Cancellation Amount - Equity Derivatives Provision
2002 ISDA Equity Derivatives Definitions
Section 12.8 in a Nutshell™
Full text of Section 12.8
Content and comparisons
- 12.8(a) “Cancellation Amount”
- 12.8(b) “Means of determination”
- 12.8(c) “Determination”
- 12.8(d) “Quotations”
- 12.8(e) “Liquidation of hedges”
- 12.8(f) “Determining Party”
- 12.8(g) “Commercially reasonable procedures”
If it’s a beast under the 2002 ISDA Equity Derivatives Definitions, it was going to be worse under the (ill-fated) 2011 ISDA Equity Derivatives Definitions, though it seems, after nearly a decade of solemn inactivity, we will never now know just how bad it was going to be.
But we can take some solace that, somewhere out in the multiverse there is an alternative us, inhabiting a world just like this one, only in which the market adopted the 2011 Equity Derivatives Definitions instead of roundly ignoring them, as ours has done.
In that accursed parallel universe, our mortal equivalents — good people; kind people; people who otherwise resemble you and me, readers — who live, love and aspire to intellectual and moral fulfillment, just as we do — those poor souls have had to endure this unending hardship. We may not know, we cannot tell what pains they have had to bear, so it falls to Clifford Chance — not without some hubris, we feel — to imagine it for us:
- “This provision has been amended heavily and now runs to over 10 pages. It sets out different optional methods of calculating the transaction value, rather than following a purely replacement value approach (as under the 2002 Definitions) which was considered not to be appropriate in all cases. Greater detail is also provided as to how and when the Cancellation Amount is to be determined, what data is to be taken into account and how losses/gains resulting from hedge close-outs are allocated.”
On the other hand, in that parallel universe there is also a squadron of Linklaters FPML Avenger torpedo bomber pilots that survived to a ripe old age, and now while away their days in front of the hearthstone, regaling their grandchildren about the time they saved western civilisation as we know it by converting those dangerous, texty old 2002 ISDA Equity Derivatives Definitions into machine-readable markup language.
Section 12.8(a) “Cancellation Amount”
Cancellation Amount is a beast of a definition. But when you boil it down, it’s pretty straightforward. It applies when terminating a Transaction following an Extraordinary Event or an Additional Disruption Event. Importantly, by dint of Section 12.8(e), the Determining Party may pass through hedge breakage costs and losses.
Now, what gains or losses might the Determining Party incur in replacing the material terms of the Transaction if, due to wars, sanctions and other miscellaneous geopolitical hanky-panky, a market gets totally shut down? If, for example, the outside world has imposed economic sanctions on the jurisdiction in which your Shares trade (as, at the time of writing, seems far possible for Russia), of if the Shares’ jurisdiction itself imposes sanctions on money coming in from or going out to the outside world (as did Greece, for a brief moment, in 2015)?
Well, worst case, the holder of a long swap position might get a doughnut. The holder of a short position could, conceivably, lose even more, were the value of affected Shares to spike during the sanctions, but that seems practically unlikely: the nature of economic sanctions and geopolitical turmoil tends not to boost local equity markets and, we imagine, generally would make affected shares go down in price. Here the problem might instead be that the holder of the short position can’t close out, despite desperately wanting to.
In either case, the dealer’s attitude is likely to be the same: “I can’t see a bid-ask to do what I need to do to [keep a long position going/close a short position out] (delete as applicable). If you can find me such a bid or ask I can trade on I will, but if not, I regret to say you may get bupkis.”
Now the nature of geopolitical events is to be unpredictable. They may manifest themselves in different and unexpected ways, so — while no-one likes to rag on ISDA’s crack drafting squad™ more than the JC does, readers, you know that — you can’t really blame the ’squad for not setting out the myriad of unintended knock-on consequences there might be to your equity derivative portfolio as a result of an unwarranted military incursion in the Urals.
Talk to your clients
That said, it is all about managing expectations. The other typical characteristic of geopolitical hanky-panky is that it rarely comes out of the blue: it brews, there is posturing, brinkspersonship, manoeuvering before anything happens. This is a good time to get out and talk to your clients. Remember the name of the game is to manage client expectations: a client who didn’t know it had some risk, even though it should have known (or, in fact did know but in a moment of motivated irrationality had conveniently forgotten) is more likely to be upset when that risk materialises than one who did know, because you reminded it. Your goal, remember, is not to win litigation with your customers, but avoid it.
Section 12.8(b) “Means of determination”
What to make of that loaded expression commercially reasonable? A good place to look is Barclays v Unicredit, which considered what a party must do if it is required to act “in a commercially reasonable manner”. Basically it is sensible and solemn and workable — you are entitled to consider your own book, your own models and your own axes, and can’t be second guessed by some appeal to the hypothetical.
As a corrective to any irrationally giddy feelings of happiness this may induce, see also Crowther v Arbuthnot Latham & Co Ltd — yes, you can legitimately consider your own risk situation, and you are best placed to judge it, but all the same this is not a licence to do what the hell you like.
If a discretion is designed for one purpose, you can’t use it, to the exclusion of that purpose, to achieve another.
Section 12.8(c) “Determination”
From the “I never said you couldn’t” school of drafting. When acting in a commercially reasonable manner, the Calculation Agent may can consider dealer quotes, market data and its internal models. Glory be.
Section 12.8(d) “Quotations”
If, having gone out and got some dealer quotations or market data for the purpose of determining the Cancellation Amount, the Calculation Agent doesn’t like what it got, it has to use it unless with a straight face it can say to do so would be to produce some manifestly erroneous outcome. This keeps the Calculation Agent — which will be one of the parties, remember; usually the dealer — honest (if its regulatory obligations to treat customers fairly, not be a dork and so on, doesn’t).
Section 12.8(e) “Liquidation of hedges”
This makes it clear that on a Hedging Disruption, for example, the Determining Party can pass on at least the market risk of replacing any disrupted hedge (and probably the credit risk too, though where the hedge is a cash trade settling DVP there would be no credit exposure).
Section 12.8(f) (Determining Party)
We have a whole page dedicated to the Determining Party.
Section 12.8(g) “Commercially reasonable procedures”
Not a lot to say here other than in defining “commercially reasonable procedures” the definitions — inadvertently, since they predate it — provide a gloss over the common law understanding of the expression, as fabulously articulated in Barclays v Unicredit. But, in truth, not much of one.
A dispute right for Calculation Agent and Determining Party determinations?
Recognising that “should you?”, and “will you have to?”, are different questions — buyside counsel may insist, using their regular platter of exotic preparations of canard that buyside lawyers always serve up, and you may ultimately decided not to die in a ditch about it, however much it pains you — recognising all that; here — if you are doing synthetic prime brokerage business — is how it rolls.
Client’s lawyer: we must have a dispute right, so help me.
- The Dealer will be the Calculation Agent. (True.)
- The Dealer will be the Hedging Party. (True.)
- The Dealer will be the Determining Party. (True.)
- Dealers are bad, venal people. They have blackened hearts and will stop at nothing to rip their clients’ faces off. We need some check on their unfettered and sure-to-be outrageously exercised discretion. (A matter of debate and, to be sure, recent history has not looked kindly on the goings on in some dealers, but if that’s your starting point a far better question is “why are you doing business with such a rascal in the first place”? And generally, hedge funds haven’t had a spotless track record either, have they? For every Lehman, there’s been an LTCM, Amaranth, Archegos, SAC, Galleon and, er, Madoff.)
The Dealer’s lawyer: Look, dudes, you seem to be missing the point.
- Firstly, This is synthetic prime brokerage. It isn’t an arm’s length trading arrangement. It is business facilitation for you. When we hedge, we are delta neutral. That means if our hedge pays us 50, we pay you 50. So firstly, we can’t rip your face off, even though it is one only a mother could love.
- Secondly, we are owe you best execution
- Thirdly, because we delta hedge, we come up with our “determinations” by actually selling the right number of shares. It isn’t like we confect some hypothetical valuation based on a model some geek in correlation trading built in excel. We don’t go ask some stooge dealers for a soft estimate, and promise them champagne in the mail. We actually sell the stock. Our own money out the door. We can’t get it back. What you are asking is to second guess our actual transaction by you asking some stooge dealer for a soft estimate. This is like putting a bet on Crystal Palace to beat Scunthorpe and when Palace loses, telling the bookmaker: “but my buddy is a football expert, and he says Palace were dead unlucky, hit the crossbar a couple of times, and that Scunthorpe goal should have been disallowed, so really it should have been a 4:0 win to Palace. So you have to pay me anyway.”
- Fourthly, there are a ton of controls on us already, contractual, regulatory and economic:
- Contractual: Section 12.8 of the Equity Derivatives (especially Sections 12.8(b) and 12.8(g)) is shot through with requirements to act in a commercially reasonable manner, using commercially reasonable procedures, going out to leading dealers and so on. Likewise, a whenever a Calculation Agent is acts or exercises judgment in any way, it must do so in good faith and in a commercially reasonable manner (See Section 1.40). What the dispute provision is aimed to do, your adversary will say, is provide a stick to enforce that obligation. but at some point this becomes an infinite regression: what if the dispute is not registered in good faith? Where is the stick to enforce that?
- Regulatory: There's the best execution obligation. The COBS rules require us to treat our clients fairly.
- Economic: You are the client. You can pull your business. You can decide to never give us another trade. Seeing as we are delta-one hedged, we have no incentive at all to lowball, and every incentive to give you the best price we can manage.