Payment upon Certain Extraordinary Events - Equity Derivatives Provision

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2002 ISDA Equity Derivatives Definitions

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12.7 in a Nutshell

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12.7 Payment upon Certain Extraordinary Events

12.7(a) If, in respect of an Extraordinary Event, “Cancellation and Payment” or “Partial Cancellation and Payment” applies or is deemed to apply to the relevant Transaction (or a portion thereof), then an amount will be paid by one party to the other determined as provided in clause (b) or (c) below, such payment to be made not later than three Currency Business Days following the date that notice of the determination by the Calculation Agent or the Determining Party, as the case may be, of such amount (denominated in the currency for settlement of the Transaction as determined by the Calculation Agent or the Determining Party, as the case may be) and which party shall pay such amount is effective, which notice shall be provided promptly following such determination.
12.7(b) In respect of an Option Transaction, the amount to be paid by Seller to Buyer will be as agreed promptly (and in any event within five Exchange Business Days) by the parties after the Merger Date, the Tender Offer Date, the date of cancellation in respect of an Index Adjustment Event or the date of occurrence of any event described in Section 12.6, as the case may be (each such date, the “Closing Date”). If the parties are unable to agree on the amount, then:

12.7(b)(i) if “Agreed Model” is specified in the related Confirmation to be applicable to such Transaction, then the amount will be determined by the Calculation Agent as the sum of the Unadjusted Value and the Adjustment Value. For the avoidance of doubt, the Buyer shall not be required to pay any amount to the Seller as a result of the cancellation of the Option Transaction other than any unpaid Premium which Buyer will be obliged to pay to Seller as of the date that the amount determined in this Section 12.7(b)(i) is paid.
(A) “Unadjusted Value” means an amount determined by the Calculation Agent as the value of the Option Transaction (or portion thereof) on the Closing Date based on:
(1) a volatility equal to the average of the Implied Volatilities of the relevant Shares on each of the 15 Exchange Business Days ending on and including the Closing Date;
(2) expected dividends for the time period from the Closing Date until the Expiration Date based on, and payable on the same dates as, (a) amounts to have been paid in respect of gross ordinary cash dividends on the relevant Shares in the one-year period ending on the Closing Date or (b) in the event of an {{subst:Issuer}} published change to dividend policies on the relevant Shares (as determined by the Calculation Agent) prior to the Closing Date, the expected dividends determined in accordance with such published change, in each case excluding Extraordinary Dividends;
(3) a value ascribed to the relevant Shares as determined by the Calculation Agent and, if applicable, equal to the value of the consideration, if any, paid or delivered in respect of such Shares to holders of such Shares at the time of the Extraordinary Event;
(4) a combined interest rate and stock loan rate as specified in the related Confirmation for the period from, and including, the Closing Date to, but excluding, the Expiration Date; and
(5) a term of the Option Transaction from the Closing Date to the Expiration Date.
(B) “Adjustment Value” means the difference between the amounts determined pursuant to (B)(1) and (B)(2) below:
(1) a value of the Option Transaction (or portion thereof) determined by the Calculation Agent based on:
(a) a volatility equal to the average of the Implied Volatilities of the relevant Shares on each of the 15 Exchange Business Days ending on but excluding the Announcement Date;
(b) expected dividends for the time period from the Announcement Date until the Expiration Date based on, and payable on the same dates as, (x) amounts to have been paid in respect of gross ordinary cash dividends on the relevant Shares in the one-year period ending on the Announcement Date or (y) in the event of an Issuer published change to dividend policies on the relevant Shares (as determined by the Calculation Agent) prior to the Announcement Date, the expected dividends determined in accordance with such published change, in each case excluding Extraordinary Dividends;
(c) a value ascribed to the relevant Shares equal to the Settlement Price (assuming Cash Settlement were applicable) of the relevant Shares as of the Valuation Time (for which purpose the Valuation Date will be the Announcement Date);
(d) a combined interest rate and stock loan rate as specified in the related Confirmation for the period from, and including, the Announcement Date to, but excluding, the Expiration Date; and
(e) a term of the Option Transaction from the Announcement Date to the Expiration Date.
(2) a value for the Option Transaction (or portion thereof) based on the factors listed in (1)(a)-(e) above, except with a volatility equal to the average of the Implied Volatilities of the relevant Shares on each of the 15 Exchange Business Days commencing on and including the Announcement Date.
12.7(b)(ii) If “Calculation Agent Determination” is specified in the related Confirmation to be applicable to such Transaction, then the amount will be determined by the Calculation Agent, which determination may, but need not, be based on the factors and adjustments set forth in paragraph (i) above.

12.7(c) For any Forward Transaction or Equity Swap Transaction, such Transaction shall be cancelled and the relevant party or parties (as specified below) shall determine the Cancellation Amount in respect of such cancelled Transaction.

(i) In respect of a cancelled Transaction where there is one Determining Party, the Determining Party will calculate the Cancellation Amount and will determine which party will pay such amount.
(ii) In respect of a cancelled Transaction where there are two Determining Parties, each party will calculate a Cancellation Amount and an amount will be payable equal to one-half of the difference between the Cancellation Amount of the party with the higher Cancellation Amount (“X”) and the Cancellation Amount of the party with the lower Cancellation Amount (“Y”) and Y shall pay it to X.

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Overview

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Not to be confused with Cancellation and Payment as they appear in section 11.1(b) relating to Adjustments and Modifications, and Partial Cancellation and Payment as it relates to Merger Events in section 12.2(f).

Extraordinary Events under Article 12 are of a more existential nature, and will require either termination or adjustment with mutual consent of the parties. These are:

What happens upon Cancellation following Extraordinary Events depends on whether your Transaction is an Option Transaction — in which case Section 12.7(b) applies and there is all kinds of fun with Agreed Models or Calculation Agent Determination — or a Forward Transaction or Equity Swap Transaction, in which case the shorter Section 12.7(c) will apply, and unless you’ve been unwise enough to agree there should be two Determining Parties, the Hedging Party (in its guise as Determining Party) will close out its hedge and present the bill.

Summary

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The calculation of Cancellation Amounts following Extraordinary Events is one of those classic negotiation oubliettes that opposing counsel will gladly fall into, the way Unlucky Alf falls into open manholes. The JC has seen storied partners of serious law firms get in quite the lather about this, from positions of apparent ignorance, hotly insisting co-caclulation agency to be a matter of life or death, predicated on the assumption that given half a chance, these venal swap dealers won’t break a stride before ripping hunks off their customers’ faces.

They will say, “my customer must have the right to challenge your price. It must be allowed to consult its favourite dealer, and ask it what the Cancellation Amount should be. We must have a dealer poll. Something like that. Take the average. You know.”

This is a wonderful narrative, vouchsafing as it does tedious, remunerative arguments that their customers may indeed believe save them from great peril — but it really need not be that complicated.

Firstly: remember the commercial imperative. As the old saying has it, “he who burns his customer’s shed down, steals his oxen and sells his children into slavery cannot expect to sit at his customer’s annual broker review without the subject coming up”.

Secondly, ask why, if your customer’s other broker is so damn good, it didn’t get the trade in the first place?

Thirdly, remember what is going on here: the dealer — who the customer selected precisely because it is such a good broker, with unbeatable access to liquidity, flawless execution and competitive pricing, right? (and if not, why not?) — is struggling to find a good price for a stock because it has been de-listed, nationalised, gone insolvent, or been subject to some awful liquidity crunch. Your dealer, not having a dog in the fight, will want to get the best price it can to terminate the hedge as it will pass that on to its customer.

Extraordinary Events being, well, extraordinary, this will not happen often, and no dealer with a functioning brain[1] will just terminate a position against its customer’s wishes without consulting its customer. It will say, “look, here’s the price we see: does this work for you?” If the customer can source a better price — as in, “firm, tradable price” then the dealer will happily take it. But honestly it isn’t that likely: all the customer can really do is ask another broker, who is likely to see a similar picture. Colour me wrong on that, but if so, happy days: as long as our Determining Party can lift the offer, it will take it and everyone will be simpatico. But, still, it is unlikely.

And in the mean time, while the customer is going through its agonised machinations — should I? shouldn’t I? — the price that its dealer did get can go quickly stale. Once it’s off the table, the customer loses its right to trade at that price. There needs to be this tension: dealers are not writing options here: the customer only gets a price the dealer can actually trade on.

Accordingly, the dealer will be most unamused if a customer asks it to consider an alternative price someone else has come up with to value its own hedge liquidation. This is like saying, to a football fan, “look, I know Crystal Palace lost to Scunthorpe in extra time at the weekend, but my mate 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 called off-side, so why don’t we call this 4:0 to Palace?”

So when a customer huffily expects a right to provide a second opinion that is not a tradable price, it — and its lawyers — can expect a rather plainly spoken response. To the complaint that, “but the stock has been delisted! There is no price in the market! I can’t be sure this price is right!” comes the answer: friend: that is exactly the risk you ran when you bought a swap on this stock. You are buying precisely the risk that it goes insolvent, gets nationalized or is delisted.

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  • The JC’s famous Nutshell summary of this clause

Template:M premium Equity Derivatives 12.7

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See also

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Section 12.7. Payment upon Certain Extraordinary Events

12.7(a) (Cancellation and Payment; Partial Cancellation and Payment)
12.7(b) (Effect of Extraordinary Events on Option Transactions)
12.7(c) (Effect of Extraordinary Events on Forward Transactions and Equity Swap Transactions)

References

  1. I know, I know.