Viewpoint: A step in the right direction
Winston Ma , an associate in the equity capital and derivatives markets group at JP Morgan Securities in New York, examines how a recent SEC interpretive letter could help develop the US structured products market
Equity-linked derivatives and structured products transactions are an integral and pervasive feature of corporate finance. US companies are fairly familiar with convertible bond offerings through the Rule 144A regime, and during the past several years convertible bonds have become an important financing alternative for certain issuers. Recently, the Securities and Exchange Commission (SEC) issued a significant interpretive letter, which provided welcome guidance for issuers to raise capital through structured products transactions with broker dealers and investment banks.
The US securities laws prohibit underwriters from selling shares into the public market without the issuer registering the sale under the Securities Act of 1933 or obtaining an exemption from the Securities Act's registration requirements.
The SEC interpretive letter may facilitate certain derivatives transactions between issuers and investment banks. Pursuant to the interpretive advice, investments banks could, following certain sales under a registration statement, effect dynamic hedging transactions without further registration or prospectus delivery. In practice, the investment bank needs to deliver prospectuses on its initial hedging, where it sells the full number of shares underlying the derivatives transaction and buys back appropriate shares to reach the desirable "delta" position. Thereafter, no further prospectuses are required to be delivered on any dynamic hedging sales. Upon settlement, shares delivered to the investment bank may be delivered, without any requirement to deliver another prospectus, to third-party stock lenders to close out stock loans related to the derivatives.
The interpretive letter covers any forward or option-based transaction with issuers, affiliates and restricted stockholders, covering products such as forwards, swaps, options, collars, spreads. Such products could be potentially applied in issuers' hedging transactions, financing for merger/acquisition, and customised convertible transactions. The interpretive advice from the SEC provides issuers with flexibility in structuring equity derivatives transactions to manage execution and share price impact.
One important application is found in "registered forward sale transactions". The basic feature involves an issuer entering into a forward contract to sell its stock to investment bank, the counterparty of the forward contract. Following SEC guidance, the investment bank on the contract date will borrow and short the full number of shares underlying the forward contract, and upon settlement (a future date), the issuer delivers shares to the investment bank against receipt of the forward price of the shares.
The strategy may be beneficial to issuers who are contemplating acquisitions in the next six to 18 months and want to lock in equity financing. For example, USI Holdings entered into a forward sale contract in September 2004. The proceeds from the forward contract, per prospectus disclosure, are expected to be used for working capital and general corporate purposes, including possible acquisitions. Separately, the forward sale could be used for opportunistic financing, where the issuer can lock-in equity price today to allow management to meet their financing need on a just-in-time basis.
The views and opinions expressed in this article are solely those of the author and not necessarily the view and opinion of JPMorgan Chase & Co or any of its divisions or affiliates. This article is for informational purposes only and is not intended as an offer or soliciation for the purchase or sale of any financial instrument. This article is not to be deemed as legal advice.
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