Adjustments to Share Transactions and Share Basket Transactions - Equity Derivatives Provision

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2002 ISDA Equity Derivatives Definitions
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Resources About the Equity Derivatives Definitions | (full wikitext) | (nutshell wikitext)
Hot topics Synthetic Prime Brokerage Anatomy | The Triple Cocktail | Cancellation and Payment | Calculation Agent
TOC | 1 General Definitions | 2 Option Transactions | 3 Exercise of Options | 4 Forward Transactions | 5 Equity Swap Transactions | 6 Valuation | 7 Settlement | 8 Cash Settlement | 9 Physical Settlement | 10 Dividends | 11 Adjustments and Modifications | 12 Extraordinary Events · 12.8 Cancellation Amount · 12.9 Additional Disruption Events · 12.9 List of ADEs · 12.9(b) Consequences of ADEs | 13 Miscellaneous

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Section 11.2 in a Nutshell
Use at your own risk, campers!

11.2. Adjustments to Share Transactions and Share Basket Transactions.

11.2(a)Method of Adjustment” means a method for working out how to adjust a Share Transaction or Share Basket Transaction following an event that the Calculation Agent determines diluted or concentrated the theoretical value of the Shares.
11.2(b): Options Exchange Adjustment: If the Method of Adjustment is “Options Exchange Adjustment” then following adjustment to exchange-traded options the Calculation Agent will adjust any relevant variable under that Transaction that it thinks necessary to reflect the Options Exchange adjustment, effective as of the same date.
If there aren’t any exchange-traded options options on the Shares, the Calculation Agent will adjust the Transaction as it thinks fit to account for the diluting or concentrative effect of any event that, would have led to an adjustment under the Options Exchange’s rules had options in the Shares in question been traded on it.
11.2(c) If “Calculation Agent Adjustment” is the Method of Adjustment for a Share Transaction or Share Basket Transaction (or if none is specified) then following the Issuer’s declaration of an Potential Adjustment Event, the Calculation Agent will determine whether the Potential Adjustment Event will concentrate or dilute the value of the Shares. If it will, the Calculation Agent may:
(i) adjust any relevant variable under that Transaction it considers necessary to account for that dilution or concentration (without adjusting just for changes in volatility, expected dividends, stock loan rate or liquidity) and
(ii) determine the effective dates of any adjustments.
The Calculation Agent may refer to adjustments an Options Exchange makes to corresponding options when doing so.
11.2(d)Options Exchange” will be specified in the Confirmation and includes any successor or substitute exchange or quotation system on which options contracts on the Shares have relocated (on which the Calculation Agent is satisfied there is comparable liquidity). If one is not specified, it will be the Related Exchange the Calculation Agent determines is the primary market for listed options contracts relating to the relevant Share.
11.2(e)Potential Adjustment Event” means any of:
(i) a subdivision or reclassification of Shares (not counting a Merger Event) or a free bonus distribution of any such Shares to existing holders;
(ii) a distribution to existing holders of the relevant Shares of:
(A) such Shares; or
(B) securities granting the right to dividends or the proceeds of liquidation of the Issuer proportionately to holders of those Shares; or
(C) securities of an entity owned by the Issuer as a result of a spin-off; or
(D) any other securities, rights or assets for consideration of less than their prevailing market price as determined by the Calculation Agent;
(iii) an Extraordinary Dividend;
(iv) an Issuer call over partially-paid Shares;
(v) a repurchase by the Issuer or any of its subsidiaries of relevant Shares;
(vi) any shareholder’s rights being distributed or separated from the Issuer’s shares under a shareholder rights arrangement that provides for distribution of preferred stock, warrants, debt or rights below their prevailing market value, as determined by the Calculation Agent, provided that any adjustment effected following such an event must be readjusted if those rights are redeemed; or
(vii) any other event that may dilute or concentrate the relevant Shares.

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Full text of Section 11.2

Section 11.2. Adjustments to Share Transactions and Share Basket Transactions.

11.2(a)Method of Adjustment” means a method for determining the appropriate adjustment to make to the terms of a Share Transaction or Share Basket Transaction upon the occurrence of an event having, in the determination of the Calculation Agent, a diluting or concentrative effect on the theoretical value of the relevant Shares.
11.2(b) If “Options Exchange Adjustment” is specified as the Method of Adjustment in the related Confirmation of a Share Transaction or Share Basket Transaction, then following each adjustment to the exercise, settlement, payment or other terms of options on any relevant Shares traded on any Options Exchange, the Calculation Agent will make the corresponding adjustments, if any, to any one or more of:
(i) in respect of a Share Option Transaction or a Share Basket Option Transaction, the Strike Price, the Number of Options, the Option Entitlement, the Knock-in Price, the Knock-out, and the relevant Number of Shares;
(ii) in respect of a Share Forward Transaction or a Share Basket Forward Transaction, the Forward Price, the Forward Floor Price, the Forward Cap Price, the Knock-in Price, the Knock-out Price, and the relevant Number of Shares;
(iii) in respect of a Share Swap Transaction or a Share Basket Swap Transaction, the Initial Price, the Equity Notional Amount, the Knock-in Price, the Knock-out Price, and the relevant Number of Shares;
and, in any case, any other variable relevant to the exercise, settlement, payment or other terms of that Transaction, as determined by the Calculation Agent, which adjustment will be effective as of the date determined by the Calculation Agent to be the effective date of the corresponding adjustment made by the Options Exchange. If options on the relevant Shares are not traded on the Options Exchange, the Calculation Agent will make such adjustment, if any, to any one or more of the relevant variables referred to above or any other variable relevant to the exercise, settlement, payment or other terms of the Transaction as the Calculation Agent determines appropriate, with reference to the rules of and precedents (if any) set by the Options Exchange, to account for the diluting or concentrative effect of any event that, in the determination of the Calculation Agent, would have given rise to an adjustment by the Options Exchange if such options were so traded.
11.2(c) If “Calculation Agent Adjustment” is specified as the Method of Adjustment in the related Confirmation of a Share Transaction or Share Basket Transaction (or if no Method of Adjustment is specified in the related Confirmation for such Transaction), then following the declaration by the Issuer of the terms of any Potential Adjustment Event, the Calculation Agent will determine whether such Potential Adjustment Event has a diluting or concentrative effect on the theoretical value of the relevant Shares and, if so, will
(i) make the corresponding adjustment(s), if any, to any one or more of:
(A) in respect of a Share Option Transaction or a Share Basket Option Transaction, the Strike Price, the Number of Options, the Option Entitlement, the Knock-in Price, the Knockout Price, and the relevant Number of Shares;
(B) in respect of a Share Forward Transaction or a Share Basket Forward Transaction, the Forward Price, the Forward Floor Price, the Forward Cap Price, the Knock-in Price, the Knock-out Price, and the relevant Number of Shares;
(C) in respect of a Share Swap Transaction or a Share Basket Swap Transaction, the Initial Price, the Equity Notional Amount, the Knock-in Price, the Knock-out Price, and the relevant Number of Shares;
and, in any case, any other variable relevant to the exercise, settlement, payment or other terms of that Transaction as the Calculation Agent determines appropriate to account for that diluting or concentrative effect (provided that no adjustments will be made to account solely for changes in volatility, expected dividends, stock loan rate or liquidity relative to the relevant Share) and
(ii) determine the effective date(s) of the adjustment(s).
The Calculation Agent may (but need not) determine the appropriate adjustment(s) by reference to the adjustment(s) in respect of such Potential Adjustment Event made by an options exchange to options on the relevant Shares traded on such options exchange.
11.2(d)Options Exchange” means the exchange or quotation system specified as such in the related Confirmation, any successor to such exchange or quotation system or any substitute exchange or quotation system to which trading in options contracts relating to the relevant Share has temporarily relocated (provided that the Calculation Agent has determined that there is comparable liquidity relative to such options contracts on such temporary substitute exchange or quotation system as on the original Options Exchange) or, if no such exchange or quotation system is specified in the related Confirmation, the Related Exchange (if such Related Exchange trades options contracts relating to the relevant Share) or, if more than one such Related Exchange is specified in the related Confirmation, the Related Exchange selected by the Calculation Agent as the primary market for listed options contracts relating to the relevant Share.
11.2(e)Potential Adjustment Event” means any of the following:
(i) a subdivision, consolidation or reclassification of relevant Shares (unless resulting in a Merger Event), or a free distribution or dividend of any such Shares to existing holders by way of bonus, capitalization or similar issue;
(ii) a distribution, issue or dividend to existing holders of the relevant Shares of (A) such Shares, or (B) other share capital or securities granting the right to payment of dividends and/or the proceeds of liquidation of the Issuer equally or proportionately with such payments to holders of such Shares, or (C) share capital or other securities of another issuer acquired or owned (directly or indirectly) by the Issuer as a result of a spin-off or other similar transaction, or (D) any other type of securities, rights or warrants or other assets, in any case for payment (cash or other consideration) at less than the prevailing market price as determined by the Calculation Agent;
(iii) an Extraordinary Dividend;
(iv) a call by the Issuer in respect of relevant Shares that are not fully paid;
(v) a repurchase by the Issuer or any of its subsidiaries of relevant Shares whether out of profits or capital and whether the consideration for such repurchase is cash, securities or otherwise;
(vi) in respect of the Issuer, an event that results in any shareholder rights being distributed or becoming separated from shares of common stock or other shares of the capital stock of the Issuer pursuant to a shareholder rights plan or arrangement directed against hostile takeovers that provides upon the occurrence of certain events for a distribution of preferred stock, warrants, debt instruments or stock rights at a price below their market value, as determined by the Calculation Agent, provided that any adjustment effected as a result of such an event shall be readjusted upon any redemption of such rights; or
(vii) any other event that may have a diluting or concentrative effect on the theoretical value of the relevant Shares.

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Content and comparisons

Article 11. Adjustments and Modifications Affecting Indices, Shares and Transactions
Section 11.1 Adjustments to Indices

11.1(a) (Successor Indices)
11.1(b) (Index Adjustment Events)
11.1(b)(A) (Calculation Agent Adjustment (Adjustment Events))
11.1(b)(B) (Negotiated Close-out (Adjustment Events))
11.1(b)(C) (Cancellation and Payment (Adjustment Events))

Section 11.2. Adjustments to Share Transactions and Share Basket Transactions

11.2(a). Method of Adjustment
11.2(b). Options Exchange Adjustment
11.2(c). Calculation Agent Adjustment
11.2(d). Options Exchange
11.2(e). Potential Adjustment Event

Section 11.3. Adjustments to Certain Share Transactions and Share Basket Transactions in European Currencies
Section 11.4. Correction of Share Prices and Index Levels

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Summary

“...an event having a diluting or concentrative effect...”

And what might these events be? Where you reference Options Exchange Adjustment, they are not specified, it being supposed that the Options Exchange’s say so, as an independent party in the middle of the action but with no dog in the fight, ought to be good enough for everyone not to argue about it. But that doesn’t help explain what this provision is meant to do. But the corresponding text under 11.2(c) (Calculation Agent Adjustment) helps. The events and circumstances we are talking about are these (not a comprehensive list):

  • Things that might dilute share value: Any unilateral action by an issuer that would mean existing holders are given more “stuff”, in whatever form: share subdivisions, distributions, convertibles, exchangeables, Extraordinary Dividends. Note this excludes anything that would count as a Merger Event, that event being dealt with elsewhere.
  • Things that might concentrate share value: Any unilateral action by an issuer requiring a holder to pony up, or give up, anything: calls over partially-paid shares, for example.
  • Things that could do either: So any significant buy back by the Issuer of its own shares (especially if not at prevailing market value.

Where there are no exchange-traded options

You do have to love ISDA’s crack drafting squad™, don’t you: for who else would take the time to consider[1] what to do when you have selected Options Exchange Adjustment for Shares that don’t have any exchange-traded options. Look, folks, if there are no exchange-traded options on the underlying shares, then don’t select Options Exchange Adjustment as your Method of Adjustment for crying out loud.

If he were in a more patient mood, the JC might suppose that options may unexpectedly cease trading on exchange after a Transaction is executed, or may be temporarily suspended — and perhaps “an event having a concentrative or dilutive effect on the value of the shares” might be just the thing to cause a suspension or delisting. But even this is a recommendation to plump for Calculation Agent Adjustment under 11.2(b). You would think. I know, I know: but the Calculation Agent — usually the broker dealer counterparty to the transaction, of course —might rip my face off!

But, firstly, what choice have you got? If the options aren’t traded on exchange, what else are you doing to do: have a dealer poll? If they are traded on exchange, and the Calculation Agent makes a determination at variance from the one the Options Exchange makes, it will have to justify how it is acting “in good faith and a commercially reasonable manner”, being the standard required of it by Paragraph 1.40. Furthermore, if it is delta-one-hedging (as it will be, if you you are doing synthetic prime brokerage), its is market neutral and has no interest in delivering you a bad outcome, and indeed every incentive, under the commercial imperative to deliver you a good one.

Retrospective adjustments

Now what might happen under a total return swap if such a Potential Adjustment Event happens retrospectively, after a Transaction has been terminated (or has matured)? This does happen from time to time. For example:

A total return swap transaction is traded on 1 January. It matures and is settled on 1 June. On 1 September, following an accounting error coming to light, the Issuer declares a bonus share issue to all holders of record on 1 March. which it pays out on 1 December.

First thing: just because the Transaction has passed its term, doesn't mean it winks out of existence, white rabbits and no returns. Payment obligations which were due under the term remain due and payable afterward - see the commentary to Termination Date in the 2006 ISDA Definitions.

So the question is which is the material date the date on which the Potential Adjustment Event happened (in the above, 1 September, outside the term of the trade), the date on which it was settled (1 December, also outside the term of the trade) or the date on which was deemed to be effective (being 1 March, during the transaction)?
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See also

Template:M sa Equity Derivatives 11.2
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References