UK AND US TRENDS IN THE TREATMENT OF DERIVATIVES, SHORT
SALES, AND CONTRACT FOR DIFFERENCES IN CONNECTION WITH
BENEFICIAL OWNERSHIP DISCLOSURE AND MARKET
MANIPULATION
June 30, 2008
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The current disclosure regimes in the U.K. and the U.S. generally do not
require disclosure of derivatives related to registered/listed securities since
the regulatory framework in both countries focuses primarily on direct or
indirect control of voting rights (or in the case of the U.S., the power to
control disposition of the voting rights). However, as the derivatives market
has expanded, issuers and investors have raised concerns regarding the
lack of disclosure of holdings of such derivatives and that such derivatives
enable the holders to influence and increase stakes in companies or an
undisclosed basis. The following memorandum covers the results of the
recent case involving derivatives and the proxy fight involving a hedge fund
and the railroad CSX, a proposal by the Financial Services Authority on
how to treat contract for differences in counting beneficial ownership of the
related shares, and short selling developments in the US.
US Court Finds Total Return Swaps to Confer Beneficial Ownership for
Disclosure Purposes
The U.S. District Court for the Southern District of New York issued an
opinion that affects the analysis of when an economic interest in publicly
traded shares acquired through a cash-settled total return swap (TRS) will
be considered to confer beneficial ownership for purposes of the filing
obligations imposed by the U.S. securities laws on owners of more than 5
percent of a company's voting equity securities on the grounds that the
counterparty may have to vote the shares as the other party wishes.
CSX argued in proxy fight litigation that the dissidents should have
disclosed sooner the 12.3 percent stake that they maintained through
equity swaps. The Children's Investment Fund (TCI) had started the swap
arrangements in October 2006 and by January 2007, the swaps related to
10.5 percent of CSX's stock by January 2007. The SEC's opinion on the
issue concluded that a swap arrangement between a hedge fund and a
counterparty is not sufficient to trigger Schedule 13D obligations, but the
court noted that the SEC is considering whether to propose a rule to
address swaps.
The court agreed with CSX on the 13D claims but against both CSX and
the funds on their assertions of proxy violations. The court held that TCI
and 3G had failed to disclose that they had formed a group with respect to
their holdings in CSX shares in February 2007, while their disclosure only
occurred in December.
TCI and 3G swapped the right to receive the dividends and the increases
in price movement on the CSX securities in exchange for the requirement
by TCI/3G to pay the counterparty/short party the downside price
movement on the securities plus an agreed interest rate on the value of the
securities. According to the court, an investment firm or commercial bank
swap counterparty almost always hedges a swap based on publicly traded
securities by purchasing the underlying security and TRS market practices
usually resulted in the long party's ability to obtain the securities at the
termination of the swap, ensure that the short party held the securities, and
ensure that the short party generally locked up the securities. The court
also found that short parties are motivated, in order to attract business as a
short party, to appear willing to vote hedging shares in a manner desired
by the long parties and that, generally hedged counterparties have no
economic interest in the shares to distinguish their views on voting the
shares from those of the long party. Since the court's approach could
implicate short parties that participate (knowingly or unknowingly) in
schemes or groups to evade the long parties' disclosure requirements,
short parties, for example the investment and commercial bank
counterparties in this case, may wish to obtain representations from their
TRS long parties that the holdings of the long party, with TRS interests
included, do not exceed 5 percent of the issuer's shares.
.
The court found that TCI/3G(the long party) in a cash-settled TRS does not
have the legal power to control either of voting or disposition of the
securities,but determined, based on SEC pronouncements for the
proposition that "control" exists, if the long party has influence on the voting
or disposition. This approach differed from that of the SEC staff which
argued that a swap arrangement between a hedge fund and a
counterparty is not sufficient to trigger Schedule 13D obligations, but the
court noted that the SEC is considering whether to propose a rule to
address swaps.
Since Regulation 13D-G definition of beneficial ownership is used in other
contacts, additional consequences may follow from a holding that TRS
long parties hold beneficial ownership. Such as the triggering of state
takeover statutory provisions, poison pills and other corporate charter,
bylaw and contractual provisions.
Since the definition of beneficial ownership for 13D is used or read into
other contexts, the court's ruling may affect the outcome on decisions of
the SEC short swing profit rules, state takeover statutory provisions,
poison pills, and corporate charter, bylaw and contractual provisions.
FSA Rules on Short Positions
The UK Financial Services Authority (FSA) has issued guidance with
respect to its new rule on short selling in rights issues. Starting on 20 June
2008 the Code of Market Conduct will require disclosure of short positions
representing an economic position of 0.25% of issued shares in stocks
admitted to trading on prescribed markets which are undertaking rights
issues.
Long and short positions may be netted, and only a net short position
of 0.25% or above must be disclosed.
The net short position is calculated based on the number of shares
prior to the rights offering.
Derivative positions must be included in the calculation of net short
position (even options that cannot be exercised during the rights issue
period).
Economic interest in a company held as part of a basket or index is
disregarded for purposes of calculating the net short position.
There is no obligation to update the initial disclosure when the short
position increases or decreases.
An intra-day short position of 0.25% or more need not be disclosed if
it is unwound by midnight that same day.
A fund manager with discretion over more than one fund should
aggregate the positions over all of its discretionary funds to determine
whether or not the 0.25% threshold is reached.
The consequences of non-disclosure could include a fine or public
censure.
FSA Consultation Paper of Contracts for Differences
A contract for difference (a CfD) is an arrangement made in a future
contract, whereby differences in settlement are made through cash
payment rather than the delivery of goods or securities.
The Financial Services Authority (the " FSA") issued a consultation paper,
where the consultation process ended in February 2008, on disclosure
obligations relating to economic interests in listed shares held through
derivatives such as contracts for difference (CfDs). As of that time, the
FSA Disclosure and Transparency rules only covered control of voting
rights, but the Takeover Code required disclosure of dealings by holders of
economic markets in 1% of target securities.
The FSA, therefore, proposes considering a CfD holder to have access to
voting rights unless the CfD agreement (1) explicitly precludes the holder
from exercising or seeking to exercise voting rights, (2) excludes further
arrangements relating to the sale of underlying shares and (3) states the
holder does not intend to use the CfDs for voting rights. CfDs that do not
meet these three criteria would be aggregated with other interests in voting
rights. The holder of aggregated voting rights above 3% must disclose
under the FSA under the UK disclosure. Moreover, the proposal would
authorize investigation to determine and disclose holder of economic
interests above 5%. The FSA also is considering general disclosure
requirements in relation to all economic interests above 5%.
.
Short Selling Developments in the US
Although, short selling increases market efficiency, the SEC has sought to
ensure that short selling is not used to manipulate markets.The SEC
adopted Regulation SHO in January 2005, to help protect against
manipulative short selling.
Regulation SHO requires (among other things) a broker to locate shares
that can be lent to its customer before allowing the customer to sell short.
Hedge funds who attempt to order short sales can be liable under theories
of aiding and abetting, or causing, the broker's violation and failing to
inform the broker of the absence of adequate borrow can constitute a
violation by the
short seller of the securities laws' antifraud provisions.
Some hedge funds have allegedly sold securities short without the broker
first determining that the shares are available to borrow. Congressional
hearings have been conducted this past summer into whether or not hedge
funds have been secretly arranging for independent research agencies to
issue negative reports on a company based on false and misleading
statements, shorting the stock in advance of the release of those negative
research reports and then covering the short sales following a drop in the
company's stock price after the negative research was published.
In late 2007, the SEC prohibited any self-regulatory organization (SRO)
from having a price test whereby short sales were allowed.
The SEC also took active steps to end instances of "naked shorting" in the
market. Regulation SHO was enacted in part to reduce the frequency of
"fail to deliver" positions. The regulation require, among other things, that a
broker-dealer "close out" short positions (i.e., purchase securities of like
kind and quantity) in so-called "threshold securities" (i.e., securities that
experience designated levels of "fails to deliver") if that broker-dealer has a
"fail to deliver" position in a threshold security for thirteen (13) consecutive
settlement days. Although the enactment of Regulation SHO significantly
reduced the number of fail-to-deliver securities, certain threshold securities
have remained on the threshold lists since the adoption of Regulation
SHO, prompting the SEC to seek the elimination of existing exemptions as
a means of eliminating persistent fails to deliver.
Current Disclosure Regimes and Market Manipulation Rules Need
Updating to Deal with New Financial Products and Practices
Court Treats Total Return Swaps as Conferring Beneficial Ownership on
Long Party Under Circumstances Where Short Party Hedges with
Underlying Security and Other Criteria Are Met
FSA RULES ON SHORT POSITIONS
FSA RULES ON CONTRACTS FOR DIFFERENCES
US DEVELOPMENTS ON SHORT SALES
Next Razor Alert: US Rating Agency Developments
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