Structured Thoughts: News For The Financial Services Community - Volume 3, Issue 14 December 18,2012

Dividend Adjustments on the Way

To help shareholders benefit in the event that Congress does not retain the lower rates for dividends in connection with the ongoing "fiscal cliff" negotiations, a variety of companies have increased their fourth quarter dividends in 2012. Some companies have accelerated the payment dates of their planned dividends to ensure that they are paid before the end of the year. Some have increased their planned dividend payments above prior quarterly levels. Other companies may pay a special dividend payment. In some cases, the fourth quarter increase will be offset by a decrease in the subsequent first quarter's dividend. In each case, these dividend payments may trigger the dividend adjustment provisions of structured notes linked to the relevant underlying stocks.

Most stock-linked notes have provisions that adjust the price of the stock, and therefore, the return on the notes, when the linked stock pays a special or extraordinary dividend. After the applicable "ex date", a special dividend may reduce the stock price, in order to account for the smaller amount of cash held by the company. Consequently, for typical stock-linked notes, which are bullish on the linked stock, a special dividend would usually reduce the note's return if protections are not built into the note terms. And of course, holders of structured notes usually don't benefit from the dividend on the linked stock. Dividend adjustment provisions protect the investors' interests by, under certain circumstances, adjusting upwards the price of the linked stock for purposes of the notes, offsetting the negative impact of the special dividend.

Various dividend adjustment provisions exist:

A special dividend must exceed a certain size threshold to be triggered. A special dividend must be deemed "material" by the calculation agent in order to be triggered. Mainly in the case of single-stock linked notes purchased by institutional investors, a provision that is automatically triggered whenever the dividend exceeds, or is less than, a "base dividend" agreed to at the time of pricing. This type of provision can differ from the other two types. Instead of providing only "investor protection," this type of provision can also work "adversely" to an investor when the linked stock reduces its dividend, because the provision will cause the stock price, for purposes of the notes, to decrease. As a result, depending upon the terms of a structured note, the planned dividend increases may cause an upward adjustment of the stock price. For a smaller set of notes, mainly notes for institutional investors described in the third bullet above, a potential Q1 dividend decrease after the Q4 increase may then decrease the stock price after the initial upward adjustment.

Depending on the circumstances of the relevant company, stockholders may receive the same total amount of cash with or without the special dividend. They could simply receive it sooner and at a lower average income tax rate. In contrast, depending on the terms of a structured note, some notes may have increased returns due to the increased dividend, and then, may or may not have a decreased return due to the Q1 decreased dividend. In this regard, calculation agents for structured notes may wish to review the adjustment provisions for notes subject to a special dividend, and the extent to which they have discretion to require an adjustment, or to modulate the extent of the required adjustment.

Federal Court Decision Supports Use of "Big-Boy Letters"

Introduction

"Big-Boy Letters" are often used as a tool to limit an issuer's or broker-dealer's potential liability in connection with a private sale of securities. In these letters, the investor represents that, as a "big boy," it is a sophisticated party that can fend for itself. Often, these letters also contain an explicit waiver of all claims against the inside party arising from the nondisclosure of non-public information, including violations of Rule 10b-5 under the Securities Act of 1933.

"Big Boy Letters" serve several useful purposes for both the inside and outside parties as they can:

increase the execution speed of time-sensitive transactions; reduce the costs and risks of potential claims and liability from frustrated counterparties; and facilitate the contractual allocation of risks between sophisticated parties. These letters can be particularly useful in connection with private sales of sophisticated structured products to institutional investors. For example, the security may have particularly complex terms, and/or an affiliate of the issuer may possess material non-public information that relates to the security, such as business or financial information about the stock linked to the structured note.

Are They Enforceable?

The enforceability of "Big-Boy Letters" has been the subject of dispute.1 This uncertainty stems from tension between the "sanctity of a contract," on the one hand, and Section 29(a) of the Securities Exchange Act of 1934, which states that waivers of liability for securities fraud are void as a matter of public policy. However, a recent U.S. District Court decision has articulated a means to honor the contractual relationship created by "Big-Boy Letters" without characterizing their effect as a waiver of securities fraud liability and thus as void as a matter of public policy.

Pharos Capital

In Pharos Capital Partners, L.P. v. Deloitte & Touche, LLP, plaintiff Pharos Capital Partners ("Pharos") filed suit alleging fraud in connection with its $12 million equity investment in National Century Financial Enterprise, Inc. ("NCEF") an investment that lost its full value when NCEF proceeded to file for bankruptcy.2 Pharos claimed that defendant Credit Suisse Securities, LLC ("Credit Suisse"), acting as co-placement agent in connection with the offering, failed to disclose material information while also materially misrepresenting NCEF's business operations. Credit Suisse's defense rested primarily on the existence of a "Big-Boy Letter," in which Pharos acknowledged that it was a "sophisticated institutional investor" who was "relying exclusively" on its own due diligence and would bear the risk of an "entire loss" of its investment.3

Rather than treating the "Big-Boy Letter" as a waiver of liability, the court focused on its effect on a crucial element of successful fraud claims. In granting summary judgment in favor of defendant Credit Suisse, the court noted that common law claims for fraud and negligent misrepresentation require the aggrieved party to have justifiably relied upon the alleged misrepresentation or omission. The court then went on to cite the clear language of the "Big-Boy Letter" to hold that any reliance on the part of Pharos was unjustifiable and thus does not support a claim for fraud or negligent misrepresentation.4 In other words, the existence of a well-crafted "Big-Boy Letter" does not waive liability for securities fraud; rather, it may eviscerate the underpinnings of such a claim.

Pharos demonstrates the value to underwriters of furnishing "Big-Boy...