Q&A: equity derivatives in USA

Overview

Other than transactions between dealers, what are the most typical types of over-the-counter (OTC) equity derivatives transactions and what are the common uses of these transactions?

Typical issuer equity derivatives products include the following:

• accelerated share repurchase (ASR) products allow an issuer to accelerate the purchase of its shares by entering into a forward on its own stock with a dealer in connection with which the dealer borrows shares in the stock lending market, shorts them back to the issuer and covers its short position over a calculation period by buying shares in the open market;
• bifurcated call spread and unitary capped call products allow an issuer of convertible debt to raise the effective strike price of the convertible debt’s embedded call option;
• bond hedge products allow an issuer of convertible debt to issue synthetic debt through the combination of the bond hedge and convertible debt;
• a variety of share repurchase products entered into at the time of pricing a convertible debt issuance, including all the above-listed products, allow the underwriter to facilitate hedging by convertible debt investors and the issuer to repurchase its stock;
• issuer borrow facilities, structured as issuer share loans or zero strike call options between an issuer and the underwriter of the issuer’s convertible debt allow the underwriter to facilitate hedging by convertible debt investors;
• registered forwards between an issuer and the underwriter of its common equity allow the issuer to lock in equity financing for future acquisitions or other purposes, while retaining flexibility to cash settle the forward with the underwriter rather than issuing stock;
• convertible notes, convertible preferred stock and tangible equity units allow an issuer to raise capital in the most effective way from the tax, accounting, cash flow, corporate or regulatory perspective; and
• sales of shares combined with a purchase of a capped call from the underwriter allow an issuer to raise equity financing at a smaller discount to the market price and limit dilution.

Typical equity derivatives products that allow a shareholder to acquire a substantial position in a publicly traded equity or to monetise or hedge an existing equity position include the following:

• structured margin loans allow a borrower to finance an acquisition of shares or to monetise an existing shareholding;
• calls, puts, covered calls, collars, collar loans and variable prepaid forwards allow a holder to both finance and hedge an acquisition of synthetic long exposure to a stock or to hedge and monetise an existing shareholding;
• put and call pairs, cash-settled or physically settled forwards and swaps allow a holder to acquire synthetic long exposure to the underlying stock, which may be transformed into physical ownership of the stock at settlement;
• ‘reverse ASRs’ allow shareholders to accelerate dispositions of shares in a manner that minimises its impact on the market price;
• sales of shares combined with a purchase of a capped call from the underwriter allow a shareholder to dispose of its shareholding at a smaller discount to the market price and retain some upside in the stock; and
• mandatory exchangeables, such as trust-issued mandatories, holder’s own balance sheet mandatories or borrowed balance sheet mandatories, allow a shareholder to monetise and hedge a large equity position while minimising a negative impact on the share market price.

May market participants borrow shares and sell them short in the local market? If so, what rules govern short selling?

Many equity derivative transactions depend on a liquid stock borrow market to allow participants to hedge their exposure under the transaction. For example, arbitrage funds investing in convertible notes and dealers hedging the upper warrant in a call spread may both need at certain points during the transaction to establish a hedge position by short selling shares borrowed from stock lenders. The convertible notes indenture and warrant agreement almost always have certain protections for those arbitrage funds and dealers to handle situations in which the stock borrow market becomes illiquid or shares may be borrowed only at a high cost. Such situations may occur where M&A activity has been announced and has increased demand for borrowed shares, or where issuers have conducted significant repurchase activity and reduced the available free float.

To sell short in the US, the seller’s broker must locate a security to borrow to cover the sale, as ‘naked’ short selling is prohibited. Short sales of securities in the US are subject to the general anti-manipulation rules under the Securities Exchange Act of 1934 (the Exchange Act) and Regulation SHO. As the Securities and Exchange Commission (SEC) has noted, the vast majority of short sales are legal, but abusive practices to create actual or apparent active trading in a security or to depress the price of a security for the purpose of inducing the purchase or sale of the security by others are prohibited. Regulation SHO requires generally that:

• short sale orders being placed with a broker-dealer be marked as such;
• subject to certain limited exceptions, if a stock on any trading day declines by 10 per cent or more from the stock’s closing price for the prior day, short sale orders may be displayed or executed for the remainder of that day and the following day only if the order price is above the then-current national best bid;
• broker-dealers must have reasonable grounds to believe that a stock may be borrowed before executing a short sale order; and
• brokers and dealers that are participants in a registered clearing agency must close out any positions within a specified period after a seller fails to deliver securities to the buyer when due.

In addition, section 16(c) of the Exchange Act prohibits insiders from selling common stock that they do not own (section 16 of the Exchange Act does not apply to holders of equities in ‘foreign private issuers’, which are issuers listed in the US filing their annual reports on Form 20-F). This prohibition not only covers traditional short selling, but also applies to derivative transactions that are ‘put equivalent positions’ (for example, sale of a call or purchase of a put, or both).

Finally, the SEC is considering amendments to the applicable short selling rules in the wake of recent highly publicised short squeezes. While no amendments have been specified yet, it is possible that there will be further restrictions in the near future.

Describe the primary laws and regulations surrounding OTC equity derivatives transactions between dealers. What regulatory authorities are primarily responsible for administering those rules?

The primary laws surrounding OTC equity derivative transactions between dealers (and between market participants generally) have traditionally been the Securities Act of 1933 (the Securities Act) and the Exchange Act, and in particular the registration requirements of section 5 of the Securities Act, the anti-fraud and anti-manipulation provisions of sections 9 and 10(b) of the Exchange Act and the short-swing profit rules applicable to insiders under section 16 of the Exchange Act. While the SEC administers the rules promulgated under those sections, private rights of action may attach, some of which are prosecuted by active plaintiffs' bars. Inter-dealer transactions must comply with these rules in the same manner as trades with non-dealer counter­parties. For example, dealers must ensure that their long hedge positions do not cause them to become section 16 ‘insiders’ by virtue of holding more than 10 per cent of an issuer’s common stock. Section 16 is not applicable in the case of ‘foreign private issuers’.

Since its passage in 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd–Frank Act) has imposed additional requirements on market participants. Title VII of the Dodd–Frank Act established a regulatory regime for swaps and security-based swaps. Depending upon the type of equity derivative, such a trade may be a swap, a security-based swap, or both. Swaps are subject to the jurisdiction and regulatory oversight of the Commodity Futures Trading Commission (CFTC) and security-based swaps are subject to the jurisdiction and regulatory oversight of the SEC. Certain OTC equity derivatives, such as physically settled swaps and forwards and equity options, are excluded from the ‘swap’ and ‘security-based swap’ definitions and, as a result, are not subject to the Dodd-Frank Act requirements.

In addition to Title VII of the Dodd–Frank Act, the Volcker Rule, which is set forth in Title VI of the Dodd–Frank Act, generally prohibits ‘banking entities’ (as defined therein) from, among other things, engaging in proprietary trading in financial instruments, such as securities and derivatives, unless pursuant to an exclusion or exemption under the Volcker Rule. Accordingly, the Volcker Rule’s proprietary trading prohibition may, in the absence of an applicable exclusion or exemption under the Volcker Rule, restrict certain underwriting, market-making and risk-mitigating hedging activities when a ‘banking entity’ is acting as dealer. The Bank Holding Company Act of 1956, as amended, may also place additional restrictions on banks acting as dealers that should also be taken into consideration.

Foreign broker-dealers that wish to transact with US entities without having to register under the Exchange Act may also need to comply with the ‘chaperoning’ requirements under Rule 15a-6 under the Exchange Act.

Other applicable regulations include those imposed by securities exchanges; rules enforced by the Financial Industry Regulatory Authority, Inc (FINRA), a self-regulatory organisation for its broker-dealer members; rules enforced by the National Futures Association, a self-regulatory organisation for swap dealers and certain other CFTC registrants; rules implemented by the International Swaps and Derivatives Association, Inc (ISDA); and, as applicable, various regulatory margin and capital requirements imposed by the SEC, the CFTC or a prudential regulator, such as the Federal Reserve Board or the Office of the Comptroller of the Currency.

Notwithstanding that most swap and security-based swap regulatory obligations fall on dealers, regulations do require that all counterparties obtain and maintain a ‘legal entity identifier’ prior to entering into, and throughout the life of, any OTC equity derivatives transaction that is a swap or a security-based swap.

In addition to dealers, what types of entities may enter into OTC equity derivatives transactions?

The entities most commonly facing dealers in equity derivative trades are public company issuers and various types of counterparties holding or acquiring publicly traded shares (such counterparties generally have to own at least US$10 million of assets). Publicly traded issuers frequently utilise equity derivatives to hedge their equity-related obligations, such as call spreads and capped calls to hedge against potential dilution from conversions of convertible securities. Issuers may also be involved in setting up a stock borrowing facility to facilitate certain hedging activities by its convertible noteholders, or executing through a forward contract an accelerated share repurchase of its common stock to achieve certain financial and strategic goals. Counterparties with large equity stakes often enter into equity derivative transactions to monetise or hedge their holdings, or both. Examples of pure monetisation transactions include certain margin loan structures, while prepaid forward contracts and funded collars can be used to simultaneously monetise the position and hedge against future price fluctuations. Counterparties may also use equity derivatives to accumulate large equity stakes in public companies or to gain synthetic exposure to such equities.

Describe the primary laws and regulations surrounding OTC equity derivatives transactions between a dealer and an eligible counterparty that is not the issuer of the underlying shares or an affiliate of the issuer? What regulatory authorities are primarily responsible for administering those rules?

In practice, because most non-dealer counterparties to equity derivative transactions are typically listed issuers, hedge funds, private equity funds, and other sophisticated and well-funded market participants, there are few additional requirements for them to transact with the investment banks and their broker-dealer affiliates that normally act as dealers in such transactions. These non-dealer counterparties will normally easily qualify as ‘eligible contract participants’, as defined in the Commodity Exchange Act and ‘accredited investors’, as defined under the Securities Act. In certain instances, particularly where the counterparty is a wealthy natural person rather than an investment fund or other legal entity, the dealer may need to conduct additional due diligence to ensure that the counterparty meets those requirements. Dealers may also have to determine that a recommended transaction is ‘suitable’ for its customer under FINRA rules. Finally, antitrust rules may also come into play where a third party is using the derivative to accumulate a large stake in the issuer.

Do securities registration issues arise if the issuer of the underlying shares or an affiliate of the issuer sells the issuer’s shares via an OTC equity derivative?

Yes. If the dealer in the OTC equity derivative sells the issuer’s shares into the public market in connection with an equity derivative to which either the issuer or any of its affiliates is a party, then that sale must either be registered or exempt from registration under the Securities Act. The procedures for registering a dealer’s short sales or conducting such sales pursuant to an exemption from registration are set out in a series of SEC no-action letters dealing with certain hedging and monetisation transactions.

Determining a party’s affiliate status is critical to structuring any OTC equity derivative. Under the Securities Act, an ‘affiliate’ of an issuer is a person that directly, or indirectly through one or more intermediaries or contractual arrangements, controls or is controlled by, or is under common control with, the issuer. Whether ‘control’ exists depends on the facts and circumstances, and typically involves an analysis of a person’s aggregate shareholdings in the issuer, presence on the issuer’s board of directors, veto rights over certain corporate actions, and other factors. ‘Control’ over an entity does not require a majority of the voting power over such entity; rather, market participants typically consider there to be a rebuttable presumption of ‘control’ at 10 per cent of the issuer’s voting power, and a nearly irrefutable presumption of ‘control’ at 20 per cent of the issuer’s voting power (although the presumption can be overcome based on certain facts and circumstances – for example, if the relationship between the issuer and the 20 per cent holder is openly hostile). The same general thresholds and presumptions apply to voting power on the board of directors. However, a combination of significant voting power as a shareholder and control of board seats may suggest ‘control’, even though both are below 10 per cent.

May issuers repurchase their shares directly or via a derivative?

Yes, and both types of repurchase transactions are common. There are relatively few requirements for issuers to repurchase their own equity (although under state law, contracts by an issuer to repurchase its shares while insolvent are generally voidable or void), and US issuers tend to repurchase more of their own shares than do issuers in Europe and Asia. In addition to typical ‘agency’ transactions where a broker-dealer will repurchase shares in specified amounts at specified prices in the open market for a commission, ASR transactions are popular with US issuers. These transactions allow issuers to repurchase their shares at a discount to the average market price over a specified calculation period by ‘selling’ the volatility in their stock to the dealer. The issuer benefits by buying its shares back at a discount, and the dealer profits to the extent it is able to purchase the shares during the calculation period at less than the discounted price (which depends on the stock remaining volatile during the course of the trade). The issuer also benefits because the dealer typically delivers around 80 to 85 per cent of the shares underlying the transaction shortly following execution, which has an immediate impact on the issuer’s earnings per share. Other structures, such as capped and collared forwards, capped calls and issuer put options are also common.

These transactions (including hedging activities of the dealer in connection with an ASR) are structured to avoid the anti-manipulation provisions of section 9 of the Exchange Act and the anti-fraud provisions of Rule 10b-5 under section 10(b) of the Exchange Act. Rule 10b-18 under the Exchange Act offers a safe harbour from certain types of manipulation claims for an issuer if the issuer repurchases its shares in accordance with certain manner, timing, price and volume conditions. ASRs are typically structured such that the dealer’s hedging activity would comply with Rule 10b-18 if the safe harbour were available to it. Trades involving certain of the issuer’s ‘affiliated purchasers’ (as defined in Rule 10b-18) may also be structured to meet the requirements of Rule 10b-18.

In addition, section 10(b) of the Exchange Act and Rule 10b-5 thereunder are anti-fraud provisions concerning purchases and sales of securities. Regulation M under the Exchange Act (Regulation M) addresses certain activities that could be viewed as artificially impacting the price of an offered security. It prohibits an issuer or selling security holder engaging in a ‘distribution’ of its securities, and participants in such distribution and affiliated purchasers, from bidding for or purchasing the securities being distributed or related securities during a ‘restricted period’ applicable to the distribution.

Issuers that have received financial assistance under the Coronavirus Aid, Relief and Economic Security Act (the CARES Act), passed on 27 March 2020, may be restricted from repurchasing their shares. Subtitle A of Title IV of the CARES Act prohibits certain companies (and their affiliates, in certain cases) that have received direct loans or loan guarantees under such programmes from repurchasing their own shares or shares of their parent entity that are listed on any national securities exchange. The prohibition exempts preexisting contractual obligations, and is effective for as long as the loan remains outstanding and for a one-year period after the loan is repaid or loan guarantee expires. Prior to seeking any funding under the CARES Act, Issuers who are party to or considering entering into share repurchase transactions, including ASRs and capped calls, should consider the implications of such funding on their share repurchase programmes.

On 14 December 2022, the SEC adopted amendments to Rule 10b5-1 insider trading plans and related disclosures under the Securities Act, and the amendment became effective on 27 February 2023. The amendments have imposed new conditions on the availability of the Rule 10b5-1 affirmative defense to insider trading and require enhanced disclosures regarding the adoption, modification and termination of Rule 10b5-1 plans and other trading arrangements, issuers’ insider trading policies and procedures, and certain equity awards granted close in time to the release of material non-public information, which would affect the manner US issuers conduct share repurchase programmes, including ASRs. Further details of the amendments are discussed in section 1.10.

In addition, the SEC has also proposed amendments that would require, if adopted, issuers including foreign private issuers and certain registered closed-end funds, to disclose detailed share repurchase activities. Under the proposed rules, in order to qualify for the affirmative defence under Rule 10b5-1 and the non-exclusive safe harbour under Rule 10b-18, an issuer or any affiliate purchaser of such issuer is required to file a new Form SR in connection with any repurchases of the issuer’s equity securities that are registered under section 12 of the Exchange Act within one business day of such repurchases.

What types of risks do dealers face in the event of a bankruptcy or insolvency of the counterparty? Do any special bankruptcy or insolvency rules apply if the counterparty is the issuer or an affiliate of the issuer?

The main risks that dealers face are the imposition of the ‘automatic stay’ under the US Bankruptcy Code that would prevent them from collecting against their counterparty; the inability to rely upon the bankruptcy default provisions (called ipso facto provisions) in the ISDA Master Agreement as the basis for terminating and closing out the transaction; and the counterparty’s potential status as a ‘bankruptcy affiliate’ of the issuer. Under section 362 of the US Bankruptcy Code, if a bankruptcy petition is filed in respect of the counterparty, an automatic stay goes into effect that prevents other parties from collecting on pre-bankruptcy claims and taking other actions against the counterparty, including foreclosing on any collateral. The automatic stay is generally intended to help the debtor counterparty preserve its assets, to maximise the assets’ value and to ensure that creditors are repaid in an orderly and equitable manner. In addition, under section 365 of the Bankruptcy Code, if a bankruptcy petition is filed in respect of the counterparty, parties to contracts with the counterparty are prevented from exercising contractual rights to terminate or modify such contracts based on the counterparty’s bankruptcy or financial condition. If these provisions were applied to equity derivative contracts, the automatic stay and the inability to terminate the contract would expose the non-debtor dealer to the risk of price movements in the underlying stock, which could force non-debtor dealers into financial distress, causing them to default on their contracts with other parties. To mitigate the risk of a domino effect, certain classes of protected contracts are exempted from these provisions (both the automatic stay and the prohibition on the enforcement of ipso facto defaults), including `securities contracts’ (which term includes margin loans) and `swap agreements’. In addition to concerns about the automatic stay and bankruptcy termination rights, dealers entering into transactions with certain large shareholders may face the risk that their counterparty could be a ‘bankruptcy affiliate,’ meaning an ‘affiliate’ (as defined in the Bankruptcy Code) of the issuer of the equity that is the subject of the equity derivative contract. Under section 510 of the Bankruptcy Code, claims arising under a contract with the issuer of the subject equity or its affiliate (in this case a 20 per cent or more equity holder) for the purchase or sale of equities of the issuer could be subordinated to the level of equity in the issuer’s or the affiliate’s bankruptcy.

What types of reporting obligations does an issuer or a shareholder face when entering into an OTC equity derivatives transaction on the issuer’s shares?

Sections 13 and 16 of the Exchange Act are the typical sources of reporting obligations for OTC equity derivatives trades. Section 13(d) and (g) of the Exchange Act impose reporting requirements on beneficial owners of 5 per cent or more of any registered class of equity securities of a US-listed issuer, and section 16 of the Exchange Act imposes reporting requirements on insiders (beneficial owners of 10 per cent or more of any such class of equity securities or a director or executive officer of a US-listed issuer other than a foreign private issuer). Under Rule 13d-5 of the Exchange Act, if two or more persons agree to act together for the purpose of acquiring, holding, voting or disposing of equity securities, such persons will be considered a group and their holdings will be aggregated for the purpose of determining beneficial ownership. Moreover, under Rule 13d-3, a person is deemed to beneficially own all shares that the person has the right to acquire within 60 days, including through the exercise or conversion of a derivative security. These sections are generally intended to provide the investing public notice when certain investors have accumulated large blocks of securities of an issuer but they also determine whether a person is an insider for the purposes of section 16 of the Exchange Act (eg, beneficially owns 10 per cent or more of any class of equity securities of a US-listed issuer other than a foreign private issuer).

A shareholder must disclose its ownership within 10 days of becoming a 5 per cent beneficial owner on schedule 13D, which requires the shareholder to disclose, among others, the source of the funds used to make the purchase and the purpose of the acquisition, and must report material changes to its ownership ‘promptly’ thereafter. In lieu of a schedule 13D, certain ‘passive investors’ (along with other types of investors) may file a short form schedule 13G with a certification that, among others, the securities were acquired in the ordinary course of business and were not acquired for the purpose of changing or influencing the control of the issuer. A shareholder must report its ownership on becoming a section 16 insider on a form 3 and must report any subsequent changes to its ownership on a form 4. Under Rule 16a-4 of the Exchange Act, the acquisition or disposition of any derivative security relating to equity securities of the issuer must be separately reported on a form 4. Reporting is required even if the derivative security can be settled only in cash. Starting from 27 February 2023, bona fide gifts of equity securities are no longer reported on Form 5, but instead would have to be reported on Form 4 and filed before the end of the second business day following the date of the gift. Starting from 1 April 2023, Form 4 and Form 5 filers are required to indicate by checkbox that a reported transaction was intended to satisfy the affirmative defense conditions of Rule 10b5-1(c). 

An issuer selling options or warrants to acquire its shares or securities convertible into its shares in a transaction that is not registered under the Securities Act must report such sales in its quarterly and annual reports and on a current report on form 8-K. The issuer’s quarterly and annual reports must also disclose its purchases of shares in connection with a derivatives transaction (for example, an ASR). In addition, if the issuer enters into a material contract in connection with an OTC derivatives transaction, the issuer must disclose certain information about the material contract on a form 8-K.

Additionally, a US-listed issuer must disclose the use of Rule 10b5-1 and other trading arrangements by an issuer, and its directors and officers for the trading of the issuer’s security quarterly on a form 10-Q. A US-listed issuer as well as a foreign private issuer also must disclose its insider trading policies and procedures annually on a form 10-K or Form 20-F, as applicable, and also in proxy and information statements on Schedules 14A and 14C.

CFTC swap data reporting regulations may also apply to an issuer or a shareholder that is entering into an OTC equity derivatives transaction that is a swap with a non-US counterparty that is not itself registered with the CFTC as a swap dealer. Security-based swaps are subject to analogous requirements under the SEC’s recently implemented security-based swap data reporting regulations.

On 10 February 2022, the SEC proposed rule amendments governing beneficial ownership reporting under Exchange Act sections 13(d) and 13(g) that, if adopted, would significantly shorten the period for making initial filings and amendments, 'deem' holders of certain cash-settled derivatives (other than cash-settled security-based swaps) to 'beneficially own' the underlying securities if such derivatives were held in the context of changing or influencing control of the issuer of the underlying securities and expressly require any Schedule 13D filer to disclose interests in all derivatives in connection with the issuer’s equity securities (including any cash-settled options or security-based swaps). In addition, the SEC is proposing to change the rules in connection with 'group formation' applicable to two or more persons and provide related exemptions. While the proposed rule amendments have not been adopted as of this writing, it is expected that the SEC will take the final action soon.

Are counterparties restricted from entering into OTC equity derivatives transactions during certain periods? What other rules apply to OTC equity derivatives transactions that address insider trading?

Issuers and controlling shareholders avoid entering into transactions during certain ‘blackout periods’ when they may be in possession (or be thought to be in possession) of material non-public information regarding the issuer or its securities. The principal insider trading laws derive from section 10(b) of the Exchange Act and Rule 10b-5 thereunder. Issuers typically restrict insiders from trading during certain windows when the issuer is likely to be in possession of material non-public information, such as prior to release of earnings. Certain affiliates that may have access to inside information by virtue of holding board seats or through other means may also subject their personnel to the issuer’s window period policies to avoid the potential appearance that they may be trading on material non-public information during ‘blackout’. However, insiders often enter into Rule 10b5-1 ‘plans’ while not in possession of material non-public information, which generally are structured to allow dealers to trade securities on the insider’s behalf while the insider may be in possession of material non-public information, as long as the insider is not able to influence how those trades are effected at that time. Many OTC equity derivatives are themselves structured as 10b5-1 ‘plans’. Trading effected in compliance with a 10b5-1 plan provides an affirmative defence to a claim of insider trading, but is not a safe harbour.

Under the amended Rule 10b5-1, effective on 27 February 2023, insiders and issuers are subject to various limitations with respect to a 10b5-1 plan:

• directors and officers are subject to a cooling-off period of the later of (i) 90 days after the adoption or modification of the 10b5-1 plan and (ii) the earlier of (x) two business days following a Form 10-Q or Form 10-K filing (or in a Form 20-F or Form 6-K filing for foreign private issuers) and (y) 120 days after the adoption or modification of the 10b5-1 plan, and persons other than directors, officers or issuers are subject to a 30-day cooling-off period;
• multiple overlapping 10b5-1 plans are prohibited; and
• only one single-trade 10b-5 plan is allowed per 12-month period.

The amended Rule 10b5-1 does not require a cooling-off period for an issuer when it enters into or modifies a 10b5-1 plan to trade in its own securities. However, the SEC indicated that further consideration is warranted whether a cooling-off period should be required for issuers in the share repurchase context.

Additionally, the amended Rule 10b-5 requires directors and officers to include a representation in their Rule 10b5-1 plan certifying that they are not aware of any material non-public information and that they are adopting the plan in good faith. The amended Rule 10b-5 also requires the person who enters into the Rule 10b5-1 plan to act in good faith throughout the operation of the plan (instead of just when adopting the plan).

What additional legal issues arise if a counterparty to an OTC equity derivatives transaction is the issuer of the underlying shares or an affiliate of the issuer?

Securities acquired directly or indirectly from an issuer or an affiliate of the issuer in a transaction not involving any public offering will be ‘restricted securities’ in the hands of the acquirer under Rule 144 under the Securities Act, and must be resold after specified holding periods to meet the safe harbour under Rule 144. In addition, any securities sold by an affiliate of an issuer or sold for the account of an affiliate of the issuer (even if the affiliate purchased them in the open market) become what are commonly known as ‘control securities’ for the purposes of Rule 144 (although the term is not defined in the rule). Additional volume, manner of sale and filing requirements apply to sales of control securities to meet the Rule 144 safe harbour requirements. Securities may be both restricted securities and control securities.

If a counterparty to an OTC equity derivatives transaction is an insider under section 16, then the insider must disgorge to the issuer any profits derived from any purchase and sale of any equity security of the issuer, any derivative security, or any security-based swap agreement involving any such security if the transactions occurred within a period of less than six months, subject to certain exemptions. Amendments, resets or extensions of derivative securities in many cases may be deemed purchases or sales that are subject to reporting obligations and profit disgorgement under section 16.

What types of taxation issues arise in issuer OTC equity derivatives transactions and third-party OTC equity derivatives transactions?

OTC equity derivatives raise a number of tax issues. First, the Internal Revenue Service (IRS) may re-characterise the transaction in a manner that is different from its stated form, including by treating the transaction as a transfer of beneficial ownership of the underlying equity for US tax purposes. In addition, complex rules govern the timing and character of payments for tax purposes. Payments to a non-US party may also be subject to withholding. Additional issues, such as integration of instruments, may arise depending on the nature of the transaction.

Describe the liability regime related to OTC equity derivatives transactions. What transaction participants are subject to liability?

Market participants are typically most concerned with section 10(b) of the Exchange Act and Rule 10b-5 thereunder. Derivative trades between dealers and issuers or controlling shareholders are often structured such that the dealer is acting as ‘principal’ for its own account, rather than as the agent of the counterparty. Nevertheless, market participants often deem the dealer’s hedging activity to be attributable in some form to the counterparty, as the dealer is engaged in the market activity to facilitate a transaction with the counterparty. Therefore, if the counterparty is in possession of material non-public information at the time of the trade, both counterparty and dealer may have liability for any resulting purchases and sales by the dealer in connection with its hedging activity. Similarly, trades will often be structured such that the dealer’s purchases would be made in compliance with Rule 10b-18 if the Rule 10b-18 safe harbour were available to it.

Dealers and counterparties must also ensure that the dealer’s hedging activities in connection with trades with issuers and their affiliates do not result in an unregistered offering of securities in violation of section 5 of the Securities Act. Questions may also arise as to whether the freely tradeable shares that a dealer purchases in the open market to hedge a transaction with an affiliate of the issuer may thereby become tainted as ‘control securities’ under Rule 144, as they were purchased to some degree for the benefit of an affiliate. This analysis flows from the paradigm under the US securities laws that transactions, rather than securities, are registered, and once freely tradeable securities may become tainted if repurchased by an affiliate. These issues require careful trade-by-trade analysis.

Corporate insiders entering into equity derivative transactions may also be forced to disgorge short-swing profits from trades within six months of one another, and dealers must be careful not to become section 16 insiders themselves in connection with their hedging activity.

What stock exchange filings must be made in connection with OTC equity derivatives transactions?

An issuer typically must file a listing application with the relevant stock exchange if it may issue new shares in connection with its entry into a derivative contract. This filing requirement arises most commonly in convertible note offerings, in which the shares deliverable to investors upon conversion of the convertible notes, as well as the shares deliverable to call spread dealers upon exercise of the upper warrants, must be approved for listing.

What types of documents are typical in an OTC equity derivatives transaction?

OTC equity derivatives transactions are typically documented on a ‘confirmation’ that incorporates the terms of the ISDA Master Agreement and the ISDA 2002 Equity Definitions. While the Master Agreement is normally subject to minimal negotiation and is adopted as a ‘form’ without any schedule, the confirmations in complex OTC equity derivative trades are typically ‘long-form’ confirmations that make extensive modifications to the standard terms of the Equity Definitions. For example, the standard terms of the Equity Definitions will be inadequate for trades that are based on volume-weighted average prices rather than closing prices. For funded collars, variable prepaid forwards and other transactions in which the counterparty pledges securities, the confirmations may also contain the collateral terms.

Parties to OTC equity derivatives transactions that are swaps may also be required by their dealer counterparties to adhere to ISDA protocols or execute similar bilateral documentation for the purpose of complying with various CFTC swap regulatory requirements. Security-based swap dealers may also require that their security-based swap counterparties adhere to analogous ISDA protocols or enter into similar bilateral documentation to comply with the newly implemented SEC security-based swap regulatory regime.

For what types of OTC equity derivatives transactions are legal opinions typically given?

Legal counsel will typically render opinions for margin loans, call spreads and capped calls, prepaid forwards, registered forwards and zero-strike call options. Legal opinions are not typically given for ASR transactions, but may be given by local counsel where the counterparty is a foreign entity. For trades involving lending or pledging of restricted securities or securities held by affiliates of the issuer, counsel will typically be required to give ‘de-legending’ opinions to allow the securities to be transferred under contractually agreed conditions.

May an issuer lend its shares or enter into a repurchase transaction with respect to its shares to support hedging activities by third parties in the issuer’s shares?

Yes. Registered borrow facilities in connection with convertible notes offerings are one example. Certain convertible note investors that are arbitrage funds will hedge by shorting the shares simultaneously with the purchase of the convertible bond and by purchasing credit protection on the bond through a credit default swap. If there is insufficient stock borrow available for short selling, issuers would have difficulty marketing the convertible notes to such investors. Therefore, in a registered borrow facility, the issuer issues a number of shares corresponding to the number of shares underlying the convertible bond and lends them to a dealer, which offers those shares in an SEC-registered offering, thereby creating a short position for the dealer. The dealer then transfers this short position to arbitrage funds via cash-settled total return swaps, which in turn allows the arbitrage funds to establish their short position for the convertible notes. For Delaware issuers, the loan fee paid to the issuer by the dealer will be equal to the par value of the shares to comply with state law requirements that the share lending fee for newly issued shares must cover the aggregate par value of the shares.

These transactions must be carefully structured to comply with Regulation M, Rule 10b-5, section 5 of the Securities Act and other applicable restrictions. Moreover, the impact of the market activity by the dealer and the convertible note investors needs to be adequately disclosed.

What securities registration or other issues arise if a borrower pledges restricted or controlling shareholdings to secure a margin loan or a collar loan?

Most large, complex margin loans and collar loans must be structured around a number of issues relating to the character of the pledged securities and the pledgor. Controlling shareholders often acquire their holdings through private investment agreements rather than a public offering (making such securities ‘restricted securities’) and also may be affiliates of the issuer by virtue of their large shareholdings or right to board representation (making such securities ‘control securities’). Like any other person, a foreclosing lender that wishes to sell securities must either register the sales or comply with an exemption from registration. Although, as described below, lenders may be able to sell the pledged securities pursuant to a registration statement or through other exit options, Rule 144 under the Securities Act is the key safe harbour that lenders seek to rely on to sell the pledged shares publicly without registration.

If the securities are restricted, the seller must satisfy the relevant holding period under Rule 144 prior to the sale – six months since the securities were acquired from the issuer or an affiliate (or in some cases 12 months if the issuer has not satisfied certain filing requirements). If an affiliate pledges restricted securities ‘with recourse’, the lender or pledgee may include the time that the affiliate or pledger held the securities prior to the pledge in calculating the holding period. The meaning of the phrase ‘without recourse’ is subject to much debate and interpretation. Particularly where the pledgor is a special purpose entity, market participants generally consider that a guarantee by a parent entity would be required for the pledge to be considered ‘with recourse’.

Because the pledged securities often were not issued in a public offering and are not initially freely tradeable, they are typically held either in physical, certificated form, or in dematerialised form as restricted book entries on the books of the transfer agent, in each case with legends describing the transfer restrictions. In addition to the securities laws restrictions, these securities are often subject to various ‘lock-up’ provisions in the related investment agreements that must be drafted to carve out the pledge and foreclosure sale by the lender. Lenders will seek to pre-establish procedures with the issuer and its transfer agent to ensure that, in the event of a foreclosure, the shares can be quickly de-legended (if permissible at the time of foreclosure) and transferred to a potential purchaser or purchasers, preferably through the facilities of The Depository Trust Company.

Lenders may also sell under an effective registration statement and may require borrowers to pledge their rights under any registration rights agreement with the issuer, although this is not typically a favoured method. The availability of the registration statement can never be assured; there is a risk of underwriting liability and potential unavailability of due diligence defences, and lenders may learn about material non-public information not disclosed in a prospectus from affiliate borrowers. Registration rights agreements may also impose lock-up restrictions on parties to the agreement in certain circumstances.

If no ‘public exit’ is available, lenders may have to dispose of the collateral via private placement, although it will be subject to a liquidity discount and the purchaser will acquire restricted stock.

Lenders often contractually limit the number of shares they can hold on foreclosure (blocker provisions) and the manner in which they can sell those shares (bust-up provisions) to ensure that they do not themselves become an affiliate of the issuer.

If a borrower in a margin loan files for bankruptcy protection, can the lender seize and sell the pledged shares without interference from the bankruptcy court or any other creditors of the borrower? If not, what techniques are used to reduce the lender’s risk that the borrower will file for bankruptcy or to prevent the bankruptcy court from staying enforcement of the lender’s remedies?

Under section 362 of the US Bankruptcy Code, an automatic stay takes effect immediately on a debtor’s bankruptcy filing and prevents creditors from foreclosing on collateral for pre-bankruptcy claims. However, section 362 enumerates certain classes of protected contracts in respect of which the automatic stay does not apply. ‘Securities contracts’, which are defined to include ‘any margin loan’, are one such class. The term ‘margin loan’ is not defined in the US Bankruptcy Code, however. Market participants often worry that only those transactions that have been historically characterised as margin loans (ie, buying stock on margin through a broker) qualify as margin loans for the purposes of the definition of securities contracts, and that the more structured and complicated transactions known to equity derivatives participants as margin loans may not be eligible for protection. Careful structuring of a margin loan to make it more like a ‘classic’ margin loan (eg, ensuring compliance with margin regulations applicable to banks or brokers, ensuring that each lender in a multi-lender facility has individual rights with regard to its portion of the collateral) may afford market participants some comfort that their remedies against a borrower would not be subject to the automatic stay. Judicial interpretation of the phrase ‘margin loan’ in the context of the US Bankruptcy Code is lacking, so there is uncertainty as to the outcome of any litigation of this issue.

In the light of this uncertainty, market participants are careful to structure margin loans to minimise the risk of a borrower bankruptcy in the first instance. Lenders typically require a would-be borrower to create a new ‘bankruptcy-remote’ special purpose vehicle (SPV) to serve as the pledgor and borrower. This technique has the benefit of assuring the lender that the borrower has no legacy indebtedness or obligations that could be the impetus for a bankruptcy filing. Lenders also often demand certain separateness and limited purpose provisions in the loan documents and SPV’s organisational documents. These provisions generally require the SPV to maintain a separate and distinct existence from any other entity (decreasing the likelihood that the SPV’s bankruptcy will be consolidated with that of its parent or affiliates) and prevent the SPV from incurring other indebtedness or obligations and from engaging in any other activities (other than the borrowing and related pledge) that could result in the SPV having any other creditors that could file the SPV for bankruptcy. It has also become standard for a lender to require that the SPV appoint an independent director to be an objective evaluator of fiduciary duties without any biases in favour of the parent, whose affirmative vote is required to, among other things, permit the SPV to file for bankruptcy.

What is the structure of the market for listed equity options?

The largest US exchange by volume is the Chicago Board Options Exchange (CBOE), which normally accounts for around one-quarter of the total market share. In recent years, approximately 88 per cent of the total options contracts traded have been equity options, and approximately 12 per cent have been index options. Most of the main options exchanges trade all (or nearly all) equity options, with only the CBOE trading a significant number of index options (approximately 43 per cent in 2017). Securities underlying listed options must be ‘optionable’ under the rules of the applicable options exchange, meaning that they must meet certain criteria relating to share price, liquidity and other factors.

Although listed options have standardised features, such as the number of underlying shares, strike prices and maturities, certain listed options incorporate various characteristics of OTC equity options. ‘FLEX options’ allow investors to customise certain terms, such as the exercise prices, exercise styles and expiration dates, while maintaining the benefits of listing and clearing. ‘LEAPS options’ have longer maturities than typical shorter-dated options, with exercise dates of up to three years in the future.

All listed equity options are issued, guaranteed and cleared by a single clearing agency – the Options Clearing Corporation (OCC) – which is a registered clearing agency with the SEC. The OCC is the largest equity derivatives clearing organisation in the world.

Describe the rules governing the trading of listed equity options.

The trading of listed equity options is largely governed by the laws applicable to broker-dealers under the Exchange Act and FINRA rules, as well as the rules and by-laws of the OCC and options exchanges.

Broker-dealers are subject to a number of rules when trading listed equity options for their own account or the account of others, including position and exercise limits for listed equity options imposed by FINRA and exchange rules with respect to proprietary and customer positions. FINRA rules also require FINRA members to enter into agreements with listed options customers containing certain minimum terms, send confirmations and obtain explicit authorisation from a customer before exercising discretionary power to trade in options contracts for the customer.

Exchange rules and systems regulate the manner of trading on the exchange, including the manner in which orders may be submitted to the exchange, market maker quoting, display of orders and the priority of order interaction. Exchanges also establish a range of requirements and prohibitions on members’ proprietary and agency activities on the exchange. For example, exchange (and FINRA) rules prohibit trading ahead of customer orders.

Unlike OTC equity options, in which the parties may elect how to determine what adjustments should be made to account for certain corporate events involving the underlying security – such as stock splits or combinations, mergers and acquisition activity or dividend payments – all adjustments for listed options are made by OCC.