IM Staff Okays Global Consents in Principal Trades Involving 'Mirror' Call Options
No, the Division of Investment Management’s August 31 no-action letter permitting Credit Suisse First Boston to obtain global consents is not a sign that the Division’s views on principal trades are changing.
The letter "is definitely limited to the narrow facts presented," according to Division chief counsel Douglas Scheidt.
Nonetheless, it’s an interesting letter, worth a read by anyone who has ever been frustrated by the transaction-by-transaction consents currently required by Advisers Act Section 206(3) for principal trades. If nothing else, the letter indicates a willingness by the staff to consider instances where global consents might be appropriate.
Here’s the story, based on CSFB’s August 17 request letter penned by Mayer, Brown, Rowe & Maw partner Kathryn McGrath: CSFB offers a special service to its very high net worth clients (in the $20 million net worth vicinity) that hold very large positions in individual equity securities: using a quantitative analytical model, CSFB is able to manage a complementary portfolio of call options to generate additional income for clients and, when appropriate, to help clients exit some or all of their positions.
Returns on long-only equity positions "depend entirely on future developments affecting the price of that particular stock," explained CSFB. "However, the volatility that defines this return is itself an asset which the investor can monetize," by entering into CSFB’s "volatility management program."
In other words, by managing not only the client’s underlying stock positions, but a portfolio of call options based on those positions, CSFB can make money for clients in the form of the premiums paid by the buyers of the options (CSFB terms this a "synthetic dividend"). CSFB also can use the call options to help clients exit positions at particular prices.
What’s all this got to do with Advisers Act Section 206(3)?
To fully utilize the volatility management program, CSFB explained, clients have to sell call options in a range of maturities and strike prices. This can’t always be accomplished over an exchange, since listed call options meeting the specific criteria specified by the CSFB’s quantitative model aren’t always available.
When CSFB’s model dictates that a client sell a particular call option that is not available on the listed market, CSFB goes over-the-counter and seeks bids from two or three counterparties. However, before a CSFB client can sell a call option to a counterparty, the counterparty requires the client to open up an account directly with the dealer.
And, oh, you wouldn’t believe the hassle.
"The process of establishing an account can take up to several weeks and involves voluminous paperwork that must be reviewed and signed by the client and most often reviewed and/or negotiated by the client’s legal counsel," said CSFB. The process of opening an account with a dealer to engage in an OTC options transaction "is neither quick nor simple, and it is a process that the client must go through separately with each separate dealer, one by one." Moreover, said CSFB, clients are "often confused about why it is necessary to establish yet another account with a third-party broker-dealer" in addition to their CSFB account.
So, CSFB came up with a solution: its affiliated OTC derivatives dealer could interposition itself between the client and the various third-party broker-dealer counterparties. Under such a scenario, when CSFB’s model dictates that a client sell a particular call option that is not available on the listed market, CSFB would seek bids from two or typically three counterparties, as usual. If an acceptable bid is received, CSFB’s derivatives affiliate would simultaneously buy the call option from its client, and sell a "mirror" call option, with identical terms, to the third-party counterparty. The CSFB affiliate would not have the right or power to exercise the call option purchased from the client independent of the initial decision by the third-party dealer to exercise its mirror option.
Since this would involve a principal trade, CSFB asked IM whether its clients could make global consents. CSFB argued that there simply wasn’t time for transaction-by-transaction consent when writing call options. "Many of these clients cannot always be reached on short notice," it noted (presumably, they all hang out on yachts and leave their Blackberries at home). Moreover, it added, "most clients do not want to be contacted" about every call option transaction, having considered and agreed to the volatility management program in advance.
The Division agreed, subject to a host of safeguards and conditions. Each global consent obtained from a client would, at most, cover only one year. Clients would be provided with a written statement spelling out the capacities in which CSFB and its affiliate would be acting and CSFB’s potential conflicts of interest resulting from the arrangements. CSFB would seek bids from at least two qualified third-party dealers before buying a call option from a client.
Moreover, CSFB’s compensation would be limited to its standard advisory fee (not contingent on the number of transactions in the account) and a service fee paid to the CSFB affiliate. The service fee, which would be fully disclosed to and approved by the client in advance, would be designed to compensate the CSFB affiliate for its back-office and "middle office" work in matching the call options to third-party dealers and booking both sides of the mirror trades. "These functions are performed manually, are paper-work intensive, and involve a significant amount of follow-up by telephone to ensure that all required steps to complete and secure the transaction have been taken," CSFB explained.