Template:GMSLA compensation for mismanagement

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.

Such disputes can take years — decades even — to iron out, can take any number of different forms and, if viewed as Income, represent a significant tail risk in a Borrower’s trading book.

On one hand, the definition of Income is very wide:

Income means any interest, dividends or other distributions of any kind whatsoever with respect to any Securities or Collateral;

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.

The Short-seller bets that the truth will eventually come out and, when it does, the securities will fall in price. It can then buy them back, take a profit, and deliver them back to the Lender.

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.