The U.S. securities laws prohibit underwriters from selling shares into the public market without the issuer registering the sale under the Securities Act of 1933 or obtaining an exemption from the Securities Act's registration requirements. This basic tenet of U.S. securities law affects a broker-dealer's ability to enter into transactions to hedge its exposure on equity derivatives in which the counterparty is the issuer of the underlying shares. A recent Securities and Exchange Commission staff interpretive letter, however, known as the "Hedging Letter"1 should provide broker-dealers with more flexibility when entering into these types of hedging transactions.
Forward Contracts
In the case of an issuer forward contract, the issuer would sell shares to the broker-dealer for future delivery at a fixed price or at a price based on the price of the shares over a specified period of time. The broker-dealer could pay the purchase price in full at the time of entering into the contract or upon settlement. The broker-dealer would have long exposure to the issuer's shares and would hedge this position by borrowing freely tradable shares of the issuer and selling the borrowed shares short. If the short sales were seen as being made on behalf of the issuer, however, the broker-dealer could be viewed as an underwriter under the Securities Act.2
A forward transaction may feature minimum and maximum delivery obligations. In this case, the number of shares delivered would depend on the price of the shares during an averaging period prior to maturity. Because of this optionality, a broker-dealer would adjust its hedge through further purchases and sales of the issuer's shares--known as delta hedging. If the broker-dealer were to use a registration statement for the initial hedging, one concern would be that a prospectus would have to be delivered for the delta hedging, as well.
At maturity, the issuer could settle the contract physically, by delivering shares to the broker-dealer, or by using cash, where the issuer would pay or receive the net amount owed under the forward contract. If the issuer chose cash settlement, it would have the further option of satisfying any payment obligation by delivering a number of shares equal in value to the payment amount, known as net physical settlement. Also at maturity, the broker-dealer would need to return shares to its stock lenders to cover its open short positions. However, in the absence of the Hedging Letter, shares that the broker-dealer acquires directly from the issuer would not be freely tradable and ordinarily could not be delivered to stock lenders.
Option Contracts
In an option contract, the issuer would enter into one or more option transactions on the issuer's shares with the broker-dealer. For example, an issuer could purchase a put option from, or write a call option to, the broker-dealer on the issuer's shares. An option contract would typically be out-of-the-money or at-the-money at the time of entry, but also could be struck in-the-money. An option contract, if exercised, could require the issuer to deliver either a fixed number of shares or a variable number of shares that would depend on the price of the shares at exercise. In hedging its related exposure, a broker-dealer would generally face the same types of securities law concerns as with a forward contact. Note that these concerns do not arise when the broker-dealer buys a put option from the issuer, as the broker-dealer would not hedge its exposure through short selling.
Pledge & Loan Of Shares
With respect to both forward and option contracts, the issuer may agree to pledge a number of shares to the broker-dealer to secure its share delivery obligation. The issuer would need treasury or other shares available to be pledged. The broker-dealer would be entitled to rehypothecate or borrow the pledged shares, either immediately or after some specified date. The issuer could also lend shares to the broker-dealer upon entering into or during the term of the contract. The Hedging Letter states that any pledged shares rehypothecated or borrowed from the pledge arrangement or otherwise borrowed from the issuer could not, if returned, be rehypothecated or reborrowed during the term of the contract.
Interpretive Advice Under The Hedging Letter
The SEC staff gave interpretive advice to broker-dealers entering into forward or option contracts with issuers where the issuer, prior to entering into a contract, registers the maximum number of shares deliverable under the contract. In such a case, the broker-dealer would be required to deliver a prospectus in connection with its initial hedging. The broker-dealer could settle sales related to its delta hedging with freely tradable shares (acquired other than from the issuer) and cover its related short positions with shares received from the issuer (up to the maximum number of deliverable shares). In either case, the shares could be delivered without registration or the delivery of prospectuses.
The SEC staff's advice was based on the followings facts in the Hedging Letter. The issuer would be eligible to file a Form S-3 or F-3 registration statement for a primary offering of securities and would file a registration statement covering at least the maximum number of shares deliverable under the contract. The plan of distribution contained in the registration statement would contemplate the possibility of the issuer entering into an equity derivatives contract and the related selling activity that would be conducted as part of the broker-dealer's hedging of the contract.
Hedge Sales
The broker-dealer would likely borrow a number of freely tradable shares equal to the maximum number of shares deliverable by the issuer under the contract. The broker-dealer would sell these shares under the registration statement and deliver prospectuses to the purchasers. The broker-dealer would also purchase the number of shares it needs to reduce its short position to the desired delta level. The broker-dealer would deliver freely tradable shares upon settlement of its short sales. The Hedging Letter states that the shares would be actively traded as defined in Regulation M under the Securities Exchange Act of 1934. While Regulation M restricts simultaneous purchases and sales of shares, the Hedging Letter states that an exemption from Regulation M would be available.
The broker-dealer would then delta hedge its position without delivering a prospectus in connection with its short sale delta hedging. No shares pledged by or borrowed from the issuer, or purchased in the open market in connection with a cash or net physical settlement, would be used to settle these short sales. The broker-dealer would make all decisions regarding its delta hedging (e.g., timing, size and prices of sales and purchases) solely in its own discretion and independent of the issuer. The terms of the contract would not be based on the purchases and sales of the shares during the delta hedging, and the issuer would have no economic interest in these purchases and sales.
Covering Short Positions
Having established the short positions described above, the broker-dealer would close out the stock borrow related to these short positions by delivering any of the following: (1) shares it otherwise owned or borrowed from stock lenders (other than the issuer), (2) pledged shares that the broker-dealer has rehypothecated or borrowed from the issuer, or (3) shares received from the issuer upon settlement of the contract. No registration statement would be filed, and no prospectus would be delivered, in connection with the delivery of any such shares to close out borrowings. Pledged or borrowed shares would be used only to close out open stock borrowings resulting from sales used to hedge the contract or to settle sales where prospectuses have been delivered.
Settlement
Upon settlement of a contract, the broker-dealer would deliver any shares received from the issuer to stock lenders to cover its open positions. If any of the initial, registered hedge sales (but not any sales related to its delta hedging) were settled by delivery of pledged shares or borrowed shares, the issuer's obligation to deliver shares upon physical or net physical settlement would be netted against the broker-dealer's obligation to return those pledged or borrowed shares to the issuer. The Hedging Letter stated that any shares received from the issuer upon settlement, or pledged or borrowed during the term of the transaction--in an aggregate amount not exceeding the maximum number of deliverable shares--would be eligible for delivery to close out short positions without registration under the Securities Act or any prospectus delivery requirements.
If the contract were settled in cash or pursuant to net physical settlement, the broker-dealer would purchase shares in the market to close out the hedge. The Hedging Letter states that any shares purchased in the open market to close out open borrowings of shares, in an amount not exceeding the difference between the maximum number of deliverable shares and the aggregate number of pledged or loaned shares or other shares received at settlement, could be delivered to share lenders without registration or the delivery of a prospectus.
If the broker-dealer had covered its hedge sales with pledged shares or borrowed shares, the shares the broker-dealer purchased in the market would be used to replace the pledged or loaned shares and returned to the issuer.
Conclusion
The Hedging Letter provides welcomed guidance to broker-dealers and issuers when entering into forward and option contracts. Issuers should consider including in their registration statements language that allows them to enter into these contracts. Foot note four of the Hedging Letter provides suggested language for this purpose.
