Copyright (c) 1997 New York University School of Law Ta Law !eview "inter# 1997 $% Ta L& !

ev& 119 LENGTH: %9'(1 wor)s *!T+CL,- The +nfl.ence of Ta Law on Sec.rities +nnovation in the Unite)States19'1/1997 NAME: 0*!1 2& 3,!3,N 4 *N5 2*UL* SC60+T7 44 BIO: 4 2rofessor University of Te as School of Law& "e thank participants at the 6arvar) Law School Ta 2olicy Conference# 8e89ers of the Co.ncil of the *:* Ta Section# an) 0ichael Schler for their co88ents on )rafts& 44 *ssociate# 2orter ; 6e)ges# LL2# *.stin# Te as& SUMMARY: &&& <.st in the last year or so yo. 8ay have rea) a9o.t T!U2S# a sec.rity )esigne) for 9anks an) ins.rance co8panies in the hope that it wo.l) 9e treate) as )e9t for ta p.rposes 9.t e=.ity for reg.latory p.rposes# a 8assive e change 9y 3eneral 0otors of o.tstan)ing preferre) stock for T>2rS# which is another for8 of ?ta )e).cti9le preferre) stock#? the .se of 2,2S# a sec.rity with a payoff pegge) to the val.e of Netscape# 9y Ti8es/0irror to cash in on its invest8ent in Netscape witho.t recogni@ing a h.ge ta gain# an) ?step/)own preferre) stock#? which was )esigne) to allow a 9orrower to )e).ct principal as well as interest repai) on a loan& &&& Si8ilarly# iss.ers capt.re) 8ost of the val.e of the investorAs ta shiel) on )ivi)en)s on 5.tch *.ction 2referre) Stock# altho.gh they )o not capt.re it all# an) there are contrary instances involving iss.ers whose cre)itworthiness ca8e into =.estion where the rate rose a9ove the co88ercial paper rate as well as occasional instances of a.ctions where the interest rate was 9i) .p with no e planation other than thin participation& &&& Looking 9ack even farther# 0+2S are si8ilar in a key feat.re to an ol) sec.rity known as an inco8e 9on)# which gives the iss.er the right to )efer an) acc.8.late interest pay8ents for several years witho.t )efa.lting& &&& The story of the 9rief an) .nhappy life of the B'$ reg.lations that clarifie) the )istinction 9etween )e9t an) e=.ity# which were propose) 9y Treas.ry in 19'B an) with)rawn in 19'B# also s.pports the clai8 that ta law .ncertainty i8pe)es innovation& &&& The 0+2S str.ct.re 8ay not have see8e) any riskier to Te aco on the )e9t/e=.ity iss.e than a 1CC/year 9on)& &&& >.r arg.8ent that ta law .ncertainty can s.ppress financial innovation can D.stify the e isting practice of Congress an) Treas.ry of applying 8ost r.le changes prospectively& &&& TEXT: [*119] +& +ntro).ction 2erio)ic stories in the financial an) ta press reporting profita9le new ta /saving sec.rities an) transactions create the i8pression that "all Street is feasting on the carcass of the U&S& ta syste8& <.st in the last year or so yo. 8ay have rea) a9o.t T!U2S# 1 a sec.rity )esigne) for 9anks an) ins.rance co8panies in the hope that it

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wo.l) 9e treate) as )e9t for ta p.rposes 9.t e=.ity for reg.latory p.rposes# a 8assive e change 9y 3eneral 0otors of o.tstan)ing preferre) stock for T>2rS# 2 which is another for8 of ?ta )e).cti9le preferre) stock#? the .se of 2,2S# a sec.rity with a payoff pegge) to the val.e of Netscape# 9y Ti8es/0irror to cash in on its invest8ent in Netscape witho.t recogni@ing a h.ge ta gain# 3 an) ?step/)own preferre) stock#? which was )esigne) to allow a 9orrower to )e).ct principal as well as interest repai) on a loan& 4 There is an ele8ent of tr.th in the 9leak pict.re painte) 9y these stories& :ack in 19'(# 0erton 0iller )escri9e) ta law as one of two [*120] 8aDor forces )riving financial innovation (the other was reg.latory change) 5 an) 9oth senior Treas.ry officials 6 an) "all Street lawyers 7 have warne) a9o.t the threat financial innovation poses to the inco8e ta & *)vances in the fiel) of finance are )issolving )istinctions .pon which the ta law is 9.ilt# s.ch as those 9etween )e9t an) e=.ity# capital gains an) or)inary inco8e# an) so.rces of inco8e# as well as 9l.rring concepts that are integral to ta law# s.ch as ownership# reali@ation# an) risk& 8 Ero8 the perspective of finance# the ta law is ri))le) with opport.nities for ?p.re ta ar9itrage#? 8eaning opport.nities to take risk/free an) costless financial positions that have a positive yiel) in ta es save)& 9 Einancial theorists attri9.te the s.rvival of the ta to the e istence of ?frictions? in the financial syste8# 8eaning s.ch factors as the cost of writing an) enforcing contracts# p.9lic an) private reg.latory 9arriers# an)# to a not very significant )egree# ta law 9arriers to ta ar9itrage& Those co88itte) to preserving the stat.s =.o in ta sho.l) fin) this view chilling 9eca.se financial innovation gra).ally is re).cing these frictions& 10 [*121] +n this *rticle# we tell the story of 8any of the sec.rities innovations in the last two )eca)es that are perceive) as having 9een ta / )riven& >.r goal is to 9etter .n)erstan) how ta law infl.ences sec.rities innov !"#$ an) to investigate so8e i8portant =.estions regar)ing how ta policy8akers o.ght to respon) to sec.rities innovation in the a9sence of f.n)a8ental ta refor8& Section ++ e plains the i8portant role of invest8ent 9anks an) e changes in sec.rities inn#v !"#$% Section +++ e plains how ta law a))s val.e to so8e sec.rities an) the cr.cial role of )ifferent ta clienteles in creating this val.e& Section +F 8akes the )escriptive clai8 that invest8ent 9anks an) e changes have fo.n) it s.rprisingly )iffic.lt to 8arket new for8s of sec.rities that e ploit these potentially profita9le feat.res of ta law& Section F provi)es a theoretical e planation for this )iffic.lty& >.r e planation )raws on a feat.re of ta law / its .ncertainty / that is largely ignore) in theoretical finance& "e arg.e that ta law .ncertainty )a8pens sec.rities innovation 9eca.se of the organi@ation of sec.rities 8arkets aro.n) ta clienteles& There is irony in this arg.8ent# if it is right# for the sa8e feat.re that 8akes it profita9le to engineer sec.rities in ways that alter the ti8ing or character of inco8e 8akes it )iffic.lt to 8arket innovative sec.rities that have .ncertain ta treat8ent& "e hasten to a)) that there are other pla.si9le e planations for the )iffic.lty in 8arketing new ta / a)vantage) sec.rities# incl.)ing what 9roa)ly 8ay 9e )efine) as psychological factors# as well as a gl.t of alternative ta / 8ini8i@ing strategies& The secon) half of the *rticle )raws on the points 8a)e in the first half to e plore two i8portant policy =.estions that have receive) little attention to )ate& Section F+ lays the gro.n)work for the policy analysis that follows 9y e plaining the so.rces of social val.e in sec.rities innovation an) o.r nor8ative perspective& Section F++ analy@es whether a change in ta law that eli8inates profita9le ano8alies (so8e wo.l) say that ?closes ta loopholes?) sho.l) 9e 8a)e retroactive 9y applying the change to sec.rities iss.e) prior to the change& "hile we )o not o9Dect to the c.rrent practice of Treas.ry an) Congress of .s.ally gran)fathering sec.rities iss.e) prior to a change or clarification in the law# we arg.e that law8akers sho.l) 9e 8ore willing to .se the threat of retroactive r.le8aking to reg.late har8f.l ta / )riven innovations& "e propose a test for recogni@ing s.ch innovations&

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Section F+++ a))resses the provocative =.estion whether ta /)riven financial innovation 8ay have socially 9eneficial effects 9eca.se it [*122] re).ces ta /9ase) financial )istortions& Eoc.sing on two cases that raise so8ewhat )ifferent iss.es / ta stra))les an) recent sec.rities that fall .n)er the la9el ?ta /)e).cti9le preferre) stock? / we arg.e that these innovations are likely to e acer9ate# rather than alleviate# ta law )istortions once their f.ll effects are taken into acco.nt& >ne .pshot of this concl.sion is o.r reco88en)ation that Treas.ry revisit its 199G r.lings that have 9een interprete) as i8plicitly 9lessing so8e for8s of ta /)e).cti9le preferre) stock& "e close in Section +H with a 9rief )isc.ssion of the history of ta stra))les as a ca.tionary note& This history shows how an ill/a)vise) Treas.ry r.ling that 9lesses p.re ta ar9itrage can open floo)gates& There are so8e i8portant li8its on the scope of this *rticle& 0ost i8portantly# we foc.s on p.9licly tra)e) sec.rities# f.t.res contracts# an) options# p.tting to the si)e ?private? financial innovation in the for8 of non/p.9licly tra)e) contracts (s.ch as 8ost swaps)& This 8ight see8 o))# for the street wis)o8 is that the 8ost aggressive financial transactions fro8 a ta perspective are )one privately# 11 an)# as we shall show# al8ost every innovative p.9licly tra)e) sec.rity ha) a private prec.rsor& "e foc.s on innovations in p.9licly tra)e) instr.8ents partly o.t of necessity / it is )iffic.lt to o9tain relia9le infor8ation on private transactions / 9ringing to 8in) the story of the )r.nk 8an who searche) .n)er a street light for keys he lost elsewhere 9eca.se he was a9le to see .n)er the light& 12 [*123] Nevertheless# there are pla.si9le reasons to foc.s on innovations in p.9licly tra)e) instr.8ents& Eirst# ta /saving strategies are cheaper an) less risky to i8ple8ent when they can 9e )one .sing p.9licly tra)e) instr.8ents rather than private contracts# an) so the threat p.9licly tra)e) instr.8ents pose to the p.9lic fisc is greater than that pose) 9y private contracts& Eor e a8ple# only the very wealthy can engage in an e=.ity swap (a contract that per8its a ta payer to eli8inate risk on a position in appreciate) stock witho.t for8ally selling the stock an) so recogni@ing the gain) 9eca.se of transaction costs an) cre)itworthiness concerns& 13 "ith the intro).ction of long/ter8 options# the sa8e thing can 9e )one cheaply 9y 9.ying a long/ter8 p.t an) selling a call (the stock co.l) 9e poste) as collateral on the call to protect the co.nterparty on the call fro8 cre)it risk)& Secon)# as the last e a8ple ill.strates# 8any private ta /saving strategies .se p.9licly tra)e) instr.8ents& 14 +n )esigning r.les for a new p.9licly tra)e) instr.8ent# ta policy8akers co.l) try to take into acco.nt s.ch potential .ses& Thir)# p.9lic an) private financial innovation raises so8ewhat )ifferent policy concerns an) pro9a9ly are 9est )ealt with thro.gh )ifferent reg.latory tools& 0.ch can 9e acco8plishe) towar)s )eterring .n)esira9le private innovation 9y a)opting r.les that re=.ire )isclos.re& * s8all step in this )irection was taken in the Ta payer !elief *ct of 1997# which re=.ires the registration of corporate ta shelters offere) .n)er con)itions of confi)entiality& 15 5isclos.re also sho.l) 9e re=.ire) of private transactions with ter8s that allow the transaction to 9e .nwo.n) on certain ta events# or that 8ake the [*124] pro8oterAs fee contingent .pon certain ta events& No )isclos.re r.le is nee)e) for p.9licly iss.e) sec.rities& "hile# in theory# the govern8ent co.l) re=.ire that iss.ers of novel sec.rities seek r.lings on their ta treat8ent prior to iss.ing a sec.rity# s.ch a r.le is .nnecessary 9eca.se very few innovative sec.rities pose a significant i88e)iate threat to the ta syste8 an) .nwise 9eca.se the govern8ent cannot act with s.fficient spee)& "e have little to say in this *rticle a9o.t so8e i8portant =.estions# incl.)ing the appropriate s.9stantive r.les for ta ing )ifferent types of sec.rities# the for8 the law sho.l) take ()etaile) r.les or general principles i8ple8ente) thro.gh case/specific r.lings)# an) the appropriate process for changing the law (legislation# reg.lation# or r.ling)& * fair a8o.nt has 9een written on the first =.estion& 16 +n the long [*125] r.n# we feel# like others# 17 that the 9est sol.tion to the pro9le8 of ta ing sec.rities

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an) other invest8ent assets lies in eli8inating the corporate inco8e ta an) 8oving to a syste8 .n)er which all li=.i) assets with 8onitora9le prices are ta e) on a 8ark/ to/8arket 9asis an) other invest8ent assets are ta e) .sing an e pecte) yiel) or retrospective 8etho)& "hen we 9egan this proDect# we hope) to a))ress the secon) an) thir) =.estions a9o.t the for8 the law sho.l) take an) the process 9y which it wo.l) 9e change) pen)ing 8ore ra)ical refor8& "e ha) in 8in) a proposal .n)er which Treas.ry wo.l) e ten) an) change the law# an) 8ake ta policy# incre8entally thro.gh r.lings on specific sec.rities# rather than thro.gh 8assive reg.latory proDects or 9y seeking legislation fro8 Congress& 18 The general i)ea of 8oving to a less r.le/ 9ase) approach is not new# 19 an) 8any of the arg.8ents in favor of s.ch an approach are fairly o9vio.s& Law an) policy alrea)y are 8a)e in this area in reaction to )evelop8ents in the 8arket& 2lainly# Treas.ry can react to a new )evelop8ent 8ore =.ickly thro.gh a case/specific r.ling than it can react thro.gh reg.lation or than Congress can react thro.gh legislation& 2ro9a9ly# law an) policy will 9e 8a)e 8ore intelligently in this fashion 9eca.se fewer )e8an)s are place) on law8akers an) policy8akers to pre)ict f.t.re )evelop8ents& "e still 9elieve that s.ch an approach wo.l) 9e an i8prove8ent over the stat.s =.o& :.t we )o not )efen) this proposal in this *rticle 9eca.se it raises )iffic.lt legal =.estions regar)ing the law8aking power of Treas.ry .n)er e isting stat.tes an) the )egree of )iscretion ta payers have in interpreting the law .n)er the e isting syste8 an) .n)er a less r.le/9ase) syste8& ++& *n >verview of 6ow Sec.rities +nnovation >cc.rs in the Unite) States * history of financial innovation over the last generation has yet to 9e written& 20 >.r story is piece) together fro8 scholarship in the fiel) [*126] of finance on the process of financial innovation# case st.)ies of specific instr.8ents# an) reports fro8 the financial an) ta press& "hat is often )escri9e) as a ?revol.tion? in finance 9egan in the 197CAs& 21 5.ring that )eca)e# the co88o)ity e changes 9egan to co8pete in offering new for8s of options an) f.t.res# 8ortgage sec.riti@ation 9egan# an) the first 8oney 8arket 8.t.al f.n)s were for8e)& The innovative )e9t an) e=.ity instr.8ents an) )e9t hy9ri)s that are the centerpieces of this *rticle 9egin to appear in the 19'CAs# starting with @ero co.pon 9on)s in 19'1# 22 tho.gh# looking 9ack to the 19%CAs an) earlier# si8ilar sec.rities can 9e fo.n)& 23 The innovat"#$& see8 to have 9een sti8.late) 9y the t.r8oil in financial an) co88o)ity 8arkets in the 197CAs an) 19'CAs# technological 9reakthro.ghs (s.ch as the p.9lication of the :lack/Scholes option 8o)el in 197B 24 an) contin.al a)vances in co8p.teri@ation)# an) perhaps changes in govern8ent policy an) law (s.ch as the a)vent of floating e change rates in 197B# the creation of the CETC in 197G# an) the creation of shelf/registration in 19'%)& 25 +nvest8ent 9anks are the pri8ary innovators of sec.rities# tho.gh the govern8ent has playe) a significant role in creating or sti8.lating 8arkets for certain sec.rities# an) acco.nting fir8s an) co88ercial [*127] 9anks so8eti8es offer services or pro).cts that co8pete with invest8ent 9anks& 27 , changes are the pri8ary innovators of f.t.res contracts an) options& !o9ert 0erton has propose) a 8o)el of innovation 9y invest8ent 9anks an) e changes that is ro.ghly consistent with what we fo.n)& 28 +nnovators )erive i)eas for new sec.rities fro8 o9serving invest8ent strategies in the 8arketplace& New sec.rities are )esigne) to replicate 8ore costly ?synthetic? invest8ent strategies&

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The story of Li=.i) Yiel) >ption Notes (?LY>Ns?)# a sec.rity that first appeare) in 19'$# is consistent with an) ill.strates 0ertonAs point& 29 * LY>N is a @ero co.pon corporate 9on) co.ple) with a conversion or call option on the stock of the iss.er# a right to p.t the 9on) for cash prior to 8at.rity# an) a right of the iss.er to re)ee8 or call the 9on) for cash or its stock (at the 9on)hol)erAs option)& There is a gra).ally narrowing positive sprea) 9etween the 9on)hol)erAs cash p.t price an) the iss.erAs cash call price# 9oth of which rise an) converge to e=.al the face a8o.nt of the 9on)

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at 8at.rity& The n.89er of shares of stock to which the 9on) can 9e converte) is constant& The genesis of LY>Ns was the o9servation 9y Lee Cole# who was then at 0errill Lynch# that 8any retail c.sto8ers p.rs.e) a strategy of investing in low risk 8oney 8arket f.n)s while .sing a part of the interest inco8e fro8 those acco.nts to p.rchase highly volatile e=.ity options& Cole ca8e .p with LY>Ns as a lower cost 8eans to p.rs.e that strategy 9y co.pling interest inco8e fro8 the iss.erAs high/ gra)e )e9t with a call option on the iss.erAs stock& 30 The option e89e))e) in a LY>N cannot 9e cheaply replicate) 9y other 8eans 9eca.se of its e ten)e) 8at.rity& The hol)er of the 9on) ha) two [*128] years of fairly har) call protection in the first iss.e of LY>Ns# 31 while p.9licly tra)e) stock options at that ti8e ha) a 8.ch shorter ter8& 32 !o9ert 0ertonAs 8o)el of sec.rities innovation s.ggests that the i88e)iate val.e of a new sec.rity will lie in the re).ction of transaction costs fro8 the s.9stit.tion of p.9licly tra)e) contracts for 8ore co8ple an) costly synthetic he)ging strategies& 0erton co88ents that transaction costs can 9e re).ce) in this 8anner 9y a factor of 1C# tho.gh he )oes not e plain how he ca8e .p with that fig.re& 33 7ero co.pon 9on)s# which appeare) in 19'1 an) 19'%# ill.strate the general point that innovative sec.rities are low/cost s.9stit.tes for 8ore costly synthetic strategies& +nstit.tional investors were one so.rce of )e8an) for high/gra)e @eros / i)eally strips of U&S& Treas.ry sec.rities& 6igh/gra)e @eros offere) the8 a 8eans to lock in an effective rate of ret.rn 9y eli8inating the interest rate risk create) 9y receiving a strea8 of co.pon pay8ents to reinvest& 34 >ther )yna8ic strategies e iste) to he)ge reinvest8ent risk# 9.t @eros were cheaper an) foolproof& The growth of the @ero 8arket also ha) secon)ary val.e 9eca.se of the price infor8ation it provi)e)& The yiel) c.rve can 9e )eter8ine) 9est thro.gh the price of @ero co.pon govern8ent sec.rities& Th.s# 8any financial strategies that e ploit changes in the yiel) c.rve can 9e sai) to owe their e istence in)irectly to the )evelop8ent of @eros& 35 !elia9le )ata is )iffic.lt to co8e 9y on the cost to an invest8ent 9ank or an e change to )esign# 8arket# an) 8aintain a 8arket in an innovative contract& "illia8 Sil9er esti8ate) that ).ring the 197CAs# the cost to an e change of )eveloping an entirely new f.t.res contract was aro.n) I 7C#CCC& This was the )irect cost of professional staff )evote) to pro).ct )evelop8entJ it )i) not incl.)e 8arketing costs or [*129] in)irect costs# s.ch as 8anage8ent ti8e& 36 No )o.9t the cost to an invest8ent 9ank to )evelop a tr.ly innovative sec.rity is significantly higher# partic.larly if it raises )iffic.lt ta # acco.nting# or reg.latory iss.es& 5evelop8ent costs have 9een reporte) in only one case that we know of# ?S.perShares#? which were create) 9y a s8all# highly innovative invest8ent fir8& 37 5evelop8ent costs initially were esti8ate) at I (CC#CCC for a si /8onth effort 9y the fir8# 9.t the cost event.ally 9alloone) to I 1C 8illion in what t.rne) o.t to 9e a five/year effort& 38 No )o.9t these fig.res are high since S.perShares were notorio.sly costly to )evelop& *ss.8ing a innovative sec.rity is likely to take aro.n) one year of intensive effort to )evelop# 39 an) e trapolating 9ackwar)s fro8 the e pecte) an) act.al cost of )eveloping S.perShares# we ca8e .p with a 9allpark fig.re of I 1 to I % 8illion to )evelop an innovative sec.rity& * New York Ti8es story )escri9ing the reso.rces Shearson Leh8an )evote) to )eveloping ?Un9.n)le) Stock Units? 40 8akes 8ore concrete the effort nee)e) to create an) 8arket a new sec.rity& The i)ea was to carve .p co88on stock into three sec.rities- a BC/year )eep )isco.nt 9on) also paying a rate of interest e=.al to the c.rrent cash )ivi)en) on the co88on# a share of preferre) stock paying a )ivi)en) e=.al to any increase in the )ivi)en) on co88on# an) a warrant to p.rchase a share of co88on in BC years at a price e=.al to the val.e of the 9on) at 8at.rity& The proDect was ).99e) ?The 0anhattan 2roDect? within Shearson# which gives a sense of the perception of its scale within the fir8& * tea8 of at least five Shearson e8ployees / all of who8 were highly skille) an)# pres.8a9ly# highly co8pen [*130] sate) / )evote) a significant part of their ti8e for al8ost a year to )eveloping the i)ea& No

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)o.9t# the i)ea was reviewe) 9y ShearsonAs legal )epart8ent an) its o.tsi)e co.nsel 9efore it was 8arkete)& *fter the i)ea was )evelope)# it was presente) to GC corporations# an) once fo.r corporations willing to convert a portion of their o.tstan)ing stock into .n9.n)le) .nits were fo.n)# there was f.rther intensive negotiations an) tinkering with the .nits to satisfy the .serAs partic.lar nee)s& :ringing the i)ea to fr.ition event.ally re=.ire) that Shearson work with the corporate legal )epart8ents for each of these corporations# their o.tsi)e co.nsel# their acco.nting fir8s# the rating agencies# the New York Stock , change# an) the S,C& This effort was for na.ght& The pl.g was p.lle) on Un9.n)le) Stock Units in the spring of 19'9# reporte)ly in response to an a)verse S,C r.ling on their acco.nting treat8ent# 41 altho.gh there are other e planations& 42 6a) Un9.n)le) Stock Units gone forwar)# Shearson wo.l) have inc.rre) a))itional costs# for it was co88itte) to hol) s.9stantial inventories in the .nits to 8aintain a secon)ary 8arket& 43 The s.9stantial cost of creating an) 8aintaining a secon)ary 8arket in the sec.rity is pro9a9ly the reason why 0errill Lynch 8aintaine) a ?near 8onopoly? over LY>Ns thro.gh the 8i)/199CAs& Since the sec.rityAs intro).ction in 19'$# there has 9een a stea)y strea8 of iss.es of LY>Ns& 44 The cost to 0errill in 8aintaining a secon)ary 8arket in LY>Ns is s.9stantial& 0errillAs tra)ing )esk on average 8aintains an inventory of I 1 9illion in LY>Ns# an) fro8 the intro).ction of the contract# the fir8 has 9een p.9licly co88itte) to 8aintaining a narrow 9i)/ask sprea)# re).cing investorsA tra)ing costs# ins.ring li=.i)ity# an) creating a))itional val.e in hol)ing the contract& 45 The h.ge invest8ent in capital necessary to s.pport tra)ing poses a high 9arrier [*131] to entry for other invest8ent 9anks atte8pting to create si8ilar sec.rities& ,ntry into the 8arket also is )eterre) 9y the specter of potentially significant tra)ing losses& 0errill reporte)ly lost I 1$C 8illion on its inventory of converti9le 9on)s in 199G# 8.ch of it on LY>Ns# which like @ero co.pon 9on)s# have 8.ch greater price volatility than co.pon paying 9on)s& 46 6ow )o invest8ent 9anks reco.p these )evelop8ent costsK St.)ies 9y "illia8 Sil9er 47 an) 2eter T.fano 48 of innovations in sec.rities an) f.t.res 9y invest8ent 9anks an) e changes in the 197CAs an) 19'CAs s.ggest that the rewar) to an invest8ent 9ank for a s.ccessf.l innovation (8any innovations fail nG9) is early 8arket )o8inance in the s.ccessf.l contract 9y the ?first 8over&? 2rofessor T.fa# e a8ine) $' financial innovations (sec.rities as well as f.t.res contracts) fro8 197G/19'(& 50 Thirty/five of the innovative sec.rities were i8itate) 9y rival invest8ent 9anks within one year of their intro).ction to the 8arket 9y the pioneer invest8ent 9ank& Twenty/three of the innovative sec.rities were either not i8itate) at all or i8itate) 8ore than one year after their first intro).ction to the 8arket& 51 2rofessor T.fano concl.)e) that invest8ent 9anks ten) to p.rs.e two )ifferent strategies to reap the first/8over a)vantage& So8eti8es invest8ent 9anks .n)erprice) their s.ccessf.l innovative sec.rities (typically 9y 8aintaining a low sprea) 9etween the offer an) asking price)# ostensi9ly to in).ce iss.ers an) investors to co88it to the first transaction& 52 2rofessor T.fano fo.n) that pioneers were a9le to recover the costs of innovation 9y capt.ring 8arket share 9y 9eing the first 8over& The pioneersA 8arket shares in i8itate) sec.rities were al8ost %&$ ti8es greater than the 8arket shares for the rival i8itating invest8ent 9anks& 53 2rofessor T.fano fo.n) noni8itate) sec.rities tra)e) with higher sprea)s than the i8itate) sec.rities& This le) hi8 to theori@e that the higher sprea)s ena9le) the innovating fir8 to recover the costs of specially )esigning sec.rities for narrowly )efine) clienteles& 54 [*132] 0any .lti8ately s.ccessf.l innovations )o not catch on =.ickly& 55 3ol)8an SachAs 0onthly +nco8e 2referre) Shares (?0+2S?) is the first in a new line of sec.rities that we )efine generically as ta /)e).cti9le preferre) stock& +n its original for8# 0+2S were very long 8at.rity# s8all )eno8ination sec.rities paying a 8onthly )ivi)en) that the iss.er co.l) s.spen) for 1' 8onths witho.t )efa.lting& 0.ch of the attraction of the sec.rity lies in the fact that it is treate) as )e9t for ta p.rposes 9.t e=.ity for

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rating an) acco.nting p.rposes& 56 +t [*133] took two years fro8 the first iss.e of 0+2S for the sec.rity to catch on# as Chart + shows& 57 The flow 9.ilt gra).ally after the first iss.e of 0+2S in >cto9er 199B& 3ol)8an Sachs ha) the 8arket to itself for only a9o.t nine 8onths# .ntil <.ly an) *.g.st 199G# when co8peting sec.rities offere) 9y other invest8ent 9anks 9egan to appear& 58 There was a floo) of [*134] new iss.es of 0+2S an) sec.rities that provi)e si8ilar 9enefits (which are generically )escri9e) as ta /)e).cti9le preferre)) 9y the latter half of 199$ an) the first half of 199(& +n)ee)# 9y *.g.st 199$# 7CL of new iss.es of preferre) were of this type& 59 Strips# @ero co.pon 9on)s create) 9y stripping the interest co.pons off interest/ 9earing 9on)s# have an .n.s.ally steep traDectory& 60 0errill Lynch le) the way in iss.ing tra)e8ark @ero co.pon Treas.ry sec.rities in *.g.st# 19'%& 0errill strippe) the interest co.pons fro8 U&S& Treas.ry sec.rities# place) the8 in separate tr.sts# an) sol) interests in those tr.sts as T+3!s (Treas.ry +nvest8ent 3rowth !eceipts)& [*135] MS,, C6*!T +N >!+3+N*LN >ver the ne t few 8onths# other invest8ent 9anks r.she) to 8arket strips of 8any stripes (so8e invest8ent 9anks iss.e) strips in large )eno8inations targeting instit.tional investorsJ others iss.e) strips in s8all )eno8inations targeting the retail 8arket)# 61 an) the vol.8e 9oo8e)& 62 "e 9elieve that the e planation for the e traor)inarily steep traDectory of strips lies in the enor8o.s )e8an) for the sec.rity in 19'%& The high an) volatile interest rates of the perio) 8a)e @eros attractive to instit.tional investors# partic.larly pension f.n)s# who wante) to eli8inate reinvest8ent risk& 63 E.rther8ore# there was a floo) of 8oney into in)ivi).al ta / e e8pt retire8ent acco.nts sti8. [*136] late) 9y ta law changes in 19'1& 64 These acco.nts constit.te the )o8estic retail 8arket for @eros& 65 The floo) of @ero co.pon 9on)s tra)e8arke) 9y the invest8ent 9anks .n)er )ifferent na8es an) essentially tra)e) as )ifferent sec.rities ha) tro.9ling short/ter8 effects# which ill.strates one of the potential )ownsi)es of e cessive innovation& The plethora of si8ilar 9.t nonf.ngi9le sec.rities create) a 8ore conf.sing# costly# an) less li=.i) 8arket for investors# 66 slowe) the 8arket penetration of the sec.rity for iss.ers# an) increase) 8arket 8aking costs for the iss.ing invest8ent 9anks& So8e invest8ent 9anks were s.e) 9y in)ivi).al investors who co8plaine) they ha) 9een cheate) 9eca.se the strips they 9o.ght were e pensive an) illi=.i)& 67 >ther invest8ent 9anks respon)e) 9y 8arketing f.ngi9le strips# an) event.ally in 19'$# Treas.ry allowe) separate registration an) tra)ing of strips of Treas.ry 9on)s& 68 [*137] +++& 6ow Ta Law *no8alies *)) Fal.e to So8e Sec.rities an) "ho !eaps that Fal.e +n this Section# we e a8ine the feat.res of ta law that can a)) val.e to so8e sec.rities& 69 3enerally# ta )istorts the relative val.e of sec.rities 9eca.se of ?)iscontin.ities? an) ?inconsistencies? in ta law& "e take 9oth concepts# which we generically )escri9e as ta law ?ano8alies#? fro8 <eff Strna)& 70 The concepts can 9e graspe) 9y pict.ring financial positions / a position can consist either of a single sec.rity or of a co89ination of sec.rities / as locate) within a space 9ase) on their f.n)a8ental econo8ic characteristics& 2rofessor Strna) )efines the location of a position in this space 9y the co89ination of ?p.re sec.rities? nee)e) to e press the position& 71 >ne 8oves thro.gh the space 9y a))ing# or s.9tracting# p.re sec.rities& * ta law inconsistency e ists when a single financial position# that is# a .ni=.e set of p.re sec.rities# is ta e) in 8.ltiple ways )epen)ing .pon the real worl) sec.rities an)

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contracts co8posing the position& +n other [*138] wor)s# a ta law inconsistency e ists when a p.rely for8al )ifference in a position can alter the ta it 9ears& * ta law )iscontin.ity e ists when a s8all econo8ic change in a position has a )isproportionate ta conse=.ence& *n opport.nity for p.re ta ar9itrage# which involves the taking of perfectly offsetting long an) short positions that# in the aggregate# have a positive after/ta yiel)# 8ay e ist when there is a ta law inconsistency& 72 ?+8p.re? ta ar9itrage / that is# the taking of positions that )o not perfectly offset 9eca.se of the positive after/ta yiel) / is possi9le when there is a ta )iscontin.ity# 9.t i8p.re ta ar9itrage co8es at a real cost since the long an) short positions )o not perfectly offset& 73 +nconsistencies an) )iscontin.ities 8ay 9e tro.9ling for reasons other than the potential for ta ar9itrage& * )iscontin.ity 9etween the ta ation of two positions )istorts choices 9etween those positions# which can 9e socially har8f.l 9eca.se of the real sacrifices ta payers 8ake in taking the ta /favore) position& That corporations 8ay )e).ct interest pai) on )e9t 9.t not )ivi)en)s pai) on e=.ity is a fa8iliar e a8ple of a )istortionary ta r.le that is tho.ght to have har8f.l social conse=.ences& Ta law inconsistencies nee) not entail privately or socially har8f.l conse=.ences for# 9y )efinition# the two positions are e=.ivalent in all respects save ta & Einancial innovations that reveal latent inconsistencies in ta law are pro9le8atic 9eca.se of the reven.e loss as ta payers shift to the ta /favore) position& !elatively few of the ta /saving strategies we e a8ine in this *rticle involve ta ar9itrage# that is# the taking of offsetting positions for their positive ta yiel)& +nstea)# the effect of inconsistencies an) )iscontin.ities in ta law often is to )istort a ta payerAs choices 9etween positions with si8ilar financial characteristics& Eor e a8ple# in 19'1 an) 19'%# the )iscontin.ity 9etween the ta ation of )isco.nt 9on)s an) or)inary [*139] 9on)s in).ce) corporations to s.9stit.te )isco.nt 9on)s for or)inary 9on)sJ we know of no case where a corporation iss.e) )isco.nt 9on)s to invest in or)inary 9on)s& The history of @ero co.pon 9on)s can 9e .se) to ill.strate these 9asic concepts an) to ill.strate the i8portance of the e istence of )ifferent ta clienteles to the val.e that sec.rities )erive fro8 ta law ano8alies& +n the years i88e)iately prior to 19(9# there was a 8is8atch in the ta ation of interest on )isco.nte) 9on)s / an iss.er that .se) the accr.al 8etho) co.l) )e).ct interest on a straight line 9asis while a cash 8etho) investor )i) not have to incl.)e the interest in inco8e .ntil 8at.rity& 74 This 8is8atch create) a )iscontin.ity in the ta ation of 9on)s paying c.rrent interest an) )isco.nte) 9on)s in the han)s of cash 8etho) ta payers& +n theory# a ta payer who .se) the cash 8etho) of acco.nting co.l) take a)vantage of this )iscontin.ity 9y 9orrowing to invest in )isco.nte) )e9t since it wo.l) have a net interest )e).ction while the two positions wo.l) offset econo8ically& This is a for8 of ta ar9itrage# tho.gh it wo.l) not 9e p.re ta ar9itrage 9eca.se this strategy was open 8ostly to in)ivi).als# an) the interest rate on in)ivi).al 9orrowing e cee)s the interest rate on high/gra)e corporate )e9t& The pa.city of )isco.nt 9on)s also 8a)e it )iffic.lt or i8possi9le to create positions with precisely offsetting cash flows& +n 19(9# legislation re=.ire) i8p.tation of interest on a straight line 9asis 9y cash 8etho) hol)ers& 75 * ta law ano8aly re8aine) 9etween )isco.nte) 9on)s an) 9on)s paying c.rrent interest since straight line i8p.tation of interest on )isco.nte) 9on)s res.lte) in interest 9eing front/loa)e)& This is the ta reason why iss.ers fo.n) @eros very attractive in the high/interest environ8ent of the early 19'CAs& The 19(9 change p.tting all hol)ers of )isco.nte) 9on)s on the accr.al 8etho) 8eant that the hol)erAs interest inco8e wo.l) 9e front/loa)e) as well# 9.t @eros were sol) to ta clienteles who were in)ifferent to this fact& The 8arket for @eros an) )isco.nte) )e9t was co8pose) of <apanese investors# 76 who were not s.9Dect to U&S& ta on the interest inco8e an) so were in)ifferent to front/loa)ing of interest inco8e# an) who [*140] also o9taine) a 9enefit .n)er <apanese ta law# along with U&S& pension f.n)s an)

Page 8 of 31

in)ivi).als p.rchasing for ta /e e8pt acco.nts# loa)ing of interest inco8e&

77

who also were in)ifferent to front/

Congress change) the law again in 19'% to re=.ire i8p.tation of interest on a )isco.nte) 9on) on a co8po.n) or econo8ic 9asis& 78 This change re).ce)# 9.t )i) not co8pletely eli8inate# the ano8aly 9etween the ta ation of 9on)s paying c.rrent interest an) )isco.nte) 9on)s& *n ano8aly re8ains so long as the yiel) c.rve is not flat since the aggregate interest i8p.te) on @eros hel) in a portfolio will change over ti8e as the shorter 8at.rity @eros are retire)# while the interest on a 9on) paying c.rrent interest will 9e constant over ti8e& 79 This ano8aly 8ay 9e an instance of ta inconsistency# an) so 8ay 9e an opport.nity for ta ar9itrage# 9eca.se the )evelop8ent of 8arkets for @ero co.pon 9on)s 8ight 8ake it possi9le for a corporation with a gil)e) 9on) rating to iss.e an or)inary 9on) an) invest in a portfolio of Treas.ry strips with precisely offsetting cash flows& +f the yiel) c.rve rises# these offsetting positions pro).ce a s8all ta ar9itrage profit& The ta profit is slight per )ollar investe) so the transaction re=.ires enor8o.s leverage an) the transaction costs wo.l) have to 9e very s8all to 8ake this profita9le& 80 [*141] 7eros are an e a8ple of a gen.ine financial innovation& The pattern of cash flows offere) 9y a @ero co.pon 9on) was new an) .ni=.e a8ong the .niverse of then e isting sec.rities& So8eti8es innovation# however# takes the for8 of tinkering with the ele8ents of an e isting sec.rity to p.sh the sec.rity closer to a ta law 9o.n)ary in a way that gains so8e econo8ic or other nonta 9enefit of a sec.rity that is on the other si)e of the 9o.n)ary& The 9l.rre) 9o.n)ary 9etween )e9t an) preferre) stock is the loc.s of 8.ch s.ch innovation& +n the 8i)/ 19'CAs# there were a lot of new instr.8ents in the for8 of a)D.sta9le rate an) a.ction rate preferre) stock that were )esigne) to 9e as si8ilar as possi9le to 8oney 8arket acco.nts 9.t that wo.l) 9e ta e) as preferre) stock# ena9ling corporate investors to shiel) interest inco8e earne) on cash hol)ings with the )ivi)en)s receive) )e).ction& 81 3ol)8an SachAs 0+2S an) other for8s of ta )e).cti9le preferre) stock are )esigne) to )o the opposite# 9eing ta e) as )e9t tho.gh it is treate) like preferre) stock for ratings p.rposes& *)D.sta9le rate an) a.ction rate preferre) stock provi)e a striking ill.stration of the i8portance of ta clienteles to the val.e sec.rities )erive fro8 ta law ano8alies& *)D.sta9le rate an) a.ction rate preferre) stock ten)s to 9e price) at a fraction of the short/ter8 co88ercial paper rate# altho.gh s.ch stock is at least as risky as short/ ter8 co88ercial paper& 82 The e planation is that *)D.sta9le !ate an) [*142] *.ction !ate 2referre) Stock is price) to sell to corporations# which can shiel) the )ivi)en)s fro8 ta with the )ivi)en)s receive) )e).ction& 83 Typically# s.ch sec.rities are iss.e) 9y corporations with low 8arginal rates (so8e versions give the iss.er the option to convert into )e9t# at a higher interest rate# sho.l) it ever profit fro8 the interest )e).ction)# 84 who lose less 9y forgoing the interest )e).ction on )e9t than the p.rchasing corporation gains fro8 the )ivi)en)s receive) )e).ction& 85 To say that the 8arket for *)D.sta9le !ate an) *.ction !ate 2referre) Stock is organi@e) aro.n) these two ta clienteles is not to say that 8arket is co8pose) entirely or even 8ostly of high/ta /rate corporate 9.yers an) low/ta /rate iss.ers / in fact# this was not the case for preferre) stock in the 19'CAs 86 / it is to say instea) [*143] that these are the 8arginal participants in the 8arket who )eter8ine price& Nor is price invaria9ly set 9y the fir8s or in)ivi).als who are 8ost sensitive to a change in a ta attri9.te of a sec.rity& Eor e a8ple# corporations that have offere) ta /)e).cti9le preferre) in e change for tra)itional preferre) stock have achieve) s.ccess rates of aro.n) $CL altho.gh they increase the co.pon rate 9y an a8o.nt that represents a s8all fraction of what wo.l) 9e necessary to co8pensate a corporate hol)er for loss of the )ivi)en)s receive) )e).ction& 87 These offers pres.8a9ly s.ccee) 9eca.se a significant n.89er of the hol)ers of the preferre) are in)ivi).als who are in)ifferent to the loss of the )e).ction&

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Ta clienteles are i8portant to .n)erstan)ing how sec.rities )erive val.e fro8 ta law ano8alies 9eca.se often (9.t not always# as the e a8ple of )isco.nt 9on)s prior to 19(9 ill.strates) 88 the parties to a sec.rity are ta e) sy88etrically so that a positive effect on the ti8ing or character of inco8e or e pense to one party 9eca.se of a sec.rityAs ta attri9.tes will 9e offset 9y a negative effect to the other party& This is 8ost plainly the case when the ano8aly in ta law goes to the ti8ing of inco8e an) e pense# as it )oes with @ero co.pon 9on)s# for [*144] if the interest e pense is front/loa)e)# so too is the interest inco8e& 89 Th.s# if in 19'1# all iss.ers an) investors in 9on)s ha) face) the sa8e 8arginal ta rate# the aggregate ta pai) 9y the8 wo.l) have 9een the sa8e (s.9Dect to one caveat)# 90 whatever the 8i t.re of @eros an) 9on)s paying c.rrent interest& +n s.ch circ.8stances# an iss.er sho.l) 9e in)ifferent 9etween the two for8s of 9on)s 9eca.se it wo.l) e pect the iss.e price of @eros to 9e lower so that its after/ta cost of f.n)s wo.l) 9e no 9etter than on an iss.e of 9on)s paying c.rrent interest& The val.e to the iss.er of the ta law ano8aly )erive) fro8 the fact that @eros were sol) to ta /e e8pt investors (in partic.lar# <apanese investors an) U&S& investors 9.ying for ta /e e8pt acco.nts)# who were in)ifferent to the front/loa)ing of interest inco8e& The ta val.e of innovative sec.rities )oes not always lie in altering the ti8ing or character of inco8e an) e pense# an) a ta 9enefit to one party )oes not always i8pose a )etri8ent on the co.nterparty& Eor e a8ple# in 19'9# Eor) ha) so8e of its U&S& s.9si)iaries iss.e voting# a)D.sta9le rate preferre) stock in or)er to )econsoli)ate those s.9si)iaries# a 8ove that provi)e) a s.9stantial ta 9enefit to Eor) 9eca.se the interest e pense inc.rre) 9y those U&S& s.9si)iaries was not allocate) against the inco8e of its foreign s.9si)iaries for p.rposes of )eter8ining foreign ta es pai) on which a U&S& cre)it co.l) 9e taken& 91 There was no offsetting )etri8ent to investors in the s.9stit.tion of preferre) for )e9tJ in)ee) preferre) is 8ore val.a9le to a significant class of investors 9eca.se of the )ivi)en)s receive) )e).ction& "ho reaps the ta val.e of an innovative sec.rityK Those who 8ay stan) to gain incl.)e the iss.er# the 9.yer of the sec.rity# or the innovator (for e a8ple# an invest8ent 9ank or an e change)& The answer to the =.estion is i8portant 9eca.se the )ivision of the gains fro8 innovative ta /a)vantage) sec.rities affects the incentives to pro).ce s.ch sec.rities& +nnovators have an incentive to pro).ce ta / a)vantage) sec.rities only to the e tent they )irectly or in)irectly capt.re so8e of the gains& Si8ilarly# potential iss.ers can 9e sol) on the ta a)vantages of a new sec.rity only to the e tent that they )irectly or in)irectly capt.re the gains& [*145] , perience s.ggests that iss.ers .s.ally capt.re 8ost of the ta val.e of an innovative sec.rity& "hen o.tstan)ing preferre) stock is converte) into ta /)e).cti9le preferre)# it ten)s to 9e price) at yiel) only BOG points higher than the )ivi)en) rate on preferre) stock# 92 which i8plies that the iss.er capt.res 8ost of the val.e fro8 converting non)e).cti9le )ivi)en)s into )e).cti9le interest& This concl.sion nee)s to 9e taken with a grain of salt# however# for ta /)e).cti9le preferre) stock is not strictly co8para9le to preferre) stock& 6ol)ers have greater rights on ta /)e).cti9le preferre) than on preferre) stock / in partic.lar# )ivi)en)s 8ay not 9e )eferre) for a perio) longer than five years# an) so8e iss.es li8it )eferral to two years& To the e tent their rights are strengthene) witho.t a correspon)ing sacrifice in yiel)# hol)ers i8plicitly capt.re so8e of the val.e of the replace8ent of preferre) stock with ta /)e).cti9le preferre)& +t see8s that invest8ent 9anks / who are the act.al innovators / capt.re only a s8all fraction of the sec.rityAs ta val.e& "hile this fact 8ight see8 o))# it is consistent with T.fanoAs hypothesis that invest8ent 9anks innovate to capt.re 8arket share& 93 "e fo.n) .n)er [*146] writing fees on 0+2S an) their variants thro.gh 199( to 9e co8para9le to fees on straight preferre) (in the range of BL to GL of iss.e price) 9.t significantly higher than the fees on )e9t (aro.n) &$L of iss.e price for high/gra)e

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)e9t)& 94 The 8ost o9vio.s way in which invest8ent 9anks reap a))itional profits on ta /)e).cti9le preferre) is fro8 )oing conversions of o.tstan)ing preferre) or o.tstan)ing )e9t into the new sec.rity# of which there have 9een a fair n.89er& * st.)y fin)s that .n)erwriting fees pai) in conversions of straight preferre) into ta / )e).cti9le preferre) were less than one/tenth of the present val.e of the esti8ate) ta savings& 95 +ss.ers see8 to have capt.re) 8ost of the ta val.e of other instr.8ents& 96 <ohn Einnerty has )one a )etaile) st.)y of Stock +n)e 3rowth Notes (?S+3Ns?)# an early iss.e of )e9t that pai) interest contingent on the perfor8ance of an e=.ity in)e # an) concl.)e) that the iss.er (the *.strian govern8ent) capt.re) al8ost all of the ?ta ar9itrage gain&? 97 There is also evi)ence that wo.l) allow one to infer that iss.erAs capt.re) the val.e of the ta 9enefit on )isco.nte) )e9t prior to <.ly 1# 19'%& 98 Si8ilarly# iss.ers capt.re) 8ost of the val.e of [*147] the investorAs ta shiel) on )ivi)en)s on 5.tch *.ction 2referre) Stock# altho.gh they )o not capt.re it all# 99 an) there are contrary instances involving iss.ers whose cre)itworthiness ca8e into =.estion where the rate rose a9ove the co88ercial paper rate as well as occasional instances of a.ctions where the interest rate was 9i) .p with no e planation other than thin participation& 100 Ero8 a theoretical perspective# the =.estion of who capt.res the ta val.e of a sec.rity in the short r.n 101 is pri8arily a f.nction of the [*148] position of the 8arginal p.rchaser of a sec.rity (that is# the p.rchaser who sets the 8arket clearing price)# an) in partic.lar the ta position of the 8arginal p.rchaser& 102 3enerally# if the 8arginal p.rchaser is in the opti8al ta position to hol) a sec.rity# the iss.er sho.l) capt.re its ta val.e& The pricing of ta /e e8pt 9on)s often is .se) to ill.strate this 9asic point& +f the 8arket/clearing price for ta /e e8pt 9on)s is set 9y investors who face the top 8arginal ta rate (that is# the investors who reap the greatest val.e fro8 the e e8ption)# iss.ers sho.l) capt.re the entire val.e of the e e8ption& *s the s.pply of ta /e e8pt 9on) increases# yiel)s rise as the 9on)s are price) to sell to investors who face )ecreasing 8arginal ta rates an) therefore val.e the e e8ption less& *s the yiel) rises# infra8arginal investors capt.re an increasing share of the val.e of the ta e e8ption& This rise in yiel) often is e presse) as a )ecline in the i8plicit ta 9orne 9y the 9on)hol)er& 103 *n i8plication of this si8ple analysis is that when only a s8all n.89er of investors are in a position to take ta a)vantage of a high/vol.8e sec.rity# they will capt.re the sec.rityAs ta val.e& Th.s# we wo.l) pre)ict the potential ta val.e of L,*2s (long/ter8 options) in constr.cting synthetic @eros will 9e capt.re) 9y investors / an) not iss.ers / so long as relatively few investors .se L,*2s for that p.rpose& Nonta factors 8ay also li8it the clientele for a sec.rity& 104 Eor e a8ple# the clientele for 0+2S is pri8arily in)ivi).al investors 9eca.se [*149] instit.tional investors prefer =.arterly rather than 8onthly pay8ents& :oth large )ollar )eno8ination an) s8all )ollar )eno8ination strips were create) in the early 19'CAs 9eca.se they ha) )ifferent clienteles (instit.tional investors an) in)ivi).al investors respectively)& 105 LY>Ns are sol) 8ostly retail to in)ivi).al investors p.rchasing for ta / e e8pt acco.nts# 106 an) the packaging of a 9on) an) an option on the iss.erAs stock is 8ost val.a9le if the iss.er has an invest8ent gra)e 9on) rating an) a volatile stock price& These nonta clientele restrictions can 9e significant in the case of e otic sec.rities that have a li8ite) clientele either 9eca.se of their .n.s.al econo8ic characteristics or 9eca.se of the 8anner in which they are 8arkete)& Nonta factors that li8it the opti8al clientele for a sec.rity increase the chance that the 8arginal p.rchaser will pay less than the theoretically 8a i8.8 price# 107 allowing infra8arginal p.rchasers to capt.re so8e of the ta val.e& +F& +nvest8ent :anks 6ave Eo.n) +t 5iffic.lt to 0arket New Sec.rities 5esigne) to , ploit Ta *no8alies

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Ta law is ri))le) with ano8alies# lea)ing so8e to pre)ict the i88inent collapse of the inco8e ta as financial innovation creates new or cheaper 8eans to e ploit opport.nities for ta ar9itrage& 108 +n this Section# we arg.e that# at least to )ate# invest8ent 9anks have fo.n) it )iffic.lt to 8arket to potential iss.ers new sec.rities that e ploit ta law ano8alies in the initial iss.es& To 8ake this point# we )elve a little 8ore )eeply into the stories of three sec.rities / @ero co.pon 9on)s# strips# an) 0+2S (ta /)e).cti9le preferre) stock)& "e also s.ggest so8e possi9le e planations for this )iffic.lty& "e think that ta law .ncertainty is a key reason for the 9elate) appearance of strips an) ta /)e).cti9le preferre) stockJ why ta law .ncertainty 8ight have s.ch an effect is e plaine) in the ne t Section& The 9elate) appear [*150] ance of @eros cannot 9e e plaine) 9y ta law .ncertaintyJ in that case# we arg.e that the answer pro9a9ly lies instea) in what 8ight 9e calle) the tactical nat.re of ta planning- Ta consi)erations see8 to co8e into play in financial planning only once f.n)a8ental choices are 8a)e& 109 7ero co.pon 9on)s are one of two financial innovations single) o.t 9y 0erton 0iller as ta /)riven& 110 5isco.nte) 9on)s historically ha) very attractive ta attri9.tes& 2rior to 19(9# a cash 8etho) hol)er co.l) )efer interest inco8e while an accr.al 8etho) iss.er co.l) )e).ct i8p.te) interest& 111 Notwithstan)ing this highly favora9le ta treat8ent# we co.l) fin) no evi)ence of corporations iss.ing @ero co.pon 9on)s ).ring this perio)& 112 Ero8 19(9 to 19'%# the iss.erAs interest )e).ction was front/loa)e)# 9.t corporations iss.ing high/gra)e )e9t )i) not e ploit the ta 9enefit in )isco.nte) )e9t for over a )eca)e .ntil 19'C# when so8e )eeply )isco.nte) 9on)s were privately place)& 113 The first p.9lic iss.es of )isco.nte) 9on)s followe) in Ee9r.ary an) 0arch of 19'1& +n the following 1' 8onths# .ntil the ta law change)# over I 7 9illion was raise) thro.gh the iss.e of @eros& 114 The intrig.ing =.estion is why )i) ta paying corporations wait so long to iss.e @eros an) )isco.nte) 9on)s given the ta a)vantage prior to <.ly 1# 19'%K *n answer fro8 a vice/presi)ent of Sal8on :rothers is that corporate treas.rers ten) to 9e conservative an) chary of inno [*151] vative sec.rities# 115 an) that it took the e traor)inarily high interest rates of the early 19'CAs# along with the .n.s.al inverse shape of the yiel) c.rve (short/ter8 rates e cee)e) long/ter8 rates) to 8ake the ta 9enefits of )isco.nte) )e9t s.fficiently attractive to overco8e this resistance& 116 :eca.se of the o)) shape of the yiel) c.rve# there was a general shift 9y corporations fro8 short/ter8 financing to long/ter8 financing in the early 19'CAs& 117 The ta treat8ent of the accr.e) interest e pense a8plifie) the val.e of long/ter8 )e9t 9y accelerating the interest )e).ctions& +t appears that even in this favora9le environ8ent# )isco.nte) )e9t was har) to sell to iss.ers& 118 The rel.ctance of CE>s to 9e the first iss.er nee) not 9e ascri9e) to their 9eing irrational& There are costs to innovation / fro8 the iss.erAs perspective# not so 8.ch the cost of )esigning a new contract# which the innovating invest8ent 9ank is likely to 9ear# 9.t rather# in this case# the fear of sen)ing a falsely negative signal that oneAs corporation ha) cash flow pro9le8s# for .ntil the early 19'CAs# only )istresse) corporations .se) )isco.nte) )e9t& Nor )oes the first corporate iss.er capt.re the offsetting 9enefits of a s.ccessf.l innovation# for the first 9enefits in.re to the innovating invest8ent 9ank an) later to all .sers of the instr.8ent& Th.s# psychological factors see8 to e plain 9est why p.9licly iss.e) @eros were not 8arkete) .ntil 19'1& These factors 8ay have incl.)e) )isco8fort with novelty or with a sec.rity with negative connotations& *t least as significant# we 9elieve# was the shift in preferences regar) [*152] ing long/ter8 )e9t that res.lte) fro8 the changing interest environ8ent& +t was only once that shift 8a)e long/ter8 )e9t attractive that the ta gi88ick ca8e to the fore as a planning consi)eration& "hat this s.ggests is that investors an) iss.ers 8ake f.n)a8ental choices a9o.t the risk# cash flows# an)

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ter8 str.ct.re of their assets an) lia9ilities witho.t regar) to the ta tra)eoffs& +f this hypothesis is correct# ta consi)erations co8e into play 8ostly in choosing a8ong )ifferent )evices to i8ple8ent these f.n)a8ental choices& The 9elate) p.9lic appearance of strips / the first iss.e of T+3!s 9y 0errill Lynch was in *.g.st# 19'% / 8ight see8 even 8ore )iffic.lt to e plain than the 9elate) appearance of @eros& +n the early 19'CAs# stripping co.pons fro8 a 9on) was tho.ght to offer i8pressive ta 9enefits to 9oth the p.rchaser an) the stripper& The p.rchaser of the strippe) co.pon or principal pay8ents (which is e=.ivalent to a @ero co.pon 9on)) was not ta e) on the i8plicit interest .ntil 8at.rity or sale of the instr.8ent& +f the stripper sol) the principal pay8ent an) kept the co.pon pay8ents# he co.l) clai8 an artificial ta loss since all 9asis was allocate) to the principal& 119 These ta 9enefits were eli8inate) as of <.ly 1# 19'%# 9efore the first iss.e of T+3!s& 120 "hile it is clear that strippe) U&S& Treas.ry sec.rities were sol) privately at least as early 19'1 (an) pres.8a9ly even earlier)# 121 we co.l) fin) no evi)ence that s.ch private activity was wi)esprea)& 7eros (8ostly create) 9y stripping) thrive) after the 19'% ta law changes& *t the en) of 199G# 8ore than I %CC 9illion of Treas.ry sec.rities were hel) as strips& The )elay in p.9lic stripping of U&S& Treas.ry sec.rities can 9e attri9.te) partly to resistance fro8 the Ee)eral !eserve :ank of New York# which warne) the pri8ary govern8ent 9on) )ealers that it viewe) tra)ing of strippe) sec.rities as an .n)esira9le 8arket practice& 122 This policy change) when the ta treat8ent change) in 19'%& :.t it still is not clear why so8e a)vent.ro.s fir8 )i) not strip high/ gra)e corporate 9on)s an) iss.e p.9licly tra)e) receipts .sing tr.sts& The tr.st str.ct.re was not novel& "e think that the answer 8ay lie in [*153] .ncertainty over whether the ta 9enefits of stripping wo.l) withstan) legal challenge& 123 The arg.8ent that a hol)er of a co.pon or principal strip )i) not have to i8p.te interest relie) on a stat.tory lac.na# which see8e) too goo) to 9e tr.e given the i8p.tation of interest on a @ero interest 9on)& 124 "e think the late appearance of 0+2S# or ta /)e).cti9le preferre)# also can 9e attri9.te) to ta law .ncertainty& The first iss.e of 0+2S was in 199B# an) in the last several years# ta /)e).cti9le preferre) has )o8inate) new iss.es of preferre) stock& The original 0+2S str.ct.re .se) an offshore entity ta e) as a partnership 125 create) an) owne) 9y Te aco# which iss.e) preferre) interests an) then lent the procee)s to Te aco on a $C/year note that co.l) 9e e ten)e) 9y Te aco for another $C years& Te aco )e).cts the interest pai) on the note# which e=.als the )ivi)en)s pai) 9y the offshore entity on the preferre) stock& The investors incl.)e that interest in inco8e as an ite8 of partnership inco8e& The econo8ic keys to the 0+2S str.ct.re are the long 8at.rity an) the right of the corporate parent to )efer pay8ent of interest# in the case of Te acoAs 0+2S# 1' 8onths& Later for8s of ta /)e).cti9le preferre) ten) to have shorter 8at.rities# ranging fro8 %C to $C years# an) longer perio)s in which interest can 9e )eferre)# now typically five years& !atings agencies )o not treat the sec.rity as )e9t 9eca.se of these feat.res# 126 an) these feat.res give the iss.er 8.ch the sa8e financial c.shion as preferre) stock& 127 [*154] The 9asic i)ea 9ehin) 0+2S was not new in 199B& 128 5ean "itter !eynol)s ha) trie) to acco8plish so8ething si8ilar .sing a partnership in 19'$ in a private )eal )one for Continental +llinois :ank# which involve) Continental +llinois iss.ing preferre) stock to a wholly/owne) s.9si)iary that .se) the stock to finance a 9ank loan& That )eal fo.n)ere) when the S,C ref.se) to allow the iss.e to 9e reporte) as e=.ity so long as the E*S: was .n)eci)e) on the iss.e& 129 3ol)8an Sachs s.ccee)e) where 0errill Lynch ha) faile) 9eca.se the ratings agencies agree) to look thro.gh the offshore entity an) treat the loan as preferre) stock on Te acoAs 9alance sheet& 130 Looking 9ack even farther# 0+2S are si8ilar in a key feat.re to an ol) sec.rity known as an inco8e 9on)# which gives the iss.er the right to )efer an) acc.8.late interest

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pay8ents for several years witho.t )efa.lting& 0+2S s.ggest two interesting aftertho.ghts to a point 0erton 0iller 8a)e in 1977 a))ress& 131 +n e plaining how corporations choose 9etween iss.ing )e9t an) e=.ity# 2rofessor 0iller 9egan 9y assailing the then conventional wis)o8 that corporations 9ear the greater ta cost of e=.ity 9eca.se of the 9ankr.ptcy protection it affor)s& "ere this the reason corporations iss.e) e=.ity# he arg.e)# corporations wo.l) t.rn to sec.rities like the inco8e 9on)# which also c.shion against 9ankr.ptcy# since the inco8e 9on) per8its the iss.er [*155] to )efer interest for several years witho.t )efa.lt# while provi)ing an interest )e).ction& :.t there was a scarcity of inco8e 9on)s# s.ggesting that 9ankr.ptcy protection was not the reason for .sing e=.ity& 2rofessor 0illerAs wry co88ent on the conventional wis)o8 e plaining the )earth of inco8e 9on)s 9ears repeating-

The conventional wis)o8 attri9.tes this )earth to .nsavory connotations that s.rro.n) s.ch 9on)s& They were )evelope) originally in the co.rse of the railroa) 9ankr.ptcies in the 19th cent.ry an) they are pres.8e) to 9e still associate) with that )is8al process in the 8in)s of potential 9.yers& *s an invest8ent 9anker once p.t it to 8e- ?They have the s8ell of )eath a9o.t the8&? 2erhaps so& :.t the o9vio.s retort is that 9it of ancient !o8an wis)o8- pec.nia non olet (8oney has no o)or)& +f the stakes were as high as the conventional analysis of the ta s.9si)y to )e9t see8s to s.ggest# then ingenio.s sec.rity sales8an# invest8ent 9ankers or ta a)visers wo.l) s.rely have long since have fo.n) ways to overco8e investor rep.gnance to inco8e 9on)s& 132

Eifteen years after 2rofessor 0iller gave this speech# a way was fo.n) to 8arket )e9t that gave the iss.er the right to )efer interest for several years witho.t )efa.lt / 0+2S& +n)ee)# several offspring of 0+2S / s.ch as 3ol)8anAs P.arterly +nco8e 5e9t Sec.rities (PU+5s) 133 / are no 8ore than long/ter8 9on)s with a five/year interest )eferral option# an inco8e 9on) plain an) si8ple witho.t the 9ells an) whistles of a partnership or tr.st fo.n) in the original 0+2S str.ct.re& 134 The s.ccess of ta /)e).cti9le preferre) stock s.ggests that 2rofessor 0iller was wrong- There is )e8an) for a sec.rity that provi)es so8e of the financial fle i9ility of preferre) stock 9.t that also provi)es an interest )e).ction& :.t why )i) it take so long to )evelop s.ch a sec.rityK 2erhaps the e planation is the one 2rofessor 0iller reDecte) / perhaps inco8e 9on)s ha) a ?9a) s8ell? fro8 the e perience with the8 )eca)es earlier& There are# however# two other pla.si9le e planations that he ignore)& >ne factor is the )ifference in the acco.nting treat8ent of the two sec.rities& 135 * key attraction of ta / [*156] )e).cti9le preferre) stock to so8e iss.ers is that it is acco.nte) for as e=.ity& 136 * secon) factor is .ncertainty a9o.t the ta treat8ent of inco8e 9on)s# for there was case law on 9oth si)es of the =.estion whether inco8e 9on)s were tr.ly )e9t& 137 +n)ee)# the lea)ing treatise on corporate ta attri9.te) the ?)is.se? of s.ch ?hy9ri) sec.rities? to their ?.ncertain ta conse=.ences&? 138 The initial iss.es of 0+2S were .n)er a clo.) as 8.ch for their long 8at.rity as for the a9ility to )efer interest& 0.ch of the .ncertainty regar)ing the ta characteri@ation of 0+2S was )ispelle) in the Spring of 199G when the govern8ent iss.e) a r.ling an) two notices that were wi)ely interprete) as a 9lessing of the 9asic str.ct.re& 139 New .ncertainty was create) in 5ece89er 19'$ when Treas.ry propose) legislation that wo.l) have treate) long/8at.rity )e9t instr.8ents as [*157] e=.ity that was to 9e effective fro8 the )ate of the proposal# 140 9.t this was )ispelle) a few 8onths later when the Chair8en of the "ays an) 0eans an) Einance Co88ittees anno.nce) that if

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s.ch legislation were enacte)# it wo.l) 9e effective fro8 the )ate of enact8ent& 141 2erhaps this ta law .ncertainty slowe) the penetration of the new sec.rity& "e think so# for a reason we e plain ne t& F& "hy Ta Law Uncertainty Can +8pe)e Sec.rities +nnovation- The Clientele ,ffect !epresentatives of the invest8ent 9anks an) the financial press often co8plain that ta law .ncertainty i8pe)es sec.rities innovation& 142 +n this Section# we s.ggest this 8ay 9e so 9eca.se financial 8arkets are str.ct.re) aro.n) )ifferent ta clienteles& Typically# ta law .ncertainty e ists 9eca.se a new sec.rity )oes not plainly fit within a partic.lar legal category or ?c.99y/hole? (for e a8ple# )e9t# e=.ity# or option)& Ta law .ncertainty 8ay also e ist 9eca.se changes in e isting law are propose)# perhaps in response to innovation& "hile Congress an) Treas.ry .s.ally have 9ent over 9ackwar)s to 8ini8i@e the effects of ta law .ncertainty 9y applying 8ost r.le changes prospectively# 143 occasionally Treas.ry acts in ways that see8 calc.late) to create .ncertainty 9y proposing controversial legislation an) reg.lations that wo.l) take effect fro8 the )ate of the proposal if ever enacte)& There is a fair a8o.nt of anec)otal evi)ence that ta law .ncertainty inhi9its the sale of sec.rities& * striking e a8ple of this effect can 9e fo.n) in the 8arketAs reaction 144 to a Treas.ry proposal in 5ece89er# 199$ of legislation that wo.l) )eny the interest )e).ction on )e9t that ha) too 8any e=.ity feat.res# incl.)ing )e9t with a 8a i [*158] 8.8 ?weighte) average 8at.rity? of GC years or 8ore& 145 Treas.ry sai) it wante) the legislation to 9e effective fro8 the )ate of the anno.nce8ent& The anno.nce8ent was reporte) to have a st.nning effect on "all Street# p.tting 8ost new iss.es 9y )o8estic corporations of @eros with a 8at.rity of 8ore than GC years on hol)J only ta /e e8pt iss.ers (foreigners an) ta /e e8pt entities) procee)e) with s.ch offerings .ntil the clo.) was re8ove)& 146 Ta /e e8pt iss.ers are in)ifferent to the risk that a long/ter8 9on) will 9e classifie) as e=.ity& The 8arket for s.ch long/ ter8 9on)s is reporte) to 9e pension f.n)s# 147 which are also in)ifferent on the iss.e of classification& +f one 9elieves the financial press# ta law .ncertainty s.ppresse) the U&S& 8arket for contingent pay8ent )e9t instr.8ents in the perio) fro8 199% to 199(# an) in partic.lar# )e9t instr.8ents that pai) interest contingent on the perfor8ance of an e=.ity in)e or portfolio of e=.ity stocks& 148 0errill LynchAs 0arket +n)e Target Ter8 Sec.rities (?0+TTS?)# which were first iss.e) in *.g.st 199%# 149 are an e [*159] a8ple of s.ch a sec.rity& The first iss.e of 0+TTS ha) a five/year ter8 an) g.arantee) the repay8ent of principal pl.s 11$L of any gains in the S;2 $CC over the perio)& +t was tra)e) on the New York Stock , change& The ta treat8ent of contingent pay8ent )e9t instr.8ents was .ncertain prior to <.ne# 199(& Treas.ry ha) propose) reg.lations on contingent pay8ent )e9t instr.8ents in 19'( that wo.l) have )eferre) recognition of interest .ntil the contingency was resolve)& 150 +n 1991# Treas.ry propose) new reg.lations# which were to have taken effect fro8 the )ate they were propose)# that wo.l) have re=.ire) 9if.rcation of a contingent pay8ent )e9t instr.8ent into a )e9t instr.8ent an) an option with the p.rchase price allocate) 9etween the two portions 9ase) on their respective val.e& 151 +nterest wo.l) have 9een i8p.te) on the )e9t portion an) there was a concern that the e89e))e) option on an e=.ity in)e in 0+TTS wo.l) 9e ta e) on a 8ark/to/8arket 9asis& +n 199B# Treas.ry release) yet another set of reg.lations that wo.l) have i8p.te) interest on the entire instr.8ent 9ase) on its e pecte) yiel)& 152 These reg.lations were with)rawn an) were never for8ally iss.e)& Certainty )i) not co8e to this area .ntil 199( when the reg.lations along the lines of those p.9lici@e) in 199B were finali@e)& 153 Ta law .ncertainty )oes see8 to have affecte) the 8arket for 0+TTS& "hen 0errill Lynch anno.nce) the first iss.e of 0+TTS in 199%# a n.89er of co88entators sai)

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that the iss.e wo.l) 9e )iffic.lt to sell 9eca.se of the .ncertainty a9o.t its ta treat8ent& 154 +n fact# the first iss.e of the sec.rity sol) =.ite well# 9.t 0errill Lynch li8ite) [*160] its sales efforts to ta /e e8pt acco.nts& 155 "hile the prospect.s for this an) later iss.es of 0+TTS incl.)e) a lengthy ta opinion fro8 :rown ; "oo) taking the position that the hol)er co.l) )efer interest .ntil 8at.rity# 156 the financial press reports that 0errill Lynch 8a)e no effort to sell the sec.rity on the 9asis of this ta a)vantage& 157 0errill Lynch )i) fo.r a))itional iss.es of 0+TTS in 199B while )esigning the sec.rity in or)er to try to avoi) potential application of the 1991 propose) reg.lations# tho.gh it contin.e) to foc.s its sales efforts on ta /e e8pt acco.nts& 158 0errill Lynch also intro).ce) an alternative sec.rity# S0*!TS# that g.arantee) a ret.rn of principal an) pai) a contingent yiel) 9ase) on the perfor8ance of an in)e 9.t that was engineere) to eli8inate the ta law .ncertainty an) the possi9le ta a)vantage of )eferral 9y paying an ann.al ret.rn 9ase) on the perfor8ance of the in)e each year& 159 No other iss.es of 0+TTS were )one .ntil 199(# altho.gh 0errill Lynch planne) an iss.e in 199G with a payo.t pegge) to a portfolio of !,+TS that was )esigne) to ena9le investors to take a position in !,+TS witho.t accr.ing inco8e& The plans for this iss.e were scotche) reporte)ly 9eca.se 8arket con)itions t.rne) against it& 160 5.ring this perio)# tra)ing in 0+TTS was often reporte) as sl.ggish# 161 which is consistent with reports that selling was li8ite) to private ta /e e8pt acco.nts# an) in 199$# it was [*161] reporte) that instit.tional investors still preferre) to 8ake s.ch contracts privately 9eca.se private 8arkets were cheaper an) as li=.i) as p.9lic 8arkets& 162 "hen the contingent pay8ent )e9t instr.8ent reg.lations were finali@e) in <.ne# 199(# 0errill Lynch took a)vantage of a (C/)ay gap 9etween the p.9lication of final reg.lations an) their effective )ate to )o two iss.es of 0+TTS# on which it took the position no inco8e accr.e) .ntil 8at.rity& 163 The story of the 9rief an) .nhappy life of the B'$ reg.lations that clarifie) the )istinction 9etween )e9t an) e=.ity# which were propose) 9y Treas.ry in 19'B an) with)rawn in 19'B# 164 also s.pports the clai8 that ta law .ncertainty i8pe)es innovat"#$% The reg.lations pro8pte) invest8ent 9anks to craft sec.rities that p.she) o.t to the newly clarifie) 9o.n)ary 9etween )e9t an) e=.ity& 165 The sec.rity that got Treas.ryAs )an)er .p# *)D.sta9le !ate Converti9le Notes (?*!CNs?)# when 9oile) )own to its essentials# was a co89ination of a )e9t instr.8ent that pai) varia9le interest at a rate that was e pecte) to 9e well 9elow the 8arket rate of interest co.ple) with a )eep/in/the/8oney option on the iss.erAs co88on stock that the hol)er co.l) 9e e pecte) to e ercise on 8at.rity of the )e9t instr.8ent& Treas.ry learne) that *!CNs were on the )rawing 9oar) fro8 a concerne) practitioner# 166 an) it r.she) o.t a reven.e r.ling )eclaring the instr.8ent to 9e e=.ity 9eca.se of the strong likelihoo) that the option wo.l) 9e e ercise )& 167 Treas.ry also with)rew the B'$ reg.lations& The clarity of the B'$ reg.lations 8a)e *!CNs possi9leJ the with)rawal of the reg.lations an) the warning shot of the reven.e r.ling stoppe) )evelop8ents along the line of *!CNs for al8ost a )eca)e& Not .ntil the early 199CAs )i) practitioners 9egin to p.sh gently at the e)ge of the envelope in )esigning converti9le sec.rities 9y creating )e9t instr.8ents that pai) a 8arket rate of interest [*162] an) that also gave the iss.er the power to convert its o9ligation into preferre) stock& 168 +t is not self/evi)ent why ta law .ncertainty sho.l) inhi9it the sale of sec.rities& 5iffic.lt pro9le8s in the val.ation of new sec.rities that are a pro).ct of .ncertainty are )ealt with every )ay on sec.rities e changes# 8ost pro8inently in initial p.9lic offerings (?+2>s?) 9y closely hel) fir8s an) in the iss.ance of 9on)s# s.9Dects on which a great )eal has 9een written& 169 The pro9le8 of ta law .ncertainty is )ifferent in str.ct.re fro8 the infor8ational pro9le8s .s.ally confronte) in pricing +2>s# which are tho.ght to 9e )iffic.lt to val.e 9eca.se iss.ers know 9etter than investors their circ.8stances an) iss.ers can alter their 9ehavior in ways that har8 investors (or# 8ore generally# +2>s are s.9Dect to asy88etric infor8ation an) 8oral ha@ar))& :.t these str.ct.ral )ifferences s.ggest that 8arket 8echanis8s sho.l) 9e 9etter

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e=.ippe) to )eal with ta law .ncertainty# not worse# since the infor8ation 9earing on the eval.ation of that risk is p.9lic an) the risk is not within the control of either party& E.rther# the str.ct.res that have evolve) to overco8e the val.ation pro9le8s with +2>s / invest8ent 9anks an) rating agencies are tho.ght to have an incentive to caref.lly 8onitor relevant infor8ation to 8aintain their cre)i9ility 170 / in theory# sho.l) work as well to ass.re iss.ers an) investors that a ta opinion is 8eas.re) caref.lly& "e think that one e planation for why ta law .ncertainty i8pe)es sec.rities innovation )erives fro8 the fact that financial 8arkets are organi@e) aro.n) ta clienteles& That ta law .ncertainty can re).ce the val.e of a sec.rity 9eca.se of the organi@ation of 8arkets aro.n) ta clienteles is clear within the contrive) 8o)el that was .se) 9y 0erton 0iller in 5e9t an) Ta es to 8ake the provocative point that [*163] the val.e of a fir8 in theory co.l) 9e in)epen)ent of its capital str.ct.re even in a worl) where )e9t an) e=.ity are ta e) )ifferently& 171 2rofessor 0iller ass.8e) progressive in)ivi).al rates ranging fro8 @ero to a rate a9ove the corporate rate# a flat corporate rate# an) two types of sec.rities# 9on)s an) e=.ity# with e=.ity 9earing @ero in)ivi).al ta es& Eig.re 1 )epicts the e=.ili9ri.8 in the 8arket for 9on)s .n)er these ass.8ptions& [*164] MS,, E+3U!, +N >!+3+N*LN The =.antity of 9on)s o.tstan)ing in the 8arket as a whole is :4# which is the point where the rising )e8an) c.rve for 9on)s intersects with the 8arket/clearing# risk/ a)D.ste) rate of ret.rn for 9on)s& Un)er 0illerAs analysis# this price t.rns o.t to 9e the ta /e e8pt rate of ret.rn grosse) .p 9y the corporate ta rate& 172 5ifferent ta clienteles appear in the rising )e8an) c.rve for 9on)s& The flat part of the c.rve is the )e8an) 9y ta /e e8pt investors who are in)ifferent 9etween e=.ity (which is ass.8e) to 9e ta /free) an) )e9t& The rising )e8an) c.rve )epicts ta clienteles with increasingly high 8arginal ta rates who )e8an) an increasingly high risk/a)D.ste) rate of ret.rn on 9on)s to 8ake the8 in)ifferent after ta 9etween hol)ing ta /free e=.ity or )e9t& +n effect# the e=.ili9ri.8 corporate 9on) rate is set at the price where the val.e to the corporation of the interest )e).ction# which is a f.nction of the corporate ta rate# e=.als the a))itional ta pai) 9y the 8arginal investor 9y forgoing the ta e e8ption of e=.ity& * single fir8 is in)ifferent 9etween iss.ing higher/cost )e9t an) lower/cost e=.ity 9eca.se the after/ta cost of capital is e=.al& +ntro).ce to this worl) a hy9ri) sec.rity that has financial val.e# which we )eno8inate as v 9.t .ncertain ta classification& Un)er 2rofessor 0illerAs 8o)el# there is a loss of val.e in this hy9ri) sec.rity as a res.lt of ta law .ncertainty .nless the sec.rity is sol) to an investor [*165] locate) at point :4 on the )e8an) c.rve& +t is only at this point on the )e8an) c.rve# where the 8arginal ta rate of the investor e=.als the corporate ta rate# that the investor an) the corporation are Dointly in)ifferent as to whether the corporation gets the interest )e).ction or the investor gets the ta shiel) on e=.ity& 173 There is a Doint loss 9eca.se of the ta law .ncertainty for any investor not at point :4& To the left of point :4# it is in the Doint interest of the iss.er an) investor to characteri@e the sec.rity as )e9t 9eca.se the investorAs 8arginal ta rate is lower than the corporate rate& Sho.l) the sec.rity 9e classifie) as e=.ity# the parties will 9e Dointly worse off# for the iss.erAs loss fro8 losing the interest )e).ction will e cee) the investorAs gain fro8 9eing shiel)e) fro8 ta & 174 The opposite is tr.e to the right of point :4& +t is in the Doint interest of the parties to characteri@e the sec.rity as e=.ity 9eca.se the investorAs 8arginal rate is higher than the corporate rate& Sho.l) the sec.rity 9e reclassifie) as )e9t# the investorAs loss fro8 losing the ta shiel) will e cee) the iss.erAs gain fro8 o9taining the interest )e).ction& * hy9ri) sec.rity of .ncertain classification 8ight s.ccee) even if the

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8arket clearing 9.yer is not at point :4# 9.t only if v is s.fficient to co8pensate whichever party 9ears the loss fro8 the ta risk for that loss& There is little solace in the fact that the e=.ili9ri.8 investor in 0illerAs analysis stan)s at point :4# where the iss.er an) investor are Dointly in)ifferent to how the sec.rity is classifie) for ta p.rposes# for .nlike in the .s.al e=.ili9ri.8 analysis# s.ch an investor is the only person to who8 the [*166] sec.rity co.l) 9e sol) witho.t there 9eing a pre8i.8 val.e v to co8pensate for ta riskJ in the .s.al e=.ili9ri.8 analysis# those at the 8argin stan) after all those to one si)e of the c.rve as price takers& E.rther# even an investor at the 8argin 8ay 9e risk averse an) therefore )isincline) to ?9et? on the ta iss.e# or 8ay 9e )eterre) 9y the prospect of the transaction costs of a)D.sting his ta lia9ility& "hile 8any fa.lts have 9een fo.n) in 0illerAs 8o)el an) its i8plications 175 8ost of these fa.lts )o not .n)er8ine the si8ple point for which we are .sing the 8o)el& The effect we )escri9e will e ist for a new sec.rity that is a hy9ri) of two sec.rities with )ifferent ta characteristics that have )ifferent val.e/8a i8i@ing ta clienteles so long as the prices of these alternative sec.rities a)D.st so8ewhat to reflect their favora9le or .nfavora9le ta characteristics / that is# it is necessary that ta /favore) sec.rities 9ear so8e i8plicit ta # altho.gh it is not necessary that a ta 9enefit 9e f.lly capitali@e) in the price& 176 This will 9e tr.e so long as the sec.rities 8arkets are loosely organi@e) aro.n) ta clienteles& :y this we 8ean that# all other factors 9eing e=.al# fir8s choose to raise capital 9y iss.ing sec.rities for which their ta profile gives the8 a co8parative a)vantage (for e a8ple# fir8s that face a @ero or low 8arginal rate prefer e=.ity over )e9t)# an) the iss.er an) .n)erwriter e pect that for a sec.rity offering to 9e s.ccessf.l# it 8.st appeal to 9.yers who also are looking for a sec.rity for which their ta profile gives the8 a co8parative a)vantage (for e a8ple# investors who face a high 8arginal rate are incline) to 9.y ta /e e8pt sec.rities or long/ter8 sec.rities that 9ear )eferre) inco8e)& "hen these con)itions are present# a new hy9ri) sec.rity that is of .ncertain classification will 9e )iffic.lt to 8arket 9eca.se the [*167] val.e/8a i8i@ing clienteles for the sec.rity at one classification (for e a8ple# the iss.er an) investors whose ta profiles give the8 the greatest co8parative a)vantage) will also 9e those who stan) to lose the 8ost .n)er the alternative classification& This effect hol)s only for new sec.rities that are a hy9ri) of two sec.rities that appeal to )ifferent ta clienteles& Step/)own preferre) stock presents a )ifferent case 9eca.se it is not s.ch a hy9ri)& +nstea)# it is a new strain of an e isting sec.rity that tries to 8agnify the )esira9le ta characteristics of that sec.rity (one 8ight think of it as ?s.per/ )e9t? fro8 a ta perspective)& 177 The sec.rity was )esigne) to 8agnify interest )e).ctions availa9le to an iss.er of )e9t& "hile the ta 9enefit to the iss.er involves a correspon)ing )etri8ent to the hol)er# this feat.re of the sec.rity increases the Doint e pecte) ret.rn (ignoring the cost of a)D.sting the ta lia9ility an) risk aversion) at all points on 5iagra8 1 e cept for point :4# an) the f.rther the )istance fro8 point :4# the larger the increase in the Doint e pecte) ret.rn& +n the act.al case# the sec.rity was sol) to ta /e e8pt instit.tional investors# that is# investors in the lowest region of the )e8an) c.rve& +n this region# the sec.rityAs feat.re of possi9ly 8agnifying interest e pense an) inco8e ha) positive val.e to the iss.er an) no negative val.e to the investor& There is a si8pler e planation for why so8e new sec.rities that offer .ncertain ta 9enefits )erive little or no val.e fro8 this feat.re& +t is that there is s.ch a gl.t of invest8ents that offer the sa8e 9enefits that investors looking for those 9enefits can o9tain the8 with only a s8all sacrifice in yiel) (for e a8ple# there is trivial capitali@ation of the ta 9enefits in price) an) witho.t any .ncertainty& 178 The prospect of the transaction costs of a)D.sting ta lia9ility an) risk aversion co.l) easily e plain why investors 8ight accept a s8all sacrifice in yiel) to avoi) ta law .ncertainty& 0errill LynchAs e perience with 0+TTS is consistent with this theory& !ecall that while

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0errill Lynch o9taine) a legal opinion that 0+TTS yiel)e) )eferre) inco8e# it )i) not 8arket the sec.rity on that 9asis# instea) selling the sec.rity to ta /e e8pt acco.nts& The int.itive e planation for why 0errill Lynch .n)ersol) the sec.rity 9y not seeking o.t investors who co.l) 9enefit fro8 )eferral is that 0+TTS co.l) not co8pete on this 9asis with other sec.rities that yiel)e) )eferre) inco8e with no ta law .ncer [*168] tainty (8arket )isco.nt 9on)s are an e a8ple)& 179 This answer only 8akes sense if investors )i) not have to 8ake a significant sacrifice in yiel) to p.rs.e these other )eferral strategies& >.r theory cannot e plain 0errill LynchAs 9ehavior& "e close this Section 9y looking at the e perience of 0+2S 9eca.se it casts light on how the forces o.r theory i)entifies as cr.cial 8ay play o.t in the real worl)& There was so8e )egree of .ncertainty regar)ing the characteri@ation of 0+2S as )e9t prior to <.ne# 199G when Treas.ry iss.e) a set of r.lings an) notices 180 i8plying that it wo.l) look with for9earance on the sec.rity so long as its 8at.rity was not overlong& "hile these prono.nce8ents re).ce) the apparent risk on 0+2S# a fair a8o.nt of risk re8ains regar)ing the characteri@ation of so8e 0+2S variants# in partic.lar T!U2S& 181 "hy wo.l) a fir8 looking to raise capital choose 0+2S over preferre) stock# which# in theory# sho.l) co88an) a higher price 9eca.se of the shiel) of the )ivi)en)s receive) )e).ction# or over )e9t# which provi)es an interest )e).ction with no .ncertaintyK The first part of this =.estion is easier to answer& The price a)vantage of preferre) stock over )e9t (or 0+2S) is slight for sec.rities with long 8at.rities an) fi e) yiel)s# 182 which i8plies that the val.e of the )ivi)en)s receive) )e).ction to investors is capitali@e) in the price of preferre) stock only to a s8all )egree& !elate)ly# an) even 8ore to the point# 0+2S were targete) at in)ivi).al investors# an) offers to convert o.tstan)ing preferre) to ta /)e).cti9le preferre) stock# which ten) to 9e accepte) 9y aro.n) one/half of the preferre) sharehol)ers# pres.8a9ly have 9een accepte) 9y investors who were in)ifferent to the )ivi)en)s receive) )e).ction& The .pshot is that ta /)e).cti9le preferre) respon)s to a financial ano8aly# the fact that ta paying corporations finance with preferre) stock that is hel) (or was hel)) in s.9stantial percentage 9y in)ivi).al investors& [*169] "hile this e plains why ta /)e).cti9le preferre) 8ight 9e appealing when co8pare) to tra)itional preferre)# it )oes not e plain the attraction of 0+2S over tra)itional )e9t so long as the ta classification of 0+2S is .ncertain& The val.e of the interest )e).ction was so great that the financial val.e of 0+2S over straight )e9t (an 1'/8onth interest )eferral option in the first iss.es an) a long 8at.rity) wo.l) see8 to 9e swa8pe) at any significant ta .ncertainty& Nevertheless# in a s.9stantial n.89er of cases where fir8s have iss.e) ta /)e).cti9le preferre)# one state) .se of the f.n)s was to retire )e9t& 183 The s.9stit.tion of 0+2S for )e9t is least .n)erstan)a9le early on when the ta law .ncertainty regar)ing the sec.rity was the greatest& "hat were the o9Dectives of the first iss.ersK ,nron Corp& an) Capital !e Corp& 9oth cite) rating concerns& ,nron was trying to raise its 9on) rating 9y re).cing its )e9t/e=.ity ratio while Capital !e wante) to preserve a single/* rating 9y keeping its )e9t/e=.ity ratio 9elow %CL& 184 The i8pression is that these fir8s ha) settle) on a financial strategy that precl.)e) the8 fro8 iss.ing a))itional )e9t an) that 8a)e the8 a8ena9le to a proposal that offere) a chance to lower the cost of p.rs.ing that strategy& Ero8 the perspective of an iss.er co8paring 0+2S to preferre) stock# 0+2S )o8inate over preferre) so long as the price )ifferential is not too large# an) it was in fact s8all# since even a low chance of an interest )e).ction will co8pensate for the sacrifice in price& "e have seen 9ehavior like this in other conte ts- *cco.nting concerns often in).ce 8anagers to forgo opti8al ta strategies# an) ta consi)erations often co8e into play only once 9asic financial )ecisions are 8a)e& Te acoAs p.9lic state8ents in)icate that the ratings a)vantages of 0+2S were not )o8inant in its 8in)& !ather# Te aco was p.rs.ing a strategy# of iss.ing very long/

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ter8 )e9t (earlier in 199B it ha) iss.e) $C/year 9on)s) 185 an) it saw 0+2S (which potentially ha) a 1CC/year 8at.rity) as a nat.ral e tension of that strategy# with the a))itional 9enefits of 9eing a9le to sell the sec.rity to the retail 8arket an) of the financial fle i9ility of 9eing a9le to )efer co.pon pay8ents for a short perio) an) to call the sec.rity after five years& 186 The clincher 8ay have 9een the fact that 0+2S were sol) at a co.pon rate 9elow the yiel) on Te acoAs o.tstan)ing $C/year 9on)s an) what was )e [*170] scri9e) as an historic low yiel) even for preferre) stock& 187 There was strong ta /e e8pt instit.tional )e8an) for long/8at.rity 9on)s at the ti8e (at a9o.t the sa8e ti8e 5isney an) CokeAs iss.es of 1CC/year 9on)s were well/ receive))# as well as strong retail )e8an) for preferre)& 188 The 0+2S str.ct.re 8ay not have see8e) any riskier to Te aco on the )e9t/e=.ity iss.e than a 1CC/year 9on)& "hile Treas.ry has stren.o.sly o9Decte) to characteri@ing long/8at.rity o9ligations as )e9t# it has never o9Decte) to the interest )eferral feat.re& The str.ct.re ha) the a))itional attraction of provi)ing entree to the retail 8arket& Te acoAs e planation is re8iniscent of the story 9ehin) @ero co.pon 9on)s with two new twists& Con)itions in financial 8arkets 8a)e very long/ter8 )e9t attractive to Te aco& *n iss.e of 1CC/year )e9t ca8e at so8e legal risk alrea)y# 189 so Te aco 8ay not have perceive) 0+2S as involving 8.ch greater ta risk& *n) 0+2S ha) the a)vantage of allowing Te aco to tap new 8arkets& +ronically# the story Te aco tells s.ggests that it was attracte) to the sec.rity 9eca.se it ha) gen.ine financial val.e reflecte) in the )e8an) for e tre8ely long/ter8 )e9t& F+& The Social Costs an) :enefits of ?Ta /+nfl.ence)? Sec.rities +nnovation "hat are the social costs an) 9enefits of ?ta /infl.ence)? sec.rities innovationK "hat )o those costs an) 9enefits s.ggest a9o.t how ta policy8akers sho.l) respon) to financial innovationK +t so8eti8es is sai) that the social val.e of financial innovation lies in ?co8pleting the 8arket&? 190 The theoretical concept of a co8plete 8arket is not helpf.l as a policy tool& Co8plete 8arkets e ist in financial theory only 9eca.se financial econo8ists 8.st ass.8e they e ist in or)er to )erive an e=.ili9ri.8 price for sec.rities# notwithstan)ing the fact that h.8ans have )ifferent risk preferences& 191 Th.s# it is o)) to say [*171] that a new sec.rity ?co8pletes the 8arket#? for finance theory ass.8es that the 8arket is alrea)y co8plete& +n)ee)# new sec.rities al8ost always replicate positions that can 9e taken with e isting sec.rities& This is tr.e even of the innovation that is 8ost like the theoretical ?p.re sec.rity? 192 / @ero co.pon 9on)s& The pattern of cash flows offere) 9y a @ero co.pon 9on) was new an) .ni=.e a8ong the .niverse of then e isting sec.rities& :.t even witho.t @eros# it was possi9le to constr.ct 9on) portfolios with the sa8e ).ration or interest rate sensitivity as a @ero co.pon 9on)& 193 +n the real worl)# there is this para)o that innovative sec.rities that see8ingly 8ake the financial 8arket 8ore co8plete 9y creating new ways to he)ge risks 8ay the8selves 9e replicate) 9y a co89ination of e isting sec.rities an) therefore are at least theoretically re).n)ant& >ne way to get aro.n) this para)o is to look 9eyon) the theoretical concepts of finance to the .ses to which the theory is p.t& Two co88on goals in the )evelop8ent of new instr.8ents are to ena9le in)ivi).als or fir8s to he)ge risks or price assets 8ore cheaply or acc.ratelyJ in)ee)# .n)er the CETCAs ?econo8ic p.rpose? test# these are the only recogni@e) goals in contract innovation# for a new f.t.res [*172] contract will 9e approve) for tra)ing only if it can 9e shown that the contract will 9e .se) ?8ore than occasionally? 9y pro).cers# 8erchants or cons.8ers to he)ge against the risk of loss or to )eter8ine prices& 194 New instr.8ents 8ay have val.e for other reasons& 0.ch of finance theory# an) in partic.lar corporate finance# is concerne) with )evising contracts to 8ini8i@e what 9roa)ly 8ay 9e calle) agency pro9le8s# typically 9y altering 8anagerial incentives& There also 8ay 9e val.e in creating a sec.rity that lowers the transaction cost of

195

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satisfying o)) 9.t wi)ely hel) in)ivi).al invest8ent preferences& Eor e a8ple# the perceive) )e8an) for LY>Ns 9y investors was ).e to a preference of in)ivi).als for a strategy of 9etting inco8e while preserving principal& 196 * )iffic.lt =.estion is how a reg.lator sho.l) respon) to financial innovations that )erive their val.e fro8 re).cing )ifferences in prices that res.lt fro8 reg.latory or ta ?friction&? 197 The =.estion of what is the proper role of govern8ent in reg.lating financial innovation a))s another layer of iss.es# for it is necessary to take acco.nt of s.ch risks as reg.latory error an) capt.re& 198 U&S& [*173] reg.latory agencies have 9y an) large a)opte) a laisse@/faire policy in reg.lating new for8s of sec.rities or f.t.res contracts# i8posing so8e infor8ational an) =.alitative re=.ire8ents to protect against fra.) an) 8arket 8anip.lation# 9.t otherwise allowing the 8arket to esta9lish the val.e of a new sec.rity or f.t.res contract& ,ven the CETC has a)opte) this policy# notwithstan)ing its r.le re=.iring that a f.t.res contract 9e shown to serve an ?econo8ic p.rpose? 9efore it can 9e liste)# 9eca.se the CETC looks pri8arily to co88ercial .tili@ation of a contract in applying this r.le& 199 Criticis8s of this laisse@/faire policy range fro8 9roa) assa.lts on the ass.8ptions .n)erlying the policy (the ass.8ptions are that investors are generally rational an) 8arkets are generally efficient) 200 to arg.8ents for specific for8s of intervention to respon) to i)entifia9le instances of 8arket fail.re& 201 +n the analysis that follows# we ass.8e a laisse@ faire policy# at least in the a9sence of i)entifia9le instances of 8arket fail.re# which is gro.n)e) on welfarist val.es& These are not re8arka9le ass.8ptions for 8ost ta an) financial policy analysis .s.ally is )one fro8 this stance& >.r .lti8ate goal is to )eter8ine what r.les an) proce).res for changing ta law least )istort financial 8arkets an) the path of financial innova!"#$ while preserving the reven.e 9ase& "e p.t to the si)e what are pro9a9ly the 9est options for eli8inating ta )istortions / a =.ick 8ove to a p.rer inco8e or cons.8ption ta co.ple) with so8e for8 of corporate integration / as 9eing politically .nfeasi9le& "e also p.t to si)e cases where ta law negatively )istorts the val.e of an innovative sec.rity or contract in)epen)ent of the effect of ta .ncer [*174] tainty& 202 +n s.ch cases# innovators an) .sers 9ring great press.re to 9ear on Treas.ry an) Congress to change ta law to eli8inate the )istortion& 2olitical power ar8ore) in tr.th see8s invinci9le on these 8atters& 203 0ore tro.9ling are cases where ta law ca.ses a positive )istortion in the val.e of an innovative sec.rity / @eros an) 0+2S are goo) e a8ples& Typically# there is no nat.ral )yna8ic 9ringing s.ch cases to Treas.ryAs attention# 204 tho.gh the financial an) ta press play a helpf.l role as watch)ogs& S.ch innovations often are )escri9e) peDoratively as ?ta /)riven? or ?ta /8otivate)&? 5escri9e) this way# the innovations see8 socially har8f.l 9eca.se the private effort in creating the8 an) the p.9lic effort in respon)ing to the8 is wastef.l& This wo.l) s.ggest a)opting a policy of s.ppressing s.ch innovations# which 8ight incl.)e changing the law to close whatever ?loophole#? ?gap#? or ?a89ig.ity? the innovation e ploits (taking care of the f.t.re) an) a policy of applying that r.ling retroactively (the threat of a retroactive r.le change re).ces the incentive to p.rs.e s.ch paths of innovation)& Section F++ e plores the =.estion of retroactivity& Section F+++ asks whether it is also )esira9le to close loopholes& F++& Sho.l) !.le Changes :e *pplie) !etroactivelyK This Section consi)ers when changes in ta law that are 8a)e in response to innovative sec.rities or transactions sho.l) 9e applie) retroactively to sec.rities iss.e) or transactions occ.rring prior to the change& Ta r.le changes .s.ally apply to transactions fro8 the )ate of the change 205 while changes in ta r.les regar)ing sec.rities .s.ally [*175] apply to sec.rities iss.e) fro8 the )ate of the change& 206 "hen a [*176] change clarifies the law# the govern8ent ten)s to ac=.iesce to any

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reasona9le position taken on transactions that occ.r prior to the clarification# 207 in effect giving ta payers a right to choose a8ong pla.si9le positions .n)er prior law& The .n.s.al instances of retroactive r.le8aking take on legal positions that are perceive) as weak .n)er e isting law& 208 "e arg.e that if efficiency is the goal# the govern8ent sho.l) 9e 8ore aggressive in applying r.le changes retroactively& To 9egin# it is .sef.l to separate the i88e)iate effects of a )ecision whether to apply a r.le change retroactively to transactions or sec.rities that are the s.9Dect of the r.le fro8 the 9roa)er effects of a)opting a policy on retroactivity for all transactions where ta payers anticipate that the law regar)ing their transactions 8ight 9e change)& +f a retroactivity )ecision ha) only i88e)iate effects (i8agine that people see no portent in a )ecision for f.t.re retroactivity )ecisions)# then fro8 an econo8ic perspective# the 9etter policy is to apply changes retroactively& >ne reason is general& Unanticipate) ta es are [*177] efficient 9eca.se they are a non)istortionary so.rce of reven.e& 209 The other reason is specific to ta law changes affecting p.9licly tra)e) sec.rities& 3ran)fathering sec.rities iss.e) prior to the )ate of a change in the law frag8ents the 8arket in the relevant sec.rity when the )ifference in ta treat8ent affects the price of the sec.rity& 0arket frag8entation can )ecrease li=.i)ity an) increase the cost of 9.ying an) selling sec.rities& The econo8ic arg.8ent against a policy of 8aking changes in the law retroactive is gro.n)e) in the view that s.ch a policy wo.l) increase ta law .ncertainty an) that this has the .n)esira9le effect of inhi9iting sec.rities innova!"#$% "e accept that ta law .ncertainty can inhi9it sec.rities innovation& 210 The iss.e is whether this effect is .n)esira9le& The welfare effect of inhi9iting financial innovation can 9e either positive or negative )epen)ing .pon the social val.e of the inhi9ite) innovations& 211 *t this point# the arg.8ents in )efense of a policy of not .sing the threat of retroactive r.le8aking to s.ppress .n)esira9le innovation are the general arg.8ents for p.rs.ing a laisse@/faire policy in reg.lating financial innovation- "e (or# 8ore to the point# the reg.lators who will a)8inister the policy) are not co8petent to assess the social val.e of an innovation# an)# at least to )ate# .nreg.late) innovation see8s to have ha) 9eneficial social conse=.ences& The co8petence arg.8ent is so8ewhat stronger in the ta conte t for ta policy8akers are likely to 9e weaker in eval.ating innovations than reg.lators at the Ee)eral !eserve# the S,C# or the CETC& :.t the historical arg.8ent is so8ewhat weaker# for there are [*178] a fair n.89er of cases of sec.rities or transactions that see8 ta / )riven that have )o.9tf.l val.e in)epen)ent of their ta feat.res (stra))les an) step/)own preferre) stock are e tre8e casesJ a)D.sta9le rate preferre) stock is a less e tre8e case)& The co8petence arg.8ent can 9e overstate)& "hile there is )isagree8ent within the finance co88.nity a9o.t the act.al social val.e of 8.ch financial innovation# there is a fair a8o.nt of consens.s a9o.t where# in theory# the potential social val.e in financial innovation lies& 2rofessor 0erton has i)entifie) three general ways financial innovation can i8prove econo8ic perfor8ance- (1) offering ?e pan)e) opport.nities for risk/sharing# risk/pooling# he)ging# an) interte8poral or spatial transfers of reso.rces?# (%) lowering transaction costs# an) (B) re).cing agency pro9le8s& 212 2rofessor 0ertonAs list o8its one potential so.rce of val.e / the possi9ility that opport.nities for reg.latory or ta ar9itrage create) 9y innovation i8proves econo8ic perfor8ance 9y )i8inishing the welfare losses i8pose) 9y reg.latory or ta syste8s& "e a))ress an aspect of this iss.e in the ne t Section# where we concl.)e that once reven.e losses an) transaction costs are taken into acco.nt# ta ar9itrage thro.gh financial innovation pro9a9ly )i8inishes social welfare& The potential negative social conse=.ences of innovation incl.)e reso.rces e pen)e) in pro).cing innovations (co8prising 9oth the cost to the innovator of )esigning an) 8arketing the innovation an) the cost to potential .sers of eval.ating the innovation)# the conf.sion of choices 9y .sers# 8arket frag8entation that re).ces li=.i)ity an) increases transaction costs# 213 an) whatever negative conse=.ences flow fro8 ar9itrage i8pairing 8eritorio.s ta

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or reg.latory goals& !estricting the ta policy o9Dective to 8ini8i@ation of ta /9ase) )istortions of financial innovation (or )istortions of financial )ecisions generally) a8eliorates the co8petence pro9le8& This restriction foc.ses the attention of ta policy8akers on a so.rce of 8arket fail.re that they are co8petent to D.)ge- "hen an innovation )erives a significant part of its val.e fro8 its ta 9enefits# there is a potential )iscrepancy 9etween the private ret.rn fro8 the innovation an) the p.9lic ret.rn 9eca.se 8.ch of the private ret.rn represents a transfer of wealth thro.gh the ta syste8& Not all s.ch innovations will 9e inefficient& Ero8 an econo8ic perspective# the wealth transfer itself 8ay have a ne.tral i8pactJ the social har8 lies in the reso.rces e pen)e) in proc.ring the transferJ that is# it lies in the cost of pro).cing an) .sing the new sec.rity& 0oreover# the i)ea for a new sec.rity 9eing in the nat.re of a p.9lic goo)# there 8ay 9e p.9lic 9enefits [*179] fro8 the pro).ction of a new sec.rity that are not capt.re) 9y the pro).cer an) the initial .sers& This possi9ility e ists when a sec.rity has positive econo8ic val.e in a))ition to its ta val.e an) it passes into general .se& +n other wor)s# one potential so.rce of 8arket fail.re (the wealth transfer thro.gh the ta syste8) 8ay offset another (the p.9lic goo)s nat.re of the i)ea for a new sec.rity)& *t this point# it see8s to .s that there is little strength left to the co8petence o9Dection# at least as a general 8atter& "e know that ta law creates incentives for inefficient innovation so we s.spect that )oing nothing is costly& *n) we can i)entify so8e of the 8ore o9vio.s characteristics of inefficient innovation (high transaction costs yiel)ing none of the 9enefits i)entifie) 9y 2rofessor 0erton) so we can craft a policy that targets innovations that are likely to 9e inefficient& The pro9le8 of co8petence 9eco8es a 8atter of line )rawing that can 9e )ealt with 9y resolving )o.9ts against retroactivity in cases where we are not confi)ent a9o.t o.r D.)g8ents& "e wo.l) apply r.le changes retroactively to sec.rities that )erive significant val.e fro8 their ta characteristics if the sec.rity is pro).ce) an) .se) at high transaction costs an) it yiel)s none of the 9enefits associate) with financial innovation& This policy is a change fro8 the stat.s =.o# 9.t not a ra)ical one so long as it is applie) with )iscretion& 0any sec.rities that now are gran)fathere) wo.l) contin.e to 9e .n)er this policy& 7ero co.pon 9on)s are an easy case for gran)fathering 9eca.se they have significant positive econo8ic val.e (they 8a)e it cheaper an) easier to eli8inate reinvest8ent risk an) provi)e) val.a9le price infor8ation) an) =.ickly passe) into general .se& 0+TTS an) other e=.ity/in)e e) )e9t instr.8ents are an easy case for si8ilar reasons& Step/)own preferre) stock is an easy case where retroactivity wo.l) 9e appropriate& 214 +t has no real financial val.e for# ta consi)erations asi)e# it is e=.ivalent to )e9t e cept for its high iss.e cost& 215 So8e sec.rities pose close cases even resolving )o.9ts against retroactivity& , changea9le )e9t is a so8ewhat har)er case# 9.t we )o not think it passes 8.ster& 216 This sec.rity is )e9t iss.e) 9y a corporation that is co.ple) with a call option on a large 9lock of stock of a [*180] secon) co8pany that is hel) 9y the iss.ing corporation& 217 The conventional wis)o8 is that ta consi)erations )rive e changea9le )e9t- Corporations iss.e e changea9le )e9t to ?8oneti@e? (translation- sell) their position in another co8pany while )eferring ta on the gain& 218 The arg.8ent that the sec.rity has val.e for other reasons / it is s.9stantially cheaper for a corporation to .n)erwrite a )e9t iss.e than to .n)erwrite a secon)ary offering of stock it owns 219 / is not pers.asive& The cost of iss.ing e changea9le )e9t sho.l) 9e co8pare) not to the cost of a secon)ary offering of the stock 9.t rather to the cost of iss.ing straight )e9t pl.s the cost of selling options on the .n)erlying stock# for that is the 8ore co8para9le position& +f the alternative to e changea9le )e9t is really a sale# the sec.rity entails an a))itional cost in the )istortion of the ta payerAs choice& The .pshot is that were the ta r.les regar)ing e changea9le )e9t change) to ta the transaction

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as a constr.ctive sale of the .n)erlying sec.rity# we wo.l) apply that change retroactively& 0+2S an) other for8s of ta /)e).cti9le preferre) stock pose an even closer case& The sec.rity raises a pro9le8 we ).cke) earlierJ so8e of its val.e lay in reg.latory ar9itrage (8aking )e9t appear as e=.ity for financial reporting p.rposes)& >pinions )iffer as to the val.e of 0+2S for financial reporting p.rposes# 220 9.t it is clear that iss.ers think there is so8e val.e for they have inc.rre) s.9stantial e pense to convert )e9t into ta /)e).cti9le preferre)& "e nee) a 9etter .n)erstan)ing of the econo8ic role acco.nting plays to )eter8ine whether these financial reporting gains are )el.sional or co8e at the [*181] e pense of those who rely on financial reports& There is gen.ine financial val.e in long 8at.rity# fi e) inco8e sec.rities# 221 which is the attri9.te of 0+2S that 8ost 9othere) Treas.ry& These possi9le nonta val.es wo.l) 9e s.fficient in o.r 8in) to protect iss.ers an) investors fro8 the threat of a retroactive r.ling classifying 0+2S as e=.ity were it not for the analysis in the ne t Section# where we concl.)e that p.shing o.t the 9o.n)ary 9etween )e9t an) e=.ity 9y allowing )e9t instr.8ents to take on 8ore characteristics of e=.ity pro9a9ly worsene) the har8f.l )istortionary effects of the corporate inco8e ta & Taking this loss into acco.nt an) the significant transaction cost of converting preferre) stock into ta /)e).cti9le preferre)# we think a case can 9e 8a)e for applying retroactively a r.ling clarifying that sec.rities with the e=.ity/like characteristics of 0+2S are ta e) as e=.ity& The real payoff is not in the effect on the 8arket for 0+2S 9.t rather in the tacit threat to invest8ent 9anks an) iss.ers regar)ing f.t.re sec.rities& The in=.iry we a)vocate in 8aking retroactivity )ecisions )iffers in several respects fro8 the in=.iry now 8a)e tho.gh# not s.rprisingly# these )ifferent in=.iries converge in easy cases& C.rrent law allows Treas.ry to iss.e retroactive reg.lations to )eal with ?a9.sive? transactions# 222 9.t 8ost of the factors that are tho.ght to 9e in)icative of an a9.sive transaction are of only weak inferential val.e& That ta savings were at the forefront of the 8in) of the iss.er or 9.yer of a sec.rity (we )isc.ss the e pectations of the innovator 8o8entarily) is relevant 9.t not )eter8inative# for this will 9e tr.e in the case of 8any sec.rities that have significant val.e in)epen)ent of ta consi)erations& 7ero co.pon 9on)s co8e to 8in)& That ta 9enefits were tr.8pete) in the 8arketing of a sec.rity o.ght not 9e )eter8inative for the sa8e reason& 223 That the sec.rity was 8arkete) to special ta clienteles is .nhelpf.l for that pheno8enon is pervasive& 224 The strength of the legal a.thority for the position taken is irrelevant& "hen the law is .ncertain (as it was regar)ing contingent pay8ent )e9t instr.8ents prior to 199()# it 8ay 9e appropriate to gran)father a choice a8ong co8peting positions 9eca.se the .ncertainty can 8ake it )iffic.lt to sell a sec.rity in a 8arket str.ct.re) aro.n) )ifferent ta clienteles& "hen the law see8s clear on its face 9.t flawe) (as see8e) the !,+T r.les that were e ploite) 9y the creators of step/ )own preferre) stock)# only the risk of a retroactive change in the law can )isco.rage innovators fro8 e ploiting those flaws& [*182] The key to solving the pro9le8 of i)entifying sec.rities with no nonta val.e 8ight see8 to lie in getting into the 8in)s of the innovators for they sho.l) know 9est the potential val.e of their creations& * sec.rity that the creator thinks has no strong selling points apart fro8 its ta 9enefits pro9a9ly has none& 225 There is# however# no goo) way to get into the 8in) of an innovator& The answer of an invest8ent 9anker to a )irect in=.iry a9o.t the .ses for a sec.rity is likely to 9e self/serving& "hen Treas.ry officials 8et with representatives of the invest8ent 9anks in the spring of 199G to )isc.ss 0+2S# they were tol) that the sec.rity wo.l) not 9e .se) as a s.9stit.te for preferre) stock& 226 This representation prove) wrong# an)# it see8s to .s# was pre)icta9ly so& The paper entrails of a sec.rity are a 8ore relia9le in)icator of the e pectations of its creator& S.ch evi)ence was very helpf.l to the Ta Co.rt in .ntangling a co8ple corporate ta shelter in *C0 2artnership v& Co88issioner 227 9eca.se it was clear fro8 recor)s pro).ce) 9y the invest8ent 9ank that p.t together

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the transaction# 0errill Lynch# that while the ta payer ha) ancillary financial o9Dectives for engaging in the transaction# 228 what )rove the transaction fro8 the )ate the plan was first conceive) at 0errill Lynch thro.gh its 8arketing an) i8ple8entation was the goal of creating an artificial ta loss to shelter capital gains& Un)er c.rrent r.les# this sort of evi)ence is )iscovera9le 9y the govern8ent only thro.gh litigation# an) it can take years to a8ass an) interpret# so it will not 9e availa9le [*183] to a policy8aker who is face) with the nee) to 8ake a =.ick r.ling on a sec.rity& * loose i)ea of the e pectations of an innovator for a sec.rity 8ay 9e o9taine) fro8 the way in which the innovator e tracts its rewar) for innovation& +f the innovator charges a pre8i.8 for .n)erwriting a sec.rity offering# one can infer that it e pecte) the sec.rity wo.l) have a short life# fro8 which one can infer f.rther when the selling point of a sec.rity was its ta 9enefits that the innovator perceive) the sec.rity ha) no other selling point& This is the strategy :ear Stearns p.rs.e) in selling step/)own preferre) stock& Not only )i) :ear Stearns charge a higher than nor8al fee# 9.t also it has 9een reporte) that# in so8e instances# the fees were 8a)e paya9le in install8ents that were con)itione) on the )eal not 9eing .nwo.n) 9eca.se of a change in ta law# 229 a concession 9y :ear Stearns that wo.l) see8 necessary to attract iss.ers an) accepta9le to :ear Stearns only if the fee was set at a pre8i.8& Conversely# if no pre8i.8 is charge) in an .n)erwriting an) the innovator see8s to 9e p.rs.ing a strategy of 9.il)ing 8arket share thro.gh innovation# as see8s to have 9een the case with 0+2S an) other for8s of ta /)e).cti9le preferre) stock# one 8ight infer that the innovator tho.ght the sec.rity ha) selling points other than its ta 9enefits so long as there was a reasona9le prospect of those 9enefits 9eing )enie) within a year or two& 230 * pro9le8 with this line of in=.iry is the weakness of the inferences& *n innovator 8ight p.rs.e a strategy of 9.il)ing 8arket share for a sec.rity that has only ta 9enefits as a selling point 9eca.se it is confi)ent that the ta law will not change# or it 8ight fin) ways other than charging a pre8i.8 fee to reap rewar)s for offerings that are e pecte) to 9e short/live)& 231 Conversely# a specially tailore) sec.rity [*184] that is .n)erwritten at a pre8i.8 8ight offer .ni=.e nonta 9enefits as well as .ni=.e ta 9enefits& 232 E.rther# whether a pre8i.8 is charge) 9y an .n)erwriter for a sec.rity offering 8ay 9e )iffic.lt to ascertain for a n.89er of varia9les affect .n)erwriting fees# incl.)ing the si@e of the offering# the risk to the .n)erwriter# the legal co8ple ity# an) the correlation of these varia9les to pricing is not well .n)erstoo)& F+++& 6ow Sho.l) Ta 2olicy8akers !espon) to !e).n)ant Sec.rities that , ploit Ta Law *no8aliesK The =.estion of how ta policy8akers sho.l) respon) to sec.rities that )erive their val.e entirely (or al8ost entirely) fro8 e ploiting ano8alies in ta law is not as si8ple as it 8ight see8# if the goal is re).cing ta )istortions# 9eca.se# in theory# a sec.rity that is re).n)ant fro8 a financial perspective can re).ce ta )istortions& 233 "e will .se ta /)e).cti9le preferre) stock (the 8ost fa8o.s sec.rity in this class 9eing 0+2S) as an e a8ple# now procee)ing on the ass.8ption that the sec.rity has no val.e in)epen)ent of its ta characteristics& * pla.si9le case can 9e 8a)e that ta / )e).cti9le preferre) stock has social val.e even if it is p.rely ta /)riven& The case is gro.n)e) on the pre8ise that the ta law )e9t/e=.ity )istinction )istorts corporate capital str.ct.re in ways that )i8inish general social welfare& >f partic.lar relevance to the analysis of ta /)e).cti9le preferre) stock is the view that the a)vantageo.s ta treat8ent of )e9t ca.ses corporations to 9e over/leverage)# increasing the likelihoo)# an) so the e pecte) cost of# financial )istress# which is generally tho.ght to have [*185] negative social i8plications as well as negative private i8plications& 234 "hen one gets )own to the n.9 of the 8atter# the effect of the Treas.ry prono.nce8ents that were interprete) as 9lessing 0+2S as )e9t so long as the 8at.rity was not

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overlong was to 8ake it possi9le for a corporation to provi)e for li8ite) )eferral of interest pay8ents in a sec.rity witho.t i8periling classification of the sec.rity as )e9t for ta p.rposes& To the e tent these prono.nce8ents in).ce) corporations to loosen the ter8s of the )e9t they iss.e to per8it interest )eferral# it wo.l) lessen the likelihoo) that a corporation wo.l) )efa.lt on its )e9t an) so the prono.nce8ents wo.l) see8 to have a positive welfare effect& The possi9le social val.e of ta /)e).cti9le preferre) stock in this regar) is 9ase) on a 8ore general point# which is that ta law# an) in partic.lar )iscontin.ities in ta law# are the8selves a so.rce of ?friction? that interferes with the f.nctioning of 8arkets& Einancial innovation can have social val.e 9eca.se it re).ces these ta frictions# D.st as it can have social val.e 9eca.se it re).ces s.ch ?nat.ral? so.rces of friction as transaction costs or the in)ivisi9ility of sec.rities& 235 +n)ee)# in finance# the ter8 ?reg.latory ar9itrage? / which refers to 9ehavior that is si8ilar to ta ar9itrage 9.t that is ai8e) at the reg.latory apparat.s of the state rather than the ta apparat.s / is not a ter8 of oppro9ri.8& Sec.rities innovations that )erive val.e fro8 re).cing ta )istortions in the econo8y can 9e tho.ght of as ?self/ help? ta refor8& * Treas.ry policy of ena9ling s.ch self/help ta refor8 thro.gh r.lings is palliative in nat.re for it lessens the severity of the sy8pto8s of ta law )istortions witho.t c.ring the .n)erlying ills& "e arg.e in this part# however# that palliative 8eas.res are .nlikely to have positive welfare effects& "e co8e 9ack to ta /)e).cti9le preferre) stock shortly# 9.t first we take .p an easier case / ta stra))les / to ill.strate how the negative effects of reven.e losses fro8 a palliative 8eas.re can overwhel8 the 8eas.reAs positive effects in re).cing ta law )istortions when the costs of engaging in the relevant transaction an) the )istri9.tive conse=.ences once investors have respon)e) to the 8eas.re are taken into acco.nt& "e reali@e that o.r analysis of stra))les will see8 9esi)e the point to those who 9elieve [*186] that ta stra))les were o9Dectiona9le for legal reasons or ethical reasons other than inefficiency& "e )o not 8ean to )is8iss s.ch o9Dections& "e p.t the8 to the si)e 9eca.se it is not clear how s.ch concerns play o.t when it co8es to sec.rities s.ch as ta /)e).cti9le preferre) stock# which are not tho.ght as o9Dectiona9le on these other gro.n)s& Un)er the law prior to 19'1# 236 in a very si8ple ta stra))le# the ta payer took offsetting long an) short positions in co88o)ity f.t.res or options& +88e)iately prior to the en) of the ta a9le year# the ta payer close) his position in the losing leg an) reali@e) an or)inary loss or a short/ter8 capital loss& 237 The ne t year# after si 8onths ha) elapse)# the ta payer wo.l) close o.t the other leg an) reali@e a long/ ter8 capital gain# ta e) at preferential rates& Ero8 a li8ite) perspective# the 8ass 8arketing of ta stra))les in the late 19(CAs an) 7CAs can 9e sai) to have lessene) ta )istortions& Ta stra))les ena9le) in)ivi).als to re).ce the ta rate on interest inco8e# an) perhaps even wage inco8e# to the capital gains rate# which wo.l) have the positive effect of re).cing ta )istortions of the choices 9etween cons.8ption or invest8ent an) 9etween la9or or leis.re& The flaw in the clai8 that ta stra))les were welfare enhancing is that it )isregar)s the reven.e loss fro8 ta stra))les& The reven.e loss will re=.ire a fiscal response / raising other ta es# 9orrowing# or spen)ing re).ctions / which itself 8ay have )istortionary effects or 8ay have )istastef.l )istri9.tive conse=.ences& 238 [*187] +t is fairly clear that whatever positive welfare effects allowing ta payers to o9tain a ta rate re).ction 9y engaging in stra))les ha)# 9eca.se it )i8inishe) )istortions in invest8ent or la9or )ecisions# was overwhel8e) in the short ter8 an) 8i) ter8 9y the negative welfare effects of the reven.e loss& The net welfare loss is a conse=.ence of the high transaction cost of converting or)inary inco8e into capital gain thro.gh stra))les (the evi)ence we co.l) collect in)icates that 9rokers fees

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range) fro8 aro.n) 1CL to GCL of ta es save))&

239

The effects of a stra))le can 9e 8o)ele) as a re).ction fro8 the in)ivi).al ta rate to the capital gains rate# p.rchase) at the a))itional e pense of a transfer pay8ent fro8 the ta payer to other in)ivi).als (the 9rokers)& The rate re).ction pro).ces a reven.e loss on the ta collecte) on the previo.s level of la9or or invest8ent (the rectangle with the right 9or)er *E in Eig.re %)J the rate re).ction sti8.lates an increase in la9or or invest8ent that pro).ces a welfare gain in the for8 of a re).ction in the e cess 9.r)en of the ta along with so8e a))itional ta reven.e# 9.t the 8agnit.)e of these gains is )ecrease) significantly 9y the transfer pay8ent that appears on top of the rate re).ction& 240 The net effect is a larger reven.e loss for a s8aller welfare gain& The transfer pay8ent creates an a))itional )istortion for it will attract la9or an) capital to the 9rokerage in).stry an) capital to the co88o)ities 8arket& 241 +n the long r.n# the costless nat.re of stra) [*188] MS,, E+3U!, +N >!+3+N*LN )les / they are p.rely paper transactions that nee) not even infl.ence prices in f.t.res 8arkets / s.ggests that the fee charge) 9y 9rokers o.ght to have )ecline) over ti8e to near @ero# which wo.l) have 9ro.ght the effect into line with a straightforwar) rate re).ction& :.t this )evelop8ent wo.l) have heightene) a secon) tro.9ling effect of stra))les# for the inco8e ta wo.l) 9e 8a)e less progressive since the top 8arginal rate wo.l) ten) )own towar)s the capital gains rate& +n)ee)# the inco8e ta 8ight 9eco8e regressive in the 8i))le an) .p [*189] per 9rackets for the cost of engaging in stra))les wo.l) likely lessen with inco8e or wealth& 6ow )oes the 0+2S r.ling# which was wi)ely perceive) as co.ntenancing a for8 of ta /)e).cti9le preferre) stock# stan) .p when its total effects are consi)ere)K Not very well# 9.t for a reason that is in a))ition to the reasons that ta stra))les were o9Dectiona9le& "e ass.8e away transaction costs (tho.gh these are positive at least insofar as fir8s )i) transactions they otherwise wo.l) not )o to convert e isting preferre))& 242 Ta /)e).cti9le preferre) stock is not as o9Dectiona9le as ta stra))les on )istri9.tive gro.n)s# altho.gh the sec.rity re).ces corporate ta reven.es# 243 9eca.se it is not clear who 9ears the 9.r)en of the corporate inco8e ta & * reason ta /)e).cti9le preferre) stock is o9Dectiona9le in)epen)ent of transaction costs is that it 8ay act.ally increase the )istortionary effect of the )istinction 9etween )e9t an) e=.ity& 3enerally# in choosing whether to iss.e )e9t or e=.ity to raise capital# corporate 8anagers in so8e way 8ake a tra)eoff 9etween the e pecte) val.e of the interest ta shiel) an) the e pecte) cost of financial )istress if the corporation cannot 8eet its co88it8ents& 244 The effect of a Treas.ry r.ling that clarifies that a re).ction in the rights of hol)ers will not alter the classification of an instr.8ent as )e9t is that corporate 8anagers can have it 9oth ways / they can re).ce the rights of hol)ers an) so )i8inish the e pecte) cost of financial )istress witho.t forgoing the interest ta shiel) (tho.gh investors 8ay )e8an) a pre8i.8 for the rights they forgo)& S.ch a r.ling [*190] co.l) have a positive welfare effect if its pre)o8inant effect is to sti8.late fir8s to weaken the rights of hol)ers of instr.8ents that otherwise wo.l) 9e iss.e) as )e9t 9eca.se of the re).ction in the e pecte) cost of financial )istressJ the r.ling is likely to have negative welfare effects if a significant effect is to sti8.late fir8s to strengthen the rights of hol)ers of instr.8ents that otherwise wo.l) 9e iss.e) as e=.ity in or)er to achieve )e9t classification& Eig.re B ill.strates this point& +t ass.8es that the 8arginal val.e to a fir8 of the interest ta shiel) is constant as the fir8As )e9t/e=.ity ratio increases (this is to

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si8plify 8atters) while the e pecte) cost of financial )istress rises& The fir8As opti8al )e9t/e=.ity ratio is at point L1& *rea *:L1 is the e pecte) private loss the fir8 inc.rs in response to the interest )e).ction& There is also a social loss co8prising s.ch things as e pecte) transaction costs in the event of financial )istress# whatever loss in val.e 8ight occ.r fro8 the 9reak.p of the fir8# an) e pecte) losses to thir) parties (s.ch as e8ployees) fro8 financial )istress& This e pecte) social loss 9ears so8e .ncertain relation to the e pecte) private cost of financial )istress& MS,, E+3U!, +N >!+3+N*LN Eig.re B co8pares two hypothetical r.le changes that ena9le iss.ers to weaken the rights of hol)ers of a sec.rity witho.t sacrificing classification of the sec.rity as )e9t& Change H in).ces the fir8 to weaken the rights of hol)ers on sec.rities that wo.l) have 9een str.ct.re) as )e9t in any event& +t re).ces the e pecte) cost of financial )istress 9y the 9anana shape) area 9etween points C an) :& Change Y also in [*191] ).ces the fir8 to weaken the rights of hol)ers on so8e )e9t iss.es (th.s the re).ction in the e pecte) cost of financial )istress shown in area ,:E) 9.t it has the a))itional effect of in).cing the fir8 to strengthen the rights of hol)ers of so8e sec.rities that otherwise wo.l) have 9een iss.e) as e=.ity in or)er to o9tain )e9t classification& The )e9t/e=.ity ratio 8oves to point L% an) there is 9oth a significant reven.e loss (area :5LQ%RLQ1R) an) a net increase in the e pecte) cost of financial )istress (area E5LQ%RLQ1R 8in.s area ,:E)& This analysis s.ggests that the welfare effects of a r.ling that 9lesses as )e9t a new sec.rity that weakens the rights of hol)ers )epen)s on whether the new sec.rity is .se) significantly as a s.9stit.te for e=.ity that wo.l) confer even fewer rights on hol)ers& Th.s# it is worriso8e that 0+2s an) other for8s of ta /)e).cti9le preferre) stock often are .se) in precisely this way& 245 The 8ost striking evi)ence is in the aggregate )ata on new an) o.tstan)ing iss.es of preferre) stock& Since 199B# the vol.8e of new iss.es of tra)itional preferre) stock has )ecline) at a re8arka9le rate while the vol.8e of new iss.es of ta / )e).cti9le preferre) has increase)& 246 +n)ee)# the vol.8e of o.tstan)ing preferre) has shr.nk 9eca.se of re)e8ptions& +n the first half of 199(# for e a8ple# preferre) was re)ee8e) at 8ore than )o.9le the rate of new iss.es& 247 The potentially har8f.l )istortionary effects of the 0+2S r.ling res.lt fro8 the fact that the r.ling re=.ires that an iss.er sacrifice rights that it wo.l) possess on straight preferre) in or)er to get a favora9le [*192] ta classification& 248 +n theory# these effects co.l) 9e eli8inate) if Treas.ry took an even 8ore li9eral approach 9y 9lessing as )e9t for ta p.rposes a sec.rity that was e=.ivalent to co88on stock& 249 S.ch a r.ling wo.l) res.lt in a significant reven.e loss# 9.t its long/r.n effect wo.l) 9e e=.ivalent to a9olishing the corporate inco8e ta as corporations 8ove) to replace co88on stock with the new sec.rity# an effect 8any st.)ies pre)ict wo.l) pro).ce 8ore than offsetting welfare gains& 250 S.ch a ra)ical 8ove see8s 9eyon) the power of Treas.ry# an) it 8ight 9e ill/a)vise) in any event 9eca.se this path to ta refor8 8akes it )iffic.lt for the govern8ent to capt.re the win)fall gains fro8 the a9olition of the corporation inco8e ta & 251 +H& * Ca.tionary Tale- Ta Stra))les The story of ta stra))les in the 197CAs is the 8ost striking co.ntere a8ple to o.r thesis that ta consi)erations are not a significant force )riving p.9licly 8arkete) financial innovations& "hile precise )ata is har) to co8e 9y# it is clear that there was an enor8o.s a8o.nt of stra))le activity in the 8i)/197CAs an) early 19'CAs& Treas.ry esti8ate) in 19'1 that the anti/stra))le r.les wo.l) increase reven.es 9y [*193] I 1&B 9illion in 19'% n%$%J there was a significa! change in year en) tra)ing patterns an) vol.8e in f.t.res 8arkets after the ta law change 253 (an) this .n)erstates the

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e tent of stra))le tra)ing 9eca.se 8.ch stra))le tra)ing occ.rre) off organi@e) e changes)J an)# in 19'G# there were over 1$#CCC stra))le cases on the Ta Co.rtAs )ocket# 254 creating a 9.r)en that i8pelle) the Service to offer an across/the/9oar) settle8ent& The lea)ing U&S& invest8ent 9anks were )eeply involve)& 0errill Lynch ha) a ta stra))le )epart8ent at least as early as the late 19(CAs# which 8arkete) stra))les as a 8eans to shelter short/ter8 capital gains fro8 ta & 255 >ther invest8ent 9anks were involve) as well& +t was reporte) that in 19'C# 2aine "e99er )erive) 1$ to %CL of the reven.es on its co88o)ities )esk fro8 stra))le tra)ing& 256 +t )i) take years for ta stra))les to catch on# which 8ight see8 consistent with o.r thesis that invest8ent 9anks are slow to p.9licly 8arket risky ta /saving strategies& +t is clear that the strategy was well/known 9y the late 19(CAs# 257 an) it has 9een reporte) that the strategy was known an) .se) in the invest8ent co88.nity )eca)es earlier& 258 :.t the 8ost pla.si9le e planation for the )elaye) e plosion in ta stra))le tra)ing is not lethargy or risk aversion in the financial in).stry& !ather the e plosion of ta stra))les in the 8i)/197CAs can 9e )irectly trace) to an ill/conceive) Treas.ry r.ling in 197G that significantly e pan)e) the clientele for stra))les& 2rior to that r.ling# stra))les were sol) to ta payers who co.l) .se short/ter8 capital losses& The r.ling lai) the 9asis for ta payers to clai8 or)inary losses fro8 stra))les in options& 259' This opport.nity was gra99e) =.ickly& [*194] The lea)ing stra))le case in the Ta Co.rt# 260 which involve) tra)ing in Lon)on options# at one ti8e involve) over 1#GCC ta payers an) I (1 8illion in ta )eficiencies# 8ostly fro8 tra)es )one in 197$ an) the first half of 197(# 261 9efore the law was change) in 8i)/s.88er to eli8inate the or)inary )e).ction on tra)ing in co88o)ity f.t.res& 262 The change in law in 197( )i) not halt stra))le ta tra)ing (while 8ost of the litigate) cases involve pre/197( transactions# there is evi)ence of s.9stantial stra))le activity in the early 19'CAs)& :.t the e traor)inary a9ility in the years 197G to 197( to convert .nli8ite) a8o.nts of wage or interest inco8e into long/ter8 capital gains# while also )eferring ta # ha) create) an in).stry an) heightene) the visi9ility of ta stra))les& >nce esta9lishe)# the in).stry sp.n on 9y fin)ing a way aro.n) the 197( r.ling (s.ch as 9y constr.cting stra))les o.t of T/9ill f.t.res) 263 or 9y converting short/ter8 capital gain into long/ ter8& The story of ta stra))les is a healthy re8in)er that invest8ent 9ankers are not angels& They will 8arket p.rely ta /)riven strategies# so8eti8es even in the face of enor8o.s legal risk& 264 +t wo.l) 9e a cop/o.t to say that ta stra))les are o.tsi)e the scope of this *rticle 9eca.se they are transactions an) not sec.rities& The story of ta stra))les shows that even the 8ost socially la.)a9le sec.rities innovations / in 19'(# 0erton 0iller ranke) the )evelop8ent of co88o)ity 8arkets first in i8portance in recent finan(" )'"$$#v !"#$& 265 / can have 9alef.l ta conse=.ences 9eca.se it creates opport.nities for ta ar9itrage& [*195] 2.tting 9rakes on financial innovation is not the answer to this pro9le8& Ta stra))les got o.t of han) in part 9eca.se the Treas.ry 8a)e an ill/a)vise) r.ling in 197G& *s i8portantly# Treas.ry )i) not have the tools to co89at ta stra))les& +t so.ght legislation# which takes ti8e# an) the changes in ta law were 8a)e prospectively& "hile the Service event.ally won 8ost of the ta stra))le cases# it was on the .npre)icta9le gro.n) that the transactions were sha8s& Ta stra))les 8ight have 9een nippe) in the 9.) if the Treas.ry ha) 8ore an) 9etter/traine) people# or if Treas.ry ha) the power to re8ake ta law governing financial instr.8ents thro.gh r.lings or reg.lations rather than 9y seeking legislation# or if ta payers ha) e pecte) that changes in the law that were )one to nip ta /8otivate) transactions wo.l) 9e applie) retrospectively& H& So8e Concl.sions "e want to concl.)e 9y s.88ari@ing so8e of the i88e)iate policy i8plications of o.r

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analysis& >.r arg.8ent that ta law .ncertainty can s.ppress financial innovation can D.stify the e isting practice of Congress an) Treas.ry of applying 8ost r.le changes prospectively& "e arg.e# however# that the govern8ent has 9een too lenient in this regar) an) that it o.ght to .se the threat of retroactive r.le8aking to reg.late what is pro9a9ly inefficient ta /)riven financial innovation& "e propose a policy of applying r.le changes retroactively to new sec.rities that )erive significant val.e fro8 their ta characteristics if the cost of creating an) .sing the sec.rity is high an) the sec.rity serves none of the positive f.nctions associate) with financial innovation& S.ch a policy is not as ra)ical as it 8ay see8& The govern8ent has a higher s.ccess rate in challenging ta /8otivate) transactions s.ch as ta stra))les than the strength of the govern8entAs legal arg.8ents in those cases wo.l) lea) one to pre)ict& The policy we a)vocate 8akes it clearer to innovators an) ta payers that however strong their technical legal arg.8ents 8ight 9e# there is so8e risk in )evising new ways to e ploit ano8alies in ta law& >.r analysis s.pports Treas.ryAs )ecision to 8ake the r.ling on step/)own preferre) stock retroactive& >.r analysis is also relevant to the =.estion of the appropriate ta policy for )ealing with innovations in the area of asset/9ase) financing or sec.riti@ation& 266 Since 19'(# when Treas.ry )eter8ine) that a tr.st [*196] with 8.ltiple classes of interests wo.l) 9e ta e) as a corporation# 267 ta law has presente) an .nfavora9le environ8ent for innovations in this area 9eca.se sec.riti@ation vehicles ha) to 9e str.ct.re)# at so8e legal risk# as tr.sts with only one class of e=.ity# an)# failing that# so that they co.l) pass as partnerships& Nevertheless# so8e innovations flo.rishe) in this .nfavora9le legal environ8ent 9eca.se of strong 8arket )e8an)# an) after the fact# Congress steppe) in to create special ta regi8es / the !,0+C r.les in 19'( 268 an) the E*S+T r.les in 199( 269 / that were closely tailore) to e isting sec.riti@ation str.ct.res& * policy of 8aintaining an .nfavora9le legal environ8ent for innovations in sec.riti@ation is )efensi9le only if one 9elieves either that ta law .ncertainty is not a significant )eterrent to sec.rities innovation when a new sec.rity has real val.e in the 8arketplace# or that in a worl) with less ta law .ncertainty# the pockets of Treas.ry =.ickly wo.l) 9e picke)& >.r analysis in)icates that the first point is not tr.e& The secon) concern can 9e a))resse) in a 8ore targete) 8anner thro.gh retroactive r.lings& >ne possi9ility wo.l) 9e for Congress to enact legislation esta9lishing 9roa) principles to g.i)e Treas.ry in r.ling on partic.lar sec.riti@ation str.ct.res& The e8ergence of long/ter8 e=.ity options in the for8 of L,*2S raises ta iss.es si8ilar to those raise) 9y the intro).ction of @ero co.pon 9on)s in the 19'CAs an) the i8prove8ents in the co88o)ities 8arkets in the 197CAs that facilitate) ta stra))les& Like @eros an) co88o)ities f.t.res# L,*2S have gen.ine val.e 9eca.se they offer a low/cost an) foolproof 8eans of he)ging riskJ D.st as 8arket con)itions in the early 19'CAs sti8.late) )e8an) for @eros an) 8arket con)itions in the 197CAs sti8.late) )e8an) for co88o)ity f.t.res# 8arket con)itions in the late 199CAs sho.l) sti8.late )e8an) for L,*2S& :.t also D.st as the floo) of @eros in 19'1 an) 19'% re=.ire) new r.les on )isco.nte) 9on)s an) the e plosion in the .se of ta stra))les re=.ire) the anti/stra))le r.les# the intro).ction of cheap# long/ter8 p.9licly tra)e) e=.ity options will re=.ire new r.les to prevent ta ar9itrage& >.r analysis s.pports what will .n)o.9te)ly 9e the policy of Treas.ry or Congress when they 8ove in response- any changes 8a)e in the ta ation of options sho.l) 9e 8a)e prospective only& [*197] Einally# o.r analysis s.ggests that Treas.ry was right in 19'G in with)rawing reg.lations that wo.l) have clarifie) the )istinction 9etween )e9t an) e=.ity for the .ncertainty of that )istinction is a 8aDor i8pe)i8ent to the creation of sec.rities that p.sh the envelope of the )efinition of e=.ity& >.r analysis also s.ggests that Treas.ry 8ay have 9een wrong in 199G in iss.ing a r.ling that re).ce) .ncertainty a9o.t the ta characteri@ation of 0+2S an) other for8s of what has co8e to 9e calle) ta / )e).cti9le preferre) stock& +f we are right# that r.ling not only res.lte) in a significant reven.e loss (which is .n)enia9le)# 9.t also it perversely e acer9ate) the )istortions

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ca.se) 9y the )istinction 9etween )e9t an) e=.ity in ta law&

L*+ )'T#,"(&: Eor relate) research an) practice 8aterials# see the following legal topics:anking Law - :ank *ctivities - Sec.rities - Einancial E.t.res Tra)ing

Contracts Law - Types of Contracts - E.t.res

Sec.rities Law - !eg.lation of Sec.rities 0arkets - Tra)ing 9y , change 0e89ers

.OOTNOTES: n1& To8 2ratt# :eyon) 0ips- SollyAs ?T!U2s? *re Newest 5e).cti9le ,=.ity# +nv& 5ealersA 5ig&# 0ay (# 199(# at 1% Mhereinafter :eyon) 0ipsNJ Lee *& Sheppar)# 5e9t Fers.s ,=.ity- * 2ackage 5eal# 9( TNT 11B/G# <.ne 1C# 199(# availa9le in L,H+S# Ee)ta Li9rary# TNT Eile Mhereinafter 2ackage 5ealNJ see note $'&

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