Template:M summ 2000 GMSLA 6.1

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What is the significance of the wording “... would have been entitled to receive...”? What if the Issuer is obliged to make the payment, but doesn’t? Does the Borrower of such a stock guarantee the Issuer’s performance? It is hard to see how this is intended, but that is one way you could read the wording.

In the 2010 GMSLA it the wording is modified (Clauses 6.2 and 6.3) to provide “... that would be received ...”

...Income paid in relation to any Loaned Securities

Another example of that loose prepositional phrasein relation to” being used carelessly in the 2010 GMSLA. The preposition in question here really ought to be “under” or, if you really must, “pursuant to”.

This is Income paid by the issuer under the terms of the contract comprising the Loaned Securities or Collateral; “in relation to” might be misread to imply something a little looser. For example, moneys paid by someone else in relation to the securities —— a derivative counterparty or credit default insurance provider, or even a payment made by the issuer that relates to the shares, but is not a distribution under them: for example, a liability under a private suit to a shareholder as a result of misstatement to the market.

Must the Loan be outstanding on the Income payment date??

Paragraph 6.1 says, of manufactured income:

“Where Income is paid in relation to any Loaned Securities [...] on or by reference to an Income Payment Date ...”

Say I hold Securities on their Income Payment Date (NB: this is 2000 GMSLA speak for the Income Record Date[1]), being the date by reference to which the Income was payable, but then I artfully redeliver Equivalent Securities back to you before the date on which the relevant Income is actually paid, then must I manufacture the dividend?

A common sense economic analysis would say yes: the Lender was not the holder of record on the record date, by reason of the Borrower having borrowed the shares. So the Borrower should manufacture the payment.

Also, any other view would be an easy end-run for a nefarious Borrower: once the Income record date passes, it could redeliver the shares back to the Lender before the payment date, and avoid ever having to manufacture a dividend. that can’t be the intention, right?

Well, on a literal reading, maybe: when the Income is paid, the Securities are not “Securities which are ...” — present tense — “... the subject of an outstanding Loan.”

The 2010 2010 GMSLA deals with this by using the same expression, Loaned Securities[2] in a subtly different way in Paragraph 6.1:

Where the term of a Loan extends over an Income Record Date in respect of any Loaned Securities, Borrower shall, on the date such Income is paid by the issuer [...] pay or deliver to Lender...

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[3] has jemmied some extra cash out of a reluctant issuer. Had it not done so no one would have been any the wiser.

A more sober legal argument

That is what JC the bon viveur might say, over a bottle of claret, when (as often it does, after dinner in the Contrarian house) the subject of corporate malfeasance comes up in polite conversation. It is all very gnomic. So let us put it in better shape, for the more literal minded:

  • The definition of “Income” in respect of shares is restricted to dividends and distributions of an analogous nature: unconditional payments payable to all shareholders under their shares pro-rata to reflect a distribution by the issuer following the profitable operation of the business.
  • Compensation paid by a company as a result of misstatements of its books, leading to mispricing of its shares on public exchanges, is not “Income” on Securities under the 2010 GMSLA.[4] Indeed, it does not arise under the contract that comprises the shares at all.
  • Income” is defined as meaning “any interest, dividends or other distributions of any kind whatsoever with respect to any Securities …”:
  • with respect to”: In the context of a securities lending arrangement, Income can only relate to payments made under the terms of the Securities themselves. That is, payments made by the issuer, to shareholders, in their capacity as shareholders. That is, dividend-like payments: rewards to all shareholders on the income record date ratably for the prudent management and healthy profitability of the company in general.
  • Payments under a court settlement for negligent misstatement of public accounts are not payable ratably to all current shareholders, but only to those who bought or sold (or did not buy or sell) in reliance on the statement. Nor do they reflect the company’s good management. They are made to specific investors, as compensation for misrepresentations which may have influenced their decisions with regard to their shareholding (to buy, or not to sell). In the case of “buyers”, these representations may have been made when they were not shareholders.
  • Compensation therefore addresses tortious — i.e., non-contractual — claims for negligent misstatement. The claimant’s purchase, or holding and non-sale of securities in reliance on the statement is relevant to its measure of loss, but does not define the nature of the wrong (being the misstatement itself).
  • “any securities”: bolstering this — though possibly almost into “the lady doth protest too much” territory — income to be manufactured should be available pari passu to all shareholders of the same class that is subject to the stock loan. The distribution must be “…with respect to any Securities … ”, not just some of them. The contract cannot function otherwise.
  • Unconditional: “Income” describes unconditional payments made to all holders of record as of the Income record date without any conditionality or consideration attaching to it. Participation in a private settlement obliges a claimant to take positive action and waive rights it might otherwise have to take action against the company.
  • Therefore, this is not a claim in contract under the Securities themselves: as a matter of basic principle, negotiable instruments of a given ISIN are necessarily fungible: their intrinsic rights must be identical. A payment to owing to some, but not other shareholders, cannot be a direct function of share ownership itself. That the payment arises independently of entry on the share register and is not available to all shareholders means it must be due as a result of the issuer’s breach of a correlative duty it owed to some particular investors (and potential investors) but not others.
  1. That this is sloppily expressed is another whole conversation — in any case it was (partially) fixed in the 2010 2010 GMSLA.
  2. Defined exactly the same way as Loaned Securities in the 2000 GMSLA
  3. What? What?
  4. Or much less a “Dividend” as contemplated by the 2002 ISDA Equity Derivatives Definitions, for that matter.