THE LOCK-IN EFFECT OF CAPITAL GAINS TAXES: EVIDENCE FROM THE RJR NABISCO … · 2016-08-31 · the lock-in effect of capital gains taxes: evidence from the rjr nabisco leveraged buyout

THE LOCK-IN EFFECT OF CAPITAL GAINS TAXES: EVIDENCE FROM THE RJR NABISCO LEVERAGED BUYOUT WAYNE R. LANDSMAN* & DOUGLAS A. SHACKELFORD”

Abstract - Inability to observe investors’ complete opportunity set has restricted prior analyses of capital gains taxes. This study overcomes these data limitations by examining involuntary capital gain realizations arising from the 1989 RJR Nabisco leveraged buyout. Confidential shareholder records permit precise estimates of the shareholders’ tax bases. We find a negative correlation between price and tax basis for the shares sold. The direct evidence of investor tax-rationality is consistent with the lock-in effect and sup- ports assertions that the lock-in effect ex- erts upward pressure on the supply curve in equity acquisitions.

INTRODUCTION

This paper estimates the lock-in effect of capital gains taxes on the sale of RJR Nabisco stock during its 1989 leveraged buyout (LBO). Tests of the association between the price of the stock and shareholders’ tax bases at the time of

*Kenan-Flagler Business School, Chapel Hill, NC 27599-3490

University

sale are conducted using confidential shareholder records. We find a negative correlation between the price of the stock and the average tax basis of the shares sold during the 76 trading days from initiation to completion of the buyout. The results are consistent with the lock-in effect and provide evidence that differences in capital gains taxes are a source of heterogeneous tendering responses during an acquisition.

The lock-in effect of the capital gains taxes is widely recognized as a transac- tion cost that arises from the deferral of taxation until realization.’ Understanding the magnitude of the lock-in effect is important for tax policymakers and tax planners. The lock-in effect is central to continuing policy discussions about the appropriate level of capital gains taxes and the taxation of accrued, but unrealized gains (“mark-to-market” accounting). To the extent capital gains taxes re- strict portfolio management, deadweight costs arise from inefficient resource allo- cation and costly restructuring designed to reallocate resources without triggering capital gains taxes.2

Numerous studies have estimated the

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lock-in effect indirectly by measuring the of tax basis to the prices of the stock responsiveness of capital gain reaiiza- during the buyout enable direct measure tions to capital gain taxes.3 These studies of the lock-in effect. typically compare capital gain realizations (or a proxy measure based upon realizations) to an estimate of the marginal tax rate. They use individual tax return data and apply cross-sectional and time-series methodologies. No consensus has been reached regarding the responsiveness of capital gains realizations to changes in marginal tax rates. Conclusions vary from highly sensitive (e.g., Feldstein, !;lemrod, and Yitzhaki, 1980) to rela- tively insensitive (e.g., Minarik, 1981). By assuming the lock-in effect to be increasing in the sensitivity of realizations to taxes, the magnitude of the lock-in effect is inferred from the estimates of the responsiveness of capital gains realizations to changes in marginal tax rates.

Kiefer (1990) notes that although these studies aid our understanding of the responsiveness of capital gain realizations to tax rate changes, they suffer from data limitations. In particular, virtually none of the studies includes observations associated with accrued, but unrealized, capital gains and losses and ac- c:rued gains that escape capital gains taxes at death. The econometric implica- tion of limiting observations to realizations only is that the regression models are misspecified, resulting in biased regression coefficients (Tobin, 1958). These studies usually acknowledge this source of model misspecification by dis- cussing the lack of understanding about why individuals realize capital gains.4

This study overcomes these problems by examining shareholders who had no choice but to dispose of their stock because the company was acquired. Thus, the opportunity set available for investors with regard to the acquired company’s stock is observable. Shareholder records permit precise measures of each shareholder’s capital gains. Comparisons

The direct evidence about the impact of taxes on stock sales during an acquisition also extends the corporate finance literature that relates upward-sloping supply curves in the equity markets to heterogeneous tenderin$ responses. To motivate their theory fof upward-sloping supply curves, both Stult (1988) and Bagwell (l991) assert thlat the lock-in effect is a potential varianit among shareholders that could resultl in differences in valuation. However, neither provides any empirical evidence that the lock-in effect is a source of upward-sibping supply curves. Several studies (e.g., Brown and Ryngaert, 1991; Kadapalkkam and Seth, 1991) attempt to estima/te indirectly the effect of capital gains tdxes on acquisition prices. Direct estimates of the lock- in effect for equity acqulisitions have been impossible becausq shareholders’ tax bases have been un+ailable. With access to shareholder records, this paper overcomes this data limitation and is the first to estimate directly ;he lock-in effect on tendering resporlses. Our results are consistent with the @k-in effect contributing to an upwalrd-sloping supply curve in the RJR Nabisco LBO.

The remainder of the palper is organized as follows. The next sect/ion sketches the events at RJR Nabisco djlring the period that we used to estimatq the lock-in effect, inclulding a discussibn of the tax and trading options that shareholders faced during this period. The third section presents the empiriqal tests and results. Concluding remarl(s follow.

RJR NABISCO’S LEVERAGEiD BUYOUT

Background

On October 20, 1988, F. Ross Johnson, RJR Nabisco’s CEO, offeled to purchase the company in a manadement-led le-

246

THE LOCK-IN EFFECT OF CAflTAL GAINS TAXES

veraged buyout.5 On November 30, 1988, the board of directors accepted Kohlberg, Kravis Roberts & Co.‘s (KKR) bid of $25 billion, consisting of cash for 74 percent of the shares and debt and preferred stock for the remainder of the shares. KKR acquired 74 percent of the stock in a tender offer on February 9, 1989, and distributed $18 billion in cash on February 2 1, 1989. Because the tender offer was oversubscribed, there was insufficient cash to redeem all tendered shares. As a result, the redemption of each tendered share was completed with a small portion of debt and preferred stock. On April 28, 1989, the remaining shareholders exchanged all of their shares for debt and preferred stock. The major events during this period are summarized in Table 1.

Shareholder Tax and Trading Options

From the date of the original offer by Johnson to the date of the tender offer (the buyout period), RJR Nabisco’s stock price increased from $55.875 to $100.6 However, during the buyout period, shareholders faced considerable uncertainty about the future value of the stock. There was uncertainty about (1) whether the board of directors would agree to sell the company to any bidder, (2) the valuation of the postacquisition securities,7 and (3) KKR’s ability to ar- range financing and to gain regulatory and legal approval. Ignoring taxes, the decision to sell was a function of the investor’s expectations about the resolu- tions of these uncertainties and risk aversion.8

This study examines the extent to which tax factors also impacted the decision to sell. Prior to the agreement with KKR, shareholders could sell their shares and pay capital gains taxes immediately. Af- ter the agreement with KKR, but before the tender offer, investors had three options. They could (1) sell the stock on

the open market; (2) tender the shares for cash from the company; or (3) exchange the shares for debt and preferred stock of the postacquisition RJR Nabisco.g The first two options resulted in immediate taxation.” The third option resulted in immediate taxation for the debt portion of the exchange and tax deferral for the preferred stock portion of the exchange.”

In addition to opting for tax-deferred preferred stock, investors could reduce their capital gains taxes through strategic timing of their capital gains. First, shareholders could offset capital gains with capital losses.” Although tax advi- sors for shareholders tell us that this strategy was employed, they add that the magnitude of the capital gains arising from the RJR Nabisco LB0 far exceeded the capital loss potential for most shareholders. Second, shareholders could distribute the capital gains across the taxable years of 1988 and 1989 to use fully the progressivity in the statutory rates. However, we find that only six percent of the shareholders in this study sold stock in both 1988 and 1989. This is consistent with multiyear sales providing little value to most shareholders because their other income exceeded the lower brackets.13

The limitations on tax minimization strategies caused by the surprise of the acquisition, the short planning period from announcement to disposition, and the forced disposition provide a particularly strong experimental setting for computing the lock-in effect.14 In the RJR Na- bisco LBO, capital gains were realized and taxes were paid because investors had no other choice. Thus, the link between capital gains taxes and price should be unusually strong in this study because tax planning comprises a dispro- portionate percentage of the investors’ discretion.

The forced disposition associated with

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TABLE 1 TIMETABLE OF KEY EVENTS ASSOCIATED WITH THE BUYOUT

PLOT OF RJR NABISCO STOCK PRICES FROM OCTOBER 1988 UNTIL COMPLETION OF THE BUYOUT ---

110

60

50 - List of Events (1) October 20, 1988: F. Ross Johnson, CEO of RJR Nabisco, initiates managernent-led leveraged buyout for $17.6 bil-

lion. (2) October 24, 1988: KKR announces a tender offer amounting to $20.6 billlon. (3) November 30, 1988: RJR Nabisco’s board of directors reaches an agreement with KKR to purdhase the company for

$25.1 billion. (4) December 31, 1988: end of tax year for indtviduals and RJR Nabisco. (5) February 8, 1989: last trading day before acquisition. (6) February 21, 1989: cash exchanged for RJR Nabisco shares.

the acquisition largely overcomes two related data limitations that generally con- found studies of capital gains and the lock-in effect. First, our incomplete understanding of why investors realize capital gains is not relevant to this study. Second, the realized capital gains in this study do not arise from self-selection. TIIUS, problems caused by omitted correlated variables, such as tax evasion, other investments, and risk, are miti- gated in this study.“’

MODEL

Theory

At all times, shareholders apparently be- lieve that the present valyle of the proceeds from selling stock and paying taxes on the capital gains in the future exceeds the current price of the stock less thle capital gains taxes that would be generated from immegiate sale. If not, the shareholders wotild sell the

I THE LOCK-IN EFFECT OF CAPITAL GAINS TAXES

stock, pay the capital gains taxes, and reinvest in alternative investments. Thus, the hold/sell decision can be expressed as follows. Shareholders sell when

[PO - T&PO - B)] * (1 + I-)" > P" - T"(f" - B)

where P&P”) is the current (future) stock price; ~~(7,) is the current (future) marginal tax rate on capital gains; B is the tax basis on the stock; and f is the annual after-tax rate of return on alternative investments for n years.

As the current price changes, investors recompute the current and future after- tax proceeds and decide whether to continue to hold or to sell. Restating in- equality 1 as an equation and assuming that changes in the current price only affect the tax basis of the marginal share and expectations about future stock prices, we find that the derivative of the tax basis with respect to the current price is

as/aRJ = [(af”/aP,) * (1 - 7") - (1 + r)

* (1 - dl/[( 1 + d%l - 4

The sign of the derivative is indeterminate. The numerator will be positive if the present value of the after-tax proceeds from a future sale, (dP,/dP,) * (1 - T,), is expected to exceed the after- tax proceeds from an immediate sale, (1 - TV). The denominator will be positive if the current capital gains tax rate, TV, exceeds the present value of the future capital gains tax rate, ~,/(l + r)“.

In a related analysis, Bagwell (1991, Ap- pendix B) assumes that tax rates are constant (70 = 7,) and that future prices are independent of current prices (aP,,/ cV, = 0), i.e., the liquidation price is fixed. With these assumptions, the sign

of the derivative is unambiguously negative, indicating that higher prices induce the selling of shares with lower basis. Bagwell asserts that this pattern of selling is consistent with the lock-in effect because higher selling prices are demanded to compensate the shareholder for the additional taxes arising from the sale of shares with lower tax basis.

Although constant tax rates and price independence aid in tractability, neither assumption appears appropriate for the RJR Nabisco buyout. With regard to in- ter-temporal tax rates, shareholders are likely to have anticipated lower future capital gains tax rates at least during the early stages of the buyout when there was much uncertainty about whether the buyout would occur. In late 1988 and early 1989, there was considerable discussion about lowering the federal capital gains tax rate. Lower capital gains tax rates was a central feature of President Bush’s domestic policy in the 1988 campaign. In addition, some shareholders likely planned to hold the shares until death or to make charitable contributions (avoiding all capital gains taxes), selling the shares when their individual tax rate was low (e.g., retirement) or giving the shares to taxpayers with lower tax rates (e.g., children). During the end of the buyout period, when the sale (and capital gains taxation) became inevitable, current and future tax rates likely converged. Thus, although constant tax rates seem unrealistic, it is likely that current tax rates were at least as great as expected future tax rates, suggesting that the denominator in the derivative is likely to be positive.

With regard to the relation between current and future prices, expectations of future prices were doubtlessly revised by the unprecedented increase in current prices during the buyout period. One possibility is that the afJaP, decreased

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over time. In the early stages of the buyout, expectations of future prices may have increased by at least the change in current price, as investors impounded information that increased the likelihood that the buyout would occur. In the later stages of the buyout period, consensus about the value of the postbuyout company’s securities likely reduced the responsiveness of future prices to current prices. Moreover, for investors who were contemplating remaining as shareholders in the post-LB0 company, increases in acquisition price during the bidding war might have lowered expectations of future prices because the higher the acquisition price rose, the more heavily leveraged the postbuyout company would be. Thus, unlike the denominator, for which a positive sign is reasonably probable, the srgn of the numerator is unclear. As a result, the sign of the derivative of basis with respect to current price remains indeterminate.

Regression

To determine the relation between price and tax basis for RJR Nabisco shareholders during the buyout period, we regress the weighted average of the tax bases of the shares sold each day, BASIS,, on the daily closing price, PRICE,. BASIS, is the sum of the tax bases of the shares sold on day t divided by the number of shares sold on day t. Tax bases are mea- sured as of October 19, 1988, the last day before F. Ross Johnson announced ,a management-led buyout. The time-series regression IS estimated for 76 trading days, beginning with October 21, 1988, the day following Johnson’s announcement, and ending with the final trading day before the cash tender offer (Febru- ary 8, 1989). A negative coefficient on PRICE, will provide evidence that shareholders sold stock with lower tax basis as prices rose during the buyout period, even after considering the increase in future expected after-tax proceeds. A neg-

ative relation between PRICE and BASIS is consistent with investors’ demanding compensation for the 4 dditional capital gains taxes arising fro

1

immediate sale and will be interpreted as evidence of a lock-in effect. Unfortut-iately, finding a positive or no relation between price and tax basis will not

e nable us to reject

the hypothesis that the lock-in effect impacted shareholders’ s e II/hold decisions because other factors may empirically dominate the lock-in effect (assuming it is present). These alternative determi- nants include factors eyplicitly modeled, such as Intertemporal tax rates and expected future price revsions, as well as other unobserved sour k es of heterogene- ity, such as risk preferences.

DATA

The company providedius with a list of all RJR Nabisco shareh lders with North Carolina addresses, ex

P ept street name

holdings (i.e., sharehol ings with investment advisory services)’ as of the following dates: August IO, 988, and No- \ vember 10, 1988 (both record dates for payment of dividends), ~ December 3 1, 1988 (year-end), and Fkbruary 8, 1989 (the record date for th8 cash tender offer). I6 The shareholder ~records include the name, address, tax identification number, the number o shares issued and sold, and the date I of the issue and the sale for each sharebolder. We recon- structed the sharehold

e r records as of

October 19, 1988 (the ,day preceding F. Ross Johnson’s announ~cement of a management-led buyout) by deleting from the .30.2 million shares in the August IO, 1988 shareholder list the 1.3 million shares that were sold before October 21, 1988, and adding to the August IO, 1988 list the 1.9 million shares from the November 10, 1988 sh reholder list that

% were purchased after , ugust 8, 1988 and sold after October ~20, 1988. The re- constructed October lq, 1988 share-

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THE LOCK-IN EFFECT OF CAPITAL GAINS TAXES

holder records are identical to the actual October 19, 1988 shareholder list except that our list excludes North Carolina shareholders who held stock on neither dividend record date but who held stock on October 19, 1988 and shareholders who sold their shares on October 20, the date of Johnson’s announcement.

Based on the taxation of capital gains, we classified shareholders as (1) individuals (either directly or as beneficiaries of trusts) or corporations that are subject to immediate taxation on capital gains, (2) qualified retirement plans whose beneficiaries are subject to taxation on capital gains upon distribution of the trust assets (tax-deferred trusts), and (3) tax- exempt organizations that are never subject to taxation. Two large trusts were deleted from the sample because their beneficiaries included both shareholders who faced immediate taxation and shareholders who faced deferred taxation, and trades for the two groups cannot be separately identified.

The sample includes 19,011 shareholders who held 29.6 million shares with an average tax basis of $26 per share on Oc- tober 19, 1988.” 18,918 individuals and corporations held 23.0 million shares with an average tax basis of $22 per share. Twenty-seven tax-deferred trusts held 4.1 million shares with an average tax basis of $49 per share. Sixty-six tax- exempt organizations held 2.5 million shares with an average tax basis of $28 per share.18

Comparison of the tax bases among the three shareholder groups provides evidence that the lock-in effect impacted stock sales prior to the buyout. Consis- tent with the lock-in effect, the tax basis for tax-deferred trusts and tax-exempt organizations is higher than the tax basis for fully taxable individuals and corporations. This evidence is consistent with capital gains taxes reducing selling by

taxable investors prior to the buyout period.

Ideally we would include both taxable and nontaxable investors in our primary tests. Differences in the lock-in effect between shareholders facing immediate capital gains taxation and shareholders facing deferred or no taxation would provide strong evidence that dispositions were impacted by capital gains. Unfortu- nately, there are few tax-deferred trusts and tax-exempt organizations, and their trades are infrequent and large. One trust held 99 percent of the shares held by tax-deferred trusts. One tax-exempt organization held 96 percent of the shares held by tax-exempt organizations. Both tax-deferred trusts and tax-exempt organizations failed to sell any shares on a majority of the trading days examined in the study. In fact, 97 percent of all shares sold by tax-exempt organizations were sold in one day, and over half of the shares sold by tax-deferred organizations were sold in two (nonconsecutive) days.lg As a result, the tax-deferred trusts and tax-exempt organizations were deleted from the tests in the study.20

Of the remaining individual and corporate shareholders, 80 percent sold 19.7 million (86 percent) shares with an average tax basis of $21 prior to the tender offer on February 9, 1989. One percent tendered 1 .O million (four percent) shares with an average tax basis of $49 for cash and securities of the postbuyout company on February 9, 1989. Twenty- two percent of the individual and corporate shareholders exchanged 2.2 million (ten percent) shares with an average tax basis of $19 solely for securities in the postbuyout company.2’

Because shareholders who exchanged their stock for debt and preferred stock in the new company avoided immediate taxation on the preferred stock, this op-

251

tion may have been more attractive to shareholders facing larger capital gains. Consistent with this expectation, the average tax basis for exchlanging shareholders is lower ($19) than for shareholders who sold on the market ($21) or tendered their shares ($49). The higher tax basis for tendering shareholders relative to exchanging shareholders is consistent with tax-advantaged preferred stock.” However, because the difference between exchanging and selling shareholders is only two dollars, shareholders appear to have assigned little value to the tax-deferral features of preferred stock. This is consistent with the risk of the securities in the postacquisition company offsetting the tax benefits of the preferred stock exchange.

The remaining tests in the study focus on the 19.7 million shares sold by 15,172 taxable investors during the buyout period (October 21, 1988 to Febru- ary 8, 1989). The mean (median) stock. holdings by the taxable investors was 1,301 (370) shares, ranging from one share to 875,000 shares. One-half of the taxable investors owned between 105 and 1,000 shares. The stock traded at a record high throughout the buyout period; thus, all sales generated capital gains.

The tax bases in the company’s stock for many of the shareholders examined in this study (shareholders who were North Carolina residents) were unusually low because shares were held within families for generations, often obtained through an extensive employee stock program.2-3 Because the Tobacco Company was domiciled in North Carolina, family-held stock was alleged to be prevalent there. Our examination of the RJR shareholder records confirms that North Carolina shareholders, on average, had held RJR Nabisco stock for a longer period than other shareholders. By examining the dates that the shares were purchased,

we estimated that the Imean holding period for shares held by, residents of North Carolina as of t e initial an-

“, nouncement of manag ment’s proposed buyout was 9.9 years. bhe mean holding period for all of RJR Nabisco’s shares, estimated as the ratio oft total shares to shares traded in 1987 (as reported in the 1987 financial statements), was 1.2 years. The longer holding periods and lower tax bases likely increase the im- portance of lock-in effect for the shareholders examined in this study. At the same time, it may redu~ce the generalizability of these results to the other RJR Nabisco shareholders.

RESULTS

The regression results in Table 2, column A, present evidence that is consistent with the lock-in effect mpacting stock dispositions. The coeffi d ient on PRICE is --0.33 with a t-statistici of -2.32.24 The coefficient indicates th ‘t for every dollar increase in the current

“, rice of the

stock, shareholders sell ,shares with 33 cents less tax basis. Alternatively stated, for each dollar decrease in tax basis, shareholders demand ah additional 20 cents.25

The results are consistent with investors exhibiting a high level of tax-rationality in selling their shares. The findings sup- port earlier studies (e.g.‘, Feldstein, Slem- rod, and Yitzhaki, 198 0 ) that estimated that the lock-in effect &as large, based upon the responsiveness of capital gains realizations to changes in marginal tax rates. The results also imply that shareholders demand compe

n sation for capi-

tal gains taxes through ~acquisition pre- miums.

Sensitivity Analyses

Three sensitivity tests were conducted to determine the robustness of the findings. The first sensitivity analysis ad-

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TABLE 2 REGRESSION COEFFICIENTS (t-STATISTICS) FROM CORRELATION TESTS BETWEEN RJR NABISCO’S PRICE

AND THE TAX BASES OF SHARES SOLD FOR THE 76 TRADING DAYS BEGINNING OCTOBER 21, 1988 AND ENDING FEBRUARY 8, 1989

Regression Models Columns A through C: BASIS, = PO + p, PRICE, + E; Column D: BASIS, = PO + p, PRICEt + CBASISr + et

Column E: BASIS, = PO + p, PRICE, + l , Column F: BASIS,,, = p,, + p, PRICE,,, + E,,~

A B C D E F

Intercept

PRICE (-)

CBASIS

All Days 1988 Days

(3191, (F49,

-0.33 -0.72 (-2.32) (-2.62)

1989 Days

:18)

-0.62 (-1.62)

All Days Modified

;740,

-0.27 (-1.70)

0.55 (0.78)

Shareholder

$71)

-0.37 (- 10.59)

Shareholder Day

(:95.19,

-0.35 (-11.40)

adj R2 0.06 0.11 0.06 0.05 0.01 0.01

n 76 49 27 76 15,172 17,688

“BASISr is the weighted average of the tax bases as of October 19, 1988 for all shares sold on day t. PRlCEr is the RJR Nabisco closing stock price on day t. ZBASlSr is the sum of BASISt for days t = 1 through t = 76. bBASISi is the weighted average of the tax bases as of October 19, 1988 for all shares sold by shareholder i. PRICE, is the weighted average of the RJR Nabisco closing stock prices on the days that shareholder i sold shares. ‘BASIS,,r is the weighted average of the tax bases as of October 19, 1988 for all shares sold on day t by shareholder i. PRICE,,r is the RJR Nabisco closing stock price on day t that shareholder i sold shares.

dresses an unavoidable contaminant in the experimental setting caused by the inclusion of the end of the taxable year for individuals, December 31, in the buyout period. An alternative explanation for the findings is that shareholders facing high capital gains delayed their dispositions until 1989 so that they could shift their tax liability to the following year.26 To determine whether the disposition patterns reported above are solely attributable to strategic tax planning around the end of the taxable year, we estimated the regression coefficients for the trading days in 1988 and 1989 separately. The results, presented in Table 2, columns B and C, provide additional evidence that the lock-in effect impacted share dispositions. The estimated coefficient for PRICE is negative and significant in both years, indicating that the results are not attributable to strategic year-end tax planning. For the 49 (27) trading days in 1988 (1989), the coeffi-

253

cient on PRICE is -0.72 (-0.62) and less than zero at the 0.01 (0.06) level. Further analysis reveals that the PRICE coefficient for 1988 is significantly less than the PRICE coefficient for 1989.

The second sensitivity test addresses an assumption in the research design that the distribution of both the dependent and independent variables is time invariant. if the lock-in effect is in fact present, then the daily distribution of the dependent variable, BASIS, varies over time. If BASIS is not time invariant, then the documented empirical relation between PRICE and BASIS may be affected. Because (high basis) observations leave the population each day, the decisions that exiting shareholders would have made if they faced the same prices and price uncertainty as those who remained in the sample are not observed.

Although there is no general solution to the problem econometrically, one ap-

preach is to recast the model in a way that restores some degree of distribu- tional stationarity. For example, even though the distribution of BASIS may change over time, the distribution of the ratio of BASIS to the basis of shares available for sale each day (ZBASIS) is likely to be more stationary. Alterna- tively, the bivariate relation between BASIS and PRICE conditioned on CBASIS is likely be better specified than our primary estimating ecluation (or at least is not an inferior specification), in that the basis of shares available for sale (XBASIS) serves as a control for those shareholders who remain in the sample on a given day. Accordingly, we reestimated our basic model with the basis of shares available for sale as an additional regres- sor.

Table 2, column D presents the results from the second sensitivity test. The coefficient on PRICE remains negative; however, its t-statistic is only - 1.70. This is not surprising, because the correlation between PRICE and XBASIS is -0.45, which is significant at less than the 0.0001 level. As high-basis shareholders sold their shares early in the buyout period (consistent with the lock- in effect), CBASIS gradually fell from $20 on the first day of the buyout period to $17 on the last da,y of the buyout period. The steady decline in ZBASIS corre- sponded with the steady increase in PRICE throughout the buyout period. Consistent with its intended purpose, XBASIS is positively correlated with BASIS at the 0.09 level.

The third sensitivity analysis examines the assumption that each trading day constitutes an observation point. Trading days are reasonable observations because our price data are limited to daily quotes. Although the shareholder records include the date of sale for each share, they do not provide the price at ‘which the shares sold. To test the ro-

bustness of our finding to the unit of observation, we first re i eated the regression treating each shareholder as an observation by regr ssing average tax

I basis per share on aver ge price per share for each of the 1 b,l72 shareholders (Table 2, column E). We then treated each shareholder-day as an observation by regressing average ttx basis for every selling day for every shqreholder on closing price for 17,688 shdreholder-days (Table 2, column F).

As expected, the coefficient on PRICE is negative, highly significant for both of the regressions, and sirrjilar in magnitude to the coefficient on P ‘ICE when trades are aggregated within %I ays. Table 2, column E (F) shows that tde coefficient on PRICE using shareholders (shareholder- days) as the unit of obyervation is -0.37 (-0.135) with a t-statisti{ of -10.59 (- 11.40).*’ These result/s provide additional confirmation that’ the capital gains taxes affected the disposition patterns of RJR Nabisco shareholdehs.

Further Analysis

By using the regression Icoefficient on PRICE to estimate the derivative of tax basis with respect to culrrent price in equation 2 and assumiqg that RJR Na- bisco shareholders face4 the maximum federal and North Carolina statutory individual tax rates of 28 Ipercent and seven percent, respectively, at the time of the buyout, we can further analyze the remaining paramete/rs in equation 2-the expected futureltax rate, T,, the earnings rate on altern+ive investments, (1 + T)“, and the respoqsiveness of future prices to current pttice changes, dPJaP,. Let dB/dP, eq al -0.33 (Table 2, column A) and 7. eq al 0.3304 [28 percent i- 7 percent * 1 1 - 28 percent)l:

T,, = [(aPJaP,) - 0.56(1 + r)“]/[(aP,/aP,) + 0.331

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Since 7, is nonnegative, dP,/dP, 2 0.56(1 + r)“. Moreover, because the earnings rate is nonnegative, aPJaP, 2 0.56. If tax rates are intertemporally constant (as they likely were, once the buyout became inevitable), aPJaP, = 0.83(1 + r)” + 0.16 and the minimum value for aPJaP, is 0.99. This implies that when the buyout (and taxation) became inevitable, causing (1 + r)” to ap- proach one and current and future tax rates to converge, selling behavior re- flected the belief that future prices were increasing dollar-for-dollar with increases in current prices.

Conclusions

To our knowledge, this is the first study to present direct evidence about the lock-in effect. Other empirical studies of the lock-in effect have been limited by an inability to observe the complete opportunity set available to the investor. Access to confidential shareholder records enables us to estimate precisely the lock-in effect of the capital gains taxes during the RJR Nabisco leveraged buyout. We find a negative correlation between the price of the stock and the weighted average tax bases of the shares sold during the buyout period. Our findings indicate that for each dollar less of tax basis, shareholders demanded an additional 20 cents in the sales price as compensation for capital gains taxes. The results are consistent with the lock- in affecting share dispositions and sup- port assertions that the lock-in effect contributes to upward-sloping supply curves in the market for equity.

This research should be extended in at least two directions. First, this study examines the largest and most controver- sial leveraged buyout ever. The shareholders examined in this study had particularly strong incentives to consider capital gains taxes in their selling decision because their tax bases were low

and the premium paid for the company was unprecedented. Although these factors provide powerful tests, they also limit the generalizability of the findings. Thus, it would be useful to replicate this study on a more typical acquisition.

Second, there are two alternative expla- nations for our findings that our data are unable to test. First, recall that important factors in the selling decision during the buyout period were assess- ments of the probability that an acquisition would occur and later that KKR would be able to fulfill its commitments. It is possible that more risk-averse investors sold their shares earlier in the buyout period than less risk-averse traders. If so, because the stock price rose steadily during the buyout period, risk- averse investors would have received lower proceeds than less risk-averse shareholders. If the tax basis of shares held by risk-averse investors is higher than the tax basis of the shares held by less risk-averse investors, it is possible that the disposition patterns are a function of risk as well as taxes. One reason why risk-averse investors might have higher tax bases is that they are unwill- ing or unable (less wealthy) to hold stocks for long periods. Thus, tests of the trade-offs by shareholders between risk and taxes during an acquisition would be a useful extension.

The second possible alternative explanation relates to shareholder differences in propensities to rebalance investment portfolios. For a stock whose value is increasing over time, such as RJR Nabisco, tax bases will be increasing in shareholders’ propensities to rebalance because investors who often rebalance will have purchased their shares more recently. Thus, during a buyout period, the investors with the greatest propensity to rebalance (and thus higher basis) may sell earlier than investors with less propensity to rebalance (and lower basis). Unfortu-

255

nately, the tests in this paper could mis- (construe differences in propensity to rebalance as the lock-in effect because our Idata are unable to distinguish differences in trading behavior and taxes.

ENDNOTES

We acknowledge and appreciate officials at Bankers Trl;st Company and RJR Nabisco who provided us with information necessary to complete this study, individuals associated with the buyout who provided invaluable In- sights into the buyout but have requested an- onymity, comments by three anonymous ref- erees, the editor, Laurie Bagwell, Tim Bresnahan, Julie Collins, Bill Gentry, Jim Hines, Tom Mroz, David Ravenscraft, Peter Wilson, Shu Yuh and workshop participants at Har- vard Business School, NBER Summer Institute, New York University, the University of North Carolina, Penn State University, Stanford Uni- versity, the Second Conference on Financial Economics and Accounting, and research as- sistance by Susan Eldridge.

’ The lock-in effect refers to the dislncentlve to dispose of appreciated property in a manner that will gerlerate capital gains taxes on accrued, but unrealized, appreciation. In the absence of capital gains taxes, Investors hold those assets yielding the highest risk-adjusted rate of return. In the presence of capital gains taxes, reallocation is postponed until the yield differential exceeds the capital gains taxes im- posed upon disposition.

2 Our discussions with tax planners suggest that substantial resources are expended to mitigate the lock-in effect, including exit strategies and estate tax planning.

3 The empirical studies include the following: Feldstein and Yitzhaki (1978), Yitzhaki (1979), Feldstein, Slemrod, and Yltzhaki (1980), Mina- rik (1981), Auten and Clotielter (1982), Auten (1983), U.S. Department of the Treasury (1985), Cook and O’Hare (1987), U.S. Congressional Budget Office (1988), which includes a review of the major empincal studies, Kiefer (1990), Henderson (1990). and Cook and O’Hare (1992).

“ See Feldstein and Yitzhaki (1978) and Cook and O’Hare (1992) for representative discussions of the reasons for capital gain realizations in the context of these studies. For more background on the capital gain realization “puzzle,” see Constantinides (1983) and Stig- litz (1983).

’ Before the buyout, RJR Nabisco was viewed as a “cash cow” and an attractive takeover tar-

get because its cash from, operations was large and stable (Wall Stryet /ourna/, October 21, 1988). In the three yqars preceding the buyout, 1985-7, the tobacco subsidiary aver- aged an annual operating1 income of $1.7 billion on sales of $5.9 billiqn (a profit margin of 29 percent), and apprc/ximately $1.4 billion in cash Irom operations. However, despite the attractiveness of RJR Nab$co as a takeover candidate, news of the LE(0 shocked the investment community (and1 likely the shareholders Investigated in thib study) because of the company’s size. The qext largest LBO, Kohlberg, Kravis Roberts

d Co.‘s purchase of

Beatrice in April 1986, a ounted to “only” $6.2 billion, a quarter of the size of the RJR Nabisco LBO.

6 RJR Nabisco’s stock rose 38 percent on news of Johnson’s offer to pur hase the company.

‘b The closing price on Otto er 19, ‘1988, the day preceding the annoudcement, was $55.875 The closing pricq on October 20, 1988, the day of the annquncement, was $77.25. Because we are unable to determine whether sales on October’20, 1988 preceded or followed the announcebent, the first trading day In this study is OcFober 21, 1988, when the stock closed at b76.75. Thus, this study examines the lock-iri effect of the capl- tal gains taxes on sales d ring a period that

1 the stock increased from 76.75 to $100. In- ferences are unaltered wh/en sales on October 20, 1988 are included in jhe empirical tests.

’ KKR valued the compensation at $109 per share, but the market pricp of the stock never exceedecl $100.

” It is possible that more risb-averse investors sold their shares earlier in ~the buyout period than less risk-averse tradeds. However, because we have no data reparding the risk aversion of investors, we $e unable tlo test the effects of risk empiric;illy. Moreover, throughout the study, we iignore risk and other alternative reasons f r selling stock, such as liquidity. To the e P tent these factors impacted selling decisions ~during the buyout period, in a way unrelated1 to tax basis, they likely bias against rejectin the null hypothesis that taxes did not impact bales. If, however, these factors are correlate with tax basis, they introduce bias, altho d gh the direction of the bias IS unclear. See th+ final section of the paper for further discussion of potential biases.

” Arguably, a fourth option yeas to hold the stock in anticipation that the acquisition would not be completed. IInvestors who took this option, however, wer

P forced eventually

to exchange their shares f r shares in the

256

10

11

12

13

14

15

16

I Ht LUCK-IN tl-I-K I UP WW’I IAL WWN> IAM>

postacquisition company. However, at least in the early stages of the buyout period, this option was doubtlessly selected by many investors who felt the stock was underpriced. All shareholders, except tax-deferred trusts (qualified retirement plans) and tax-exempt organizations, were subject to tax on the difference between the proceeds received and the tax bases of their stock. The tax deferral associated with the third option proved short-lived. On July 17, 1989, less than three months after distributing the preferred stock, RJR Nabisco exchanged the preferred stock for debentures, triggering immediate taxation for holders of the preferred stock. Former company officials have told us that the exchange was undertaken because of changes in the capital markets that arose after the acquisition and was unanticipated at the time of the acquisition. Thus, we assume that, during the buyout period, shareholders assigned value to the tax-deferral opportunity available through preferred stock.

It is important to note that offsetting the capital gains taxes arising from the sale of RJR Nabisco stock with capital losses does not decrease the investor’s overall taxes unless the capital losses could not be used otherwise. Further evidence is presented below that taxes affected selling decisions in both years. We use the term, “forced disposition,” because we assume that the shareholders in this study were unable to influence the decision to sell the company. We recognize, of course, that shareholder approval (through tendering shares) is needed to complete a tender offer and the board of directors as agents for the shareholders approved KKR’s acquisition. See Yitzhaki (1979) for a discussion of how these problems relate to his research of the lock-in effect. Shareholders located in North Carolina com- prised 21 percent of RJR Nabisco’s shareholders. North Carolina shareholders include the management and many current and former employees of the R. J. Reynolds Tobacco Company, the primary subsidiary of RJR Na- bisco, whose domicile and manufacturing operations are located in the state. North Caro- lina shareholders did not include the management of RJR Nabisco, which was domiciled in Atlanta at the time of the buyout.

Although we would have preferred access to the records of all RJR Nabisco shareholders (and, for that matter, the shareholders of multiple companies), RJR Nabisco’s North Car- olina shareholders are particularly useful for

purposes of investigating the lock-in effect because the tax bases of some of these shareholders are unusually low, providing wide variability in the amount of capital gains faced upon disposition. Conversely, the variability provided by certain RJR Nabisco’s North Carolina shareholders may limit the generalizability of this study to the extent that the shareholders are not representative of other investors. More generally, because our analysis is conducted using data from a single company, we cannot determine the extent to which our findings generalize to other RJR Nabiscoshareholders, shareholders in other companies, or other acquisitions.

Tax bases are estimated by multiplying the number of shares issued by the closing stock price on the day of issue for shares issued since July 1, 1962, and by the closing price on the last day of the month of issue for all other shares. Daily stock prices are not available through the Center for Research in Secu- rity Prices (CRSP) for early dates. This method of computing tax bases is not appropriate when shares are transferred as a gift and when shares are issued through stock splits. With gifts, the donee’s tax basis in the stock is the same as the donor’s tax basis. How- ever, our data do not permit us to identify shares transferred through gifts. As a result, we assume that no shares are transferred through gifts and compute tax basis as of the date of issue for all shares. This assumption probably overstates shareholders’ tax bases in RJR Nabisco stock because the stock price generally increased over the life of the company. Shares Issued on days of stock splits are assumed to have been issued as part of the stock split. Basis is assigned to shares issued through stock splits by shifting tax basis from existing shares to new split shares according to the split ratio. This becomes problematic if the shares from which the split shares were created were not held by the shareholder at the time of the acquisition. In these cases, it is impossible to determine the basis for the split shares with our data. Thus, we assign basis from any remaining shares and, in the absence of any shares, assign zero basis. When the tests in the study are conducted, excluding shares issued on split dates, conclusions are unaltered. However, consistent with the removal of noise from the data, all results are more significant in the predicted direction. With regard to the number of shareholders, we treat each taxpayer identification number as a different shareholder because we are unable to determine families or effective control. A casual review of the shareholder records

257

suggests that this procedure likely overstates the number of shareholders and understates the number of shares that they control. Many stockholders shared the same address and the same surname, suggesting that there were extensive family holdings. In addition, many individuals held stock both personally as well as through a trust that was named after them.

” The tax basis for the tax-exempt organizations is low, relative to the tax-deferred trusts, partly because there were restrictions on the selling of RJR Nabisco stock at some large tax-exempt organizations that were funded with stock contributions from members of the company’s founding family. The actual tax bases of these restricted shares is probably even lower; however, as discussed in endnote 16, we are unable to determine the original basis of donated shares. Charitable contributions of appreciated stock by family members are consistent with the lock-in effect providing disincentives for taxable investors to sell their stock.

” During the buyout period, nontaxables sold shares on all trading days in October, 95 percent of the trading days rn November, 62 percent of the trading days in December, 52 percent of the trading days in January, and 83 percent of the trading days in February. Tax-deferred trusts sold most of their shares early in the buyout period. They sold shares on only four days in 1989 Conversely, tax- exempt organizations sold most of their shares late In the buyout period. They sold on only 34 percent of the trading days in Octo- ber and November. Selling during the later stages of the buyout period by tax-exempts reflects institutional restrictions on the ability of certain large tax-exempt organizations to sell RJR Nabisco stock prior to amendment of their bylaws. Conversely, taxable investors sold on every trading day, and on 57 (74 percent) trading days, they sold at least 100,000 shares. The daily sum of shares sold by taxable investors ranged from 3,593 to 1,248,642.

.‘” We also cornpared coefficient estimates from regressions using only currently taxable shareholders and regressions usrng other shareholders. Although the unreported findings are consistent with our expectation that tax basis is a more important determinant of trading by taxable shareholders than by nontaxable shareholders, the potential biases introduced by examining only the days that nontaxables traded and the need to weight the few and heavily traded days that nontaxables did trade raised suffic’ent doubts that the inferences

21

22

$73

24

.75

16

from the tests were reliable.

The percentages of share olders using each disposition method do n cl t sum to one because some shareholders Iused multiple meth- ods to clispose of their s h ares.

The difference in tax basi is also consistent with systematic nontax di ferences between shareholders who partici ated in the tender offer and other sharehol

I ers. For example,

shareholders participating in the tender offer may be more active in th

t stock market. If so,

their higher level of activi y in the stock market would attract the services of a broker who could assist in the p perwork necessary to sell shares through a t

:

nder offer. In addition, their higher level of activity would increase the likelihood that, they purchased their shares more recently. Because the price of the stock rose over the life of the company, more recently purchased shares~ would have higher tax bases.

In kvbarians at the Gate4 Burrough and He- lyar (1990) provide anecd

1 tat illustrations of

sha,reholder-employee loy Ity. One example noles that “. .[f]actory workers in overalls walked Into stockbrokers’, offices with paper bags full of cash and ‘buy’ orders for Reyn- olds Tobacco. A factory worker named Hobert Johnson was one of the company’s biggest shareholders for years, sn pping up all the Class A stock he could af ord every time some became available. 5 from one generation to t i

ares were handed e next, with an ad-

monition: ‘Don’t you eve4 sell that Reynolds stock.’ “(p. 48).

PRICE ranges from $77 t $100 during the buyout period with a me BA!X ranges from $10 t trading days with a %

n value of $91. $43 over the 76

mean value of $21. The correlation between PRIG and BASIS is -0.26. The null of correc under the White (1980) t ‘:

model specification st is not rejected at

the 0.05 level. To test for1 nonlinearity, we in- eluded the square of PRI E as an explanatory variable in an additional r gression. The coef-

1 ficient on the squared ter is not significantly different from zero.

When the dependent Andy explanatory variable are reversed, the coefficie n t on BASIS, the new explanatory variable, ,is -0.20, providing an alternative exposition of the relation.

The direct benefits of shifting the capital gains taxes from 1988 to 11989 are largely the time value of money for three months. Taxes arising from 1988 sales J ould be paid with the January 1989 estimat d tax payments unless the shareholder had ,’ ufficient labor income to withhold throughout the year. Like-

1 THE LOCK-IN EFFECT OF CAPITAL GAINS TAXES

wise, taxes arising from 1989 sales generally would be paid with the April 1989 estimated tax payments. However, deferral until 1989 would provide the taxpayers with additional time (the remainder of 1989) to rearrange their affairs to lower their tax liability (e.g., generate capital losses).

*’ White’s (1980) heteroskedasticity-consistent standard error estimates are used to correct for an unspecified form of model misspecification.

REFERENCES

Auten, Gerald. “Capital Gains: An Evaluation of the 1978 and 1981 Tax Cuts.” In New Directions in Federal Tax Policy for the 198Os, edited by Charls Walker and Mark Bloomfield. Cambridge, MA: Ballinger, 1983.

Auten, Gerald and Charles Clotfelter. “Perma- nent Versus Transitory Tax Effects and the Real- ization of Capital Gains.” Quarterly Journal of Economics 9? (1982): 613-32.

Bagwell, Laurie. “Share Repurchase and Take- over Deterrence.” RAND Journal of Economics 22 (1991): 72-88.

Brown, David T. and Michael D. Ryngaett. “The Mode of Acquisition in Takeovers: Taxes and Asymmetric Information.” Journal of Finance 46 (1991): 653-69. Burrough, Bryan and John Helyar. Barbarians at the Gate: The Fall of RJR Nabisco. New York: HarperCollins Publishers, 1990.

Constantinides, George. “Capital Market Equi- librium with Personal Tax.” Econometn’ca 51 (1983): 61 l-36.

Cook, Eric and John O’Hare. “Capital Gains Redux: Why Holding Periods Matter.” National Tax Journal 45 No. 1 (March 1992): 53-76. Cook, Eric and John O’Hare. “Issues Relating to the Taxation of Capital Gains.” National Tax Journal 40 No. 3 (September, 1987): 473-88.

Public Economics 9 (1978): 17-36. Feldstein, Martin, Joel Slemrod, and Shlomo Yitzhaki. “The Effects of Taxation on the Selling of Corporate Stock and the Realization of Capi- tal Gains.” Quarter/y Journal of Economics (June, 1980): 777-91. Henderson, Yolanda. “Capital Gains Tax Rates and Stock Market Volume.” National Tax Journal 43 No. 4 (December, 1990): 41 l-25. Kadapakkam, Palani-Rajan and Sarabjeet Seth. “Capital Gains Taxes and Shareholders’ Response to Tender Offers: Evidence from Dutch Auction Repurchases.” University of Houston Working Paper. Houston: University of Houston, 1991. Kiefer, Donald. “Lock-in Effect Within a Simple Model of Corporate Stock Trading.” National Tax Journal 43 No. 1 (March, 1990): 75-94. Minarik, Joseph. “Capital Gains.” In How Taxes Affect Economic Behavior, edited by Henry Aaron and Joseph Pechman. Washington, D.C.: The Brookings Institution, 1981. Stiglitz, Joseph. “Some Aspects of the Taxation of Capital Gains I’ Journal of Public Economics 21 (1983): 257-94. Stulz, Rene. “Managerial Control of Voting Rights: Financing Policies and the Market for Corporate Control.” Journal of Financial Eco- nomics 20 (1988): 25-54. Tobin, James. “Estimation of Relationships for Limited Dependent Variables.” Econometrica 26 (1958): 24-36. U.S. Congressional Budget Office. How Capi- tal Gains Tax Rates Affect Revenues: The Histori- cal Evidence. Washrngton, D.C.: 1988. U.S. Department of the Treasury. Report to Congress on the Capital Gains Tax Reductions of 1978. Washington, D.C.: 1985.

White, Herbert. “A Heteroskedasticity- Consistent Covariance Matrix Estimator and a Di- rect Test for Heteroskedasticity.” Econometrica 48 (1980): 817-83. Yitzhaki, Shlomo. “An Empirical Test of the Lock-in Effect of the Capital Gains Tax.” Review of Economics and Statistics (1979): 626-9.

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