Malt Liquidity 54
Sour grapes over short calls
Sue-cure the Funding
The case for “funding secured”
as the most expensive tweet of all time builds some more as JP Morgan sued Tesla over breaking the terms over some warrants Tesla sold it. The complaint seems to highlight some interesting scenarios, so let’s take a look.
JPMorgan and Tesla entered into a series of warrant transactions, which required Tesla to deliver either shares of its stock or cash to JPMorgan if, at the time the warrants expired, Tesla’s share price was above the contractual “strike price.” The warrants did expire with Tesla’s share price above that strike price…
Put simply, Tesla sold JP Morgan some boutique call options which allowed them to reprice the options in the case of major corporate events, such as an acquisition announcement. This makes sense - banks are informed speculators, after all. Their structuring desk performs a service - in this case, creating a product that gives Tesla cash in exchange for upside exposure to the stock. When a merger event happens, the upside volatility no longer is uncapped. The highest price the shares can go are the acquisition price, so in the case this happened, JPM was given the right to reprice their options so that they would maintain the value they had prior to the merger.
JPMorgan determined that the appropriate adjustment to account for this economic effect would be a change to the strike price of the 2021 Warrants that preserved their fair value in light of this reduction in average implied volatility, keeping all other pricing inputs constant. Following a methodology that takes into account the differences between the bespoke 2021 Warrants and the listed Tesla options for which implied volatility data is publicly available—a methodology that, like the use of an average implied volatility, would tend to result in adjustments more favorable to Tesla— JPMorgan determined that the strike price had to be reduced from $560.6388 to $424.66 (the “First Adjustment”) to maintain the same fair value for the 2021 Warrants as they had before the Announcement Event.
So we learn that the JPM options on TSLA were far out-of-the-money, and since the upside suddenly became capped at 420/share, the options’ strike was drastically reduced. They decided that, since, the volatility of the options had been crushed, to maintain the value they had prior to the announcement, the delta should be significantly repriced. Even then, these options wouldn’t be worth that much - if a merger is priced at 420/share, the stock would trade at (pre-acquisition price) + (acquisition price - pre acquisition price) * (probability merger goes through). The odds of the stock trading through its merger price would be (probability merger doesn’t go through) * (probability the stock surges), which, outside of Tesla’s case, is a remarkably low probability. This repricing seems more than fair to me, especially given that these options looked D.O.A. even after the strike price adjustment.
However, as we know now, the tweet was just that - a tweet - and Elon and Tesla settled a securities fraud lawsuit for $40 million. The announcement that Tesla was foregoing “secured funding” triggered a second repricing. Now that the merger had effectively failed, we would normally expect the stock to go down and the strike price to go up to compensate for the fact that the upside of the stock was no longer capped at 420.
JPMorgan… determined that increasing the strike price to $484.35 was the appropriate adjustment to maintain the same pre-announcement fair value for the 2021 Warrants (the “Second Adjustment” and, together with the First Adjustment, the “Adjustments”).
An interesting thing to think about is how JPM might have hedged their exposure after the tweet. Delta hedging isn’t static - when your option delta changes, you might have to short more stock as the stock price changes to maintain a certain exposure. This can hilariously backfire, as in the case of the power peg fiasco, but for the most part, delta hedging is a straightforward process that occurs constantly throughout the trading day as prices change. Presumably, as they repriced the option strikes the first time, they increased their short position as the delta would have come in. So when the blog post announcing that Tesla was not pursuing 420/share came out, they might have made a pretty penny on the short side of their hedge.
After receiving notice from JPMorgan of the Second Adjustment on August 29, Tesla protested that no adjustment should be necessary at all because it had so quickly abandoned its going-private plans. Consistent with its obligations under the Agreements, JPMorgan shared a written explanation describing its calculations, including supporting market data and quotations, and held several conference calls with Tesla to explain its calculations. Tesla did not provide any specific objection to JPMorgan’s explanations on these calls, and following these calls, Tesla did not communicate further with JPMorgan regarding the Adjustments for six months. Accordingly, JPMorgan continued to hedge the Warrants based on the adjusted strike price.
It appears we have the crux of the $162 million dollar matter here. Tesla presumably wanted their payment calculated from the original strike of 560 and change after the stock surged, while JPM insisted that their adjustment of the strike down to 484 was wholly justified by the terms of the warrant. As the warrants are coming due now, JPM is understandably looking for a court ruling in their favor regarding the adjusted strike prices.
Reading between the lines, Tesla seems to have suffered the fate of every option seller who thinks that selling far-otm options is “free money” - sometimes, the stock just does crazy things and you’re stuck paying out far more than the nickels you picked up were worth, except Tesla’s sour grapes require legal enforcement to pay out in this case.
I suppose the only thing Tesla could argue is that since the tweets were not official announcements, there was no cause for repricing the strikes, but this is invalidated by the fact that they settled a lawsuit admitting that would say otherwise. Be careful when you sell calls, folks.