Jun. 25, 2023
This explanation from a fellow reddit user explains this best. Federal Register version of the proposed rule which says: Specifically, we are proposing to: (1) Revise the current deadlines for Schedule 13D and Schedule 13G filings; (2) amend Rule 13d-3 to deem holders of certain cash-settled derivative securities as beneficial owners of the reference covered class; (3) align the text of Rule 13d-5, as applicable to two or more persons who act as a group, with the statutory language in Sections 13(d)(3) and (g)(3) of the Exchange Act; and (4) set forth the circumstances under which two or more persons may communicate and consult with one another and engage with an issuer without concern that they will be subject to regulation as a group with respect to the issuer's equity securities. [Modernization of Beneficial Ownership Reporting: Introduction] We also are proposing to add new paragraph (e) to Rule 13d-3 to deem holders of certain cash-settled derivative securities as beneficial owners of the reference covered class. Holders of derivative securities settled exclusively in cash do not have enforceable rights or any other entitlements with respect to the reference security under the terms of the agreement governing the derivative. Under certain circumstances described more fully below, however, holders of such derivative securities may have both the incentive and ability to influence or control the issuer of the reference securities. Accordingly, the proposed amendment would “deem” holders of such derivative securities to beneficially own the reference securities just as if they held such securities directly. [Modernization of Beneficial Ownership Reporting: Introduction] Proposed Amendment to Rule 13d-3 To Regulate the Use of Cash-Settled Derivative Securities We are proposing to amend Rule 13d-3 to deem holders of certain cash-settled derivative securities to be the beneficial owners of the reference covered class. Specifically, we are proposing to add new paragraph (e) to Rule 13d-3. As discussed in more detail below, in addition to setting forth the circumstances under which a holder of a cash-settled derivative security will be deemed the beneficial owner of the reference equity securities, proposed Rule 13d-3(e) also includes provisions describing how to calculate the number of reference equity securities that a holder of a cash-settled derivative will be deemed to beneficially own. [Modernization of Beneficial Ownership Reporting: Proposed Amendment to Rule 13d-3 To Regulate the Use of Cash-Settled Derivative Securities] Let's cover Beneficial Owners, Cash-Settled Derivatives, and the calculation. Beneficial Owners According to the SEC's investor.gov, most share ownership in the US is as a beneficial owner through a bank or broker-dealer in "street name". By contrast, registered owners hold shares directly with the company on the books of the Transfer Agent. From WestLaw, beneficial owners (directly or indirectly) have voting power and/or investment power. So we can already see why Dr. Susanne Trimbath tweeted how this proposal could cause problems with the voting process as this proposal would consider holders of cash-settled derivatives to "beneficially own the reference securities just as if they held such securities directly". If we thought over-voting currently has issues, can you imagine how it will be when derivatives holders get to vote in addition to shareholders??? Side note: Notice that last paragraph about how more than one person or persons can be the beneficial owner of a single security? Yeah, we have already seen beneficial owners outnumbering outstanding shares and I wrote about it in End Game: DTC and NSCC are screwed as the DTC just proved shareholders should Directly Register Shares (DRS) and End Game Part Deux: Problems at the DTCC plus The Bigger Picture. Interestingly, if this proposal passes then these cash-settled derivatives owners would get to vote alongside directly registered shares which could potentially result in significantly increasing votes counted alongside directly registered shareholders! Stuffing the ballot box, basically. Cash-Settled Derivatives Derivatives are basically financial contracts that depend on an underlying asset (e.g., a stock), group of assets (e.g., a basket of stocks), or benchmark (e.g., an index) with options and swaps the two most common types of derivatives we've seen in this sub. What Is a Derivative? The term derivative refers to a type of financial contract whose value is dependent on anunderlying asset**,** group of assets, or benchmark. A derivative is set between two or more parties that can trade on an exchange or over-the-counter (OTC) [Investopedia] The most common derivative types are futures, forwards, swaps, and options. [Investopedia] Cash-Settled means that physical delivery of the underlying assets or securities is not required. What Are Cash-Settled Options? A cash-settled option is a type of option for which actual physical delivery of the underlying asset or security is not required. The settlement results in a cash payment, instead of settling in stocks, bonds, commodities, or any other asset. [Cash-Settled Options: Definition, How They Work, and Benefits] Meaning these derivatives settle with just cash payments instead of stock moving from one owner to another. WHY SHOULD CASH-SETTLED DERIVATIVES GET THE BENEFITS OF OWNERSHIP WHEN PHYSICAL DELIVERY OF THE UNDERLYING SHARES ISN'T REQUIRED??? This gets even more interesting when you look back at the 2008 Volkswagen Short Squeeze when cash-settled options were counted as removing shares from the market. https://capital.com/volkswagen-short-squeeze-vow-interest-position So it seems the reason these cash settled options are considered part of removing shares from the market is because cash settled options can be physically settled on exercise, even though the options do not require delivery of the underlying. This is probably why the OCC has been freaking out because if those options force delivery, the Clearing Agency is on the hook to deliver shares. https://protect2.fireeye.com/v1/url?k=31323334-50bba2bf-3132d782-4544474f5631-9318b23990703066&q=1&e=855b1403-cf62-4e92-9e99-bd47aa553f5f&u=https%3A%2F%2Fthehedgefundjournal.com%2Fthe-case-of-volkswagen%2F Calculating ownership of the underlying equity securities 84 years ago, I used the options greek delta to identify worthless Deep OTM Put (DOOTMP) options that had no business ever being traded, except as a barely legal cover for naked shorts. [See Peek-a-boo! I see 103M hidden shorts! (Part Deux)] This rule proposal uses the same idea for using delta to determine how many underlying shares a cash-settled derivative (e.g., a call or put option) should be equivalent to. A DOOTMP shouldn't count as any real shares because there's basically no chance of it expiring ITM. By contrast, an ITM Call or Put option is more likely to expire and cause shares to change hands if exercised. Proposed paragraph (e)(2) of Rule 13d-3 would set forth the formula for calculating the number of equity securities that a holder of a cash-settled derivative will be deemed to beneficially own pursuant to paragraph (e)(1). This provision is necessary because derivatives may not always have a perfect “one-to-one” relationship to the reference security. Instead, the value of the derivative security, although based on the value of a reference security, may change at a multiple or fraction to any change in value of the reference security, particularly in the case of a security option. This difference in the amount by which the value of a derivative security changes as compared to the amount by which the value of the reference security changes is referred to as the “delta.” For example, a $1 change in the value of the reference security may result in a $2 change in the value of the derivative security. In that case, the delta of the derivative security would be equal to two. If the delta of a derivative security is equal to one, then the value of the derivative security perfectly tracks the changes in value of the reference security. Calculation of beneficial ownership pursuant to a derivative security is easier in these circumstances because of the perfect one-to-one relationship between the derivative security and the reference security. Proposed paragraph (e)(2) applies these concepts for purposes of determining the number of securities that a holder of a cash-settled derivative will be deemed to beneficially own pursuant to paragraph (e)(1). Proposed paragraph (e)(2)(ii) of Rule 13d-3 defines “delta” to mean, with respect to a derivative security, the ratio that that is obtained by comparing (x) the change in the value of the derivative security to (y) the change in the value of the reference equity security. Proposed paragraph (e)(2)(i) provides that the number of securities that a holder of such derivative security will be deemed to beneficially own pursuant to paragraph (e)(1) will be the larger of two calculations, set forth in proposed paragraphs (e)(2)(i)(A) and (B), in each case as applicable. If applicable, proposed paragraph (e)(2)(i)(A) would calculate the number of securities as the product of (x) the number of securities by reference to which the amount payable under the derivative security is determined multiplied by (y) the delta of the derivative security.[106] Proposed paragraph (e)(2)(i)(B), if applicable, would calculate the number of securities by (x) dividing the notional amount of the derivative security by the most recent closing market price of the reference equity security, and then (y) multiplying such quotient by the delta of the derivative security. [Modernization of Beneficial Ownership Reporting: Proposed Amendment] White & Case, a law firm, has some interesting insight into this calculation that the SEC would only consider long positions with no netting against short positions that would otherwise offset the long positions. https://www.whitecase.com/insight-alert/sec-reopens-comment-period-proposed-rule-amendments-modernize-beneficial-ownership If White & Case is correct, this proposal would open a gigantic door for certain market participants to open up a fully hedged long and short derivatives position on a stock and be considered as beneficial owners for the long position even though the overall position is net neutral and basically only costs transaction fees. And if Dr. Trimbath is correct, this effectively sanctions ballot boxes to be stuffed at low cost with no risk as DRS votes could be overwhelmed by votes from beneficial owners who only hold derivatives that may never deliver shares. In short, you are diluting my vote with options beneficial ownership where these entities don't even own the stock but can vote. I AM FIRMLY IN OPPOSITION TO THIS RULE CHANGE! -- It's not the games we play that show our humanity, it's the way we play them.