Issuers welcome a touchening of the FSA's regulations on shareholder disclosure of contracts for difference (CFDs), while banks and hedge funds express wariness. Includes overview of CFD regulation in the US and global markets.
Company boards and UK organizations including the Investor Relations Society and the Association of Investment Companies have welcomed the new openness, which will make it harder for predators to build up undisclosed stakes in potential targets.
The new rules will require the holders of long CFD positions in UK-listed firms to aggregate their positions with any shares they hold directly and to disclose this interest if it exceeds 3 percent of a UK-incorporated company’s shares. For the first time, this disclosure is extended to cover CFDs where the holder has no rights to require the physical delivery of the underlying shares or control the way these shares are voted. The new rules also potentially cover equity forwards, equity swaps and options.
‘The FSA has taken one of the toughest lines globally on CFD disclosure as it intends to combine equity and CFD holdings in calculating whether disclosure is required,’ says Andrew Shrimpton, a member of Kinetic Partners, a hedge fund consultancy. ‘The minimum threshold for disclosure of stakes is already low at 3 percent of outstanding shares so these proposals will ensure no secret shareholdings can be built up under the radar.’
Rising popularity
CFDs have taken off in recent years as a popular method for investors to benefit from share price movements without the hassle of actually buying and selling shares. They do not incur stamp duty and allow gearing because they typically require only a 10 percent margin deposit on the value of the shares. They also permit short selling as well as long buying. They are thought to account for as much as 30 percent of equity trading volumes.
The FSA’s actions are in line with an international trend toward tighter control on derivatives. Total derivative trading volumes have ballooned over the past decade as investors and banks have sought more innovative ways to slice risk, circumvent the red tape and taxes that often apply to the underlying instruments and broaden the investment options available.
Companies and their IR departments are understandably pleased that a significant element of uncertainty in their shareholder registers will be removed by the new legislation. Representatives of the banks, hedge funds and other professionals, however, point to a possible downside. ‘It will be interesting to see whether this regulation affects the amount of business booked in London,’ comments Richard Metcalfe, senior regulatory adviser and head of policy in the London office of the International Swaps and Derivatives Association.
John Tattersall, a partner in business advisers PricewaterhouseCoopers – which carried out research for the FSA on this issue – says concerns about the build-up of secret stakes may be overdone. ‘It’s the investment banks that write these things,’ he says. ‘They don’t pass on the voting power because they don’t have it to begin with.’
Dan Taylor, a partner in the financial services group of BDO Stoy Hayward, says it is sensible for the FSA to require disclosure of an economic interest in a listed company. But with the final details of the FSA regulations yet to be published, he notes that ‘it is always in the detail of the implementation that issues arise.’
The final rules are due in February 2009 for implementation on or before September 2009.
Global CFD roundup
The European Union’s (EU) transparency directive covers equities rather than contracts for difference (CFDs) but it has focused attention on the need for greater openness. Germany passed legislation known as the Risk Limitation Act in June to require the aggregation of share and derivative holdings in calculating when disclosure thresholds have been reached.
Significantly, Germany has not included cash-settled derivatives in the scope of its new legislation – unlike the FSA – and it has not changed the threshold levels for disclosure. These kick in, as before, at 3 percent, 5 percent and 10 percent, rising in stages to 75 percent of voting rights. Germany has also tightened its rules on the definition of ‘concert parties’.
Outside the EU, Switzerland brought in new rules to cover the disclosure of significant holdings in listed companies in December 2007. The Swiss authorities no longer distinguish between physical delivery and the cash settlement of derivatives, closing a significant loophole in the previous regulations, and they have set lower and additional disclosure thresholds of 3 percent, 15 percent and 25 percent of voting rights alongside the previous trigger points that started at 5 percent. Switzerland further exempts banks and securities dealers from these rules, an exemption that will figure in the UK regime, too.
Elsewhere, Hong Kong started to look at the impact of derivative investing in the late 1990s and it now requires disclosure of derivative positions. The Australian Securities Exchange lists exchange-traded CFDs in the top 50 Australian stocks and a range of foreign exchange, index and commodity instruments; previously CFDs were traded over the counter.
State of play in the US
A US court ruling that equity derivatives can confer voting control of the underlying shares – and therefore should be disclosed – has been welcomed by IR specialists, but could make life more difficult for activist investors.
Judge Lewis Kaplan of the Southern District Court of New York ruled that two hedge funds – the Children’s Investment Fund and 3G – should have reported their holdings of cash-settled, total-return equity swaps in US rail company CSX because they could influence the way shares were voted, thus rendering the funds the beneficial owners.
But the judge did not restrict the two hedge funds from voting the CSX shares because, he said, the rail company had not proved that it would suffer ‘irreparable harm’. Kaplan also left any penalties up to the SEC or the Department of Justice. The Southern District is not a specialist commercial court but ‘because of its location it is probably the leading court for securities cases,’ says Mike O’Brien, securities partner at law firm Bingham McCutchen.
CSX, the Children’s Investment Fund and 3G have all appealed against the ruling, which overturned the widely held view that equity derivatives did not confer ownership. If the ruling stands, it is unclear how widespread its implications may be because Kaplan’s judgment was described as specific to the facts of this case.
‘The appeal court decision is eagerly awaited,’ says O’Brien. ‘It had been generally assumed, with the blessing of the SEC, that if you were party to a forward contract relating to equity securities that could only settle for cash, you did not have to treat yourself as the owner of those shares.’
The ruling also appears to have run counter to the view of the SEC, which has written to the court stating that ‘as a general matter, a person who does nothing more than enter into an equity swap should not be found to have engaged in an evasion of the reporting requirements.’
The SEC’s new head of the office of mergers and acquisitions, Michele Anderson, is believed to be looking at the disclosure rules governing cash-settled swaps. And there is growing political interest in the issue: Charles Schumer, a New York senator, wrote to commission chairman Christopher Cox in June this year asking the SEC to clarify the correct treatment of equity swaps and indicating that legislation might be needed to provide serious penalties for future disclosure violations.
Companies welcome the greater transparency that would be provided if Kaplan’s ruling is upheld, according to Peter Juhng of Ilios Partners, a market intelligence firm. ‘Investors will tell you they own 1 mn shares but you don’t see it from the filing,’ he says. ‘This invalidates the ownership we track. The hedge funds know the 13F is an incomplete filing. This has changed a lot of things.’
