U.S. and non-U.S. banks have offered structured warrants in the U.S. to address the needs of both institutional and highnet worth investors. This article will describe these instruments, how they are offered, and summarize the programs that are used to offer them.
What Are Structured Warrants?
Structured warrants are a form of structured security which are designed to have many of the features of warrants or options over a reference asset. They are typically issued by financial institution issuers, such as bank holding companies. They are purchased with cash, and any required payments to the investor may be made either in cash or “in-kind,” such as in shares of the relevant stock covered by the warrant, depending on the terms of the relevant instrument. Sample structured warrant terms are in the box set forth below.
Structured warrants are not standardized options of the type issued by the Options Clearing Corporation. Purchasers of OCC standardized options have the credit benefits of guarantees and margin and collateral deposits by OCC clearing members to protect the OCC from a clearing member’s failure. In contrast, investors in structured warrants can look only to the issuer for performance of its obligation to pay the cash or other assets due upon payment.
Structured warrants are typically not listed on any securities exchange. Any secondary market for these instruments is typically much more limited than that of standardized OCC options. As is the case for structured notes, investors can typically only look to the dealer from whom they purchased the instrument for liquidity.
Sample Structured Warrants Linked to Equity Index ABC
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Key Differences from Structured “Notes”
Structured warrants differ from structured notes in a number of ways. For example, structured warrants are more likely, by their terms, to expire and lose all their value if the relevant underlying asset does not increase or decrease by the required amount. They do not pay any interest prior to maturity. Because of their terms, their trading value may be even more volatile than a “typical” structured note linked to the same underlying reference asset.
Public vs. Private Offerings
Structured warrants may be sold in a “public offering” under a registration statement. Most financial institution issuers of this product class register warrants in connection with their filing of a “universal shelf,” so that such registration statement may be used for this purpose.
In addition, structured warrants may be offered exclusively to institutional investors under Rule 144A, or to “accredited investors” under U.S. Regulation D.
Accordingly, the selection of the proper offering platform depends in large measure upon the intended purchasers. When available, using non-registered offerings will avoid the payment of SEC filing fees, help enable the investor to maintain the confidentiality of the offering terms, enable the use of reference assets that may not be permitted under the SEC’s “Morgan Stanley” no-action letter, avoid the “qualified independent underwriter” requirement discussed below, and potentially reduce the potential litigation risk of these offerings. Accordingly, a non-registered offering may be a preferred option, particularly when only institutional investors are contemplated. Of course, there are significant restrictions on the transfer of Rule 144A and Regulation D securities, and many individual investors are more comfortable (and accustomed to) investing in a registered instrument.
FINRA Suitability Rules
Because of their leveraged nature and potential for loss, structured warrants are typically regarded as complex investments. Accordingly, broker-dealers exercise caution in recommending the product to investors and screening the relevant investors for purchase. Structured warrants are typically offered only to options-eligible investors. Significant minimum purchase amounts are also often imposed in order to help reduce the likelihood that they will be purchased by less sophisticated investors.
Structured warrants are typically viewed as significantly different from structured notes. Accordingly, broker-dealers typically subject them to a new product approval process and where needed, offer new training and education to their representatives prior to permitting them to offer these investments to accounts.
Qualified Independent Underwriters
In public offerings of warrants, FINRA’s “corporate financing rule” applies. This rule requires the underwriting arrangements and underwriting compensation to be reviewed by FINRA in the absence of an exemption.Structured notes and other debt securities issued by financial institutions typically qualify for the exemption provided for investment grade debt securities. However, to the extent that structured warrants are not “debt securities,” they do not qualify for this exemption.
Accordingly, to offer structured warrants in a registered offering, the issuer typically will involve in the offering a “qualified independent underwriter” (“QIU”), as required by FINRA Rule 5121. Among other requirements, A QIU must, for example, participate in the preparation of the registration statement and prospectus, and exercise the usual standards of due diligence in respect of the offering documents.
SEC-Mandated Estimated Value Disclosures
In the case of registered offerings of structured warrants, the SEC’s required “issuer estimated value” (and related risk factors) is typically included, as is the case for structured notes. Practices vary in the case of non-registered offerings, depending upon, for example, the nature of the intended purchasers.
Structured Warrant Programs—Principal Documentation
As noted above, structured warrants may be publicly offered under a registration statement. Accordingly, in addition to the registration statement’s base prospectus, the issuer will typically create a “prospectus supplement” that describes in more detail the types of warrants that are expected to be issued. Each individual offering is then documented by a shorter “pricing supplement” that describes the specific warrants being offered and a description of the relevant risk factors and underlying asset.
In the case of a private offering, a standalone offering circular may be created that describes the terms of the program and that incorporates by reference the issuer’s financial statements and other material information from its periodic filings. This document would in turn be supplemented in each offering by a pricing supplement.
Program Agreement and Product Distribution
As is the case for debt securities, a program agreement or similar distribution agreement will be created for structured warrants. This agreement will in many respects resemble the type of agreement used for the relevant issuer’s debt securities, with appropriate terms modified to reflect the nature of the instrument.
For many issuers of structured warrants, the distributors will be one or more of the distributors who also distribute the issuer’s debt securities. Accordingly, the program agreement will often provide that some or all of the periodic auditor comfort letters and legal opinions (“negative assurance letters”) that are provided as to the debt securities will also be sufficient for the “warrant program.” A provision of this kind can reduce the ongoing cost of maintaining a program.
For those underwriters that sell these instruments through unaffiliated broker-dealers, additional documentation may be in order. For example, the existing MSDAs or similar agreements between the underwriter and the third party broker dealers may only cover “notes” or “debt securities,” but not warrants.
Warrant Agreement and Forms of Warrants
The issuer will typically enter into a “warrant agreement” or “warrant indenture” with a third party issuing and paying agent. This agreement is similar in some respects to a “paying agency agreement” used for debt securities, in that it:
- describes the role and responsibilities of the “warrant agent”;
- sets forth the mechanics for payments by the issuer to the warrant agent that will be distributed to warrant holders; and
- contains one or more forms of warrants that will be used.
This agreement may be comparable in many respects to the type of debt indenture that is used in the case of registered debt securities in order to comply with the requirements of the Trust Indenture Act of 1939.
In the case of a registered offering, the form of this agreement and the forms of warrants are typically filed as an exhibit to the registration statement.