As volatility spikes in the equity markets, UK listed corporates have been taking a proactive approach to hedging the resulting increase in risk faced by their employee share schemes (Schemes).This strategy uses equity derivatives to hedge the market risk inherent in acquiring the shares of the listed company (the Shares) needed to meet the future obligations of the Scheme. As well as hedging the market risk, this approach also removes the need to issue new shares (and dilute the existing shareholding).
The most common form of arrangement is a forward purchase of the Shares at a guaranteed price based on the volume-weighted average price of the shares on the exchange (during an initial period in which the bank counterparty establishes its own hedge for the transaction), less a discount, plus fees. The Scheme benefits from the discount facilitated by the bank’s trading systems. Based on ISDA documentation, the trustee of the Scheme will typically enter into the transaction, under the oversight of the corporate group’s treasury team. Funding for the ultimate settlement of the forward purchase would usually be provided by the corporate group. The trustee’s counterparty will be an investment bank with a strong equity market division.
These hedges raise a range of legal and commercial points to consider – highlights are set out below. Addressing these points early on in the course of any such transaction will make the process as smooth and repeatable as possible, and, in certain circumstances, permit larger hedges.
- Bank conduct: It is prudent to include additional protections for the Scheme, in the form of constraints on how the bank establishes its hedge for the transaction (to minimise the risk that the bank’s trading moves the market for the Shares and increases the cost of the forward purchase). Information obligations should also be included.
- Dividends: For tax reasons, or due to the rules of the Scheme, it may be necessary to consider how dividends paid on the Shares during the life of the transaction will be dealt with. If the Scheme cannot receive dividends, it may be possible to factor the economic value of their receipt into the agreed settlement price for the Shares.
- Tax considerations: It is important to consider any tax implications of such hedging, from the Scheme’s perspective, in particular focusing on any payments to be made by the bank to the Scheme. Tax considerations may be particularly sensitive where the Scheme is offshore for tax purposes.
- Guarantees: The bank counterparty may require a guarantee from an entity within the corporate group in order to offer the transaction, given the limited assets of the Scheme or dependence on the corporate group for funding. It will be important to consider financial assistance rules, in order to ensure that the guarantee does not constitute unlawful financial assistance (i.e. for the purposes of Section 678 of the Companies Act 2006). The involvement of the corporate group’s accounting team will be required, and the process will need to be appropriate covered by internal approvals (e.g. a board meeting).
- Legal opinions: The bank counterparty may require legal opinions in respect of the capacity and authority of the Scheme and the guarantor. The trust deed for the Scheme will therefore need to give the trustee the power to enter into the transaction on behalf of the Scheme. The relevant approvals processes (of the Scheme and the guarantor) and the financial assistance analysis will also be key to ensuring these opinions can be provided.
If you would like to receive a copy of a more detailed note on this topic, or to discuss further, please feel free to reach out to Richard Hart and Matthew Dodwell.
These hedges raise a range of legal and commercial points to consider. Addressing these points early on in the course of any transaction will make the process as smooth and repeatable as possible, and, in certain circumstances, permit larger hedges.