In recent years, there has been a significant increase throughout the world in the use of cash-settled derivatives. These transactions have sometimes been used to acquire influence or creeping control over listed companies without disclosure, in some cases despite laws that would require disclosure of significant physical shareholdings and/or mandatory public tender offers by major holders of physical shares. In response, European institutions and several national financial regulators (including the FSA in the United Kingdom and the AMF in France) have implemented changes or planned initiatives to extend disclosure obligations of significant shareholdings to positions held through cash-settled derivatives, which fall outside the scope of disclosure regulations currently in force in most EU Member States.
Following the implementation of Directive 2004/109/EC on the harmonization of transparency requirements in relation to information about listed issuers (the Transparency Directive) and recent amendments to the Italian public tender offers rules, Italian lawmakers have also intervened. The Italian financial and securities regulator (CONSOB) has been empowered to determine when cash-settled derivatives must be included in disclosures of major shareholding1 and when they must be counted for purposes of mandatory public tender offer rules (requiring holders of over 30 percent of a listed company to launch a tender offer, the Takeover Rules).2 On October 8, 2009, CONSOB released a position paper (the Position Paper) inviting responses from market participants on several options for extending the disclosure obligations and the Takeover Rules to cash-settled derivatives. This Alert summarizes the main regulatory options provided by the Position Paper for the comments of market participants.
1. The Current Italian Legal Framework
Consistent with EU law, Italian shareholding disclosure rules are based on ownership of the voting rights associated with the shares, rather than ownership of the economic interest in shares. Italian law requires disclosure when the percentage of voting rights held in a listed issuer’s shares exceeds one of the thresholds provided by applicable Italian law or by CONSOB’s issuers’ regulation (CONSOB Regulation).3 These provisions require disclosures to the market and to CONSOB of major positions in listed issuers’ voting capital4 that satisfy certain conditions5, whether held directly or indirectly (i.e., via subsidiaries, nominees or fiduciaries).6 The disclosure regime7 covers both: (i) shares whose voting rights are suspended, belong to, or are assigned to, third parties and (ii) shares whose voting rights are held or assigned to a third party pursuant to an agreement governing the exercise of such voting rights (i.e., pledge or usufruct on shares where voting rights are assigned to the pledgee or the beneficial owner).
Together with the obligation to disclose major shareholdings, current Italian law provides that shareholders whose holdings exceed the applicable thresholds must also disclose rights to acquire shares (i.e. calls) and rights to sell shares (i.e. puts).8 To be covered by the disclosure rules, rights to sell or buy shares9 must provide the holder with the sole discretion, pursuant to a legally binding agreement, to physically acquire or sell shares.10 Thus, only physically-settled instruments fall within the disclosure obligation. The rationale for this rule is that only physically-settled instruments permit the holder to physically acquire and/or sell the underlying shares, as opposed to cash-settled instruments which provide mere economic ownership. Cash-settled derivatives are not, therefore, covered by the general disclosure regime currently in force. However, to prevent market abuse and internal dealing, current Italian law11 does require disclosure of transactions by certain insiders12 in equity-linked financial instruments (including cash-settled instruments).
With respect to the Takeover Rules, only shares that give the holder the right to vote at shareholders’ meetings (and therefore potentially acquire control over the issuer) are counted towards the 30 percent threshold.13
2. Background of the Regulatory Initiative
2.1 Information Asymmetry and Market Failures
Recent cases14 and studies15 have noted that the lack of a common worldwide disclosure regime for cash-settled derivatives could lead to information asymmetry and market failures, which could, in turn, reduce investor confidence and increase the costs of raising capital.16 Commentators have observed that there are instances when cash-settled derivatives (particularly those traded over the counter (OTC)) cannot be properly considered mere arbitrage or hedging transactions, but instead can raise issues similar to those relating to physically-settled financial instruments.
In standard equity cash-settled derivatives, the holder of the long position (usually the purchaser of the instrument) benefits from price increases in the underlying shares and incurs losses if the price decreases. The holder of the short position (usually a bank or investment firm), will often assume a neutral risk position by physically acquiring the underlying shares at the strike price of the derivative. This results in a decoupling of the legal ownership of the voting rights attached to the underlying shares (held by the short party) from the economic ownership (held by the long party). In such a transaction, the short party does not bear any economic risk relating to the performance of the underlying shares and therefore it often has no incentive or interest in exercising the voting rights attached to the shares. In cases like this, the long party could direct the short party how to vote and therefore exercise de facto control over the underlying shares held by the short party.
Moreover, the long party may even be able to acquire physical ownership of the shares when the derivative is settled. The short party is unlikely to sell the shares until the settlement date and may therefore find it economically equivalent (and perhaps even more convenient) to physically deliver the underlying financial shares to the long party at settlement rather than selling them on the market and subsequently closing out the long party’s position with a cash payment.17 This settlement method could be achieved either by renegotiating the derivative’s contractual provisions (changing cash settlement to physical settlement) or simply by transferring the underlying shares outside of the contract through one or more transactions on the market and without amending the relevant settlement terms.
These situations — defined by international authors as decoupling — can be divided into two categories: hidden ownership and empty voting:
- In cases of hidden ownership, a cash-settled derivative gives the holder a long positions in a listed issuers’ shares that remains undisclosed unless (and until) the derivative is physically-settled (or the holder otherwise acquires the shares), resulting in a public disclosure obligation. This type of transaction conceals the identity of the persons who, through positions in cash-settled derivatives, could ultimately become the holder of the voting rights by acquiring the underlying shares.
- Empty voting refers to cases in which the short position holder has no interest or incentive to vote the shares and therefore votes as directed by the holder of the long position. Although the long position holder does not actually hold the shares, its mere economic interest gives it de facto power to influence the listed issuer’s corporate governance by indirectly exercising the voting rights attached to the underlying shares.
2.2 The Debate in Europe: CESR Consultation Paper
In a consultation paper, the Committee of European Securities Regulators (CESR) intervened in the debate on whether public disclosure obligations should be extended to cash-settled derivatives (CESR Consultation Paper).18 Noting the regulatory inconsistency within the European securities and financial markets, CESR recommended adopting a harmonized pan-European approach to major shareholding disclosure obligation. In the CESR Consultation Paper, CESR recommends that the disclosure regime provided by the Transparency Directive should be extended to both physically-settled and cash-settled derivatives which may have a similar economic effect to holding the underlying shares. CESR notes, however, that any additional regulation should not discourage the use of such instruments. CESR also recommends that holders should be allowed to net long and short positions, to avoid double counting.19
The CESR Consultation Paper also requested comments on the following issues (i) how should regulators define instruments with similar economic effect to holding shares and entitlements to acquire shares? (ii) what calculation criteria should be used to calculate relevant shareholding thresholds? and (iii) what exemptions should apply?
3. The CONSOB Position Paper
In light of this international debate, CONSOB issued its Position Paper requesting market comments on proposed regulatory options to extend the current disclosure obligations to cash-settled derivatives. CONSOB also asked for comments on whether these instruments should be counted towards the 30 percent threshold for a mandatory takeover bid under the Takeover Rules. CONSOB has asked market participants to specifically comment on (i) the general advisability of extending the current legal framework on major shareholding disclosure; (ii) whether the reporting obligations should cover both exchanged traded and OTC derivatives; (iii) the aggregation criteria; (iv) the definition of the relevant thresholds and (v) how the Takeover Rules should treat cash-settled derivatives.
3.1 Should Disclosure Obligations Be Extended to Cash-Settled Derivatives?
CONSOB asked market participants to evaluate whether current disclosure rules should be extended to include disclosure obligations with respect to cash-settled derivatives, considering, however, whether the costs might outweigh the benefits and whether abusive practices could be more efficiently addressed through more vigorous enforcement of current laws.
CONSOB points out that the “reform” option — extending disclosure obligations to root out cases of hidden ownership and empty voting — would involve substantial implementation costs because of the complexity and the variety of cash-settled derivatives. It would be difficult to introduce general criteria to distinguish transactions carried out for legitimate hedging and arbitrage purposes from abusive transactions carried out to avoid disclosure. Moreover, an overly broad disclosure regime might lead to excessive reporting, resulting in a possible decrease in market efficiency caused by market participants being unable to identify relevant disclosures in the mass of reports.
The CONSOB Position Paper suggests that there may be ways to address abusive cases by enforcing the current legal provisions more vigorously. However, CONSOB is of the view that this approach would not effectively prevent the abusive cases, as current enforcement provisions would be effective only after the abuse occurred.20
3.2 Scope of the Reporting Obligations
CONSOB also asks market participants to comment on the scope of reporting requirements, specifically whether disclosure obligations should be extended to cash-settled derivatives traded on both regulated markets and OTC or whether such obligations should be limited to OTC derivatives.
In the case of exchange trade derivatives, the presence of a single centralized counterparty makes it unlikely that the underlying shares to a cash-settled derivative would be acquired and, because the contracts are standardized, the settlement method cannot be amended. Thus, many of the hidden ownership and empty voting concerns may not apply with respect to exchange traded derivatives. However, CONSOB stresses that extending disclosure obligations only to OTC cash-settled derivatives may not prevent all abuses, since exchange traded derivatives can still be physically-settled.
3.3 Aggregation Criteria
With respect to aggregation criteria, CONSOB suggests that disclosures should be separated. Relevant shareholdings should be described in three parts: (i) actual physical holdings, (ii) entitlements to acquire shares, and (iii) positions held through cash-settled derivatives. CONSOB believes that this option could provide the most understandable reporting system, but might also lead to more abusive transactions aimed at circumventing the reporting obligations.21 In order to prevent such practices, CONSOB suggests that an alternative would be to aggregate all the long positions held (whether actual holdings, calls, or OTC derivatives) irrespective of the settlement method.22 A final option would be to require full aggregate disclosures of all positions only after a relevant threshold has been reached or exceeded. This approach could be added to the current disclosure regime, which is based on the separate reporting of relevant shareholdings and entitlements to acquire shares.
The definition of the relevant reporting thresholds plays a fundamental role in establishing an efficient disclosure regime, as this will prevent excessive disclosure. The Position Paper sets forth alternative options. First, the current 2 percent threshold for shareholdings and entitlements to acquire shares could be maintained. Alternatively, thresholds could be adapted according to the aggregation criteria that are ultimately adopted.
If the full aggregation regime is introduced, CONSOB indicated that the minimum 2 percent threshold must be maintained to comply with the obligations set forth by TUF.23 Similarly, if a divided disclosure regime is adopted (i.e. shareholdings described in the three categories mentioned above), the 2 percent threshold would also need to be maintained with reference to actual shareholdings, while the minimum threshold for entitlements to acquire shares could be fixed within a 5 percent limit, in compliance with EU law.24 CONSOB invites market participants to suggest an appropriate threshold with respect to cash-settled derivatives.
3.5 Cash-settled Derivatives in the Context of a Public Tender Offer
The Position Paper requests comments on whether cash-settled derivatives are relevant for mandatory public tender offers and whether specific regulations should be adopted in this context. CONSOB asks for comments on the following issues: (i) what kinds of derivatives should be included in the Takeover Rules; (ii) with respect to the calculation criteria, how should the following be treated: (a) instruments held for hedging purposes that do not cover the entire notional amount of the reference asset, (b) long and short positions on the same underlying shares held by the same person, and (c) holdings held via baskets of securities; (iii) how should exchange traded derivatives be treated for purposes of the Takeover Rules threshold.
4. Market Reactions
Some of the associations representing different categories of market participants have recently responded to the regulatory options presented by the Position Paper.
In particular, Assosim (the Italian association of investment companies) has criticized the proposed extension of the disclosure obligations to positions held through cash-settled derivatives, pointing out that such instruments have been used for abusive purposes in only a small number of cases. Moreover, Assosim argues that such abusive practices could be more efficiently addressed by amendments to the Takeover Rules (rather than increased disclosure obligations) and by more vigorous enforcement of current law.
On the other hand, Assonime (the association of the Italian joint-stock companies, representing the major listed issuers), agrees with the proposed extension of disclosure obligations to cash-settled derivatives, as long as such extension is proportionate and focused on avoiding abuses. Assonime notes that over-regulation could result in excessive burdens for the market. Therefore, Assonime believes that positions held through cash-settled derivatives should be initially communicated only to CONSOB, which could then require public disclosure of the transactions that CONSOB deems could significantly influence listed issuers’ corporate governance.