Market Disruption Events & Structured Notes

An Overview of Which Market Disruption Events To Include for the Most Common Asset Classes under a Medium-Term Note Program

A movie scene showing a day in the life of a calculation agent would likely not survive the cutting room floor of a film production company. However, on the trading floor of a major financial institution (or on some other floor perhaps in a different building altogether) on which a medium-term note (or "MTN")¹ is structured and sold, the role of that calculation agent becomes more important when determining the value of that structured note on a given day. The drama occurs when a certain underlying asset or assets to which note performance is linked cannot be properly valued due to the occurrence of a disruption in the relevant market. This is when the calculation agent springs into action, perhaps even soliciting advice from its in-house or external counsel to ensure the notes comply with the valuation fallbacks contained in the base documents. Although the aforementioned scenario is based on a true story, the discussion below will focus on how we save our hero, the calculation agent, by including a broad enough definition of "market disruption event" with respect to each underlying asset class contained in the corresponding MTN program.

Even though there are many types of assets to which the performance on structured notes can be linked, the discussion here is limited to the asset classes we most commonly see in MTN programs, which include shares (including exchange traded funds (or "ETFs")) and indices (including proprietary indices). Each note issuer may use its own terminology to describe a market disruption event in its base documents, and oftentimes different issuers describe the same event in different terms. Therefore, our discussion focuses on a generic overview of such events to be included in the definition of a "market disruption event" as it pertains to each asset class mentioned above. We use the terms "underlying asset," "reference asset" and "asset" interchangeably.

BACKGROUND

Before we discuss which market disruption events (or "MDEs") to include for a particular asset class under an MTN program, we should first ask ourselves, "What is a 'market disruption event,' and why is it so important in the world of structured notes?" In a perfect world, MDEs would never occur, and we would, therefore, never need to include them in a product supplement or offering memorandum. However, as those who have ever been unable to log into their brokerage accounts to obtain the value of their stock positions during a fastmoving market can attest, we don't live in a perfect world. In short, in the context of structured notes, this is exactly what a market disruption event is—a specific event relating to a particular asset referenced by the notes that, if it has occurred or is occurring, prevents the calculation agent from valuing such reference asset on a certain valuation date.

In the world of structured notes, uncertainty as it relates to the price or value of an underlying asset that, in turn, affects the payment due to an investor in the notes should be avoided. This is why we define MDEs in MTN programs and clearly delineate what happens if such events were to occur and how the calculation agent would value the affected asset(s) and calculate any payment(s) due under the notes.

Many market conventions in the MTN world, including MDEs, follow market practices established by the International Swaps and Derivatives Association ("ISDA") with respect to over-the-counter (or OTC) derivatives. Therefore, many note issuers use some variation of the market disruption events found in the corresponding ISDA definitions. For example, for structured notes linked to shares or equity indices, note issuers will often base MDE definitions in their MTN programs on the corresponding definitions found in the 2002 ISDA Equity Derivatives Definitions (the "ISDA Equity Definitions"). Let's take a closer look at some of these MDE definitions with respect to underlying assets that are shares and indices and examine how they follow and sometimes differ from their ISDA counterparts.

SHARES (INCLUDING ETFS)

We'll start with equity shares since, together with indices, these are by far the most popular underlying assets linked to structured notes. This section will include shares in both (i) publicly-traded companies and (ii) ETFs. The ISDA Equity Definitions include three events within the definition of an MDE: a trading disruption, an exchange disruption and an early closure. MTN programs will often define their MDEs for shares similarly.

A "trading disruption" for a share is a suspension of or limitation imposed on trading by (i) the exchange on which such share is traded or (ii) any exchange(s) on which the futures or options contracts relating to such share are traded (a "related exchange"), or both. In each case, such trading suspension and/or limitation may include price movements of such share and/or futures or options contracts exceeding the permitted limits set by such exchange or related exchange(s), as the case may be.

An "exchange disruption" for a share is an event that disrupts or impairs the ability of market participants to transact in or obtain market values for (i) such share on the exchange on which such share is listed or (ii) the futures or options contracts relating to such share on any related exchange(s) on which futures or options contracts are listed, or both. This event, as the name implies, only affects the relevant exchange and/or related exchange(s) that, in turn, affects the share and/or listed derivatives but is not specifically related to them. An early closure is specifically carved out of the definition of an exchange disruption.

An "early closure" for a share, in respect of any exchange business day of the relevant exchange or related exchange occurs when (i) the exchange on which such share is listed or (ii) any related exchange(s) on which the futures or options contracts relating to such share are listed, or both, closes prior to its scheduled closing time. The exception is when such exchange or related exchange(s) announce the early closure an hour or more before the earlier of (x) the actual closing time for regular trading on such exchange or related exchange(s) on such day or (y) the submission deadline for orders on such exchange or related exchange(s) for execution at the valuation time on such day.

For a trading disruption and an exchange disruption, ISDA further qualifies such events with each having to (i) be material, in the determination of the calculation agent, and (ii) occur within a one-hour period prior to the valuation time under the specific agreement. Note issuers will also often qualify such events with a materiality requirement and having to occur within a set amount of time prior to either a valuation time or the close of trading in that specific market.

ETF Shares

The ISDA Equity Definitions do not differentiate between shares in a publicly-traded company and shares in other types of securities, such as an ETF. However, some MTN programs carve out specific provisions for ETF shares, including MDEs. Other MTN programs simply specify that the asset conditions for shares also include ETF shares. For note issuers which include ETF-specific provisions in their base documents, it is common to include within the definition of an MDE for an ETF share some variation of a "publication suspension," which means that the entity responsible for publishing the net asset value (or NAV) of such ETF share fails to do so and such non-publication has or will have a material effect on the value of the notes. Further, by allowing for such non-publication to be prospective, this gives the calculation agent greater flexibility and discretion in determining whether such an event is applicable to the ETF share and ultimately the notes.

INDICES

Here, we look mainly at equity indices but will also touch briefly on proprietary indices. Although some MTN programs differentiate between unitary indices (where the component securities in such index trade on a single exchange) and multi-exchange indices (where the component securities in such index trade on more than one exchange), we'll discuss MDEs with respect to indices in general and not differentiate between unitary and multi-exchange types.

Equity Indices

The ISDA Equity Definitions use a single definition of "market disruption event" to apply to both shares and indices, with minor carve-outs for indices. Note issuers, on the other hand, often define an MDE separately for both shares and indices. The ISDA Equity Definitions address indices in the three events included in its MDE definition. Similar to shares, note issuers generally follow some variation of an MDE for an index as defined in the ISDA Equity Definitions.

The ISDA Equity Definitions explain that, for purposes of determining whether an MDE exists with respect to an index, we need to look at whether any MDEs have occurred with respect to individual securities included in that index (each, an "affected security"). Next, we need to determine the percentage contribution of such affected security(ies) to the level of the index by comparing (i) the portion of such index level attributable to such affected security(ies) and (ii) the overall level of such index, in each case prior to the occurrence of any such MDE with respect to such affected security(ies).

A "trading disruption" for an index is a suspension of or limitation imposed on trading by (i) the relevant exchange(s) on which the affected securities comprising 20% or more of the level of such index are traded or (ii) any related exchange(s) on which the futures or options contracts relating to such index are traded, or both. In each case, such trading suspension and/or limitation may include price movements of such affected securities and/or futures or options contracts exceeding the permitted limits set by such exchange(s) or related exchange(s), as the case may be.

An "exchange disruption" for an index is an event that disrupts or impairs the ability of market participants to transact in or obtain market values for (i) the affected securities comprising 20% or more of the level of such index on the relevant exchange(s) on which such affected securities are listed or (ii) the futures or options contracts relating to such index on any related exchange(s) on which such futures or options contracts are listed, or both. Similar to shares, this event only affects the relevant exchange(s) and/or related exchange(s) that, in turn, impacts the affected securities and/or listed derivatives but is not specifically related to them. As with shares, an early closure with respect to an index is specifically carved out of the definition of an exchange disruption for such index.

An "early closure" for an index, in respect of any exchange business day of the relevant exchange(s) or related exchange(s), occurs when (i) any relevant exchange(s) on which the affected securities comprising 20% or more of the level of such index are listed or (ii) any related exchange(s) on which the futures or options contracts relating to such index are listed, or both, closes prior to its scheduled closing time. The exception is when such exchange(s) or related exchange(s) announce the early closure an hour or more before the earlier of (x) the actual closing time for regular trading on such exchange(s) or related exchange(s) on such day or (y) the submission deadline for orders on such exchange(s) or related exchange(s) for execution at the valuation time on such day.

The qualifying clauses found in the ISDA definition of an MDE with respect to a trading disruption and an exchange disruption as they relate to shares also apply to indices but are applicable to the affected securities comprising 20% or more of the level of an index. For these qualifying clauses, note issuers would generally follow the same approach for an index that they take for shares.

Proprietary Indices

A "proprietary index" is an index that is developed and owned by a financial institution (which is also often, but not always, the index sponsor of such index). If an MTN program permits notes to reference a proprietary index, an MDE for such index should be defined more broadly than for an ordinary equity index due to the nature of proprietary indices and their greater complexity with respect to their algorithms and calculations. While note issuers could theoretically define an MDE for a proprietary index similar to an equity index and look through to the components comprising the proprietary index, this may not capture certain proprietary indices that are more algorithmically driven without actual underlying components or components that are not publicly listed. Issuers of structured notes linked to proprietary indices sometimes define an MDE simply as a failure by the index sponsor (or index calculation agent, if applicable) to calculate and publish the level of the proprietary index within the usual time frame for publication due to customized market disruption events.

THE CATCHALL CLAUSE

Many note issuers include a proviso or additional clause to their MDE definitions that are written broadly enough to serve as a "catchall" provision. Some catchall examples we've seen include, but would not be limited to, any event that (i) materially interferes with the calculation agent's ability to properly value an underlying asset, (ii) materially and adversely affects an issuer's hedge position with respect to such asset and/or (iii) materially interferes with the issuer's ability to perform its obligations under the notes. A catchall provision is included to avoid the uncertainty mentioned above and is generally a good idea to include, if possible.

CONCLUSION

With a properly crafted "material disruption event" definition with respect to the conditions for a particular asset class, our hero, the calculation agent, will have a sufficient number and variety of tools in its toolbox to save the day by valuing the underlying assets that have experienced market disruptions. Without a well-crafted MDE definition, uncertainty may rule the day and defeat our valiant calculation agent, opening up the note issuer to liability. Although we've only discussed MDEs with respect to the most common asset classes in shares and indices, at least from the perspective of U.S. MTN programs and even many European MTN (or "EMTN") programs, there are still a number of reference assets more commonly referenced in EMTN programs, including, but not limited to, commodities, foreign currency exchange rates (or "FX rates") and funds. Perhaps in another chapter we'll see our hero don its cape again to tackle the more complex and numerous MDEs relating to commodities, FX rates and funds.

Originally published in REVERSEinquiries: Volume 6, Issue 1.
Click here to read the articles in this latest edition.

Footnote

1. For a further discussion on medium-term note programs, see our "What's the Deal?" article on Medium-Term Note Programs.

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