where the timing of the closing or capital need is uncertain, including funding a transaction over time, as yet unidentified acquisitions, or future development opportunities. The transactions can also be structured to permit repayment of borrowings and for general corporate purposes. In addition to the variety of ways to use a forward sale, these agreements have a number of benefits that may be particularly attractive for REITs. These benefits are particularly useful for REITs, where the need to fund capital expenditures usually takes place over time, as opposed, for example, to a onetime acquisition cost. Additionally, these agreements protect REIT shareholders by mitigating share dilution during periods in which the capital associated with the issuance would not otherwise be put to work.
A forward sale transaction is typically structured as a public offering that is a registered transaction with the Securities and Exchange Commission. The public offering closes “regular way,” with purchasers of shares settling with the underwriters on the usual T+2 schedule. If the transaction is not paired with a simultaneous primary issuance by the issuer, no shares are actually issued by the company at the time of closing. Instead, the forward purchasers in the transaction go into the market and borrow shares to be delivered to purchasers in connection with the registered public offering.
The forward contract can then be closed out in one of two methods that allow the forward purchaser to close out its borrowing position.1The SEC has provided relief in a series of no action letters confirming that the settlement transactions by the forward purchaser do not require separate registration with the SEC (see Goldman, Sachs & Co., SEC No-Action Letter (avail. Dec. 20, 1999); Goldman, Sachs & Co., SEC No-Action Letter (avail. Oct. 9, 2003)).
1. If the company elects physical settlement, it exercises the right to sell shares to the forward purchaser at the purchase price contemplated by the contract. The forward purchaser then uses those shares to close out its borrowing position.
2. If the company elects cash or net share settlement, then there is no issuance of shares by the company and, instead the forward purchaser covers the borrowing position by making purchases in the public equity markets. If the share price at that time is greater than the purchase price fixed in the contract, then the company pays the difference to the forward purchaser. If the share price is less than the purchase price fixed in the contract, the forward purchaser pays the difference to the issuer.
Importantly, from a tax perspective it seems clear that REITs will not recognize any nonqualifying gross income under any form of settlement of a forward sale agreement. In the simplest case, where the REIT physically issues shares to the underwriter to settle the forward, no gain or loss would be recognized under section 1032 of the Code, which provides that no gain or loss is recognized on a corporation’s issuance of stock in exchange for cash or property. Even if the shares issued by the REIT have a value at delivery less than the amount paid under the forward contract, this provision should prevent any gross income from being recognized. The same result should apply if the forward contract is settled for cash. The IRS has consistently taken the view that the net cash settlement of a derivative contract with respect to an issuer’s shares should be taxed the same as physical settlement under section 1032.2For a historical synopsis of this issue, see Chief Counsel Advice 200832022 (Apr. 23, 2008), which concludes that “the Service interprets § 1032 as applying to forward contracts, whether or not stock is actually transferred, where gain or loss is determined based on the value of the taxpayer's own stock.” Accordingly, no gain or loss should result, even if no shares are issued.
Including a forward component as part of an equity strategy provides REITs with security that the equity need created by a potential investment is not only funded, but also that the need for the proceeds will match the timing for the issuance of the shares. To avoid market uncertainty, mitigate share dilution and gain flexibility, REITs may consider adding forward sale agreements to their overall capital plan.
2018 Board Trends in the S&P 500
Spencer Stuart, a leading advisory firm focused on executive and director leadership, recently released its annual Board Index Report, which is among the leading publications analyzing board governance trends among S&P 500 companies. While not specific to REITs, the trends outlined in Spencer Stuart’s report often reflect a shifting standard for “best practices,” particularly in the areas of corporate governance and board leadership. Publicly-traded REITs in particular may find these data points helpful in gauging whether their organization is responding appropriately to governance trends. Some highlights from the report include:
- Board Gender Diversity. Of the 428 newly appointed directors in 2018, a record 40% were women (up from 36% in 2017). Women now represent 24% of all S&P 500 directors. Further, 87% of S&P 500 companies have two or more women serving on their board of directors. These trends are consistent with new guidelines from leading proxy advisory firms, Institutional Shareholder Services (ISS) and Glass Lewis & Co. (Glass Lewis), whose 2019 proxy guidelines now include standards for board gender diversity. More information regarding ISS and Glass Lewis’s 2019 proxy guidelines can be found here.
- New Qualifications and Perspectives. Experience as a CEO or top corporate executive is no longer a must-have credential for board service. Only 35% of the newly appointed S&P 500 directors were active or retired CEOs, chairs, vice chairs, presidents or COOs, down from nearly half (47%) a decade ago, representing a shift toward non-traditional director skill sets. Newly appointed directors were also younger than their veteran peers, with appointees ages 50 or younger representing 17% of all newly appointed directors. More than one-third of those new directors under 50 had backgrounds in technology sectors.
- Board Leadership Structures. For the second year in a row, half of S&P 500 boards split the chair and CEO roles (up from 39% in 2008). Independent board chairs continue to gain momentum, with slightly more than 30% of S&P 500 boards chaired by an independent director, up from 28% last year and 16% in 2008. Although the roles and responsibilities of an independent chair of the board and a lead director are frequently similar, their compensation is vastly different. Independent chairs receive, on average, an additional $165,000 in annual pay, while lead directors are paid an average yearly supplement of around $40,000.