Overview

Typical types of transactions

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:

  • options and forwards pursuant to which an issuer repurchases its shares, by way of capital reduction or to hedge an employee share option programme;
  • call options purchased by the issuer of convertible debt, to create equity neutral or non-dilutive convertible debt; and
  • convertible bonds allow an issuer to raise capital in the most effective way from the tax, accounting, cash flow, corporate or regulatory perspective.

 

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:

  • margin loans allow a borrower to finance an acquisition of shares or to monetise an existing shareholding;
  • calls, puts, collars, funded collars and variable prepaid forwards allow a holder to both finance and hedge an acquisition of shares 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 shares, which may be transformed into physical ownership of the shares at settlement;
  • reverse ASRs and other structured forwards 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 dealer 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 exchangeable bonds allow a shareholder to monetise and hedge a large equity position while minimising any negative impact on the market price of the shares.
Borrowing and selling shares

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

Short selling of shares is permissible and is governed by the Short Selling Regulation (Regulation No. 236/2012) (SSR). The SSR applies to shares (and other financial instruments) that are admitted to trading on a trading venue in the EU, including when those instruments are traded outside a trading venue. The SSR also applies to derivatives in respect of such shares. There is an exemption for shares whose principal trading venue is located in a non-EU country.

Uncovered short selling is prohibited by the SSR, subject to certain exemptions for market-making activities, primary dealer activities and stabilisation activities.

The SSR imposes disclosure requirements in respect of significant net short positions. For example:

  • where the net short position is equal to at least 0.2 per cent of the issued share capital of the issuer and every 0.1 per cent increase above 0.2 per cent must be disclosed to the Financial Conduct Authority (FCA); and
  • where the net short position is equal to at least 0.5 per cent of the issued share capital of the company and every 0.1 per cent increase above 0.5 must be disclosed to the market.

 

The SSR provides the FCA with the authority to temporarily prohibit or impose conditions on short selling where there are adverse developments that constitute a threat to financial stability or market confidence.

 

Applicable laws and regulations for dealers

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

The principal laws and regulations surrounding OTC derivatives transactions (including equity derivatives) are:

  • the Financial Services and Markets Act 2000 (FSMA);
  • the Financial Services and Markets Act 2000 (Regulated Activities) Order 2001 (SI 2001/544) (as amended) (RAO);
  • the Markets in Financial Instruments Directive (2014/65/EU)) (MiFID II);
  • the Markets in Financial Instruments Regulation (600/2014) (MiFIR);
  • the Regulation on OTC derivatives, central counterparties and trade repositories (648/2012) (EMIR);
  • the Regulation amending EMIR (2019/834) (the EMIR Refit Regulation); and
  • the Market Abuse Regulation (596/2014) (MAR).

 

The UK regulatory authority with primary responsibility for all of these laws and regulations is the FCA, with the European Securities and Markets Authority (ESMA) also having certain powers and responsibilities.

The two principal restrictions under the FSMA that have general application to derivatives (including equity derivatives) are the restriction on carrying on a regulated activity under section 19 of the FSMA and the restriction on financial promotions under section 21 of the FSMA. These two restrictions provide that, unless an exemption or exclusion applies:

  • a person entering into derivatives transactions by way of business in the UK will ordinarily have to be authorised under the FSMA if the derivative constitutes an option, a future, a contract for differences or rights to or interests in investments as defined in Part III of the RAO; and
  • a person must not, in the course of business, communicate an invitation or inducement to engage in investment activity unless that person is authorised, or the content of the communication is approved by an authorised person, or the communication is covered by an exemption.

 

MiFID II and MiFIR introduced a requirement for certain declared types of the most liquid and standardised derivatives to be traded on a trading venue in the EU, rather than OTC. In addition, where this requirement applies to a class of derivatives, certain price transparency obligations will also apply. The requirement applies to financial counterparties and certain types of non-financial counterparties, as defined in EMIR; however, to date, only certain types of interest rate and credit derivatives have been declared to be subject to this obligation.

Unless an exemption or exclusion applies, EMIR (as amended by the EMIR Refit Regulation) applies to all OTC derivative transactions (including equity derivatives) and imposes requirements for transactions to be reported to regulators and either cleared or, if the clearing obligation does not apply to a particular class of derivative transaction, subject to other risk mitigation techniques (including trade confirmation, portfolio reconciliation, daily marking-to-market, exchanging initial or variation margin and capital requirements for financial counterparties). The extent to which these obligations apply depends in part upon the nature of parties to the derivative transaction. EMIR distinguishes between financial counterparties (broadly, regulated entities, which would include most dealers) and non-financial counterparties (broadly, any undertaking established in the EEA that is not a financial counterparty) and imposes the most onerous obligations where OTC derivatives transactions are entered into between financial counterparties or between a financial counterparty and a non-financial counterparty whose derivative trading activity exceeds a prescribed notional value (an NFC+), unless an exemption or exclusion applies. EMIR also applies where a financial counterparty or NFC+ enters into an OTC derivative transaction with an entity established outside of the EEA if that entity would be a financial counterparty or an NFC+ if it were established within the EEA. EMIR can also apply to OTC derivative transaction between two such non-EEA entities if that transaction has a ‘direct, substantial and foreseeable effect’ within the EEA or where necessary to prevent evasion of any provision of EMIR.

MAR established a common regulatory framework on market abuse across the EU and prohibits inside dealer, unlawful disclosure of inside information and market manipulation. It applies to conduct anywhere in the world if it relates to financial instruments within the scope of MAR. The financial instruments to which MAR applies are very broad and include (without limitation) securities (including depository receipts) that are admitted to trading on a trading venue in the EU and other instruments the price or value of which depends on or has an effect on the price or value of such securities. Accordingly, broadly speaking, equity derivatives are within the scope of MAR.

Entities

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

There are no general exclusions on the types of legal or natural persons who can enter into OTC equity derivative transactions.

Applicable laws and regulations for eligible counterparties

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?

The FSMA, RAO, MiFID II, MiFIR and MAR apply equally to OTC derivative transactions between dealers as between a dealer and an eligible counterparty that is not the issuer of the underlying shares or an affiliate of the issuer.

However, EMIR (as amended by the EMIR Refit Regulation) may apply differently to transactions between dealers to transactions between a dealer and an entity that is not a dealer. Unless an exemption or exclusion applies, EMIR (as amended by the EMIR Refit Regulation) applies to all OTC derivative transactions (including equity derivatives) and imposes requirements for transactions to be reported to regulators and either cleared or, if the clearing obligation does not apply to a particular class of derivative transaction, subject to other risk mitigation techniques (including trade confirmation, portfolio reconciliation, daily marking-to-market, exchanging initial or variation margin and capital requirements for financial counterparties). The extent to which these obligations apply depends in part upon the nature of parties to the derivative transaction. EMIR distinguishes between financial counterparties (broadly, regulated entities, which would include most dealers) and non-financial counterparties (broadly, any undertaking established in the EEA that is not a financial counterparty) and imposes the most onerous obligations where OTC derivatives transactions are entered into between financial counterparties or between a financial counterparty and a non-financial counterparty whose derivative trading activity exceeds a prescribed notional value (an NFC+), unless an exemption or exclusion applies. EMIR also applies where a financial counterparty or NFC+ enters into an OTC derivative transaction with an entity established outside of the EEA if that entity would be a financial counterparty or an NFC+ if it were established within the EEA. EMIR can also apply to an OTC derivative transaction between two such non-EEA entities if that transaction has a ‘direct, substantial and foreseeable effect’ within the EEA or where necessary to prevent evasion of any provision of EMIR.

In addition, if a party to an OTC equity derivative is (or is closely associated with) a member of the administrative, management or supervisory board or is a certain type of senior executive of the issuer of the underlying shares, MAR requires that party to notify the issuer and the FCA of that transaction within three business days of entering into the transaction if the total amount of transactions by that party has reached €5,000 in the calendar year. MAR also prohibits such a person from entering into transactions in the issuer’s securities or derivatives in respect of such securities in the 30 days prior to the announcement of interim or year-end financial statements that the issuer is obliged to make public.

If the counterparty to an OTC equity derivative transaction is not a professional client for the purposes of MiFID II, then before trading the dealer may be required to provide a standalone key information document to the counterparty and publish it on the dealer's website in accordance with Regulation 1286/2014 on key information documents for packaged retail and insurance-based investment products.

The UK regulatory authority with primary responsibility for all of these laws and regulations is the FCA, with ESMA also having certain powers and responsibilities.

Securities registration issues

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?

There are no securities registration issues that arise if the issuer of the underlying shares or an affiliate of the issuer sells the underlying shares via an OTC equity derivative.

Repurchasing shares

May issuers repurchase their shares directly or via a derivative?

An English public company is not permitted to repurchase its shares, other than as expressly permitted by and in accordance with the Companies Act 2006 (CA 2006) and any restriction or prohibition in the company’s constitutive documents. It is possible for such a company to purchase its shares directly or via derivative; however, the relevant provisions of the CA 2006 apply differently depending upon whether the repurchase is to take place ‘on market’ (ie, by the company purchasing shares on the London Stock Exchange or certain other designated recognised investment exchanges) or ‘off-market’ (ie, by the company purchasing its shares in some other way). An English public company must comply with the CA 2006 when repurchasing its shares, irrespective of whether its shares are listed on the London Stock Exchange or on another exchange anywhere in the world. 

A failure to comply with the relevant provisions of the CA 2006 is a criminal offence and renders the repurchase transaction void.

While a repurchase of shares that is conducted in accordance with the relevant provisions of the CA 2006 is itself exempt from the prohibition in the CA 2006 on financial assistance, this prohibition may be relevant in relation to other conduct of the issuer or its subsidiaries in connection with the repurchase.

If the issuer is a company with shares admitted to trading on the London Stock Exchange, any repurchase of shares by that issuer must also comply with the rules of the London Stock Exchange. The rules of the London Stock Exchange include restrictions on the number of and price at which shares can be repurchased by the issuer, as well as disclosure and notification requirements. In addition, if such an issuer is contemplating a transaction that would have an effect similar to that of such a repurchase, the issuer is obliged by the rules of the London Stock Exchange to consult with the FCA to discuss the application of those rules.

In addition, MAR contains a safe harbour from the prohibitions on market abuse for issuers conducting repurchases of their own securities, provided that the purpose, disclosure and reporting requirements and various price, volume and other trading restrictions are adhered to when conducting such repurchases. However, the safe harbour does not apply to repurchases conducted via derivatives.

Risk

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?

If the counterparty is an English company, then the risks faced by a dealer in the event of the counterparty’s insolvency are the same as for any other commercial transaction with such counterparty. There are no additional insolvency laws applicable solely due to the transaction being an OTC equity derivative transaction entered into with a counterparty that is the issuer or an affiliate of the issuer of the shares to which the derivative relates.

Under English insolvency laws, it is generally the case that contracts and rights that were validly entered into or granted prior to insolvency remain valid and enforceable in the insolvency of an English party to that contract. This means that, generally speaking, the typical close-out netting rights found in OTC equity derivative contracts should be enforceable in the event that a counterparty enters insolvency under English law.

If an English company enters administration, there is an automatic moratorium on the enforcement of security over the assets of that company. In addition, if a company is, or is likely to become, unable to pay its debts it may be able to obtain a moratorium on enforcement of security over its assets. However, in either case, if the security is structured as a ‘security financial collateral arrangement’ under the Financial Collateral Arrangements (No. 2) Regulations 2003, this moratorium will not apply.

However, transactions entered into prior to insolvency can be challenged in an insolvency in certain circumstances, for example, where those transactions are found to have involved:

  • a transfer of an asset to another party for no or insufficient consideration;
  • a desire to put a creditor in a better position than it would have otherwise been in an insolvency;
  • extortionate credit terms; and
  • an intention to put assets beyond the reach of a creditor.

 

In addition, if the counterparty is a financial institution and becomes subject to special resolution or recovery proceedings under the Banking Act 2009 (implementing the Bank Recovery and Resolution Directive (2014/59/EU) (BRRD)), restrictions on the exercise of close-out netting rights may apply and the Prudential Regulatory Authority or the Bank of England will have various rights to suspend payment and delivery obligations of the counterparty, to impose a short stay on the exercise of termination rights or the enforcement of security (typically 24–48 hours) and to bail in or impose loss sharing on contractual counterparties.

Reporting obligations

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?

There are a number of reporting obligations for an issuer or shareholder of an issuer when entering into OTC equity derivatives transactions in respect of the shares in the issuer. These include:

  • trade reporting obligations under MiFID II, MiFIR and EMIR;
  • notifications of any dealings in shares of an issuer by a person who discharges managerial responsibilities within that issuer (and persons closely associated with them);
  • notifications when an issuer repurchases its own shares; and
  • disclosure of substantial shareholdings, control of voting rights and economic long positions as required by the Disclosure and Transparency Rules (DTRs).

 

Additional disclosure obligations may apply in specific circumstances, including when a public offer is or has been made in relation to the shares of the issuer and where the issuer is a regulated institution or part of a sensitive industry.

An issuer that has financial instruments admitted for trading on a regulated market (or for which a request for admission for trading has been made) is further required to disclose, as soon as possible, all inside information that directly concerns the issuer.

Restricted periods

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?

There are no specific restrictions of general application on entering into OTC equity derivative transactions during particular periods; however, MAR prohibits a person using inside information to acquire or dispose of, or cancel or amend an order concerning, a financial instrument within the scope of MAR (which will include most equity derivatives). MAR also prohibits certain insiders from dealing in financial instruments of the issuer during prescribed closed periods.

Legal issues

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?

If the counterparty is the issuer of the underlying shares and is an English company then it must comply with the maintenance of capital and financial assistance rules set out in the CA 2006.

An English company may only make a distribution of its assets (in cash or otherwise) to its shareholders out of distributable profits. Thus, an arrangement pursuant to which a shareholder (in its capacity as such) receives or is entitled to receive, directly or indirectly, a financial benefit from the issuer of the shares at a time when the issuer has insufficient distributable reserves is likely to be unlawful unless an exemption applies.

In addition, subject to certain exceptions, it is unlawful for an English public company or its subsidiaries to give financial assistance directly or indirectly for the purpose of a person acquiring shares in that company. It is also unlawful for an English public company or its subsidiaries to give financial assistance for the purpose of reducing or discharging any liability incurred by a person for the purpose of the acquisition of shares, unless an exemption applies.

The prohibition on financial assistance is subject to a number of exemptions. These include arrangements under which the assistance is given in good faith in the interests of the company where either the company’s principal purpose is not to give assistance for the purpose of the acquisition of its shares (or those of its holding company) or the giving of the assistance is incidental to some larger purpose that it has. Where the shares have already been acquired, the exemption applies if the company’s principal purpose is not to reduce or discharge any liability a person has incurred for the purpose of the acquisition or the reduction or discharge of the liability is incidental to some larger purpose of the company (provided, in each case, that it is acting in good faith and in its own interests).

The above rules are complex and need to be considered in the context of both physically settled and cash-settled OTC equity derivatives transactions.

In addition, if a counterparty to an OTC equity derivatives transaction is a subsidiary of the issuer of the underlying shares, the transaction cannot lawfully provide for the delivery of shares to the counterparty. This is because it is unlawful for a subsidiary of an English company to be a shareholder in its parent, subject to certain exemptions applicable to subsidiaries acting as nominee or trustee and to authorised dealers in securities acting in the ordinary course of its business of dealing in securities.

Tax issues

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

There are complex rules that dictate the UK corporation tax treatment of derivatives transactions, but broadly speaking the rules (set out in Part 7 of the Corporation Tax Act 2009) are aimed at taxing transactions in accordance with their accounting treatment.

The application of stamp duty and stamp duty reserve tax (SDRT) should also be considered; however, OTC derivatives transactions can usually be structured so as not to attract stamp taxes on sale, either because the transactions fall outside of the ambit of stamp taxes or owing to the availability of specific reliefs and exemptions. For example, cash-settled options and forwards will not attract stamp duty or SDRT, as there is no underlying transfer of (or agreement to transfer) securities. Relevant exemptions include intermediary relief (which provides that no stamp taxes are payable on transfers or agreements to transfer securities to an intermediary or market maker) and stock lending relief.

Liability regime

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

OTC equity derivatives transactions may attract contractual, statutory and common law liability. Breaches of statutory requirements, such as the CA 2006, can carry criminal or civil liability for a company and its directors, as well as for involved third parties.

Stock exchange filings

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

Subject to certain exemptions, the DTRs require a person to notify the issuer and the FCA of any active or passive acquisition or disposal of voting rights (or deemed acquisition or disposal of voting rights) that results in that person’s holding (or deemed holding) of voting rights reaching, exceeding or falling below certain threshold percentages of the total voting rights attaching to the issuer’s issued share capital. As a practical matter, this notification obligation applies to acquisitions and disposals of already issued shares (to which voting rights are attached) and also to acquisitions and disposals of derivatives (and other instruments) that create either an unconditional entitlement to receive shares (to which voting rights are attached) or an economically equivalent position. As a consequence, long positions via derivatives – whether cash or physically settled – are potentially notifiable.

The notification thresholds apply when holdings of voting rights reach, exceed or fall below:

  • in the case of UK issuers: 3 per cent and each 1 per cent thereafter; and
  • in the case of non-UK issuers: 5, 10, 15, 20, 25, 30, 50 and 75 per cent.

 

To calculate the notification threshold, all holdings of shares and other relevant instruments are aggregated. Long positions held via cash-settled options are calculated on a delta-adjusted basis, but otherwise long positions held via derivatives are calculated on the full number of underlying shares.

The notification requirement may also be triggered by passive movements through these thresholds (for example, where a company purchases its own shares and the person’s shareholding is concentrated as a result). The obligation on the person dealing in the shares is to notify the issuer and this creates an obligation on the issuer to notify the market.

The notification requirement is subject to a number of exemptions. The exemptions most commonly relied upon by dealers in the context of OTC equity derivatives are the market-maker exemption (which, subject to certain conditions, allows the dealer to disregard its holdings until they reach 10 per cent) and the trading book exemption (which, subject to certain conditions, allows the dealer to disregard holdings in its trading book until they exceed 5 per cent).

Typical document types

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

An OTC equity derivatives transaction is typically documented in a confirmation forming part of an International Swaps and Derivatives Association (ISDA) Master Agreement. The confirmation would incorporate the relevant equity definitions, typically the ISDA 2002 Equity Derivatives Definitions. Although ISDA has published a new set of definitions, the 2011 ISDA Equity Derivatives Definitions, these are not currently commonly used by the market.

Depending on the type of transaction, security is taken over shares held in custody by the counterparty. It is common to have bespoke security documentation and standard form custody agreements.

Margin loans are commonly drafted using Loan Market Association documentation as a base, before being customised to take into account the security over listed shares. As is the case for OTC equity derivative transactions, margin loans have typically bespoke security documentation and standard-form custody agreements.

Legal opinions

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

Legal counsel will typically render opinions on the enforceability of security granted for margin loans and structured equity derivatives, where bespoke security and collateral arrangements are being used.

If the counterparty is not a dealer, then it is common for a dealer to request a legal opinion addressing the counterparty’s corporate power, capacity and authorisation to enter into the transaction.

In addition, in most jurisdictions, the parties rely on opinions provided to the industry by ISDA, which primarily address the enforceability of close-out netting and collateral under standard form documentation published by ISDA. 

Hedging activities

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?

Under the CA 2006, an English company is limited in what it can do with any shares that it has issued and which it holds in its own name. The company can only hold those shares, sell those shares for cash consideration, transfer those shares for the purposes of an employee share scheme or cancel those shares. In addition, an English company must only acquire its own shares in compliance with the buy-back rules of the CA 2006. For these reasons, an English company will be unlikely to lend its shares or enter into a sale and repurchase transaction with respect to its shares to support hedging activities of third parties.

Securities registration

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

The United Kingdom does not have a concept of restricted or controlling shareholdings; however, registration of the share security will be required under the CA 2006 where an English company grants security (including over shares). There is an exception to the registration requirement where the pledge would constitute a ‘security financial collateral arrangement’ under the Financial Collateral Arrangements (No. 2) Regulations 2003, but in practice this exception is not often relied upon.

If the borrower is a person discharging managerial responsibilities (or a person closely associated with such a person) at the issuer of the shares that are subject to security, then the grant of that security is notifiable under article 19 of MAR.

Borrower bankruptcy

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?

If an English company enters administration, there is an automatic moratorium on the enforcement of security over the assets of that company. In addition, if a company is, or is likely to become, unable to pay its debts it may be able to obtain a moratorium on enforcement of security over its assets. However, in either case, if the security is structured as a ‘security financial collateral arrangement’ under the Financial Collateral Arrangements (No. 2) Regulations 2003, this moratorium will not apply.

It is not uncommon for the borrower under a margin loan to be a special purpose vehicle that is set up for the purposes of holding the shares and entering into the margin loan. The corporate structure and documentation typically limit the activities that the borrower can carry on in an attempt to reduce the risk of the borrower entering into administration or any other insolvency proceedings.

Market structure

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

There is no centralised exchange for UK-listed equity options. There are three major exchanges on which listed equity options can be traded: the London Stock Exchange, Eurex and the Intercontinental Exchange. Listed equity options can also be traded on many other trading venues.

Governing rules

Describe the rules governing the trading of listed equity options.

Each exchange is responsible for making and enforcing the rules applicable to trading on it. The exchanges will provide standardised option contracts that set out the terms of the options. 

Law stated date

Correct on

Give the date on which the information above is accurate.

1 July 2020