A Primer On ISDA's User's Guide To The 2002 Equity Derivatives Definitions
To aid market participants in the adoption of the 2002 International Swaps and Derivatives Association equity derivatives definitions as the standard for documenting equity derivative transactions, ISDA recently published a User's Guide.
The User's Guide is designed to provide a general overview of the definitions as well as a section-by-section analysis of each article. It also includes a series of exhibits with flowcharts illustrating the mechanics of Cash and Physically Settled European Share Options and guidance notes on Share Basket Valuations, Consequences of Merger Events and Tender Offers, Additional Disruption Events and Averaging Date Disruptions.
One section that should be particularly helpful to users of the 2002 definitions is the discussion of Article 12 (Extraordinary Events). It includes an example of the operation of the Agreed Model provision of Cancellation and Payment, which may be selected for Share Option Transactions upon the occurrence of a Merger Event or Tender Offer. Readers familiar with the operation of the Agreed Model will recall that its underlying concept is that the Calculation Agent determines the value of the Option on the Closing Date and then makes an adjustment based on the change in the value of the Option around the Announcement Date, due to the change in the level of implied volatility of the underlying Shares. The example in the User's Guide uses hypothetical numbers to explain how the Calculation Agent would calculate the amount payable.
The User's Guide also points out jurisdiction-specific issues that parties may wish to consider in connection with their Transaction.
One such example relates to the Loss of Stock Borrow provision in Section 12.9. This Additional Disruption Event is triggered if the Hedging Party is unable to borrow or maintain a borrowing of Shares, after using commercially reasonable efforts, to hedge a Transaction at a rate equal or less than the Maximum Stock Loan Rate specified in the Confirmation. The phrasing of this provision contemplates the actual costs involved in borrowing Shares (commonly the stock lender's spread). However in the U.S., many market participants think of stock borrow costs in terms of a rate of return (i.e. the rebate or interest rate received, net of fees, on cash collateral posted to the stock lender in connection with the borrowing of Shares with respect to a Transaction). In such cases, users may wish to consider modifying Sections 12.9(a)(vii) and 12.9(b)(iv) in their Confirmations to provide that this Additional Disruption Event is triggered if the Hedging Party is unable to borrow or maintain a borrowing of Shares, after using commercially reasonable efforts, to hedge a Transaction "at a rate of return equal to or greater than [X]", where X is the amount agreed by the parties.
Another jurisdiction-specific example in the User's Guide provides insight into an issue particularly relevant for the European market, multi-exchange Indexes. The standard provisions in the definitions contemplate Indexes where the component Shares are all listed on the same Exchange. For example, the definition of Scheduled Trading Day refers to each Exchange being open and the Valuation Time is the Scheduled Closing Time on the relevant Exchange. However, for Indexes that are comprised of Shares from different Exchanges, such as the Dow Jones EuroStoxx Index, there may be different national holidays and closing times, especially where the Exchanges are located in different time zones. Each Index will have its own rules for dealing with market disruptions and market holidays for the component Shares. For example, the Dow Jones EuroStoxx Index will only be disseminated on days when at least 50% of the Dow Jones STOXX TMI's free float market capitalization and at least 50% of the exchanges are available for trading. In such cases, many market participants use customized language depending on whether the Transaction is priced using the level of the Index (based on the cash market prices of the component Shares) or the official settlement price of futures or options contracts on the Index. Sample provisions for parties to consider are attached in Exhibit H of the User's Guide.
Besides highlighting the important features of the definitions, the User's Guide is also designed to identify and discuss certain issues that are commonly addressed in Confirmations. In doing so, the User's Guide provides suggested language that parties may wish to consider as a base for their particular Transaction. Of particular interest are (i) currency disruptions and (ii) Market Disruption Events in the valuation of Transactions priced by reference to the volume weighted average price (VWAP) on the Valuation Date, as opposed to the price of the Shares as of the close of the regular trading session.
Market participants often include detailed currency disruption provisions in their Confirmations, where the settlement obligations under a Transaction are denominated in a different currency than that of the underlying Shares. The User's Guide provides, in its discussion of Section 12.9, sample language that parties may wish to consider when addressing this issue. It provides that, if a Currency Disruption Event occurs, the Settlement Date will be postponed until one Settlement Cycle following the first Currency Business Day on which no Currency Disruption Event exists. The postponement can apply for up to eight Currency Business Days, at which point the Calculation Agent will either determine the applicable Exchange Rate or designate the Local Currency as the Settlement Currency.
The User's Guide also suggests sample language for parties to consider that provides that a Market Disruption Event can be triggered at any time during the regular trading session on the Valuation Date. This language is especially useful when you consider the application of the Market Disruption Event provisions for Transactions that are valued based on VWAP on the Valuation Date. In these cases, parties may be unwinding their hedging positions over the course of the Valuation Date. However, if there is a Market Disruption Event, the provisions of the definitions are only triggered if such events occur during the one-hour period prior to the Valuation Time. The sample language in the User's Guide provides that if a Market Disruption Event occurs at any time during the regular trading session on the Exchange, "the Calculation Agent shall make adjustments to the number of Shares for which such day shall be the Valuation Date and shall designate the next Scheduled Trading Day as the Valuation Date for the remaining Shares. Such adjustments will be based on, among other factors, the duration of any Market Disruption Event and the volume, historical trading patterns and price of the Shares."
The following example illustrates the intended effect of this provision. Assume a Swap Transaction on 90 Shares that will have a Final Price of VWAP. If there is a Market Disruption Event during the middle third of the Scheduled Trading Day, then the Calculation Agent could use that day as the Valuation Date for two-thirds of the Number of Shares (applying the VWAP to 60 Shares) and use the next Scheduled Trading Day as the Valuation Date for the remaining Shares (applying that next day's VWAP to 30 Shares). Alternatively, the Calculation Agent could apply the VWAP to 30 Shares during the middle third time period on the next Scheduled Trading Day, assuming that there are no further Market Disruption Events during this period.
In conclusion, market participants should find the User's Guide useful in explaining the provisions of the definitions. ISDA also expects the User's Guide will serve as a resource that will reduce the time spent negotiating language for common provisions that parties add to their Confirmations to deal with specific events.
This week's Learning Curve was written by Glen Rae, v.p. and general counsel at Goldman Sachsin New York. He is also the chairman of the ISDA equity derivatives committee for North America and served as the co-chair of the working group that drafted the 2002 definitions and the User's Guide.