Case Analysis on

Effective “Estee-te” Tax Planning through Financial Engineering:

Estee Lauder Companies, Inc.

Financial Management II (FM2BJ22-3)

Submitted to
Prof. A Kanagaraj

Submitted by
Section BM B: Group 4
Name Roll No.
Dyutita Ajith BJ22065
Karthik R Shetty BJ22070
Kaushik BJ22072
Gurumurthy
Nikhil Vankayala BJ22075

Submitted on
24 March 2023
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Executive Summary
The purpose of the meeting with Junita Malvaez, senior banker at Goldman Sachs & Co., was to
discuss a proposed issuance of new securities to maximize the wealth of Leonard's family, which
owned nearly 90% of the outstanding ELC shares. Leonard Lauder is the son of Estee Lauder and
chairman of the board and CEO of Estee Lauder Companies, Inc. (ELC). Malvaez surmised that
Estee's 90th birthday was the trigger for the Lauder family's interest in imaginative exit plans for
her. Financial gurus started advising her to do some estate planning because her days were
numbered. The goals they sought to achieve through the completion of the transaction are listed
below.

1.Hedge themselves against the possibility of declines in their mother's shares' fair value between
the time of the sale and her passing.
2.Increase Estee's personal portfolio's diversity
3.Provide some amount of monetization for various personal interests.
4.Defer to the maximum extent possible any tax repercussions involved with pursuing these goals.

The Lauder sons could fulfill the first three objectives with an outright sale of a portion of their
mother's shares, but the federal income tax repercussions would be quick and costly. Estee would
pay long-term capital gains taxes following the sale of her shares; then any remaining assets that
she donated to her family, including the after-tax income from the sale, would be subject to federal
estate tax upon death. Advisors had suggested that leaving Estee's shares to her family in the event
of her passing was another option. The shares would be transferred to her family on a fresh basis
determined by their fair market value on Estee's passing.

It would not have any negative effects on her income tax to "step up" the base of her shares to fair
market value. Her family could sell the shares after her death and only recognize tax consequences
on the gain or loss arising after her death. Given Estée's extremely low basis in the firm equity,
giving her shares to her family permitted them to avoid paying significant income taxes. The fair
market value of the stock Estée left as a bequest would be subject to federal estate taxes. The
Lauder family would have $24 million more after federal income and estate taxes if it waited to sell
the shares until after Estée's death.

There were many strategies available in 1995 to achieve the goals of hedging downside risk,
diversifying portfolios, monetizing equity positions, and reducing tax obligations. This was due to
the emergence of derivative securities in both the debt and equity markets, as well as the
innovation of tax attorneys, investment bankers, and accountants. The following alternatives could
be used instead:

1. Outright sale of securities

2. Performance exchange
3. Protective Put
4. Equity Collar
5. Short against-the-box (SAB)
 The plan was to use SAB to partially hedge Estee's long position until her passing, at which
point the shares would pass to her heirs and receive a stepped-up basis, eliminating the
need for further tax payments. However, the new regulation as per TRA’ 97 did not favour
this. This led to researching further possibilities through hybrid security issuances. In a
manner similar to how Times Mirror had issued PEPS three years prior, GS offered to the
family that they issue securities called TRACES. The key challenge now was persuading the
client that the suggested course of action was the best one.

Issues
The fundamental issue, in this case, stems from Malvaez needing to explain, to the Lauder family,
the complexities of hybrid securities and derivatives to the customer, as they had suggested issuing
hybrid securities called Trust Automatic Common Exchange Securities (TRACES).

Moreover, before she reached the above recommendation, she faced the following issues

One of the issues she faces while attempting to accomplish the four main goals either leads to the
first three goals being reached while the tax payment issue persisted, or the first three goals not
materializing if the tax issue was resolved. So, it was vital to design a plan so that all 4 objectives
could be realized concurrently.

After extensive thought, 2 methods, i.e., outright sales of securities and short-against-the-box (SAB)
strategies were identified as the most attractive ones. But the hazard for outright sales of securities
was the low basis Estee had in her shares, which would result in complications in the tax
ramifications.

However, Adopting SAB strategy also became undesirable due to the TRA ’97, which reduced an
investor’s ability to defer taxes through a SAB transaction.

Alternatives
1. Outright sale of securities:
This option provides the best and most straightforward case for monetizing equity positions. The
options of diversifying the portfolio are also left open through the liquidity aspect

2. Performance Exchange:
This particular option was an over-the-counter derivative transaction that allowed the investor to
swap their exposure in Estee stock with exposure to other securities. Estee would simultaneously
buy the call from an investment bank which would pay them the positive difference between the
return on security and the ELC stock and sell a call option to an investment bank and pay the
negative difference between the returns. The advantages of this particular alternative allowed them
to hedge the risk in terms of ELC, earn the stock index return, and also retain the voting rights in the
family along with deferring the capital gain taxes. This option however did not provide liquidity.
The performance exchange strategy was based on the risk of the performance of the company to
generate future revenue, cash-flows, and profits.

3. Protective Put:
Protective put option helps to hedge the risk against the downside of the asset. ELC would need to
purchase a listed put option on the common stock. ELC would then exercise the option if it was in
the money and force the counterparty to buy the shares at a substantial price. This way it could
ensure its minimum gain with unlimited upside potential and also not incur capital gain taxes.
There is however the risk of potential capital loss if the stock price moved above the strike price.
This transaction needed the existence of an options market in the security and would require the
company to have an IPO. Further, the put would require upfront cash which is a function of the
options maturity and strike price as well as the volatility of the ELC stock price.

4. Equity Collar:
It involves the purchase of a put option to protect against a decline in the stock's price, along with
the sale of a call option to offset the cost of the put option. Essentially, the equity collar sets a range
of prices within which the stock's price can move without significantly impacting the investor's
position. ELC could leverage this alternative by setting the price ranges for the strike prices for the
put and call options. It would provide them with protection from upward and downward
fluctuations in the ELC stock price. The cost was a function of the strike price and the duration of
the option. This option too required the existence of an options market in the security and would
require the company to have an IPO.

5. Short against box (SAB):

In a typical SAB transaction, we can borrow shares of a company from a broker or relative and then
short the position. So here in this case Estee would have to borrow shares from other family
members to go short and then sell the borrowed shares. Benefits of this position:

1. Hedge against the market risk – every increase in the value of the long position would be
offset by the loss in the short position and vice versa
2. Estee did not get a direct equivalent of cash for the liquidity aspect. But the regulation
allowed investors to withdraw 95% of cash generated through a short position
3. If the price of the stocks appreciated before Estee’s death and both the positions were
liquidated post the death then
a. Eliminate the federal income tax consequences on the long position
b. Capital loss against the short position could be offset using the future gains
4. The transaction from the liquidation position allowed Estee to monetize her cash and
diversify her portfolio through other investments
Effect of TRA’97 on ELC’s SAB Transaction
Shorting securities in a taxable account while keeping the same securities in a non-taxable account,
such as a tax-exempt retirement account, is a short-against-the-box strategy. This approach allows
the investor to lock in a present gain on the short sell while postponing recognition of the long
position gain until later.

Prior to the TRA '97, the tax legislation enabled ELC to delay capital gains recognition on the long
position of an SAB transaction indefinitely. This makes the technique appealing to ELC looking to
limit their tax bills while preserving exposure to the assets they own.

Nevertheless, the TRA '97 imposed new restrictions that curtailed ELC' ability to postpone the
realization of gains on long positions in SAB transactions. Gains on the long position must be
recorded when the short sale is concluded under the new regulations, even if the investor continues
to hold the long position.

Finally, due to the introduction of the TRA'97, the SAB traction failed to achieve and partially failed
its purpose. Consequently the Lauder family need another way to attain their tax avoidance aim

Trust Automatic Common Exchange Securities (TRACES) and how it

works
The TRACES securities approved by GS are a sort of hybrid security that also uses derivatives. The
TRACES structure includes the usage of a put option. The put option is employed in the case of
TRACES to protect investors from losses in the value of the underlying portfolio of equities. If the
underlying portfolio's value falls below a specific threshold, the put option is exercised. This helps
to reduce the ELC's negative exposure because they may sell the portfolio at a fixed price even if the
underlying equities' values continue to fall.

It not only mitigates downside risk, but also assists the Lauders family with diversification and
liquidity. They are able to raise money for themselves by creating TRACE, which produces liquidity.
This money may be utilized for a variety of purposes, including individual explants, debt
repayment, and, most crucially, portfolio diversification. Because ELC holds the majority of the
Lauders family's fortune, they were unable to diversify their holdings and hence risk. Consequently,
TRACEs aided the Lauder family in terms of liquidity and diversification.

The issuing of TRACES enabled GS to imitate the performance of ELC's shares without actually
owning them, which was a crucial component of ELC's tax advantage.GS created TRACES that
mimicked the risk and return profile of ELC's shares while also allowing ELC to swap its shares for
the synthetic index and earn a tax advantage.