A Termination Tempest in a Teapot

A hedge fund buys a put option on a stock. A few days later, the stock in question tanks, and then is the subject of a brief trading halt. The hedge fund tries to exercise the put, and its counterparty — a major financial institution — says “no.” And then the parties bring the entire matter into court, all over a transaction that involves about $9 million.

Something seem strange here?

Namely, why would sophisticated parties bring such a small transaction to court, and into the public arena, and why would a major dealer risk its reputation with a rather shaky argument, again especially in the context of such a small trade?

The players involved are Morgan Stanley and Oasis Investments Ltd., which describes itself as a Cayman Islands corporation that “carries on business from offices in Hong Kong” as an “investment fund.” The subject of the put options was the now-infamous Sino-Forest Corporation, which has been accused of being a fraud.

Oasis bought the put options in mid-May, giving it the right to sell 500,000 Sino-Forest shares at a price of 19 Canadian dollars a share. In early June, when word of the potential fraud surfaced, Oasis tried to exercise the put, and Morgan Stanley refused, citing the trading halt in place on Sino-Forest from June 2 to 3. Instead, it offered to pay Oasis a termination payment of slightly more than 3 million dollars.

This strikes me as a bit of a stretch. Yes the International Swaps and Derivatives Association’s rules do provide for termination based on a trading halt, but must not there be some sort of reasonableness requirement? Otherwise, a five-minute halt gives the out-of-the-money party the right to terminate, and that just cannot be right.

My best guess is that Morgan Stanley feels that it got burned: Oasis buys the put, and a couple of weeks later it is hugely in the money.

But I still do not see why this was brought to court. It is a small amount of money for Morgan, and if the firm thinks the Oasis traders were playing dirty, better to pay them and tell them to never come back.

Why put out a far-fetched argument about the terms of the contract, which is just going to get you in trouble with other customers (and lead to some new language in the next confirmation)?

Morgan Stanley declined to comment on the dispute. But perhaps someone from Morgan or Oasis will explain it to me some day.