Nationalization, Insolvency and Delisting - Equity Derivatives Provision
2002 ISDA Equity Derivatives Definitions
Section 12.6 in a Nutshell™
Full text of Section 12.6
Content and comparisons
- 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)
- 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 these particular Extraordinary Events (Nationalization, Insolvency and Delisting) occur, the parties may elect to terminate (if they choose Negotiated Close-out), or the transaction will automatically terminate (if Cancellation and Payment (Extraordinary Events) or Partial Cancellation and Payment (Extraordinary Events) are selected).
- Cancellation and Payment means that on one of these Extraordinary Events occurring, the trade is terminated immediately and valued by the Calculation Agent or the Determining Party (important to check who this is!). This gives certainty and would be important in the case of a delta-1 derivative exposure with no defined termination (or where the defined termination is extremely long-dated).
- Negotiated Close-out requires the parties to agree on the termination value, with a fall back to the trade continuing until the scheduled termination date, whereupon it would be valued by the Calculation Agent in good faith (and ignoring the Additional Disruption Event that otherwise would surely be alleged). Note that the trade will terminate, but not until scheduled termination, and in the absence of mutual agreement both parties are committed to the term, which may not make a great deal of sense where the underlyer has been subject to Insolvency, Nationalization or a similarly drastic Extraordinary Event.
Note that a Delisting covers full cessation of trading but not a suspension of trading, even if indefinite. But in that case a Hedging Disruption or - at a pinch - Increased Cost of Hedging ought to get you home.
Depositary receipts and hostile governmental action
Now imagine that rather than nationalizing, a national government announced some draconian law preventing corporations in its jurisdiction from accessing the international capital markets even through depositary receipt programmes — you know, something crazy like that. So say, ooh: the DRs must be converted into underlying shares within a stipulated period, failing which the underlying shares lose their dividend and voting rights
The common sense (and economically correct) answer is “however it shakes out, this is all the customer’s risk” — remember the synthetic equity mantra: this is just equity brokerage done with swaps. Imagine what would happen, dear customer, had your broker sold you the ADR outright, a year ago, and now it has been unwound by wartime governmental manoeuvre. Whose problem would that be? Not your equity broker’s, for sure.
That said, the 2002 ISDA Equity Derivatives Definitions don’t do a magnificent job of specifically dealing with what is undoubtedly an extremely far-fetched situation. For once, we should not be too exacting on ISDA’s crack drafting squad™. I mean, who ever heard of a government forcing local issuers to unwind their GDRs just to spite hostile foreign investors?
So, anyway, you are a swap dealer, everything is messy as hell, tanks are unexpectedly rolling across foreign lands somewhere, and now your customer is on the horn asking what the hell is going on. You, naturally, will be as accommodating and constructive as you can in looking for outcomes for your client in such devilish times, but would still like the peace of mind of knowing, should everything go titten hoch, you can cancel the swap and walk away, paying a nugatory Cancellation Amount based on the worthlessness of the underliers. How can you?
- Nationalization, Insolvency and Delisting: this probably:
- It isn’t a Change in Law as that refers to laws impacting the counterparties to the trade, not the Issuer;
- It isn’t an Increased Cost of Hedging. well — it just isn’t, is it?
- It may be a Hedging Disruption – I mean it is hard to hedge an instrument that has just been compusorily dissolved, right? — though is disappearance of an instrument altogether so that there is nothing to replicate the return of at all really just a hedge disruption?
Also useful at least by way of analogy is “Tender Offer”. It’s not quite on point – but close, and perhaps useful by way of analogy should you have counterparties that are in denial about the fact that, from a very basic standpoint, they are the ones that are long local “craziest regulator in the room” risk, and not their long-suffering swap dealer.
It’s a good question that, we dare say, even ISDA’s crack drafting squad™ would struggle to capably answer, but the reality is that this people tend to disapply Insolvency Filing, as it is covered by other Additional Disruption Events so Insolvency is the important one.
- Attentive readers may wonder whether this is really a figment of the JC’s imagination, or something the Russian State Duma actually did, in April 2022.
- And therefore become largely worthless: they entitle a holder to a pro-rata share of the Issuer’s assets on a non-insolvent winding up or something like that — but who ever wound up a non-insolvent company?