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New Developments in Financial Management Dutch Auction Rate New Developmentsin Financial Management Dutch Auction Rate Preferred Stock Michael J. Alderson, Keith C. Brown, and Scott L. Lummer Michael J. Alderson is Assistant Professor, Departmentof Finance, Texas A&M University;Keith C. Brown is Assistant Professor, GraduateSchool of Business, Universityof Texas at Austin; and Scott L. Lummeris Senior Consultant,Manufacturers Hanover Trust Co., New Yorkand Assistant Professor, Departmentof Finance, Texas A&M University. I. Introduction In a search for attractive short-terminvestment reduce investmentrisk while generatingimpressive yields, many corporationshave become involved in returns. cash managementprograms that are designedto cap- An alternativeto hedged dividendcapture became italize on the corporatetax exclusionfor dividendin- availablein 1982, with the introductionof adjustable come. These "dividendcapture" programs allow the ratepreferred stock (ARPS). In principle,this instru- participatingfirm to earnafter-tax returns that far ex- mentoffered greater price stabilitythan fixed ratepre- ceed the yields of traditionaldebt-based investments. ferredstock, since the dividendwas adjustedperiodi- Unfortunately,an unhedgedposition in preferredor cally for changes in interestrates. Wingeret al. [6] commonequity is also riskierthan the usual money analyzedthe returnperformance of adjustablerate pre- marketalternatives. Recent research has examined ferredstock duringthe firsttwo yearsof its existence. methodsfor reducingthe risk of dividendcapture pro- Theirresults showed that adjustablerate issues have grams. Examplesof these strategiesinclude writing yielded slightlymore thanmoney marketinstruments coveredcall options on a marketindex, and hedging on an after-taxbasis. The incrementalreturns were individualstock holdings with positions in call op- small, however,relative to the considerablevolatility tions. Brown and Lummer[1, 2] and Zivney and Al- in holdingperiod returns experienced by each issue. derson[7] have foundthat these methodssubstantially The figuresappear to go a long way towardexplaining why adjustablerate preferredstock has fallen out of favor as a cash managementtool. The authorswould like to thank Robert A. Taggart, John D. Finnerty, A new has been the intro- and Bernard J. Winger for helpful comments and suggestions. All prominent development remainingerrors are our own. duction of dutch auction rate preferred stock 68 ALDERSON,BROWN, AND LUMMER/DUTCHAUCTION RATEPREFERRED STOCK 69 (DARPS). This instrumentwas specificallydesigned of funds than would have been providedwith debt to circumventmany of the flaws in earlieradjustable issues. Approximately$8 to $10 billion of adjustable rateequities. By providingthat the dividendyield be ratepreferred was issued betweenMay 1982 and De- reset more frequentlythan an ARPS issue, througha cember1984. In 1985, however,less than$1 billionof dutch auctionprocess, this securityenables the pur- ARPSwere brought to market.The spectaculardecline chaserto realizethe corporatedividend exclusion in a in the popularityof this instrumentis traceableto sev- nearriskless manner. eral factors.First, adjustablerate preferredstock was Thepurpose of this paperis to analyzethe character- adverselyaffected by the Deficit RecoveryTax Act of istics and investmentperformance of dutch auction 1984. Thatact increasedthe risk exposureof all divi- ratepreferred stock. The followingsection reviews the dend capture programsby increasing the required factorsthat contributedto the disappointingperform- holdingperiod for the dividendexclusion from 16 to ance of the original adjustablerate preferredissues. 46 days. The measurealso eliminatedthe so-called Section III explains the fundamental aspects of "75%rule" for mutualfunds. Under that provision, DARPS issues and the dutch auction process. The registeredinvestment companies whose dividendin- fourthsection analyzes data from a sampleof DARPS come exceeded 75% of their total revenue were al- auctionoutcomes, and comparesthe resultingyields lowed to designate100% of theirtotal payout as eligi- on these securitieswith those of moretraditional mon- ble for the 85% dividendsreceived deduction.That ey marketinvestments. The resultsshow a relationship enabledARPS mutualfunds to pass a limitedamount amongyields that,to ourknowledge, is unprecedented of ordinaryinterest income through to theirsharehold- in the cash managementliterature. Specifically, yields ers on a tax preferredbasis. Eliminationof the "75% on DARPS are found to be set in such a way as to rule" decreased the attractivenessof those mutual accommodatethe marginaltax ratesof boththe issuing funds, andthat of theirunderlying securities in a con- and purchasingcorporations. The paper concludes comitantmanner. with a discussionof the likely adjustmentin DARPS Manyproblems with the ARPS issues were caused dividendsyields underthe recenttax code changes. by the basic structureof the securityitself. Specifical- ly, the severemismatch between the 13 week dividend II. The Decline of the ARPS Market reset and the 46 day requiredholding period for the Adjustablerate preferredstock was first issued in 85% exclusion led to considerableinterest rate risk mid-1982by ChaseManhattan Corporation and Manu- exposure.This was becausecorporate investors had an facturersHanover Trust Company. The typical issue incentiveto hold the stockonly long enoughto qualify was structuredto maintaina pre-specifiedspread be- for the dividendexclusion. For manyinvestors, there- tween its dividendyield and the highest yielding of fore, the desiredholding period for an ARPSissue was threedifferent treasury securities. Dividend yields on 46 days. If interestrates changed dramatically,the adjustablerate preferred stock were reset on a quarterly price of ARPS duringthe period betweenresets was basis. affected.As such, a corporateinvestor that planned on Corporatepurchasers of ARPS issues were entitled sellingbetween reset days faced a greatdeal of uncer- to excludefrom taxable income 85%of the dividends taintywith respectto total return. received.2 Competitive market pressures tended to The popularityof ARPS issues may have also suf- drivethe pre-taxyield on these securitiesbelow thatof feredfrom deficiencies in the formulaused to resetthe comparabledebt instruments.Hence, issuers in low dividend.For most ARPS issues, the reset rate was tax bracketswere able to realizea lower after-taxcost tied to the maximumrate amongshort-term, interme- diate-term,and long-termTreasury securities. Given the term of 'In the work to follow, the term DARPS will be used exclusively to structure interestrates that has appliedin describe the general class of auction rate preferred stock issues. It recentyears, the resetwas effectivelytied solely to the should be mentioned, however, that DARPS can also be found under long-termrate. In contrast,rates on debt severaltrade names. For instance, ShearsonLehman underwrites Mon- analagous ey MarketPreferred (MMP) while Salomon Brothers uses the Dutch instruments(floating rate notes) are typicallytied to a Auction Rate Transferable(DART) acronym. short-termbenchmark, such as LIBOR. Considering the enormouspopularity of the variable-ratedebt in- 2Recentchanges in the tax code have reduced the corporatedividend it is thatthe consid- exclusion struments, likely investingpublic from 85% to 80%. The impact that this modificationhas on ers this equity-basedcash managementprograms will be explored in a subse- type of linkagepreferable to the use of a long- quent section. term rate. That being the case, if short-termrates 70 FINANCIALMANAGEMENT/SUMMER 1987 shiftedwhile long-termrates remainedconstant, the Exhibit 1. Dutch Auction Bid Rates for Initial and price of a share of adjustablerate preferredstock PotentialStockholders of DARPS changed.Hence, the reset regime of ARPS provided Initial Holding Purchase Purchase a less than perfect hedge against interest rate Bidder (# shares) Bid Rate movements. A 70 70 4.6% Declines in the creditquality of the issuerwill also B 60 60 4.9% cause a preferredstock issue to becomeless valuable. C 40 40 4.9% In this the most of the D 30 30 5.5% regard,perhaps damagingaspect E 50 4.6% structureof adjustablerate preferredstock was its in- F 30 4.8% abilityto hedge creditrisk. Since the spreadbetween G 40 4.9% the dividendyield and the Treasuryrate was fixed, H 30 5.0% ARPS holdersfaced the same degree of exposureto 200 350 creditquality as investorsin fixed-ratepreferred stock. The creditrisk factorbecame particularlyimportant, given thatthe creditrating of many ARPS issuersde- clined during 1984 and 1985.3 terest rate risk from the security. Perhapsthe most importantfeature of the dutchauction process, howev- III. Dutch Auction Rate Preferred Stock er, is that it eliminates the risk of declining credit In an attemptto addressthe observedshortcomings quality. If the default risk on a share of DARPS is of ARPS, several corporationsbegan to experiment perceivedby the marketto have increased,the yield with alternativeforms of floating rate equity. Dutch derivedat the next reset auctionwill rise to reflectthe auction rate preferredstock is the most successful heightenedrisk exposure,but the shareprice will re- productof thatexperimentation process. Since the first main at par value. offering in 1984, over $10.0 billion of the security DARPSdividends are reset every seven weeks when have been broughtto market,with about$5.0 billion all currentowners and potential buyers of outstanding issuedin 1986 alone. The primarydifferences between sharessubmit
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