Derivatives Blog

Equity Derivatives Enter the Ring

It’s not every day that we see an equity derivatives lawsuit.

On November 15, 2021, a Dealer filed suit against a Market Participant in the U.S. District Court for the Southern District of New York for breach of contract under certain equity derivatives contracts.

The complaint is straightforward — essentially the Dealer alleges the Market Participant failed to pay what the Dealer says it should have when the Dealer says it should have. What is slightly more complicated is the dispute giving rise to the claim.  

According to the public record, the Market Participant entered into a set of derivatives to mitigate risks and achieve certain tax benefits in connection with certain convertible notes that matured this year.

Issuers of convertible debt frequently enter into such derivatives. Some structure their hedge with a single trade known as a “capped call.” Others utilize a “bond hedge and warrant.” Both fundamentally do the same thing — reduce potential dilution and/or offset potential cash payments by the issuer in connection with the convertible notes.

With a capped call, the issuer buys an over-the-counter call option on its own equity from one or more financial institutions. The call option has a strike price equal to the conversion price of the convertible notes and a cap equal to a negotiated premium above the strike price.

With a bond hedge and warrant, the issuer buys an uncapped over-the-counter call option on its own equity from one or more financial institutions and sells a warrant on its own equity to the same financial institutions. The call option has a strike price equal to the conversion price of the convertible notes. The warrant has a strike price equal to a negotiated premium above the conversion price of the convertible notes.

There are various reasons to choose a bond hedge or a capped call, which we won’t get into here (for more details, please see our webinars on the subject). Here, the Market Participant chose a bond hedge and warrant structure.

As is customary, the Market Participant’s hedges were documented pursuant to the terms set forth in standard definitional booklets published by the International Swaps and Derivatives Association, Inc. (“ISDA”) and the ISDA 2002 Master Agreement. The key definitions here are the ISDA 2002 Equity Derivatives Definitions (the “Equity Definitions”).

The Equity Definitions are incorporated by reference into most over-the-counter equity derivatives and provide clarity with respect to what happens to a given trade upon the occurrence of certain lifecycle events (e.g., mergers and acquisitions, tender offers, etc.). Parties generally negotiate certain tweaks to the Equity Definitions with the goal of balancing flexibility for the issuer with the hedging and liquidity needs of the financial institution providing the trade.

This dispute primarily revolves around one of these tweaks — the negotiation of the “Announcement Event” clause. The “Announcement Event” typically tasks the financial institution providing the trade with making certain adjustments to preserve the fair value of the transaction to the parties where the issuer or other specified persons or entities announces a material transaction with respect to the issuer (for example, a take-private). When making these adjustments, the financial institution acts as “Calculation Agent” and is afforded relatively wide berth in its calculations and determinations, subject to the requirement to act in a “commercially reasonable” fashion.

The warrants at issue defined “Announcement Event” in relevant part as a “public announcement by [the Market Participant] of an intention to solicit or enter into, or to explore strategic alternatives or other similar undertaking…” and “any subsequent public announcement of a change to a transaction or intention that is the subject of an announcement of the type described [above].” The warrants further tasked the Dealer with making such adjustments to the key terms of the warrant to account for the effects of such an announcement.

Responding to a public announcement regarding potentially taking the Market Participant private, and subsequent follow-up announcements by the company regarding the same, the Dealer allegedly made adjustments to the strike price of the warrants to account for changes in volatility resulting from these announcements. When the Market Participant announced that the take-private would not occur, the Dealer allegedly made additional adjustments to the warrants. According to the Dealer’s complaint, these adjustments were made in accordance with its obligations as Calculation Agent in response to one or more Announcement Events.

Per the Dealer's filings, the Market Participant disputes the adjustments and has failed to render the payments it owed upon maturity and exercise of the warrants based on the adjusted strike price.

There’s plenty to unpack here, but the most immediately striking takeaway is probably that the adjustment language in over-the-counter derivatives confirmations may actually be tested. Market participants may be tempted to view the lengthy trade confirmations governing hedges such as the Market Participant's warrants as overly technical bundles of “rainy day” clauses that will never practically matter. This impression may be reinforced by the relationship-centric nature of the over-the-counter derivatives marketplace, where repeat players consistently engage across platforms on a wide array of transactions. And there’s some truth to this — but when push, however rarely, comes to shove, what the documents say will be an important factor in mapping the road forward.

Looking ahead, it will be interesting to see where this lands both procedurally and substantively. Because the ISDA definitions (equity or otherwise) are rarely interpreted by a court of law, any interpretative guidance may have a meaningful impact on the crafting of the related contractual clauses. That said, it’s not clear any of this will get that far.

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