The 2002 definitions are based on the 1996 International Swaps and Derivatives Association's equity derivatives definitions and, like the 1996 definitions, are primarily intended to be incorporated into confirmations documenting equity derivatives transactions. Trades executed under the 1996 definitions will not, without further action by the parties, be affected by the adoption of the new definitions. This article will discuss the key areas in which the 2002 definitions modify the 1996 version, including the expansion of product coverage, separation of settlement mechanics from product type, expansion of the consequences of merger and other events impacting the underlying shares and refinement of the consequences of market disruptions. Like the 1996 definitions, the 2002 definitions are intended to reflect a global standard of current market practice and are not necessarily meant to deal with issues that only relate to certain specific jurisdictions.
The Changes
First among the changes in the 2002 definitions is the expansion of instruments the document covers. The 1996 definitions were drafted specifically to cover American and European style equity options, both cash and physically-settled, and cash-settled equity swaps. Although the 1996 definitions provide a useful starting point when documenting transactions similar to these, such as forwards and Bermuda options, confirmations for such transactions need to be modified to include specific provisions not included in the 1996 documents. The 2002 definitions have provisions for forwards including forwards with prepayment and variable delivery features. The new provisions also expand the elections in relation to option transactions to include specific mechanics for Bermuda options and products with barrier features, such as knock-outs.
Settlement mechanics are no longer dependent on product type, which is consistent with the modular approach ISDA generally takes. In the 1996 definitions, only options permitted physical as well as cash settlement, while equity swaps were only cash-settled. Market developments have given rise to an interest in physically-settled equity swaps, which, like forwards, could always be documented by incorporating the 1996 definitions but which entailed significant modifications to achieve their objective. Separating the settlement method from the product type removes these limitations on settlement and allows a greater degree of flexibility and customization.
Another area in which the 2002 definitions modify the 1996 documents is in the treatment of Potential Adjustment Events and Merger Events. The 2002 definitions add to the list of events that can be a Potential Adjustment Event by including the activation of "poison pill-type" provisions in a shareholders' rights plan. The definition of a Merger Event has also been expanded to include reverse mergers. Once a Merger Event has occurred, the choice of elections for how to deal with the event has been expanded to include two additional consequences of Merger Events, namely Calculation Agent Adjustment and Modified Calculation Agent Adjustment. Both of these consequences allow parties to elect that the Calculation Agent will make any necessary adjustment to the transaction as a result of a Merger Event, and Modified Calculation Agent Adjustment permits the Calculation Agent to take into account changes to such variables as volatility, liquidity, stock loan rate and expected dividends when making such adjustments. The Cancellation and Payment election has also been further refined with respect to options, to provide that the calculation of the cancellation amount will take into account such variables as mentioned above according to a prescribed formula or to permit the Calculation Agent to make the determination of a cancellation amount in its sole discretion. With respect to equity swaps and forwards, the parties' determination of a cancellation amount where "Cancellation and Payment" applies will now track the "Close-out Amount" definition in the 2002 Master Agreement, while in the 1996 definitions it was based on the "Market Quotation" valuation method from the 1992 ISDA Master Agreement.
Combined Consideration
Two additional consequences are now available for Merger Events where the consideration is Combined Consideration, i.e., it consists of both New Shares and Other Consideration. "Partial Cancellation and Payment" results in the cancellation of the portion of the transaction represented by Other Consideration and the continuation of the remainder of the transaction represented by New Shares as if "Alternative Obligation" had been chosen. "Component Adjustment" provides that the consequence that has been elected for a Share-for-Share Merger Event will automatically apply to the portion of the transaction represented by New Shares and the consequence that has been elected for a Share-for-Other Merger Event will automatically apply to the portion of the transaction represented by Other Consideration. "Partial Cancellation and Payment" can also apply to basket transactions, and permits cancellation of only the portion of the transaction represented by the Share affected by the Merger Event and continuation of the remainder of the transaction on the terms then in effect.
Treatment of tender offers is now the subject of a separate section, in acknowledgement of the fact that parties may wish to adjust their transactions or otherwise deal with events that result in less than a 100% change in control, the threshold for an event to be considered a Merger Event. If the parties elect for the Tender Offer provisions to apply, the consequences available for Tender Offers are largely the same as for Merger Events, except that "Alternative Obligation" is not applicable to a Tender Offer.
Market Disruption
In response to issues regarding exercise, valuation and settlement of transactions that arose following several recent disruptions to the financial markets, amendments have also been made to the provisions dealing with the consequences to transactions of disruptions that occur in the markets that trade the share or index that is the subject of the transaction or that trade futures or options contracts on the share or index. The 2002 definitions keep the term "Market Disruption Event" but expand on it by including not only events that cause disruption in trading on the particular share or index, but also events that cause disruption on the relevant exchange generally or an unscheduled early closure of the relevant exchange. Where such events occur or are continuing for eight consecutive days on which the relevant exchange is scheduled to be open, the relevant exchange fails to open (on a day when it is scheduled to do so), or any combination of the foregoing, the Calculation Agent will make a good faith estimate of the value of the relevant share or index. In the 1996 definitions, such a deferral was only available for five days and it was only applicable to the more limited definition of Market Disruption Events (not failures of the exchange to open) relating to cash-settled transactions through the workings of the "Valuation Date" provisions. In acknowledgement of the fact that exercise of a physically-settled option should not be forced on a party in an inefficient and unsettled market, the eight-day deferral applies to the Expiration Date as well, regardless of the settlement method.
The 2002 definitions also include new, elective disruption events that permit termination of, or adjustment to, a transaction in a variety of situations including a disruption to, or material increased cost of, the underlying hedge transaction. In addition, there are several new elections throughout the 2002 definitions that increase the role of the Calculation Agent with respect to material determinations and adjustments to be made over the course of a transaction.
This Documentation Focus review was written by Thomas Jones, partner, and Ann Bradley, associate, at Allen & Overy in London.
