Template:M detail Equity Derivatives 10.1(b)

Coronavirus now: redux

You are a counterparty to an equity derivative Transaction papered under the 2002 ISDA Equity Derivatives Definitions. Hard to imagine, I know, but just go with me. So what happens if you have selected “Ex Amount” as your Dividend Amount payment method, and the Issuer has duly declared a Dividend, the record date has passed as expected, the Share has started trading ex-dividend (as by rights it should do) and then something unexpected and properly epochal happens — like the world basically ceasing to rotate on its axis for a prolonged and indeterminate time, prompting said issuer to cancel its dividend. What then?

Judged by the lights of its basic metaphysical premise, the intention of a derivative is to, well, be derivative: to replicate as closely as possible the performance of the underlying Share. No equity derivative counterparty has it in its head that it is underwriting, or guaranteeing, an Issuer’s commitment to pay a dividend that the Issuer itself does not ultimately carry though — even if the Issuer were legally obliged to perform that obligation, whereas in fact it tends not to be (however unconventional not doing so might be). So, you would think, it would be odd to find a Transaction obliging an Equity Amount Payer to pay a Dividend Amount notwithstanding cancellation of the actual dividend on the underlying Share.

To be sure — we men and women of finance being homo economici and everything, you would expect anyone writing that kind of put option to be pretty categorical about it, and to demand quite some premium for it.

Yet a cold reading of the Ex Amount method (if not modified by some kind of clawback) suggests that it what it does:

“100% of the gross cash dividend per share declared by the Issuer to holders of record of a Share where the date that the Shares have commenced trading “ex-dividend” on the Exchange occurs during the relevant Dividend Period”.

Dunno about you, but I can’t see any contingency on actual Issuer payment in there.

The above “cold reading” does not accord with the economic facts as market participants — homo economici all — understand them. The JC suspects that common sense will prevail and no one will be cavalier enough to take this point. But you just never know, and it is a hard one to crowbar into the present law of contractual mistake.So what happens if you have selected Ex Amount as your Dividend Amount payment method, and the Issuer declares a Dividend, the Record Date passes as expected, the Share starts trading ex-dividend as, by rights, it should do. and then something unexpected and properly epochal happens — like the world basically ceasing to rotate on its axis for a prolonged and indeterminate time, prompting said issuer to cancel its dividend. What then?

Clearly the intention of a derivative is to replicate as closely as possible the performance of the underlier. It cannot be expected that an equity derivative counterparty intends to guarantee an Issuer’s obligation that the Issuer itself does not ultimately perform —especially if it is not legally obliged to perform that obligation in any case (however unconventional not doing so might be) — so it would be odd to find a Transaction requiring an Equity Amount Payer to pay a Dividend Amount notwithstanding cancellation of the actual dividend on the underlying Issuer. You would expect anyone writing that kind of put option to demand quite some premium for it.

Yet that is what a cold reading of the Ex Amount method (if not modified by some kind of clawback) seems to do: :“100% of the gross cash dividend per share declared by the Issuer to holders of record of a Share where the date that the Shares have commenced trading “ex-dividend” on the Exchange occurs during the relevant Dividend Period”.

The above “cold reading” does not accord with the economic facts as market participants understand them. We suspect that common sense will prevail and no one will be cavalier enough to take this point. But you just never know.