Message-ID: <7441063.1075863629360.JavaMail.evans@thyme> Date: Tue, 20 Jun 2000 02:12:00 -0700 (PDT) From: rmatthews@velaw.com To: shackleton@enron.com, sara.shackleton@enron.com Subject: FW: (no subject) Mime-Version: 1.0 Content-Type: text/plain; charset=ANSI_X3.4-1968 Content-Transfer-Encoding: quoted-printable X-From: Matthews; Rebecca X-To: Shackleton, Sara (Enron) X-cc: X-bcc: X-Folder: \Sara_Shackleton_Dec2000_June2001_1\Notes Folders\Confirms - equity X-Origin: SHACKLETON-S X-FileName: sshackle.nsf Sara: As promised, this email discusses the securities laws issues involved with equity derivatives, I then make a few observations about the relationship between the securities and commodities laws, and I then makes some comments on the confirmations you sent me (both securities laws comments and other comments. The principal securities laws issues relate to the fact that the equity derivative itself is a security and to the issue of whether and to what extent a counterparty=01,s activities in establishing or unwinding a hedge are attributable to the issuer. When Enron enters into a derivative and the counterparty goes out into the market to make a purchase, is that purchase attributable to Enron? When it unwinds its hedge by making a sale, is the counterparty=01,s sale attributable to Enron and therefore required to be registered? Here are the principal issues: 1) Rule 10b-5. When Enron enters into a derivative, it must be sure it does not have undisclosed material inside information regarding its affairs. It is my understanding that the traders are supposed to check with Rex Rogers on the issue of whether Enron possesses such information. Although it could discharge its obligations under Rule 10b-5 by disclosing the information to the counterparty, that would probably be unacceptable since the counterparty would then be in possession of material inside information and could not engage in a market transaction to hedge. Thus, each time it enters into an equity derivative in its own stock, Enron must be confident that the public has available to it all material information regarding Enron. 2) Rule 10b-18. This rule permits issuers and persons acting in concert with issuers to repurchase the issuer=01,s shares under a =01&safe harbor=018 that says in effect tha= t if purchases are made pursuant to the rule they won=01,t be deemed to be manipulative by reason of the tim= ing and amounts of the bids or purchases. It is typical for an issuer to require its counterparty to make purchases pursuant to the rule. Sometimes this is a contractual undertaking in the confirmation, and in some cases the issuer will simply obtain an oral commitment from the counterparty to engage in its hedges pursuant to the rule. Obviously, it is better to have it in writing. 3) Registration of Sales. If Enron decides to net share settle and issues shares to the counterparty, those are obviously restricted securities that cannot be sold by the counterparty in the absence of a registration statement. But what about the resales by the issuer when it unwinds its hedge that it has put on by buying shares in the open market? Are those sales attributable to the issuer so therefore required to be registered? I have seen lots of counterparties, based on advice of their law firms, take different positions on this: a) Some counterparties say that they want registration rights covering resales of shares purchased in the open market to hedge a derivative with the issuer. If the economics of the derivative are determined based on the net proceeds from the sales, it= =01,s a more difficult case because the issuer itself is realizing benefits and detriments from the sales. b) Some counterparties say they want registration rights covering resales of shares purchased in the open market to hedge a derivative with the issuer only if there is a strong correlation at the onset of the contract between the terms of the derivative and the hedge. It it=01,s a total return swap, for example, there will be a 1:1 correspondence (i.e. the economics will tell you that the counterparty will buy 100% of the shares covered by the swap immediately upon entering into the swap); but if it=01,s something like a collar with divergent strike prices and involves dynamic hedging where it=01,s not clear whether and to what extent the counterparty will make purchases or sales in the ope= n market, then it=01,s not as easy to attribute the counterparty=01,s actions to the = issuer. In those cases these counterparties look at the correlation and if it=01,s not that great = they don=01,t ask for registration rights. c) Some counterparties say they don=01,t want registration rights for resa= les of stock purchased in the open market to hedge their position. Credit Suisse First Boston falls in category c) with respect to the May 200= 0 confirmation you sent me. Even though there is a strong correlation between the deal and the hedg= e ( i.e. even though in that case they will no doubt immediately purchase 100% of the shares covered by the transaction) they are only asking for registration rights with respect to the shares that are delivered by Enron on net share settlement. 4) Commodities Laws. Under the commodities laws there are some risks in doing equity swaps in that one has to rely on the swaps policy statement rather than the swaps exemption, but those risks are probably minimal enough that Enron is willing to take them. (The swaps exemption does not cover equity swaps.) With respect to equity options, they are outside the CFTC=01,s jurisdiction altogether. Forward contracts present the most difficult issues in that there is a lot of case law and CFTC lore about the distinction between forwards and futures, and a key distinction is that forwards are physical delivery contracts that bind the parties to make and take delivery. State bucket shop laws outlaw contracts that purport to be contracts for sale of a security that are to be settled based on market price quotations. So I would counsel Enron not to enter into any forward contract that has a cash settlement alternative. Although one can argue that net share settlement has the same defects, I don=01,t feel as strongly about that bec= ause you could get to where you want to get by physically delivering the shares and issuing new share= s in payment; the theory is that you actually delivered shares and just netted them out; that is not quite as bad as flying in the face of the case law and CFTC lore on net cash settlement. The Bear Stearns Confirmation and Cancellation. I really don=01,t have any comments on this; I think the cancellation was effective to cancel the parties obligations. The confirmation did not present any registration issues. I guess I would say that if you do something precisel= y like this you might get them to agree to make any hedge purchases pursuant to Rule 10b-18, but that=01,s it= . The Credit Suisse First Boston Confirmation. This is an extremely well written document. For the reasons discussed above, I would counsel against entering into this kind of transaction with the cash settlement feature, in light of the risk that it could be characterized as an illegal, unenforceable futures contract. A few other comments: They say automatic early termination applies, but I think that is a really bad idea. Enron had an agreement with a counterparty that took bankruptcy and Enron did not find out about it until a few days later, after the market had moved; since Enron di= d not know of the termination it did not unwind its hedge, yet the ISDA said that the amounts payable on termination would depend on the termination date pricing. So Enron took a loss. You ought to always have within your control the right to terminate. This is especially true of U.S. parties, but I would think the same would apply to foreign parties unless there is something peculiar about the law of the jurisdictio= n you are dealing with. Both Confirmations Both confirmations have language that says that if the parties have not entered into an ISDA Master then the counterparties=01, standard form controls. I think= it is not a good idea to agree to such language because you are agreeing to something you know nothing about. Additional Comment. I think that whenever a counterparty requests registration rights Rex should be involved. I think the CSFB confirmation=01,s provisions relating to registration are fine, and of course they can=01,t force us to register because the choice of net share settling is purely our choice. Nevertheless, I think that Rex needs to be involved so you and Rex need to get this point across to the business people that they shouldn=01,t just sign a confirmation and then send it to you and ask = if it is ok. But my bottom line is the only change I would make would be eliminating the net cash settlement feature in the CSFB confirmation.