Equity derivatives: selected US legal issues

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2 Equity derivatives: selected US legal issues Witold Balaban, John M Brandow, James T Rothwell and Joyce Y Xu Davis Polk & Wardwell 1. Introduction This chapter introduces selected US legal issues raised by equity derivative transactions. An understanding of these issues requires a basic understanding of the business issues presented by the transactions themselves, as well as the surrounding business practices What are equity derivatives? Derivatives are financial instruments that derive their value from the value of something else, such as interest rates, commodities or securities. 2 Equity derivatives are derivatives that derive their value from the value of underlying equity securities. Equity derivatives generally transfer the risks and benefits of owning the underlying securities from one party to another, thereby allowing parties to gain or dispose of economic exposure to the underlying equity securities. Thus, equity derivatives effectively enable their users to buy and sell equity securities synthetically. The particular securities underlying an equity derivative can be equity securities of a single issuer, an equity index or a basket of equity securities of various issuers or equity indices. This chapter focuses principally on equity derivatives that relate to shares of common stock traded in the US equity markets. 1.2 The dealer and its hedging activities Banks, broker-dealers or other financial intermediaries (for the sake of simplicity, the term dealer is used to mean any such entity) enter into equity derivatives to provide their end-user clients with the ability to gain synthetic long or short exposure to particular underlying shares. As derivatives involve a transfer of economic exposure from one party to the other, the dealer that is a party to an equity derivative transaction will have exposure on the opposite side of the market to the dealer s client. For example, if a dealer writes a swap or an option to an end user that results in the end user being long the underlying shares, the transaction will necessarily result in the dealer having short exposure. Generally, dealers that are party to these transactions are not motivated by a particular directional view as to the value of the underlying shares. Therefore, dealers will generally try to hedge their exposure to the 1 The legal issues discussed in this chapter are raised primarily by transactions that relate to equity securities (including American depositary receipts) traded in the US equity markets. 2 See John C Hull, Options, Futures & Other Derivatives (6th Ed, 2006) at p

3 Equity derivatives: selected US legal issues underlying shares so that their net economic position is neutral. For example, in an equity derivative transaction in which the end user is synthetically selling the underlying shares to the dealer, the economic risks and benefits of owning the shares are transferred from the end user to the dealer. The dealer s economic position in the transaction is long that is, its value moves in the same direction as the value of the underlying shares, increasing as the value of the underlying shares increases and decreasing as the value of the underlying shares decreases. To hedge its long position, the dealer will need to enter into a transaction or transactions that provide the dealer with an offsetting short position; this type of hedge is referred to as a short hedge. The most common short hedge is a short sale, which involves borrowing shares in the stock loan market and selling them in the cash market. 3 A short hedge could also take the form of a sale of futures contracts or call options, a purchase of put options or a short swap position. In contrast, in a transaction in which the dealer is synthetically selling shares to the end user, the economic risks and benefits of owning the shares are transferred from the dealer to the end user. The dealer s economic position in such a transaction will be short that is, its value moves in the opposite direction as the value of the underlying shares, decreasing as the value of the underlying shares increases and increasing as the value of the underlying shares decreases. To hedge its short position, the dealer will need to enter into a transaction or transactions that provide the dealer with an offsetting long position; this type of hedge is referred to as a long hedge. The most common long hedge involves buying shares in the cash market, but a long hedge could also take the form of a purchase of futures contracts or call options, a sale of put options or a long swap position. This chapter focuses principally on hedging by buying or selling shares in the cash market. Dealers generally hedge derivatives using proprietary models based on mathematical properties of the derivative. One such property, delta, measures the amount by which the derivative increases or decreases in value for a given change in the value of the underlying shares (or, in mathematical terms, the first derivative of the value of the derivative contract as a function of the value of the underlying asset). For example, consider a derivative contract relating to n shares. If the value per underlying share changes by x dollars, the value of the contract would change by an amount equal to the product of n, x and the delta of the contract. The delta of a derivative itself changes over time and as the value of the underlying shares (and other factors) change. Dealers determine the value of derivative contracts using proprietary option valuation models that apply inputs such as the strike price of the option embedded in such contract, the market value of the underlying shares, the price volatility of the shares, dividends and interest rates and the remaining term of the contract. 4 3 A short sale creates an economic short position because of the borrowed shares. The dealer must eventually return shares to the share lender. If the value of the shares increases, the dealer will need to pay more to purchase those shares in the market to return to the share lender (referred to as covering the short position) than it received in proceeds from the sale of the borrowed shares, so the dealer will lose money on the transaction as the value of the shares increases. Conversely, the dealer will be able to cover its short position more cheaply if the share price decreases, so the dealer will make money on the transaction as the value of the shares decreases. 140

4 Witold Balaban, John M Brandow, James T Rothwell and Joyce Y Xu In order to have a neutral net position with respect to an equity derivative contract, the value of the dealer s hedge position at any time must completely offset the value of the contract to the dealer at such time. Thus, in order to hedge a long position under an equity derivative contract relating to n shares, the dealer will establish and maintain a short hedge position consisting of a number of shares equal to the product of n and the delta of the contract. For example, if the contract relates to 100 underlying shares and has a delta of 0.8, the dealer s short position will be 80 shares. As a result, if the value of the shares increases by one unit, the value of the contract will increase by 80 units (one unit per share multiplied by 100 shares underlying the contract multiplied by the delta of 0.8) and the value of the short position will decrease by 80 units (one unit per share multiplied by 80 shares short), so that the dealer s net position remains neutral. As the delta of the contract changes over time, the dealer will adjust its hedge position accordingly by buying or selling shares, so that its hedge position remains neutral and it neither gains nor loses, on a net basis, when the stock price fluctuates. The dealer s long or short hedge position of the initial delta of a derivative transaction is often referred to as the dealer s initial hedge. The dealer s subsequent adjustments of its hedge position to match the changes in the delta of the contract over the term of the transaction are often referred to as dynamic adjustments. The discussions that follow focus on the US legal issues presented by different types of common equity derivative transaction. Many of the legal issues that arise in equity derivative transactions relate to the dealer s hedging activity. 1.3 Overview of US legal issues Not surprisingly, the legal issues raised by synthetic purchases and sales of equity securities through derivatives are similar to those raised by actual purchases and sales of equity securities. In the United States, these include securities law issues, bank regulatory issues, broker-dealer regulatory issues, margin issues, credit issues, short sale regulation issues and commodities law issues, among others. (a) Registration requirement under the Securities Act of 1933 Section 5 of the Securities Act of 1933 (as amended) prohibits the offer or sale of any security in the United States unless a registration statement is effective under the One valuation model is the Black-Scholes option pricing formula, which can be expressed as: where and c = option value. S0 = stock price at time 0. N(x) = the cumulative probability distribution function for a variable that is normally distributed with a mean of zero and a standard deviation of 1.0. X= strike price. T = time remaining until expiration. r = current risk-free interest rate. Û = annual volatility of stock price. Hall, supra footnote 2, p

5 Equity derivatives: selected US legal issues act or an exemption from registration is available. 5 Sales pursuant to an effective registration statement subject the issuer, selling shareholders, underwriters and other sellers to liability for material misstatements or omissions contained in the disclosure given to investors (in the form of a prospectus, which forms part of the registration statement) under Sections 11 and 12. Sections 3 and 4 of the 1933 act provide exemptions for certain securities and for certain types of offers and sales, respectively. 6 Issuers that sell their shares in the United States in a private placement to a select group of sophisticated investors may rely on the exemption provided by Section 4(2) for transactions by an issuer not involving any public offering. 7 However, if an issuer is selling its shares in the US public market and the shares being sold are not exempt from registration under Section 3 of the 1933 act, the issuer must register such sale with the Securities Exchange Commission (SEC). Investors that resell shares in the US market also need to rely on registration or an exemption from registration. Investors that sell without registration often rely on the exemption provided by Section 4(1) of the 1933 act for transactions by any person other than an issuer, underwriter, or dealer. 8 However, this exemption is generally not available if the investor is a person that controls, is controlled by, or is under common control with, the issuer (often referred to as an affiliate of the issuer), and may not be available if the investor holds shares recently acquired from the issuer or an affiliate of the issuer in a private placement. In these situations the investor may be able to rely on the safe harbour provided by Rule 144 under the 1933 act. Rule 144 provides a safe harbour from registration for anyone selling shares received from the issuer or an affiliate of the issuer in a private placement ( restricted shares ), and for affiliates selling any shares of the issuer. In order to be entitled to the safe harbour provided by Rule 144, a person selling restricted shares must have a holding period of at least one year. In addition, such a person, or any affiliate of the issuer, must: limit the number of shares sold in specified periods to a prescribed volume limit; follow certain manner-of-sale and current information requirements under Rule 144; and file a Form 144 with the SEC and the relevant stock exchange at the time of the sale. 9 A non-affiliate that has a holding period of at least two years in the restricted shares, and has not been an affiliate in the past 90 days, may sell such shares into the public market in reliance on Rule 144(k) without observing the above restrictions. 10 If an issuer, or a shareholder that is an affiliate of the issuer or holds restricted shares, enters into an equity derivative transaction with a dealer that results in the 5 See 15 USC Section 77e. 6 See 15 USC Sections 77c and 77d. 7 See 15 USC Section 77d(2). 8 See 15 USC Section 77d(1). 9 See 17 CFR Section See 17 CFR Section (k). 142

6 Witold Balaban, John M Brandow, James T Rothwell and Joyce Y Xu dealer having an economic long position, and the dealer sells shares into the US public market to hedge the transaction, the issue arises as to whether these sales by the dealer should be subject to the same registration requirement as sales made directly by the issuer or shareholder. (b) Insider trading rules and safe harbour Section 10(b) of the Securities Exchange Act of 1934 (as amended) is a general antifraud provision that makes it unlawful to use or employ, in connection with the purchase or sale of any security, any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the [SEC] may prescribe as necessary or appropriate in the public interest or for the protection of investors. 11 Rule 10b-5 under the 1934 act makes it unlawful, in connection with any purchases or sales of securities in the United States, to make any untrue statement of a material fact or to omit to state a material fact necessary in order to the make the statements made, in the light of the circumstances under which they were made, not misleading or to act in a fraudulent manner in buying or selling securities. 12 Generally, Rule 10b-5 is interpreted as prohibiting a person who has material non-public information about a company and who can be said to owe a duty of non-disclosure (eg, attorneys, accountants and employees and their families) from purchasing or selling the company s shares on the basis of that information. Under Rule 10b5-1, any person aware of material non-public information at the time a purchase or sale is made is deemed to have traded on the basis of that material non-public information. However, Rule 10b5-1 also provides an affirmative defence to an insider trading charge if the person demonstrates that the trade was effected pursuant to a binding contract, an instruction to another person to buy or sell the shares, or a written plan, in each case made or entered into at a time when the person was not aware of the material non-public information. Such contract, instruction or plan must be entered into in good faith and must: specify the amount of shares to be purchased or sold, the timing of the trades and the prices at which the share may be purchased or sold; include an algorithm or formula for determining such parameters; or give full trading discretion to a broker or other third party and not permit the person establishing the plan to have any influence over the purchases or sales. Rule 10b5-1 is available to both issuers and insiders, making it possible for them to trade the company s securities during blackout periods 13 when they might be expected to have material non-public information. 14 If an issuer or insider enters into an equity derivative transaction with a dealer, 11 See 15 USC Section 77j(b). 12 See 17 CFR Section (b) Issuers often forbid insiders from trading in their securities during periods when insiders might reasonably be expected to be aware of material non-public information, such as the period preceding the public announcement of the issuer s quarterly results. 14 See 17 CFR Section (b)

7 Equity derivatives: selected US legal issues and the dealer buys or sells shares of the same class as the underlying shares to hedge the transaction, the issue arises as to whether those purchases or sales raise the same insider trading concerns as purchases or sales made directly by the issuer or insider. (c) Section 13 reporting requirements Sections 13(d) and (g) of the 1934 act impose reporting requirements on beneficial owners of 5% or more of any class of voting equity securities of any issuer that is publicly traded or quoted in the United States. 15 In particular, upon becoming a 5% beneficial owner, the shareholder must disclose its ownership on a Schedule 13D. 16 The shareholder may be eligible to file an abbreviated filing (Schedule 13G) if it meets certain requirements. 17 A 5% beneficial owner must also report material changes to its ownership by filing amendments to Schedule 13D or 13G. 18 Schedule 13D filers must report these changes promptly and must also report, and file copies of documents relating to, transactions relating to material portions of their holdings, including derivatives (even if purely cash settled). 19 Rule 13d-3 under the 1934 act defines a beneficial owner of a security as any person who, directly or indirectly, through any contract, arrangement, understanding, relationship, or otherwise has or shares the power to vote, or to direct the voting of, such security, and/or power to dispose, or to direct the disposition of, such security. 20 Rule 13d- 3 also states that any person having the right to acquire beneficial ownership of any security within 60 days whether through the exercise of an option or the conversion of a security or other arrangements shall be deemed to be a beneficial owner of the security to be received. 21 In addition, under Rule 13d-5 under the 1934 act, if two or more persons agree to act together for the purpose of acquiring, holding, voting or disposing of equity securities of an issuer, those persons will be considered a group whose holdings in all equity securities of that issuer would be aggregated for purposes of determining beneficial ownership. 22 Such an agreement need not be in writing to create a group. In an equity derivative transaction that would result in the dealer or end user beneficially owning, or having economic exposure to, additional shares, the issue arises as to whether the position should be reported under Section 13, and whether the transaction or related agreements would result in the bank or end user becoming a member of a reporting group. 1.4 Section 16 reporting requirements and short-swing profits Section 16 of the 1934 act imposes reporting requirements and liability for shortswing profits on insiders of companies. An insider for the purposes of Section 16 is a beneficial owner of 10% or more of any class of voting equity securities of any issuer that is publicly traded or quoted in the United States, or a senior officer or 15 See 15 USC Sections 77m(d) and (g). 16 See 17 CFR Section d-1(a). 17 See 17 CFR Sections d-1(b), (c) and (d). 18 See 15 USC Sections 77m(d)(2) and (g)(2) and 17 CFR Section d See 17 CFR Section d See 17 CFR Section d See id. 22 See 17 CFR Section d

8 Witold Balaban, John M Brandow, James T Rothwell and Joyce Y Xu director of any issuer that has such a class of equity securities. 23 For the purpose of determining 10% beneficial ownership, Section 16 uses the same definition of beneficial ownership as Section 13(d). 24 Section 16 does not apply to the securities of foreign private issuers, which are generally non-us companies for which the principal equity trading market is not in the United States. 25 Section 16(a) requires an insider to report beneficial ownership upon becoming an insider of an issuer and to report any subsequent changes in beneficial ownership of equity securities of the issuer within two days. 26 Rule 16a-4 under the 1934 act specifically requires that the acquisition or disposition of any derivative security relating to shares of that issuer be separately reported. 27 Section 16(b) provides for disgorgement of theoretical profits earned by any insider from purchase and sale (or sale and purchase) transactions entered into within six months of each other. 28 Section 16(b) is a strict liability statute, and the profits required to be disgorged are the highest theoretical profits obtained by matching purchase and sale transactions within six months of each other. Depending on the actual sequence and timing of the purchases and sales, the theoretical profit may be greater than any actual trading profit earned by the insider (and in fact, the insider may even have a theoretical profit where there was an actual trading loss). 29 Under Rule 16b-6 under the 1934 act, entry into an equity derivative transaction is generally considered a purchase or sale of the underlying securities for the purposes of Section 16(b) that is matchable with other sales or purchases (or other derivatives) within six months. 30 The closing of a derivative position upon exercise or conversion of the derivative is generally exempt from Section 16(b); however, expiration of derivatives, and net cash or net share settlement methods, can give rise to transactions for which no express exemption is available. Section 16(c) prohibits any insider from executing short sales, sales that do not close in 20 days or uncovered short derivative transactions. 31 In executing equity derivative transactions, an insider should consider how and when to report the transaction, and whether the transaction will result in any matchable sales and purchases within six months. Further, a dealer entering into an equity derivative transaction should consider whether the transaction or the dealer s hedge or related arrangements could make the dealer a Section 16 insider or part of an insider group. 23 See 15 USC Section 78p(a)(1). 24 See SEC Release Nos ; ; IC-17991, at II.3 (February ) and 17 CFR Section a See 17 CFR Section 240.3a12-3. Note that Section 13 does, however, apply to the securities of foreign private issuers. 26 See 15 USC Section 78p(b). 27 See 17 CFR Section a See 15 USC Section 78p(b). 29 For example, imagine that a hypothetical insider buys a share at $100 on January 1, sells it at $90 on February 1, buys another share at $80 on March 1 and sells it at $70 on April 1. As an economic matter, the insider has lost $10 on each purchase and sale, for a total loss of $20. However, the Section 16 rules would allow the purchase at $80 on March 1 to be matched with the sale at $90 on February 1, resulting in a theoretical profit of $10, which the insider could be forced to disgorge to the issuer. 30 See 17 CFR Section b See 15 USC Section 78p(c). 145

9 Equity derivatives: selected US legal issues 1.5 Market manipulation issues and the Rule 10b-18 safe harbour Section 9 of the 1934 act prohibits transactions intended to create, or that actually create, a false or misleading appearance of active trading in any security registered on a national securities exchange, or a false or misleading appearance with respect to the market for any such security. 32 Generally, if an issuer is purchasing its own shares in the open market, it should take care to do so in a manner that does not violate Section 9. Rule 10b-18 under the 1934 act provides a safe harbour from certain types of manipulation claims 33 for purchases by an issuer of its own shares in the United States. In order to rely on the Rule 10b-18 safe harbour, the issuer must: make its purchases after the opening transaction in the market and prior to the last 10 minutes (for stocks having a $1 million average daily trading volume (ADTV) and $150 million public float) or the last 30 minutes (for other stocks) before the scheduled close of trading; not repurchase more than 25% of the ADTV for its common stock on any given day (subject to a limited exception allowing one block purchase per week); purchase shares only at prices that do not exceed the greater of the highest independent bid and the last independent transaction price quoted or reported in the consolidated system; and not engage more than one broker to buy shares on any day. 34 If an issuer enters into an equity derivative transaction with a dealer that results in the dealer having an economic short position under the transaction, and the dealer buys shares to hedge the transaction, the issue arises as to whether those purchases by the dealer raise the same manipulation concerns as purchases made directly by the issuer. 1.6 Regulation M Regulation M generally prohibits an issuer engaging in a distribution of its securities, and others that have an interest in such distribution, from purchasing or bidding for securities of the same class as, or related to, the securities being distributed during a specified restricted period applicable to the distribution. Rule 101 of Regulation M applies to distribution participants (other than the issuer or any selling security holder) and their affiliated purchasers, and provides an exemption for purchases of actively traded securities ($1 million in ADTV and $150 million of public float). 35 Rule 102 of Regulation M applies to the issuer, any selling shareholders and their affiliated purchasers, and does not have an exemption for actively traded securities. 36 If an issuer or selling shareholder enters into an equity derivative transaction that will result in the dealer purchasing shares to hedge its exposure under the transaction, and such issuer or selling shareholder is, or will be, engaged in a 32 See 15 USC Section 78i. 33 Rule 10b-18 does not provide a safe harbour from the requirements of Rule 10b-5 under the 1934 act. 34 See 17 CFR Section b See 17 CFR Section See 17 CFR Section

10 Witold Balaban, John M Brandow, James T Rothwell and Joyce Y Xu distribution of shares during the term of the transaction, an issue arises as to whether such purchases of the shares by the dealer during the distribution period could be seen to violate Regulation M. 1.7 Bank regulatory issues US banking regulation is generally relevant to equity derivative transactions in two principal respects if a US bank or a subsidiary of a US bank holding company is involved in the transaction. The first relates to whether the corporate entity in question (bank or bank holding company subsidiary) has the power to enter into the equity derivative transaction at issue. The second relates to the authority under which the bank or bank holding company subsidiary can own equity securities in order to hedge its exposure to the derivative. It is generally well established that US banks 37 (both national banks and banks chartered by US states) have the power to enter into customer-driven equity derivative transactions as a form of permissible financial intermediation that is part of the business of banking. 38 However, federal and state bank regulators may wish to evaluate a bank s systems before permitting a bank to commence such a business, in order to ensure that the business is conducted in a safe and sound manner. Similarly, non-bank subsidiaries of bank holding companies 39 have the power to engage in such transactions, because doing so has been deemed to be an activity closely related to banking within the meaning of the US Bank Holding Company Act of A bank owning shares as part of a long hedge raises concerns principally under two federal statutes Section 16 of the Glass-Steagall Act 41 and the Bank Holding Company Act. 42 Section 16, which on its face applies to national banks only, but has been extended to Federal Deposit Insurance Corporation-insured state banks by certain provisions in the Federal Deposit Insurance Act, restricts the ability of banks to own equity securities for their own account. The Bank Holding Company Act limits the amount of equity that a bank holding company and its non-bank subsidiaries may own. For many years, market participants believed that banks could not own equity securities to hedge equity derivative transactions consistent with the Glass-Steagall Act. However, in 2000 the Office of the Comptroller of the Currency, the principal regulator of national banks, stated that, subject to certain limitations, hedging equity derivatives was a permissible banking activity and did not violate the Glass-Steagall Act because it was neither an underwriting nor a dealing activity. 43 The principal limitations on this position are that the banks cannot maintain any residual positions in equities that are not directly for hedging, either on an individual or portfolio basis, 37 Bank generally means a banking institution whose deposits are insured by the Federal Deposit Insurance Corporation. 38 Many equity derivatives activities, moreover, fall within the identified banking product exception to the dealer push out rules in the Securities Exchange Act of As a result, many such activities may be conducted in a bank entity and need not be moved into a regulated broker-dealer. 39 A bank holding company is a company that owns one or more banks. 40 See Swiss Bank Corporation, 81 Federal Reserve Bulletin 185 (1995) USC Section 24 (SEVENTH) USC Sections 1841 et seq. 43 See Office of the Comptroller of the Currency Interpretive Letter 892 (September ). 147

11 Equity derivatives: selected US legal issues and that the equities held cannot be greater than 5% of a class of an issuer s stock. 44 In addition, the Office of the Comptroller of the Currency stated that its review of a bank s risk management was necessary before the bank could undertake the activity. 45 After this interpretation, hedging equity derivatives also became a permissible activity for state banks, as long as the relevant state banking supervisor also approved the activity. In 2003 the New York State Banking Department reached a similar conclusion to that of the Office of the Comptroller of the Currency in interpreting the New York State Banking Law. 46 If the equity positions that make up the hedge are not held by the bank itself, different rules apply. For example, the equity securities can be held by domestic nonbank subsidiaries, in which case there are two possible sets of rules, depending on whether the bank holding company is a financial holding company. 47 If the bank holding company is not a financial holding company, its holdings of any one issuer will generally be limited to 4.9% voting share ownership on a consolidated basis, with up to an additional 20% of non-voting shares generally allowed. 48 If the bank holding company is a financial holding company, it may own an unlimited number of voting and non-voting shares under the so-called merchant banking authority, as long as it does not routinely manage the company at issue and disposes of its shares within 10 years Broker-dealer regulation Section 15 of the 1934 act generally requires any person acting as a broker or dealer in securities to be registered with the SEC. 50 Section 3(a)(4) of the 1934 act defines broker generally as any person engaged in the business of effecting transactions in securities for the account of others, while Section 3(a)(5) of the 1934 act defines dealer generally as any person engaged in the business of buying and selling securities for such person s own account through a broker or otherwise. 51 Registered broker-dealers are also subject to regulation by the SEC and self- 44 See id. 45 See id. 46 See letter from Sara A Kelsey to Marcia Wallace (April ). 47 A financial holding company is a bank holding company whose bank subsidiaries are well capitalised and well managed and have satisfactory ratings under the Community Reinvestment Act. See id Sections et seq. 48 See 12 USC Section 1843(c)(6). 49 See 12 CFR Sections et seq. 50 See 15 USC Section 78o. 51 See 15 USC Section 78c(a). There are a number of exceptions to these general requirements, including an exclusion from the definition of dealer in Section 3(a)(5) of the 1934 act, quoted above, for a person (often referred to as a trader ) that buys or sells securities for its own account, but not as part of a regular business. Also, the SEC s Rule 15a-6 under the Exchange Act permits limited dealings by foreign brokerdealers with US institutional investors and certain other entities, subject to various limitations and requirements. Historically, US banks have enjoyed broad exemptions from the definitions of broker and dealer under the 1934 act, and therefore from the 1934 act s broker-dealer registration requirements. The Gramm-Leach-Bliley Act of 1999 amended the 1934 act to replace these broad bank exemptions (though the blanket exemption for banks from the definition of broker has not been implemented by the SEC at the time of writing), thereby pushing out many securities activities from the bank and effectively requiring that such activities be conducted by a registered broker-dealer. However, many equity derivative activities fall within an exemption to these push out requirements that permits US banks to effect transactions in certain identified banking products directly, without registering with the SEC as a broker-dealer. 148

12 Witold Balaban, John M Brandow, James T Rothwell and Joyce Y Xu regulatory organisations such as the National Association of Securities Dealers (of which they are members), including requirements on net capital and book-keeping. (a) Margin issues Regulation T adopted by the Board of Governors of the Federal Reserve System governs securities credit made (in certain cases) or arranged by SEC-registered brokerdealers. 52 The self-regulatory organisations also have margin rules that apply to extensions of credit by broker-dealers. For long equity positions, Regulation T imposes an initial margin requirement of 50% for credit extended by a broker-dealer for most equity securities that are marginable under Regulation T, if such extension of credit is for the purpose of purchasing, carrying or trading such securities. 53 New York Stock Exchange (NYSE) members are subject to an initial margin requirement for securities credit, as well as a maintenance margin requirement for most equity securities. 54 The Federal Reserve s Regulation U governs extensions of credit by US lenders that are not broker-dealers (including US branches and agencies of non-us banks), where the credit is used to purchase or carry certain types of equity securities and is secured with certain types of equity securities. 55 Margin loans subject to Regulation U must not initially exceed 50% of the value of the shares pledged. 56 The Federal Reserve s Regulation X generally restricts US persons (or persons controlled by them) from obtaining credit in respect of certain equity securities in excess of the limitations of Regulations T and U. 57 Many equity derivative transactions involve credit exposure of one party to another and/or pledges of underlying shares as collateral (or could be recharacterised as such). Such transactions raise the question of whether they could be viewed as extensions of credit that would be subject to the limitations imposed by the aforementioned margin rules. 1.9 Credit and bankruptcy issues (a) Collateral issues If an equity derivative transaction is secured by collateral in the United States, the granting and perfection of the secured party s security interest and related rights are governed by the Uniform Commercial Code (UCC). If the pledgor or the collateral for the transaction is located outside the United States, then depending on the choice of law requirements of the particular jurisdiction, non-us law may apply instead. As collateral issues are often fact and jurisdiction specific, it is important for parties entering into secured equity derivative transactions to identify and consider the appropriate applicable law. 52 See 12 CFR Section See 12 CFR Sections 220.4(b)(1) and and the NYSE Handbook, NYSE Rule 431(b). 54 See the NYSE Handbook, NYSE Rule 431(c)(1). 55 See 12 CFR Section See 12 CFR Sections and See 12 CFR Section

13 Equity derivatives: selected US legal issues (b) Automatic stay Under Section 362 of the US Bankruptcy Code (as amended), when an entity becomes a debtor under the Bankruptcy Code, an automatic stay goes into effect that prevents other parties from collecting on pre-bankruptcy claims, enforcing liens, exercising rights of set-off and taking other actions against the debtor. 58 Exemptions from automatic stay for certain classes of protected contracts include securities contracts and swap agreements and their related collateral arrangements. 59 (c) Ipso facto provisions Section 365 of the Bankruptcy Code generally prohibits parties to contracts with the debtor from exercising contractual rights to terminate or modify the contract based on the debtor s bankruptcy or financial condition. Exemptions from the prohibition against the use of such ipso facto provisions for certain classes of protected contracts also include securities contracts and swap agreements. 60 (d) Subordination risk Under Section 510 of the Bankruptcy Code, claims arising under a contract with the issuer or an affiliate of the issuer (defined for this purpose as a 20% equity holder) to purchase or sell securities of the issuer could be subordinated to the level of equity in the issuer s bankruptcy. 61 In addition, under state corporate law, contracts by an issuer to purchase its own shares while insolvent are generally avoidable or void. Therefore, if a dealer enters into an equity derivative contract with an issuer or an affiliate of such issuer that results in the issuer actually or synthetically purchasing shares, this may raise subordination risk for the dealer Short sale issues Rule 10a-1 under the 1934 act prohibits short sales of securities that are listed on any US national securities exchange from being effected at a price (a down-tick ) below that at which the last regular-way sale was reported, or at such last price (a zero-plus tick ) unless the price is above the next proceeding different price at which a regular-way sale was reported. 62 Under a pilot programme under Regulation SHO under the 1934 act, the SEC has temporarily suspended the application of Rule 10a- 1 for stocks of certain US issuers included in a list of actively traded stocks, for short sales executed in certain other stocks after 4:15pm Eastern Time in the United States and for all other securities after the close of the consolidated tape until the open of the consolidated tape the next day. 63 Regulation SHO also requires, among other 58 See 11 USC Section See 11 USC Sections 555 and See 11 USC Section See 11 USC Section See 17 CFR Section a See 17 CFR Section T and SEC Release (November 2004). The pilot programme in question is scheduled to expire on August Self-regulatory organisations also have their own shortsale requirements; see, for example, NYSE Rule 440B. Although the NASDAQ Stock Market will shortly operate as a national securities exchange, it has requested exemptive relief from Rule 10a-1. The SEC has granted this relief on a temporary basis, permitting the continued application of a bid test for NASDAQ stocks, rather than the tick test contained in Rule 10a-1. See SEC Release (January ). 150

14 Witold Balaban, John M Brandow, James T Rothwell and Joyce Y Xu things, that before executing a short sale for its own account, a broker-dealer must have reasonable grounds to believe that it will be able to borrow the shares to be delivered in the short sale; before effecting a short sale for a customer, it must also have reasonable grounds to believe that a security has been or can be borrowed. 64 Rule 10a-1 and Regulation SHO generally apply to short sales in the United States by dealers to hedge equity derivative transactions Commodities law issues The Commodities Exchange Act prohibits over-the-counter (OTC) futures contracts on single stocks (without specifically defining the term futures contract ). 65 The Commodity Futures Modernization Act 2000 clarified that certain privately negotiated derivative transactions between sophisticated parties (called eligible contract participants ), and certain hybrid instruments that are predominantly securities, are outside the scope of the Commodities Exchange Act and the jurisdiction of the Commodity Futures Trading Commission. 66 The definition of eligible contract participant includes institutional investors and certain corporate entities such as financial institutions, as well as corporate entities and individuals with total assets in excess of $10 million. 67 Hybrid instruments are instruments the payout of which is indexed to other securities or commodities. In order for a hybrid instrument to be predominantly a security, the Commodity Futures Modernization Act requires that: the issuer of the instrument receive full payment of the purchase price contemporaneously with the delivery of the instrument; the purchaser not be obliged to make any payment to the issuer other than the initial payment of the purchase price; if the hybrid instrument is a secured debt instrument, the issuer not be subject to mark-to-market margin requirements; and the instrument not be marketed as a futures contract or an option on a futures contract. 68 Equity derivative transactions on single stocks that may be cash settled and are between parties that are not both eligible contract participants generally raise the issue of whether the transaction could be considered an illegal futures contract Other issues Equity derivatives also raise numerous tax, accounting and other legal and business issues that are beyond the scope of this chapter. 2. Certain equity derivative transactions This section covers selected legal issues raised by four general categories of equity 64 See 17 CFR Section (b)(1). 65 See 7 USC Section See Sections 103 and 105(a) of the Commodity Futures Modernization Act. 67 See Section 101(4) of the Commodity Futures Modernization Act. 68 See Section 105(a) of the Commodity Futures Modernization Act. 151

15 Equity derivatives: selected US legal issues derivative transaction namely, those in which: an end user that is not the issuer of the underlying shares (a third party ) is synthetically selling shares; a third party is synthetically buying shares; an issuer is synthetically selling its own shares; and an issuer is synthetically buying its own shares. It focuses in particular on one common transaction structure within each category. Because different issues are more important to different transactions, each legal issue mentioned above is not discussed in connection with each transaction structure. Some issues (eg, broker-dealer regulation) raise similar general concerns for all of the structures discussed below, so are not discussed below in relation to any specific structure. 2.1 Transactions in which a third party synthetically sells shares A third party can synthetically sell shares in a number of ways. For example, it can sell a call option, buy a put option, enter into a collar, enter into a short swap or enter into a forward sale of the relevant shares. These are often referred to as hedging transactions because they allow the user to hedge its economic exposure to a long stock position by transferring some or all of the risks of ownership of that position to the dealer. This section focuses on one type of forward transaction in particular: a variable prepaid forward transaction (VPF). A VPF is a transaction in which the third party (referred to as the stockholder in this context) sells shares to a dealer. The stockholder receives the purchase price at or near the inception of the transaction (hence prepaid ) and is obliged to deliver shares (or the cash value thereof) at maturity, which may be years later (hence forward ). In a typical VPF, the stockholder will either: physically settle the VPF by delivering to the dealer a number of shares determined using a formula based on the stock price at maturity (subject to a cap and a floor, usually); or cash settle the VPF by paying the dealer the cash value of the shares otherwise deliverable. A VPF allows the stockholder to monetise its stock position, hedge some or all of its downside price risk and capture some or all of the appreciation in the value of the underlying shares. The stockholder will typically pledge to the dealer a number of shares equal to the maximum number of shares deliverable under the VPF to secure its obligations thereunder. The dealer s economic position under a VPF will be long, so it will establish an initial short hedge consisting of a number of shares equal to the product of the initial delta of the VPF and the number of shares underlying the VPF. Thereafter, the dealer will adjust its hedge position daily as the delta of the VPF fluctuates during the term of the VPF. Upon physical settlement of the VPF, the dealer will either: use the shares it receives from the stockholder to close out any outstanding stock loans; or 152

16 Witold Balaban, John M Brandow, James T Rothwell and Joyce Y Xu sell those shares and use the proceeds to purchase other shares to close out those stock loans (the latter technique being commonly referred to as a double print, reflecting the two transactions involved). If the VPF is cash settled, the dealer will generally use the cash it receives from the stockholder to purchase shares to close out any outstanding stock loans. (a) Registration requirement under the 1933 act As noted above, every offer or sale of securities in the United States must either be registered under the 1933 act or be exempt from registration. This section looks at the registration issues raised by each of: the dealer s initial hedge; the dealer s subsequent delta hedge adjustments; and the dealer s resale of any shares received from the stockholder upon physical settlement. Because of the variable share formula in the VPF, the dealer will establish its initial hedge of a VPF pursuant to its proprietary trading models used for hedging options. As a result, the precise magnitude of the dealer s initial hedge will often not be known to the end user. However, the end user obtains the benefit and proceeds of the VPF, and an end user could reasonably anticipate the general timing and size of the dealer s initial hedge. This raises a concern that short sales by the dealer as part of its initial hedge might be viewed as attributable to the stockholder. If the stockholder is a non-affiliate that holds non-restricted shares that could be sold freely pursuant to Section 4(1) of the 1933 act, then attribution of the dealer s hedging sales to the stockholder should not be of concern. However, if the stockholder is an affiliate of the issuer or owns restricted shares that could not be sold freely, then this attribution could be of concern unless the dealer executes its short sales pursuant to an effective registration statement or in a manner consistent with an exemption from registration available to the stockholder. This is consistent with the view taken by the staff of the SEC in a no-action letter issued in 1999 (the Rule 144 Hedging Letter). 69 In the Rule 144 Hedging Letter, the SEC staff concluded that if a dealer enters into a VPF with an affiliate of the issuer (that could sell shares pursuant to the safe harbour of Rule 144), the dealer may hedge by selling the full number of shares underlying the VPF into the market in a manner consistent with the requirements of Rule For stockholders that are unable to rely on Rule 144 (eg, because they hold only restricted shares that have been held less than one year, or they wish to sell or hedge a number of shares in excess of the Rule 144 volume limit), another no-action letter granted by the staff in (the Registered Hedging Letter) takes the position that if a dealer enters into a VPF with 69 See Goldman Sachs & Co, SEC No-Action Letter (1999 SEC No-Act Lexis 1974). 70 Because the dealer s initial delta hedge position is likely to be less than the full number of underlying shares (unless the transaction has a delta of 1.0), the dealer is likely also to purchase in the market a number of shares equal to the excess of the full number of shares underlying the transaction over the dealer s initial delta hedge position. 71 See Goldman Sachs & Co, SEC No-Action Letter (2003 SEC No-Act Lexis 720). 153

17 Equity derivatives: selected US legal issues such a holder, the dealer may hedge by selling the full number of shares underlying the VPF into the market pursuant to an effective registration statement. 72 Any subsequent sales executed by the dealer in connection with its dynamic hedge adjustments will depend entirely on changes in independent factors (eg, share price, volatility and passage of time) outside the control of the stockholder and dealer. At the inception of the transaction, the stockholder has no meaningful way to predict the timing or size of any such later sales. In addition, any such sales will be entirely for the dealer s own account, and the stockholder will receive no benefit or detriment as a result of the particular timing, size or price of execution of any of those sales. As a result, there should be less concern that those sales are attributable to the stockholder. This is generally consistent with the position taken by the staff in the Registered Hedging Letter; after the dealer sells the full number of shares underlying the VPF into the open market pursuant to an effective registration statement, the dealer s dynamic hedge adjustment sales do not require registration or prospectus delivery. The status under the 1933 act of any shares received from the stockholder will depend on the nature of the stockholder and the status of the shares in the stockholder s hands. If the stockholder is a non-affiliate and holds non-restricted shares, then those shares are freely tradable under Section 4(1) in the hands of the stockholder and will remain freely tradable upon delivery to the dealer. If the stockholder is a non-affiliate and holds restricted shares, then generally the shares will remain restricted upon delivery to the dealer, but the dealer will be considered to have a holding period in those shares for purposes of Rule 144 that started when the stockholder acquired the shares. 73 If the stockholder is an affiliate of the issuer, then the private sale of shares from the stockholder to the dealer through the VPF results in the shares becoming restricted, even if they were not restricted in the hands of the stockholder. However, if the VFP is executed in the manner described in the Rule 144 Hedging Letter, then any shares delivered upon settlement will be freely tradable in the hands of the dealer (assuming the dealer is not itself an affiliate of the issuer), and if the VPF is executed in the manner described in the Registered Hedging Letter, then any shares delivered upon settlement may be used by the dealer to return to stock lenders to close out the dealer s short positions. While the Rule 144 Hedging Letter and Registered Hedging Letter are helpful in providing a roadmap for execution of VPFs in the scenarios they describe, they leave unanswered many questions about how to execute VPFs and other hedging transactions in different scenarios. There are a number of additional methods by which market participants have concluded that affiliates of issuers and holders of restricted shares can hedge those positions. 74 (b) Insider trading issues In general, the pricing terms that a stockholder will receive in a VPF or other hedging 72 See supra footnote See 17 CFR Section (d)(1). 74 The SEC proposed a number of alternative frameworks for the regulation of hedging transactions that raise registration issues in SEC Release , RIN 3235-AH13; 17 CFR Parts 230 and 239 (February ). No action has been taken on these proposals at the time of writing. 154

18 Witold Balaban, John M Brandow, James T Rothwell and Joyce Y Xu transaction will depend on the market price at which the dealer actually does, or believes it will be able to, execute its initial hedge the higher the prevailing market price of the underlying shares, the better pricing the stockholder will achieve for its hedge. Therefore, if a stockholder were to enter into a VPF transaction at a time when the stockholder was in possession of material non-public negative information concerning the issuer, the stockholder would be taking advantage of that information in a way that it would be prohibited (by Section 10(b) of the 1934 act and Rule 10b-5 thereunder) from doing if it simply sold shares in the cash market. For this reason, well advised stockholders will generally not enter into VPF transactions or other hedging transactions while in possession of material nonpublic information, and many issuers prohibit their insiders from entering into hedging transactions during blackout periods when insiders would be prohibited from selling shares. (c) Section 13, Section 16 and bank regulatory issues Stockholders subject to the reporting requirements of Section 16 or Schedule 13D will generally need to disclose entering into a VPF. The reporting of VPF transactions, and their treatment under the Section 16(b) short-swing profit disgorgement provisions and the Section 16(c) prohibition on short sales, are complicated and beyond the scope of this chapter. 75 Under a VPF, the dealer will have beneficial ownership of the shares to be delivered upon physical settlement of the VPF at the later of the date on which the stockholder elects to settle physically the VPF (if the stockholder has a cash settlement right) and the date 60 days prior to the settlement date. (If the dealer has the right to borrow or rehypothecate shares pledged to secure the stockholder s obligations under the VPF, the dealer may have beneficial ownership of those shares sooner.) The dealer may also be considered to own shares underlying the VPF for bank regulatory purposes. As a result, if the VPF relates to a significant percentage of the issuer s outstanding shares, the dealer will need to consider its own reporting position under Sections 13 and 16, any potential exposure under Section 16(b), and its bank regulatory position. (d) Margin issues Generally, market participants take the position that a forward sale of shares secured by the full number of shares deliverable under the contract that has, in effect, been fully performed by both parties, such as a VPF, is not an extension of credit by the dealer that would be subject to the margin regulations. Variations on the structure, however, could call for a different margin analysis. (e) Credit and bankruptcy issues Market participants generally believe that a typical VPF should be considered to be a securities contract, so the dealer should be entitled to terminate the VPF based on an ipso facto provision and should be entitled to protection under the Bankruptcy Code from the automatic stay in the event of the bankruptcy of a stockholder subject to the 75 See Peter J Romeo and Alan L Dye, Comprehensive Section 16 Outline, pp , 159 (June 2005). 155

19 Equity derivatives: selected US legal issues Bankruptcy Code. Variations on the structure that make the contract look less like a protected contract could introduce a risk that the dealer s enforcement of its rights in the share collateral could be stayed in the event of a bankruptcy of the stockholder. (f) Short sale issues A dealer s hedging sales in connection with a VPF are likely to be short sales, and thus they will have to comply with Regulation SHO and Rule 10a-1 under the 1934 act (unless Rule 10a-1 is suspended pursuant to Regulation SHO). (g) Commodities law issues A VPF on a single stock shares some characteristics with a futures contract on a single stock. Therefore, VPF transactions are generally executed between eligible contract participants, although rules regarding hybrid instruments may also permit some VPF structures between parties that are not eligible contract participants. 2.2 Transactions in which a third party synthetically buys shares A third party can synthetically buy shares in a number of ways. It can sell a put option, buy a call option or enter into a long swap on the shares. This section focuses on a long swap. In a typical long swap, the third party (referred to as the counterparty in this context) and dealer enter into a contract relating to a specified number of underlying shares. During the term of the contract, the counterparty makes periodic payments to the dealer. At the maturity of the contract, if the underlying shares have increased in value from the time the contract is executed, the dealer pays the amount of that increase to the counterparty; if the underlying shares have decreased in value, the counterparty pays the amount of that decrease to the dealer. The exposure of either party may be collateralised with a pledge of cash or other assets. The dealer typically hedges a long swap by purchasing in the cash market the number of shares underlying the swap. A long swap allows the counterparty to gain leveraged long exposure to the underlying shares without an initial outlay of cash. (a) Section 13 and Section 16 issues If the counterparty is subject to the reporting requirements of Schedule 13D or Section 16, it will need to report entering into a long swap. Because such contracts are contracts with respect to securities of the issuer, they are reportable on Schedule 13D even when they do not increase the reporting person s beneficial ownership. Schedule 13G does not require disclosure of contracts with respect to securities of the issuer. For purposes of Section 16(a) reporting, entering into a long swap is considered the purchase of a call equivalent position, and for purposes of Section 16(b) liability, the long swap will be considered a matchable purchase of the underlying shares. Because a long swap gives the counterparty the risks and benefits of owning the underlying shares, it raises the question of whether the counterparty should report beneficial ownership of the underlying shares. In a typical long swap, in which the counterparty does not have any voting rights or any right to acquire or dispose of any 156

20 Witold Balaban, John M Brandow, James T Rothwell and Joyce Y Xu shares (and does not have any understanding, formal or informal, with the dealer regarding any shares that the dealer may purchase as its hedge), market participants generally take the position that the counterparty is not required to report beneficial ownership of the underlying shares. However, use of long swaps in strategic situations (eg, contests for corporate control of an issuer) may invite close scrutiny of the factual basis for non-reporting. (b) Margin issues Because a long swap allows the counterparty to gain economic exposure to the underlying shares without initially paying cash, a long swap results in a leveraged position. This raises the concern that a long swap could be recharacterised as a transaction in which the counterparty borrows cash from the dealer, uses the cash to purchase shares and pledges those shares to the dealer to secure the cash loan. This recharacterised transaction would be subject to the margin regulations. In general, market participants take the position that a typical long swap, in which the counterparty has no ownership rights in any shares and no right or understanding (formal or informal) with the dealer to acquire any shares, is not subject to the margin regulations. However, long swaps with structural variations have been the subject of recent SEC enforcement activity and should be carefully analysed. 76 (c) Credit and bankruptcy issues Market participants generally believe that a typical long swap should be considered to be a swap agreement, so the dealer should be entitled to terminate the VPF based on an ipso facto provision and should be entitled to protection under the Bankruptcy Code from the automatic stay in the event of the bankruptcy of a counterparty subject to the Bankruptcy Code. Variations on the structure that make the contract look less like a protected contract could introduce risk that the dealer s enforcement of its rights in the share collateral could be stayed in the event of a bankruptcy of the stockholder. (d) Commodities law issues A long swap on a single stock shares some characteristics with a futures contract on a single stock. Therefore, long swap transactions are generally executed between eligible contract participants Transactions in which an issuer synthetically sells its own shares An issuer can synthetically sell its own shares by selling a warrant or convertible security, or entering into a forward sale transaction. This chapter focuses on a variable forward sale transaction. An issuer variable forward sale transaction is a transaction in which the issuer sells shares to a dealer. The issuer is obliged to deliver shares (or, in some cases, the cash value 76 See Canadian Imperial Holdings Inc and CIBC World Markets Corp Securities Act Release 8592 (July ), Exchange Act Release (July ), Investment Advisers Act Release 2407 (July ), and Investment Company Act Release (July ) at 3, 4 and The fact that the counterparty may have to make a payment to the dealer if the stock decreases in value prevents the swap from qualifying as a hybrid instrument that is predominantly a security. 157