To help shareholders benefit in the event that Congress does not retain the lower rates for dividends in connection with the ongoing “fiscal cliff” negotiations, a variety of companies have increased their fourth quarter dividends in 2012. Some companies have accelerated the payment dates of their planned dividends to ensure that they are paid before the end of the year. Some have increased their planned dividend payments above prior quarterly levels. Other companies may pay a special dividend payment. In some cases, the fourth quarter increase will be offset by a decrease in the subsequent first quarter's dividend. In each case, these dividend payments may trigger the dividend adjustment provisions of structured notes linked to the relevant underlying stocks.
Most stock-linked notes have provisions that adjust the price of the stock, and therefore, the return on the notes, when the linked stock pays a special or extraordinary dividend. After the applicable “ex date”, a special dividend may reduce the stock price, in order to account for the smaller amount of cash held by the company. Consequently, for typical stock-linked notes, which are bullish on the linked stock, a special dividend would usually reduce the note’s return if protections are not built into the note terms. And of course, holders of structured notes usually don’t benefit from the dividend on the linked stock. Dividend adjustment provisions protect the investors’ interests by, under certain circumstances, adjusting upwards the price of the linked stock for purposes of the notes, offsetting the negative impact of the special dividend.
Various dividend adjustment provisions exist:
- A special dividend must exceed a certain size threshold to be triggered.
- A special dividend must be deemed “material” by the calculation agent in order to be triggered.
- Mainly in the case of single-stock linked notes purchased by institutional investors, a provision that is automatically triggered whenever the dividend exceeds, or is less than, a “base dividend” agreed to at the time of pricing. This type of provision can differ from the other two types. Instead of providing only “investor protection,” this type of provision can also work “adversely” to an investor when the linked stock reduces its dividend, because the provision will cause the stock price, for purposes of the notes, to decrease.
As a result, depending upon the terms of a structured note, the planned dividend increases may cause an upward adjustment of the stock price. For a smaller set of notes, mainly notes for institutional investors described in the third bullet above, a potential Q1 dividend decrease after the Q4 increase may then decrease the stock price after the initial upward adjustment.
Depending on the circumstances of the relevant company, stockholders may receive the same total amount of cash with or without the special dividend. They could simply receive it sooner and at a lower average income tax rate. In contrast, depending on the terms of a structured note, some notes may have increased returns due to the increased dividend, and then, may or may not have a decreased return due to the Q1 decreased dividend. In this regard, calculation agents for structured notes may wish to review the adjustment provisions for notes subject to a special dividend, and the extent to which they have discretion to require an adjustment, or to modulate the extent of the required adjustment.