Date:July 22nd 2003
To:Distribution
From:Tracy Ruparell
Subject:TRADING ISSUES AFFECTING OTC OPTIONS DOCUMENTED UNDER THE 2002 ISDA EQUITY DERIVATIVES DEFINITIONS
Please find attached a memorandumdescribing some of the key trading issues in transacting OTC Options under the 2002 ISDA Equity Derivatives Definitions (the “2002 Definitions”). Many of you will have heard of the 2002 Definitions, published by ISDA earlier this year in response to demand from broker dealers to facilitate documentation of a broader range of products and to revisit the issues relating to corporate actions and mergers. The broker dealer community is currently in the process of adopting these new Definitions, and some houses document all transactions under the 2002 Definitions already.
There are important trading issues with using the 2002 Definitions, as opposed to the 1996 ISDA Equity Derivations Definitions. I have summarised these below:
PRODUCTS / 1996 DEFINITIONS / 2002 DEFINITIONSEquity Options / Two Options Styles are available: American and European. / An additional Option Style is added: Bermuda Option (can only be exercised on a Potential Exercise Date).
Equity Swaps / Two types of Equity Swap are available: Total Return and Price Return. These can only be Cash Settled. / Total Return and Price Return remain the only forms of Swap available. Shares and Share Basket Swaps can be Physically Settled. Initial and Final Exchange Amounts may also be specified.
Forwards / No Forward specific provisions. / Provisions for documenting pre-paid, post-paid, variable and fixed obligation Forwards.
Barriers
/ No Barrier provisions. / Knock-in and Knock-out Event and Price concept included.EXERCISE, VALUATION AND MARKET DISRUPTION EVENTS / 1996 DEFINITIONS / 2002 DEFINITIONS
Exercise / An option can be exercised on any Exchange Business Day during the Exercise Period.
An Exchange Business Day is any day that is (or, but for the occurrence of a Market Disruption Event, would have been) a trading day on each Exchange and Related Exchange other than a day on which trading on any such Exchange or Related Exchange is scheduled to close prior to its regular weekday closing time. / An option can be exercised on any Scheduled Trading Day during the Exercise Period.
A Scheduled Trading Day is a day on which the Exchange and any Related Exchange are scheduled to be open for trading during their regular trading sessions, regardless of whether the Exchange or Related Exchange actually opens for trading on that day.
Valuations, Physical Settlement and Market Disruption / If a Market Disruption Event occurs on a date that would otherwise be a Valuation Date, the Valuation Date is postponed for a maximum of five consecutive Exchange Business Days. / If a Market Disruption Event occurs on a date that would otherwise be a Valuation Date, the Valuation Date is postponed for a maximum of eight consecutive Exchange Business Days.
Valuation Date must be a “Disrupted Date”: a day on which a Market Disruption Event occurs or a Scheduled Trading Day on which the Exchange or Related Exchange fails to open.
These provisions are also applicable to Expiration Dates and Potential Exercise Dates, so Market Disruption also applies to Physically Settled and Bermudan trades.
Definition of Market Disruption Event / Defined as any suspension or limitation of trading in the relevant Shares or Shares comprising at least 20% of the relevant Index (a “Trading Disruption”) that the Calculation Agent deems material and which occurs in the half hour prior to the Valuation Time. / Three categories of Market Disruption Event are recognized:
- Trading Disruption;
- Exchange Disruption;
- Early Closure
“Early Closure “: the closure of the Exchange or Related Exchange prior to its Scheduled Closing Time without at least one hour notice.
The Calculation Agent must deem that a Trading Disruption or Market Disruption is material. Such Disruption must occur in the one hour prior to the Valuation/Latest Exercise Time.
MERGER EVENTS AND / 1996 DEFINITIONS / 2002 DEFINITIONS
TENDER OFFERS
Definition of Merger Event: / A Merger Event is a reclassification, consolidation, amalgamation, merger or other takeover offer.
. / Merger Events also include Reverse Mergers, in which the shareholders of the original Issuer (who will be the surviving entity of the merger) own less than 50% of the surviving entity’s Shares following the Merger Event.
Merger Date: / The date on which all holders of the relevant Shares have agreed or irrevocably become obliged to transfer their Shares. / The closing date of the Merger Event (or, if the closing date cannot be determined by the local law applicable to the Merger Event, such other date determined by the Calculation Agent).
Tender Offers: / Tender Offers that result in a transfer of 100% of the Shares are defined as Merger Events. / Tender Offers that result in a transfer of 100% of the Shares are defined as Merger Events. Tender offers for more than 10% but less than 100% of the Shares are covered under the Tender Offer election provisions.
If Tender Offer is elected to be Applicable, the parties must specify the consequence that will apply on the Tender Offer Date (ie: the date of completion of the Tender Offer).
New Shares: / “New Shares” means shares whether of the offeror or a third party. / “New Shares” means ordinary or common share, whether of the entity or person (other than the Issuer) that are, or that as of the Merger Date are promptly scheduled to be (i) publicly quoted, traded or listed on an exchange or quotation system located in the same country as the Exchange (or, where the Shares have been listed on an exchange or quotation system within the European Union, in any member state of the European Union) and (ii) not subject to any currency exchange controls, trading restrictions or other trading limitations.
CONSEQUENCES OF MERGER EVENTS & TENDER OFFERS
Consequences of Merger Events and Tender Offers: /
- Alternative Obligation
- Cancellation and Payment
- Options Exchange Adjustment
- Alternative Obligation (not applicable to Tender Offer)
- Cancellation and Payment
- Options Exchange Adjustment
- Calculation Agent Adjustment
- Modified Calculation Agent Adjustment
- Partial Cancellation and Payment
- Component Adjustment
Alternative Obligation: / On the Merger Date, the consideration for the Merger will be designated to replace the “Shares” and the Calculation Agent can adjust the terms of the Transaction necessary to implement this designation. / Retains same definition but expressly prevents the Calculation Agent from making adjustments to account solely for changes in Stock Loan Rate, liquidity, expected dividends or volatility.
Cancellation and Payment: / The Transaction will be cancelled and a termination payment will be payable by one party to the other. / The Transaction will be cancelled and a termination payment will be payable by one party to the other.
The parties shall agree the amount to be paid within 5 Exchange Business Days of the Announcement Date.
If the parties cannot agree the amount, he termination payment may be derived by one of two methods:
- Agreed Model
- Calculation Agent Determination
Agreed Model / Not Applicable / Agreed Model: Unadjusted Value + Adjusted Value
Unadjusted Value is determined on the following basis:
- Average of the Implied Vol of the Shares on each of the 15 Exchange Business Days ending on and including the Closing Date;
- Expected dividends for the time period from the Closing Date until the Expiration Date based on (a) the gross ordinary cash dividends on the shares in the one year period ending on the Closing Date or (b) in the event of an Issuer published change to dividend policy prior to the Closing Date, the expected dividends determined in accordance with that policy.
- The value of the Share (if appropriate, equal to the value of the consideration paid to holder of shares at the time of the Extraordinary Event);
- A combined interest rate and stock loan rate as specified in the related Confirmation for period from the Closing Date to the Expiration Date;
- A term of the Transaction from the Closing Date to the Expiration Date.
- the value of the Transaction determined by the Calculation Agent based on:
- Average of the Implied Vol of the Shares on each of the 15 Exchange Business Days ending on but excluding the Announcment Date
- Expected dividends for the time period from the Announcement Date until the Expiration Date based on (a) the gross ordinary cash dividends on the shares in the one year period ending on the Closing Date or (b) in the event of an Issuer published change to dividend policy prior to the Closing Date, the expected dividends determined in accordance with that policy.
- A value of the Share equal to the Settlement Price as of the Valuation Time on the Announcement Date
- A combined interest rate and stock loan rate as specified in the related Confirmation for period from and including the Announcement Date to but excluding the Expiration Date;
- A term of the Transaction from the Announcement Date to the Expiration Date.
Implied Volatility: / Not Applicable / The implied volatility of the relevant Shares, as determined by the Calculation Agent by interpolating or extrapolating from the most comparable listed put or call option (which must be the same Option Type as the Option Transaction being cancelled), on the relevant Shares as determined by the Calculation Agent taking into account the nearest strike price, maturity and "in-the-money" or "out-of-the-money" amount, as the case may be, and such other factors that the Calculation Agent deems appropriate. To the extent that such a listed option does not exist or the Calculation Agent determines that the market for such listed option is not sufficiently liquid for the purpose of the relevant calculation, the Implied Volatility will be determined by the Calculation Agent.
Calculation Agent Determination: / Calculation Agent Determination: Calculation Agent exercises discretion to make a determination in good faith and in a commercially reasonable manner. / Calculation Agent Determination: Calculation Agent exercises discretion to make a determination in good faith and in a commercially reasonable manner.
Options Exchange Adjustment: / Calculation Agent will make corresponding adjustments to the exercise, settlement, payment or other terms of options on any relevant Shares that are made by the Options Exchange. / Calculation Agent will make corresponding adjustments to the exercise, settlement, payment or other terms of options on any relevant Shares that are made by the Options Exchange.
Calculation Agent Adjustment: / Not Applicable / Upon the completion of any Merger or Tender, the Calculation Agent will attempt to adjust the terms of the Transaction to reflect the economic impact of the Merger Event or Tender Offer on the Transaction and, if such adjustment can be made in a commercially reasonable manner, the Transaction will continue on the adjusted basis.
The Calculation Agent has discretion in the nature and amount of the adjustment to be made and can determine the date from which any adjustment would be effective. However, it is explicitly provided that the Calculation Agent may not make any adjustments to account solely for the effect of the Merger Event or Tender Offer on the volatility, Stock Loan Rate, historic dividends or liquidity of the Shares. Purpose is to ensure that Calculation Agent does not return parties to the same position prior to Merger Event or Tender Offer.
If the Calculation Agent is unable to make an adjustment that would lead to a commercially reasonable result, then the Transaction will be cancelled and Cancellation and Payment - Calculation Agent Determination (as discussed above) would be deemed to apply.
Modified Calculation Agent Adjustment: / Not Applicable / Very similar to Calculation Agent Adjustment, but it is explicitly provided in the MCAA election that the Calculation Agent may make any adjustments necessary to account for the effect of the Merger Event or Tender Offer on the volatility, Stock Loan Rate, historic dividends or liquidity of the Shares.
If the Calculation Agent is unable to make an adjustment that would lead to a commercially reasonable result, then the Transaction will be cancelled and Cancellation and Payment - Calculation Agent Determination (as discussed above) would be deemed to apply.
Partial Cancellation and Payment: / Not Applicable / Applicable to Share Basket Transaction only. Upon the occurrence of any such Merger Event or Tender Offer, the portion of the Share Basket Transaction relating to the Share that has been affected by the Merger Event or Tender Offer will be cancelled and a termination payment will be payable by one party to the other.
The parties must elect whether Agreed Model or Calculation Agent Determination will apply to the terminated portion.
Component Adjustment: / Not Applicable / May only be elected as a consequence of a Share-for-Combined Merger Event or Tender Offer. Where the consideration is a combination of New Shares and Other Consideration the Component Adjustment election allows the parties to apply the consequence that was elected for the Share-for-Share Merger Event or Tender Offer to the New Share component of the Combined Consideration and the consequence that was elected for the Share-for-Other Merger Event or Tender Offer to the Other Consideration component of the Combined Consideration.
ADDITIONAL DISRUPTION EVENTS:
Change in Law: / Not Applicable / A change in applicable law or promulgation of new law that makes holding, acquiring or disposing of Shares relating to the Transaction illegal or results in a materially increased cost in performing obligations under the transaction.
Failure to Deliver: / This event is triggered upon the failure of a party to deliver Shares when due, where such failure it due to illiquidity in the market for the Shares. Applies to Physically Settled Options only. / This event is triggered upon the failure of a party to deliver Shares when due, where such failure it due to illiquidity in the market for the Shares. Applies to physically settled Options, Swaps and Forwards.
Insolvency Filing: / Not Applicable. / If Insolvency Filing is elected as applicable, a Transaction relating to Shares of an Issuer that is in the insolvency process will be terminated at the early stages of the process, upon the filing (and without a grace period), rather than waiting for the far narrower set of circumstances contemplated under the Insolvency Extraordinary Event to occur.
Hedging Disruption Event: / Not Applicable / The Hedging Party is unable, after using commercially reasonable efforts, to acquire, maintain or unwind transactions or assets necessary for hedging the equity price risk of entering and performing its obligations under the Transaction.
Increased Cost of Hedging: / Not Applicable / A Hedging Party would incur a materially increased amount (whether of tax, duty, expense or fee) to maintain or unwind Transactions or assets necessary for hedging the Transaction. In order to avoid termination of the Transaction, the Non-hedging Party can pay a Price Adjustment to cover the increased cost.
Loss of Stock Borrow: / Not Applicable / A Hedging Party is unable, after using commercially reasonable efforts, to borrow or maintain a borrowing of the number of Shares (the "Hedging Shares") that the Hedging Party deems necessary for hedging the equity price risk of entering and performing its obligations under the Transaction at a rate equal to or less than the Maximum Stock Loan Rate. In order to avoid termination of the Transaction, the Non-hedging Party can lend, or refer the Hedging Party to a third party who will lend, the appropriate number of Shares at a rate equal to or less than the Maximum Stock Loan Rate.
Increased Cost of Stock Borrow: / Not Applicable / A Hedging Party would incur a rate to borrow or maintain a borrowing of the Hedging Shares that is greater than the Initial Stock Loan Rate. In order to avoid termination of the Transaction, the Non-hedging Party can either pay a Price Adjustment or lend or refer the Hedging Party to a third party who will lend the appropriate number of Shares at a rate equal to or less than the Initial Stock Loan Rate.
Consequence of Additional Disruption Events: / Not Applicable / Upon the occurrence of any of the Additional Disruption Events (unless, in the case of Increased Cost of Hedging, Loss of Stock Borrow or Increased Cost of Stock Borrow, an alternate stock lender is found or price adjustment is made) such Additional Disruption Event will trigger the termination of the Transaction and a subsequent payment of a Cancellation Amount by one party to the other.
Cancellation Amount: Determined based on the losses of the Determining Party, which will be one or both of the parties to the Transaction, as specified in the Confirmation.