Bank Lawyer's Blog

Equity Derivatives: A Book Review

In the five years I've been inflicting this blog upon an unwilling world, I've been asked a number of times to review books. Each time, I've refused, for a variety of reasons, most of them having to do with time, specifically the lack of it. Receiving a free book does not somehow magically expand a day by twelve hours.

I broke down recently when offered a review copy of Equity Derivatives, edited by Mayer Brown's Edmund Parker and published by Globe Law and Business. First, the title appealed to my inner geek. In addition, I've performed a fair amount of work in the past on interest rate derivatives, including options, swaps, "swaptions," fowards, caps, collars and other mind-numbing transactions, and I'm genuinely curious to learn about an area of derivatives where I have not spent time.

The book is published by a UK firm. The editor, Edmund Parker, is a London-based derivatives expert (and also the author of Credit Derivatives), and many of the other authors (in addition to Mr. Parker) are also British. Therefore, an American reader will have to be prepared to deal with the minor inconvenience of reading English as it is meant to be written, as opposed to the American version, which we Yanks like to make up as we go along. If "whilst," "amongst," "programme," and "preference shares" throw you off your game, just "butch it up" and get with the "programme." You'll be able to decipher it, rest assured.

In the preface, Mr. Parker states that the intent of the book is to give lawyers, "traders, treasurers, other finance professionals and students" and understanding of "equity derivative products, documentation, and the corporate regulatory and tax issues that arise in different jurisdictions." In my opinion, the book achieves that goal admirably.

This is not an in-depth analysis of equity derivative transactions that would be extrememly useful to experienced legal practitioners looking for insights in negotiating tactics or as to what's generally asked for and given in the way of amendments to the standard form International Securities Dealers Associations (ISDA) documentation used to "paper" transactions. That's not the intent of this book. Rather, it gives an excellent overview of what equity derivative transactions are, the financial instruments used to effect them, the ISDA equity derivative documentation (including a thorough chapter that explains the 2002 ISDA definitions), the corporate and regulatory aspects of equity derivatives, and the UK and US tax aspects. From a lawyer's perspective (which is the only perspective I'm even minimally qualified to share),  this would be an excellent book to give any associate or in-house counsel who is intent on learning what equity derivatives are, as an -in-depth introduction to such transactions. It should also function as a handy reference for those practitioners who might occasionally get bogged down in the details of negotiating the documentation of a particular transaction and need to step back and see the forest for the trees.

This is a tough subject to make simple. As is the case with all effective teachers, however, Mr. Parker is adept at taking transactions that can become quite complex and first giving a bird's eye overview, then breaking down the subject matter into separate, yet connected, broad categories that help the reader digest and retain the subject matter. For example, he begins by breaking down equity derivatives into four "constituent parts" and explains each part. Likewise, he breaks down the types of transactions into three fundamental categories, the additional and inherent risks of equity derivatives into five separate categories, and the purposes of equity derivative transactions into seven basic categories. Throughout the book, by returning to the basic categories when reviewing a specific type of transaction, he, and other authors, guide the reader to a better understanding of the transaction, how  and why it differs from other types of transactions, and, logically, what the additional or different risks might ensue from the specific transaction.

As another example of simplifying the complex, Mr. Brown and his co-author, Mayer Brown London associate Marcin Parzenowski, take the jumble of boilerplate known as the 2002 ISDA Equity Derivatives Definitions, break them down into seven categories, discuss their roles and purposes, and, finally, clarify which definitions are applicable to which types of transactions. Given my first wade through ISDA doumentation swamp in the 1990s, I now wish I'd had available this type of a road map. I might have lost fewer brain cells on my trek.

I found especially useful the charts and diagrams used throughout the book. I'm a visual learner, so perhaps I might find them more valuable than non-visual learners. Nevertheless, I returned to them repeatedly to help me sort through the written explanations. Moreover, there is frequent use of examples of transactions, most hypothetical (on the surface, at least), but some actual transactions. These, too, I found helpful.

With respect to ISDA documentation (the standard for OTC equity derivatives), Mr. Parker and Mr. Perzanowski break the documents down into three basic platforms and provide a good explanation of each platform. Again, there is a good use of diagrams to to aid the reader's understanding. There is also decent guidance provided as to what changes to the standard documentation might be necessary given a particular type of transaction, and, when standard documentation offers the user alternatives, which alternative might be be considered the customary choice. For example, although it is not essential to incorporate the 2006 ISDA Definitions in most equity derivative transactions, the authors make recommendations as to when it is advisable to do so.

I'm not competent to render any opinion as to the merits of the separate chapters on regulation in France, Germany, Italy, Spain or the UK, nor as to the tax aspects of US or UK law. The global trends overview, written by Gide Loyrette Nouel partner Alban Caillemer du Ferrage, is basically a warning against a trend in Europe and the US for greater "transparency" in derivative transactions. In the name of transparency, regulators can kill the goose that lays the golden risk-hedging eggs.

The chapter on US regulation, authored by Joyce Y Xu, Senior Counsel at Simpson Thatcher & Bartlett LP selects four types of equity transactions commonly used by US corporations (structured issuer share repurchases; issuer call spread transactions; registered issuer stock borrow facilituies; and issuer forwards with registered hedges) and discusses the US corporate and legal issues associated with them. As to those four types, the discussion is useful. Once again, diagrams aided this slow learner's efforts immensely. For a banking lawyer, there is no discussion of US banking law applicable to banks who enter into such transactions. To that extent, a bank might wish to consult another source, such as U.S. Regulation of the International  Securities and Derivative Markets.

To reiterate, I found the book a good primer for understanding equity derivative transactions and how they are documented. I'd recommend it to anyone serious about introducing themselves to the subject matter or merely refreshing their memory.

Take My TARP...Please

TCF CEO Bill Cooper is mad as hell, and he's not going to take it anymore.

The man who recently told the Treasury Department that he's got a bad case of seller's remorse and wants to give back his bank's CPP investment, got everything that's been bugging him about the nation's financial mess off his chest. According to BankThink's Rebecca Sausner, who listened to Cooper rant at yesterday's SourceMedia’s Best Practices in Retail Financial Services Symposium in Florida, it was a rare glimpse into the utter honesty of man who's been around long enough that he's not afraid of anything other than running out of Viagra.

One of my personal favorites was his no-holds-barred take on the federal government's role in the meltdown.

“I believe at least 90 percent of this crisis was government driven, created by the government through bad monetary policy, the wrong kind of regulation, the whole impetus for managing economy, lending to the poor, encouraging what was in effect bad lending. All of this stuff was encouraged by the government, and a lot of honest bankers went along with it and didn’t make good judgments.”

Another two I loved, because I find the filing of Suspicious Activity Reports (SARs) to be, for the most part, an egregious waste of time, were these:

On the value of SARs to national defense in the hands of the BSA regulators:
“What the hell? These guys couldn’t find this loan problem when it sat in front of them; they’re going to find a terrorist?"

“Does anybody think there’s not enough regulation in the banking business?” Cooper asked, to a burst of laughter. But, he argues, the regulation is misfocused on issues like BSA instead of fundamental safety and soundness. “They come in and audit the living crap out of you on BSA. Have you guys lived through this? It’s a life/death experience if you flunk BSA. …The only terrorist the BSA program has caught is Spitzer with his pants down.”

And who could resist a Henny Youngman moment.

"I thought swaps were what guys did with their wives in California."

Read them all. They're priceless.

Sunday Funnies

Some articles of interest for those of us with nothing better to do:

CIO Asia has a one year look back at the TJX breach that we've discussed (most recently here) and finds some interesting lessons. One of them is that data breaches can be incredibly costly. Who knew? TJX has spent or set aside $250 million in 12 months. On the other hand, sales are up. According to one expert, customers know they aren't going to be left holding the bag for fraudulent credit card charges, so they're continuing to shop at the company's stores.

Another lesson learned is the divide between retailers and credit card issuing banks that's become more pronounced since the security breach was announced.

The TJX breach exposed a fundamental rift, with banks and credit card companies on one side and merchants on the other. In several states, credit unions and smaller banks have lobbied the legislatures to pass new laws requiring retailers to reimburse them for the costs involved in notifying customers of breaches and reissuing cards.

But the lobbying attempts failed everywhere except in Minnesota, which last May approved the Plastic Card Security Act -- a law that holds breached entities financially responsible if they were storing prohibited card data on their systems.

In fighting the state bills, retailers have argued that the commissions they pay to card companies on each transaction are supposed to cover fraud-related costs, making any additional payments a double penalty. They also said that the only reason they store payment card data is because they're required to by the credit card companies. In October, the National Retail Federation (NRF) asked Visa and the other card companies to drop that requirement.

The NRF's request is echoed by Litan, who long has argued for fundamental changes in the card industry's payment process, via the introduction of measures such as one-time passwords and all PIN-based transactions.

I'd add that banks haven't given up on state laws that hold retailers responsible. New laws have been proposed in Michigan and Washington.

The final lesson learned by CIO Asia is that the data hackers aren't easy to catch. They're still on the loose.

At Re: The Auditors, Francine McKenna takes a look at the massive trading losses absorbed by Societe Generale and the decision of a special committee of its board of directors to bring in "independent auditors" PriceWaterhouseCoopers to assist in looking at the causes of the loss and its extent. Francine convincingly argues that not only is PWC not truly "independent," but that none of the Big 4 could be "really independent."

After all the bleating by regulators to banks about the critical use of multifactor authentication, one of the most surprising aspects of that fiasco was that the rogue trader was able to engage in his trading activities in part because he and others who had responsibility to approve his trades had access to the system through only one factor authentication, name and password. The young man purloined the passwords of the others involved in the trading process. Not state of the art authentication, exactly, was it?

Finally, the wild tale of Richard Davet, who fought foreclosure, much of the time pro se, for 11 years until finally getting the boot, is not dead. A couple of weeks ago the  US Court of Appeals for the Sixth Circuit denied his motion for a rehearing of its  previous ruling that upheld the district court's dismissal of his complaint. Undaunted, he vows to appeal to the US Supreme Court. As is every deadbeat's right.

Hedging Interest Rate Risk

How fitting that an article about how some smaller banks are delving into allegedly "risky" derivatives as a means to combat some of the risk of rising interest rates, appears in the Las vegas Business Press.

I won't address the business risks (because I'm not competent to do so), other than to observe that if a small bank decides to get into interest rate hedging through the use of interest rate Swaps (which have been around for a long time and whose risks should be well understood by most bankers) or other, less familiar, forms of "derivative hedging," and doesn't have the in-house expertise to fully understand ALL of the risks (business, regulatory and legal) of entering into such transactions, then it should hire an independent consultant who does understand the risks, to advise the bank. I emphasize "independent." In addition to being knowledgable, the consultant should owe his or her allegiance solely to the bank. He or she shouldn't be a salesman or referral source who is connected to any of the "players" on the other side of the table from the bank. The consultant should also be knowledgable about the bank's regulatory requirements (including reporting requirements and limitations) and the financial statement impacts that relate to the hedging techniques employed.

As to legal documentation, the bank should make certain that it hires someone who's done this type of work before. This isn't a job for the lawyer who may do an excellent job with other transactions for the bank, but doesn't know an ISDA from a pop tart. Although some of the major counterparties on Wall Street (and some of the major banks who work in this arena) may tell the bank that the documents are all "bolierplate" and "rarely negotiated," don't believe them. You won't know what changes you can negotiate until you ask for them. You'll be surprised at how much of the "boilerplate" turns out to be negotiable by parties who understand it.

Obviously, hedging isn't for everyone. As a University of Michigan professor observes: "Unless they have a system in place and the technical expertise, they could end up increasing their risk instead of hedging it." On the other hand, the same professor asserts that "[w]hen rates change a lot, or go up a lot, banks that are using derivatives show less change in their business than banks that aren't using it."

Bottom line: hedging through the use of Swaps or other forms of derivatives is a technique about which smaller should be cautious, but not afraid.