Manufactured payments in respect of Loaned Securities - GMSLA Provision
2010 Global Master Securities Lending Agreement
Clause 6.2 in a Nutshell™
Use at your own risk, campers!
Full text of Clause 6.2
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In other words the Borrower pays what the Lender would have received net, by reference to the Lender's own situation. This means that the Lender doesn't need to worry about different rates of tax or withholding applying to the Borrower. The Borrower, being the person who wanted to borrow the securities, takes the risk of untoward taxes related to its own position (as opposed to the Lender’s position) — if the tax is one the Lender would have suffered anyway, the Borrower doesn't have to account for this.
Makes sense, really.
Notwithstanding the starting point — the Borrower takes the risk of whatever withholding may be imposed on the taxes, in practice dealers may commit to general levels with WHT country-by-country — say 85% or something — and generally stick with these even though the specific rates applied for individual dividends may be marginally more or less. This is largely an operational convenience: no-one wants to be forensically tracing precise withholdings actually applied on every dividend, as that may vary on all kinds of factors (e.g. whether the dividend was paid out of capital reserves, whether it was a special dividend or a regular one and so on), and to commit to that is not only expensive and resource intensive, but opens the broker up to all kinds of remediation claims should the amount turn out to be even fractionally wrong — and here the dealer is short an option, as, commercially, it will never be able to recover from its customers after the fact where it has overpaid, but regulators will insist on dealers accounting to customers for any downside — treating customers fairly — even though the customers may have as little interest in receiving the extra money as the dealers do doing the work to calculate and pay it
So setting a fixed rate which is a good approximation of the expected dividend, and which you can adjust flexibly from time to time should withholding rates change or particular circumstances differ, is basically sound business management. The dealer takes some overs-and-unders risk, but it will be minimal in the context of their overall business, and would be drowned out by the cost of employing battalions of contractors in an offshore centre to do the work of reconciling to the penny in any case.
Now the odd thing here is that these accommodations will typically not be set out in the legal agreement.
...Income paid in relation to any Loaned Securities
Another example of that loose prepositional phrase “in relation to” being used carelessly in the 2010 GMSLA. The preposition in question here really ought to be “under” or, if you really must, “pursuant to”.
This is Income paid by the issuer under the terms of the contract comprising the Loaned Securities or Collateral; “in relation to” might be misread to imply something a little looser. For example, moneys paid by someone else in relation to the securities —— a derivative counterparty or credit default insurance provider, or even a payment made by the issuer that relates to the shares, but is not a distribution under them: for example, a liability under a private suit to a shareholder as a result of misstatement to the market.
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.
On one hand, the definition of Income is very wide:
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.
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 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. 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.
What about limitation periods? Unlikely to help: if the amount only becomes due ten years after the original incident that gave rise to it — modern commercial litigation does tend to rumble on a bit — but, in the elegant words of Section 5 of the Limitation Act 1980, “an action founded on simple contract shall not be brought after the expiration of six years from the date on which the cause of action accrued”. No cause of action existed until the court award was made, so the clock only just started running.
- It should be said, usually for good reasons: “I’ve cut my NAV! I’ve closed my book! I’ve suffered subscriptions and redemptions and I have no way to pass on the loss”.
- For exactly the same reasons: “I’ve cut my NAV! I’ve closed my book! I’ve suffered subscriptions and redemptions and I have no way to pass on the gain”.
- What? What?
- Or much less a “Dividend” as contemplated by the 2002 ISDA Equity Derivatives Definitions, for that matter.
- The Limitation Act 1980 was the subject of a 320 page law commission monograph in 2015 — knock yourself out — so clearly someone sees the opportunity to change the law.