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In brief: registration, reporting and liability for derivatives transactions in USA – Lexology

Liability and enforcement

Territorial scope of regulations

What is the territorial scope of the laws and regulations governing listed, cleared and uncleared equity derivatives transactions?

In general, US securities laws have a broad extraterritorial reach, and any trades with US-listed underlying equities will have to consider the implications of US securities laws even where the counterparties and governing law of the derivative contract are otherwise non-US. US-listed underlying equity in a derivative contract may also create a sufficient nexus to give rise to US bankruptcy considerations. Absent other activities in the US, however, listing equity on a US exchange generally would not subject the issuer to US net income taxation. In addition, certain specific rules may apply to swaps and security-based swaps under the Commodity Exchange Act and Exchange Act, and investors in listed equity options generally must comply with requirements imposed by broker-dealers to comply with Securities and Exchange Commission (SEC) and Financial Industry Regulatory Authority, Inc (FINRA) requirements, regardless of their location.

Registration and authorisation requirements

What registration or authorisation requirements apply to market participants that deal or invest in equity derivatives, and what are the implications of registration?

A dealer entering into equity derivatives that are Commodity Futures Trading Commission (CFTC)-regulated swaps (such as swaps referencing broad-based securities indices or US government securities) must register as a swap dealer if certain of their activities in a dealing capacity exceed stated thresholds (namely, US$8 billion over a rolling 12-month period, or US$100 million with ‘special entity’ counterparties, as defined in the rules). A counterparty that is not required to register as a swap dealer may nonetheless be required to register as a major swap participant and to become subject to rules similar to those applicable to swap dealers if its swap activity exceeds thresholds of current exposure and potential future exposure that are set out in rules; there are currently no registered major swap participants.

Similar registration requirements apply to counterparties to equity derivatives that are SEC-regulated security-based swaps, which registration requirements will become effective on 6 October 2021, subject to a transition period lapsing on 1 November 2021 for firms qualifying as security-based swap dealers on the 6 August 2021 counting date.

A person who acts as a broker or dealer (as defined in the Exchange Act) with respect to options that are securities must register with the SEC as a broker-dealer and must generally become a member of FINRA. Broker-dealers that facilitate transactions in listed equity options may also be required to become members of the Options Clearing Corporation (OCC) and an options exchange.

Reporting requirements

What reporting requirements apply to market participants that deal or invest in equity derivatives?

Equity derivatives that are CFTC-regulated swaps are required to be reported to a swap data repository (SDR). In most cases, the SDR is required to publicly disseminate certain anonymous information about the swap. Swap dealers are also subject to various financial and other reporting requirements.

Similar reporting requirements will apply to equity derivatives that are SEC-regulated security-based swaps beginning in October 2021.

FINRA member broker-dealers are required to report large options positions held by the broker-dealer or any of its customers to the Large Options Positions Reporting System, which is hosted by the OCC. Broker-dealers are also subject to various financial and other reporting requirements.

Legal issues

What legal issues arise in the design and issuance of structured products linked to an unaffiliated third party’s shares or to a basket or index of third-party shares? What additional disclosure and other legal issues arise if the structured product is linked to a proprietary index?

Structured products linked to an unaffiliated third party’s shares or to a basket or index of third-party shares raise issues about the appropriate level of and responsibility for disclosure about the issuers of those shares, baskets or index components. With respect to individual shares or baskets of shares, the SEC staff issued a no-action letter that permits third-party unaffiliated issuers to link to other issuers’ shares with minimal incremental disclosure, provided that such issuer satisfies what is referred to as the ‘reading room analysis’. If there is adequate publicly available information about the issuer of the linked shares and sufficient market interest in the shares, the prospectus for the structured product may provide a brief description of the nature of the issuer of the underlying stock, and its performance, and may refer investors to that issuer’s filings with the SEC for additional information. This ‘reading room’ principle also extends to baskets. Typically, each basket component is analysed to determine whether it complies with the requirements of the no-action letter, but some issuers may determine that components that comprise only a small part of the basket need not strictly satisfy the requirements. For structured products linked to a broad-based index of third-party stocks, most issuers conclude that disclosure about each component would not be meaningful to investors and do not apply the reading room analysis.

Broad-based indices, whether third party or of a proprietary nature, raise additional disclosure issues in light of regulatory concerns surrounding the complexity and transparency of such indices and the accountability of their sponsors. Structured product issuers must ensure that the index disclosure adequately describes the index methodology, as well as any embedded costs and fees and any conflicts of interest. Proprietary indices with limited histories have also attracted regulatory scrutiny. FINRA has a long-standing position that back-tested or ‘pre-inception performance’ data cannot be used in communications with retail investors because it does not comply with FINRA retail communications rules. However, for institutional communications, FINRA permits such data to be provided so long as it is clearly identified as being for institutional use only, the index reflects a rules-based methodology, the back-tested data shows a range of market environments, is distinguished from actual historical performance and discloses any limitations of the back-tested methodology. In addition to complying with FINRA’s conditions, disclosure relating to any proprietary index and its performance is subject to the SEC’s standards that such disclosure must not misstate or omit material information. All communications must be presented in a way that is fair and balanced to afford institutional investors the opportunity to make an informed investment decision.

Finally, in addition to disclosure considerations, other legal issues may arise. For example, when a structured product is linked to an index, discretion in the calculation of that index must be carefully analysed, in particular to avoid potential issues under the Investment Company Act and the Investment Advisers Act, as well as ERISA and tax issues. Structured products linked to shares of a US third-party corporation (or a basket or index that includes such shares) may give rise to special withholding issues for non-US holders. In addition, if the methodology for rebalancing the underlying shares in a basket or index (regardless of whether shares of a US corporate equity are included) permits a degree of discretion, changes in the composition of the basket or index may be a taxable event to a US holder of the structured product. Separately, the parties to structured products linked to discretionary baskets or indices may be required to report the transaction to the IRS. If a global distribution is contemplated, EU benchmark regulation and IOSCO principles for financial benchmarks may also be implicated when linking to third-party or proprietary indexes.

Liability regime

Describe the liability regime related to the issuance of structured products.

Issuers and other deal participants involved in offerings of structured products face potential liability for material misstatements or omissions, as well as for failing to register the sale of the structured product with the SEC (if required) or complying with one of the exemptions from registration. In addition, potential liability under state securities laws and common law fraud may arise in connection with offers or sales of securities.

In particular, for SEC-registered offerings:

  • section 11 of the Securities Act provides a cause of action if any part of a registration statement contained an untrue statement of a material fact or a material omission at effectiveness. Potential defendants include the issuer, directors, signing officers, named experts and underwriters; and
  • section 12 of the Securities Act provides a right of rescission to investors against any person who offers or sells a security by means of a prospectus or oral communication that includes an untrue statement of a material fact or a material omission, or if a security is offered or sold in violation of the Securities Act’s registration requirements.

For both SEC-registered and unregistered offerings:

  • Rule 10b-5 claims of an untrue statement of a material fact or an omission of a material fact necessary to make the statements made, in the light of the circumstances under which they were made, not misleading may also arise; and
  • Rule 10b-5 claims require fraudulent intent, or scienter (unlike claims under section 11 or section 12).

Given increasing technology-driven efficiencies, awareness of regulations and potential liability in other jurisdictions where such products may be offered or sold is also important.

Other issues

What registration, disclosure, tax and other legal issues arise when an issuer sells a security that is convertible for shares of the same issuer?

The majority of convertible security issuances are in the form of convertible notes, which are convertible at the option of the holder under certain circumstances. Typically, conversions may be settled in cash, stock or a combination thereof at the issuer’s election, depending on the accounting treatment the issuer desires. Foreign issuers who have listed American depositary shares (ADSs) in the US may also raise capital through securities convertible into their listed ADSs. In some cases, issuers choose to employ call spread or capped call derivative overlays to synthetically increase the conversion price of the notes and reduce potential dilution. The derivative overlays can be structured such that the premium paid by the issuer (normally not tax-deductible) will be treated as tax-deductible additional interest expense on the convertible debt, and the derivative instruments will receive equity accounting treatment rather than being treated as marked-to-market derivatives.

Most convertible notes are offered on an unregistered basis only to large ‘qualified institutional buyers’ that are not affiliates of the issuer under Rule 144A of the Securities Act, making them ‘restricted securities’ that generally cannot be resold to the general public unless one year (or six months if certain of the issuer’s filing requirements are met) has elapsed since the original issuance. Issuers typically agree to remove restrictive legends to allow public sales after one year, although the market for convertible notes is dominated by such qualified institutional buyers and may be traded among such entities under Rule 144A prior to de-legending. In certain circumstances, issuers will issue convertible notes in a 144A offering simultaneously with a registered equity offering, in which event issuers must structure the transactions such that the unregistered convertible notes offering is not ‘integrated’ with the registered equity offering.

In a registered offering, the issuer must simultaneously register the offering of the underlying equity if the convertible securities are convertible within one year (almost always the case). In both a registered and an unregistered offering, an exemption from registration is generally available for the issuance of the underlying securities on conversion under section 3(a)(9) of the Securities Act. In an unregistered offering, the shares received on conversion are restricted securities, but the holding period of those shares may be ‘tacked’ to the holding period of the convertible securities for the purposes of Rule 144’s holding period requirement. On 22 December 2020, the SEC proposed an amendment to Rule 144 that would, in certain circumstances, eliminate tacking of the Rule 144 holding period for securities received upon conversion or exchange of a convertible or exchangeable security. The amendment would only apply to unlisted issuers and ‘market-adjustable securities’, which the SEC defines as convertible or exchangeable securities that contain conversion rate or price adjustment terms that would offset declines in the market price of the underlying securities (other than adjustments for issuer initiated changes like stock splits and dividends). The proposed change would not apply to the majority of convertible deals, where the initial conversion rate and price are fixed, subject only to anti-dilution adjustments.

Convertible notes issuances may generate short selling by certain investors in the notes to hedge their position, as well as market activity by dealers under the call spread or capped call transactions, which must be disclosed in connection with the offering. Issuers may have to comply with stock exchange rules requiring shareholder approval where the number of shares into which the convertible security are convertible would exceed 20 per cent of the shares outstanding, unless certain exemptions are met.

Mandatory convertibles are treated as forming the same class as the underlying shares and therefore may not be offered under Rule 144A and are generally offered on a registered basis. In this case, the issuer must simultaneously register the offering of the underlying equity.

For tax purposes, a mandatorily convertible note may be characterised as equity, rather than debt. If so, among other consequences, the issuer would not be allowed to deduct interest expense and coupon payments would be subject to withholding when paid to a non-US holder. Even without re-characterisation, an issuer’s deduction of interest payments may be limited for mandatory convertibles and certain optional convertibles, and, in the case of a US issuer, may be limited or disallowed, based on the use of the proceeds. Further, US holders may need to recognise dividend income and non-US holders may have to pay withholding tax, even if no payment has been made, if conversion ratio is adjusted and certain conditions are met.

What registration, disclosure, tax and other legal issues arise when an issuer sells a security that is exchangeable for shares of a third party? Does it matter whether the third party is an affiliate of the issuer?

Exchangeable securities are exchangeable into securities of an entity different from the issuer of the exchangeable security and are often issued by a capital-raising entity that is a subsidiary of the issuer of the publicly traded common equity.

Exchangeables may also be offered on a registered basis or an unregistered basis if an exemption from registration is available. For the exemption from registration under section 3(a)(9) of the Securities Act to be available for the issuance of the underlying securities issued upon exchange, the issuer of the exchangeable security must be a wholly owned subsidiary of the underlying shares issuer and its parent must fully and unconditionally guarantee its obligations. Absent such an arrangement, the exchange must be registered at the time of the exchange or qualify for a different exemption. If the underlying shares are ‘free stock’ (underlying shares that are not restricted and not owned by an affiliate of the issuer), the exchange does not have to be registered, whether the exchangeable securities are offered on a registered basis or pursuant to Rule 144A. Where these conditions are not met, the only practical alternative is to offer the exchangeable security under Rule 144A, effect the exchange on a private placement basis and register resales of the underlying shares, as tacking under Rule 144 is not permitted in this situation.

Mandatory exchangeables may be offered on a registered basis, which requires registration of the underlying shares unless they are free stock. Mandatory exchangeables may be offered under Rule 144A only in certain circumstances where the underlying shares are free stock, the mandatory exchangeable can only be settled in cash and other technical requirements of Rule 144A are met.

For tax purposes, an issuer’s deduction of interest may be disallowed for mandatory exchangeables and certain optional exchangeables if the exchange is for shares of a third party (especially if the third party is an affiliate of the issuer). Further, interest payments may be subject to withholding when paid to a non-US holder. Unlike the conversion of a convertible security, an exchange will generally be a taxable event for the holder and the issuer.

Law stated date

Correct on

Give the date on which the information above is accurate.

1 January 2020.

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