Income - GMSLA Provision
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2010 Global Master Securities Lending Agreement
Clause Income in a Nutshell™ Use at your own risk, campers!
Full text of Clause Income
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This is the definition that underlines the dividend manufacturing process; as to which see: Para 6.2 - Manufactured payments in respect of Loaned Securities and Para 6.7 - Corporate actions.
Summary
Kinda wide, no?
Not so much.
- “Interest, dividends...”: Even this is not as wide as it looks at first glance. This does not suggest there might be interest payments on equities, but rather reflects that the Securities travelling back and forth under a stock loan might be debt securities: “Interest” refers to income payments on debt securities that you might use as Collateral; “dividends” as income payments of equity securities. To paraphrase: “interest payments on bonds, dividends on shares, and any similar distributions”.
- “with respect to” is not the greatest choice of words: it is a mealy-mouthed prepositional phrase when one begs for a firm preposition. What it means — what it can only mean is “under”. In the context of securities lending this must mean payments made under the terms of the instruments themselves. That is, payments made by the issuer, and to shareholders qua shareholders as a pure function of their ownership of the securities. Such payments are restricted to dividends and dividend-like payments: rewards to the shareholder for the prudent management and healthy profitability of the company in general.
- “any Securities”: It is implicit also that the distributions contemplated by paragraph 6.2 should be available pari passu to all shareholders of the same class that is subject to the stock loan. This we can derive from the expression “…with respect to any Securities” . The distribution must be with respect to any Securities, not just some of them. The contract cannot function otherwise, for it would be impossible to determine which distribution would be required to be manufactured under the stock loan. The Securities actually delivered to the Borrower are no more determinative than any others, for, the basic premise of a stock loan is to facilitate a short sale: it should be in no-one’s contemplation that the Borrower would hold any borrowed Securities in inventory.
- “…other distributions of any kind whatsoever”: Under general rules of contractual interpretation under English law, wherever general words follow specific words, the general words should be read to include only objects similar in nature to those specific words. So, read “other distributions of any kind whatsoever” as being subject to preceding words “dividends, interest” to mean, effectively, “any dividend-like (for shares) or interest-like (for bonds) distributions of any kind whatsoever”. This interpretation is supported by the text of the UK Tax Addendum, which relates exclusively to dividend withholding, refers to any payment made under Clause 6.2, not just dividend-like ones.
Principal repayments
Does Income include principal repayments? Economically, it must: if your Loaned Securities (or Collateral) are senior unsecured debt securities, they will at some point redeem themselves.[2] At that point:
- Loaned Securities:where Loaned Securities redeem, the Borrower must manufacture the principal redemption payment to Lender, the value of the Loaned Securities goes to zero, Lender returns Collateral to Borrower and Loan is effectively cancelled.
- Collateral: the Lender is paid its redemption value in full and the debt security disappears. This would be quite the windfall for the Lender if it could just keep the redemption proceeds and didn’t have to manufacture them back to the Borrower, since the value of the Collateral, as Collateral, has just dropped to zero.
Income versus Corporate actions
So the question is how this dovetails into the manufactured income provisions where the Income in question is in some way contingent on a corporate action, vote, or shareholding status.
For if you lent the security to me — title transfer — and I sold it short (as one does under a stock lending arrangement) and then a corporate action arose which entitled each shareholder who makes a certain election to receive a certain distribution, must I manufacture that distribution to you, even if I didn't make that election or, for that matter, even hold the share to be able to make that election?
General discussion
Retrospective compensation for corporate mismanagement
An interesting question arises as to whether settlements or judgments reflecting corporate malfeasance by issuers of Loaned Securities or Collateral — and which manifest themselves in compensation payments to shareholders of record as of a certain date (and which falls during the term of a Loan) — qualify as “Income” under the 2010 GMSLA that must be manufactured back to the Lender.
Such disputes can take years — decades even — to iron out, can take any number of different forms and, if viewed as Income, represent a significant tail risk in a Borrower’s trading book.
On one hand, the definition of Income is very wide:
Income means any interest, dividends or other distributions of any kind whatsoever with respect to any Securities or Collateral;
On the other hand — and it pains me somewhat to lay some Latin on you, but I will — the ejusdem generis rule of interpretation says where general words (here, “distribution of any kind whatsoever”) follow specific words (“dividends, interest”), the general words are cover only objects similar in nature to those specific words. So the distribution should be of the same nature as interest or dividends.
So, is a court-mandated compensation for historic corporate malfeasance “of the same nature” as voluntarily declared dividend, intended by its issuer to reflect its own satisfactory stewardship of the corporation’s commercial affairs? The JC would argue that it is not. Quite the opposite, in fact: if we take it as read that one borrows securities to short-sell them in the market we see that the short-seller’s exact view is that the securities are overvalued: this is consistent with the theory that their issuer is mismanaging the company.
The Short-seller bets that the truth will eventually come out and, when it does, the securities will fall in price. It can then buy them back, take a profit, and deliver them back to the Lender.
It can't be right that a short-seller who is so right that such an issuer is actually breaching its fiduciary duties to its shareholders, that it is not entitled to benefit from its bet. Why must it compensate the Lender in an extreme case, but not in an ordinary one?
True, true, this puts the poor Lender in a sorry spot. Because it has lent the securities by title transfer, it is not on the share register as of the Income Record Date, so however you characterise that compensation payment, it can’t claim it from anyone.
“The deal”, it will argue, “is that the Borrower should put me in the position I would have been in had I continued to hold the shares myself. I wasn’t expressing a view here. I stayed long the economic exposure of the securities. All I wanted was a lending fee.”
It is hard not to be sympathetic about this. Were the borrower to have held the securities, it might even be prepared to make an ex gratia payment on the basis that it was a windfall: it knew the company was rubbish and made its money on the short sale. But there’s the rub: The borrower didn’t hold the shares. It sold them. That is why it Borrowed them in the first place. So the Borrower is in no better place to claim that compensation from the Issuer than the Lender.
However you look at it, there’s a loser here. But remember this is essentially a windfall payment — some public-spirited activist hedge fund[3] has jemmied some extra cash out of a reluctant issuer. Had it not done so no one would have been any the wiser.
A more sober legal argument
That is what JC the bon viveur might say, over a bottle of claret, when (as often it does, after dinner in the Contrarian house) the subject of corporate malfeasance comes up in polite conversation. It is all very gnomic. So let us put it in better shape, for the more literal minded:
- The definition of “Income” in respect of shares is restricted to dividends and distributions of an analogous nature: unconditional payments payable to all shareholders under their shares pro-rata to reflect a distribution by the issuer following the profitable operation of the business.
- Compensation paid by a company as a result of misstatements of its books, leading to mispricing of its shares on public exchanges, is not “Income” on Securities under the 2010 GMSLA.[4] Indeed, it does not arise under the contract that comprises the shares at all.
- “Income” is defined as meaning “any interest, dividends or other distributions of any kind whatsoever with respect to any Securities …”:
- “with respect to”: In the context of a securities lending arrangement, Income can only relate to payments made under the terms of the Securities themselves. That is, payments made by the issuer, to shareholders, in their capacity as shareholders. That is, dividend-like payments: rewards to all shareholders on the income record date ratably for the prudent management and healthy profitability of the company in general.
- Payments under a court settlement for negligent misstatement of public accounts are not payable ratably to all current shareholders, but only to those who bought or sold (or did not buy or sell) in reliance on the statement. Nor do they reflect the company’s good management. They are made to specific investors, as compensation for misrepresentations which may have influenced their decisions with regard to their shareholding (to buy, or not to sell). In the case of “buyers”, these representations may have been made when they were not shareholders.
- Compensation therefore addresses tortious — i.e., non-contractual — claims for negligent misstatement. The claimant’s purchase, or holding and non-sale of securities in reliance on the statement is relevant to its measure of loss, but does not define the nature of the wrong (being the misstatement itself).
- “any securities”: bolstering this — though possibly almost into “the lady doth protest too much” territory — income to be manufactured should be available pari passu to all shareholders of the same class that is subject to the stock loan. The distribution must be “…with respect to any Securities … ”, not just some of them. The contract cannot function otherwise.
- Unconditional: “Income” describes unconditional payments made to all holders of record as of the Income record date without any conditionality or consideration attaching to it. Participation in a private settlement obliges a claimant to take positive action and waive rights it might otherwise have to take action against the company.
- Therefore, this is not a claim in contract under the Securities themselves: as a matter of basic principle, negotiable instruments of a given ISIN are necessarily fungible: their intrinsic rights must be identical. A payment to owing to some, but not other shareholders, cannot be a direct function of share ownership itself. That the payment arises independently of entry on the share register and is not available to all shareholders means it must be due as a result of the issuer’s breach of a correlative duty it owed to some particular investors (and potential investors) but not others.
See also
References
- ↑ Note: this contains significant JC editorialising about what this clause is meant to, but if read literally, does not achieve: See commentary under Income.
- ↑ And it is not just debt securities. Grandma Contrarian is expecting that I will, sometime, redeem myself. Every dog has its day, mum.
- ↑ What? What?
- ↑ Or much less a “Dividend” as contemplated by the 2002 ISDA Equity Derivatives Definitions, for that matter.