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Dow Jones Business News
Hedge-Fund Managers Wary of Tax Penalty on Short Selling
Thursday June 5, 2:17 pm ET
By Allison Bisbey Colter


NEW YORK -- This year's tax package, which was designed to boost the U.S. economy, puts a crimp in one of the most profitable businesses on Wall Street: lending stock to people making bearish bets on the market.
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A key provision of the Jobs and Growth Tax Relief Reconciliation Act of 2003, which was signed into law last month, is a reduction in the top tax rate investors pay on stock dividends to 15% from 35%.

Not all dividends are created equal, however. Among other exceptions are payments investors receive instead of a dividend when they lend their stock to short sellers. Referred to as either "payments in lieu of dividends" or " substitute payments," these aren't eligible for the new lower rate.

That means the cost of betting on declines in the prices of stocks that pay dividends is likely to increase, since investors will want to be compensated for the higher taxes they incur on substitute payments. Some investors may not be willing to lend their stock at all, making it difficult to sell these securities short at any price.

"It's basically a hidden tax" on short selling, said John Van, chief financial officer of Van Hedge Fund Advisors International, a Nashville-based hedge-fund tracker and consultancy.

Mr. Van said hedge funds and other short sellers help financial markets operate more efficiently by letting some of the steam out of stocks with inflated prices. And they are often the first to sniff out accounting fraud and other corporate wrongdoing.

Making it more difficult to short stocks means that when there's a scandal akin to the ones of Enron Corp. , WorldCom Inc. or Global Crossing Ltd. , "it's going to take longer for that economic information to trickle down to the performance of a stock," he said.

A short position is a bet on the decline in the price of a security. An investor borrows stock and then sells it to a third party in the hopes of buying it back at a lower price to repay the loan.

The introduction of a tax penalty on lending stock comes as the practice of short selling has been under attack from some companies and their investors. The New York Attorney General's Office is reportedly looking into allegations that hedge funds in the New York area acted improperly in connection with a bearish positions in certain stocks.

The Securities and Exchange Commission has also been looking at the market impact of short selling as part of a broader probe of the hedge-fund industry.

Some hedge-fund managers say they're not too concerned about a possible increase in the cost of borrowing stock. For one thing, stocks that pay dividends aren't the most frequent target of bearish bets. Most short sellers bet on declines in the prices of fast-growing companies, which tend to use their cash to invest in new businesses, rather than pay dividends. Distressed companies, also frequent targets of short sellers, rarely have the cash to pay a dividend.

"From time to time there are utility stocks that fall out of favor, like Duke Energy ," said Charles Gradante, a principal of the Hennessee Hedge Fund Advisory Group. "But when a hedge-fund manager looks to short a stock, he's looking to make over 25% on the position. If a dividend is 2%, it's not a big factor."

And the supply of stock available for short sellers to borrow isn't likely to dry up completely. Plenty of big investors that are tax-exempt, like pension funds and endowments, will still be willing to lend their stock.

Other managers say the tax penalty for stock lending will only contribute to the recent run-up in the prices of stocks that pay dividends, and create the potential for companies to manipulate their stock prices.

"If you take away stock available for borrow, you're going to provide an artificial bias for the market," said Mark Zinn, a professional trader based in Fort Lauderdale, Fla. "If you have the ability to buy a stock, you should be able to short it just as easily. To hinder short selling is to hinder the freedom of the market," he said.

Mr. Zinn noted that investors don't necessarily short stocks because they expect the share price to fall; short positions can be used to hedge against declines in other holdings.

- Allison Bisbey Colter, Dow Jones Newswires; 201-938-5298



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