Equity Derivatives in Australia

Overview

Other than transactions between dealers, what are the most typical types of over-the-counter (OTC) equity derivatives transactions and what are the common uses of these transactions?

While the Australian market for OTC equity derivatives (ie, the market for OTC equity derivatives over Australian underliers such as shares of Australian listed companies) is not as established as the OTC equity derivatives markets in some other global financial centres, the Australian OTC equity derivatives market is active and growing. Some of the more common types of OTC equity derivatives transactions in the Australian market are:

• equity swaps and other equity derivatives used in a mergers-and-acquisitions context as part of the strategy to acquire a substantial equity stake;
• collars and prepaid forwards used to hedge or monetise shareholdings;
• margin loans used to finance or leverage shareholdings;
• equity swaps and other equity derivatives used by investors to gain synthetic exposures; and
• certain structured retail products that reference equities or equities indices.

May market participants borrow shares and sell them short in the local market? If so, what rules govern short selling?

‘Naked’ short selling is prohibited in Australia, subject to certain limited exceptions. ‘Covered’ short selling (ie, where the seller has acquired a ‘presently exercisable and unconditional right to vest’ the relevant shares prior to selling the shares) is permitted. The regulation is generally contained in the Corporations Act 2001 (Cth) (Corporations Act) and associated guidance from the Australian Securities and Investments Commission (ASIC).

There are reporting obligations in respect of short selling, both at a transactional level and a positional level.

Describe the primary laws and regulations surrounding OTC equity derivatives transactions between dealers. What regulatory authorities are primarily responsible for administering those rules?

The following are the primary laws and regulations applicable to inter-dealer activities in the Australian OTC equity derivatives market:

• The Corporations Act and the Australian Securities and Investments Commission Act 2001 (Cth) (ASIC Act) are relevant statutes, and the relevant regulator is the ASIC.
• Australia has also implemented a legislative framework and rules in the areas of OTC derivatives reporting, clearing of OTC derivatives through central counterparties, execution of OTC derivatives on trading platforms and margin requirements for non-centrally cleared derivatives. The primary regulators in these areas are the Minister and the Council of Financial Regulators (comprised of the ASIC, the Reserve Bank of Australia and the Australian Prudential Regulation Authority (APRA)).

In addition to dealers, what types of entities may enter into OTC equity derivatives transactions?

Apart from a particular entity’s capacity or authority restrictions and (to the extent the transaction confers on the entity a relevant interest (within the meaning prescribed under the Corporations Act) in the underlying securities) restrictions that may apply to acquisitions of interests by a foreign person or in a sensitive business such as the media sector, broadly speaking there is no general prohibition under Australian law on the types of entities that may enter into OTC equity derivatives transactions. However, transactions should be analysed on a case-by-case basis to assess whether the entry by a particular type of entity may be prohibited or restricted under any applicable law or regulation.

Apart from dealers, other types of entities that also enter into OTC equity derivatives in the Australian market include:

• corporates;
• shareholders;
• asset managers;
• investment funds;
• family office and high net worth individuals; and
• insurance companies.

Describe the primary laws and regulations surrounding OTC equity derivatives transactions between a dealer and an eligible counterparty that is not the issuer of the underlying shares or an affiliate of the issuer? What regulatory authorities are primarily responsible for administering those rules?

OTC equity derivatives transactions are regulated under the Corporations Act. ASIC has responsibility for administering the Corporations Act and accordingly has oversight of OTC equity derivative transactions. ASIC has established certain rules in relation to derivative transaction reporting (the ASIC Derivative Transaction Rules (Reporting) 2013) and published a number of regulatory guides that set out guidance applicable to OTC equity derivative transactions.

The Takeovers Panel, a body that is given statutory power to resolve disputes in takeovers and other change of control transactions, has also issued guidance with respect to disclosure of OTC equity derivatives that are relevant in the context of control transactions, as discussed further in question 14.

Do securities registration issues arise if the issuer of the underlying shares or an affiliate of the issuer sells the issuer’s shares via an OTC equity derivative?

The Corporations Act does not permit an issuer to hold shares in itself (including as treasury stock). Accordingly, under Australian law an issuer cannot sell shares in itself (whether via an OTC equity derivative or otherwise).

An ‘affiliate’ is not defined under the Australian Corporations Act. It is possible for a controlling shareholder to enter into an OTC equity derivative transaction to sell shares in the issuer. However, such a controlling shareholder would need to ensure that it does not contravene, among other things, the prohibitions against insider trading under the Corporations Act if the shareholder is in possession of inside information regarding the issuer (see question 10 and the prohibitions against market manipulation).

May issuers repurchase their shares directly or via a derivative?

Under Australian law, an issuer may repurchase its own shares pro­vided that doing so does not materially prejudice its ability to pay its creditors and that the procedures set out in the Corporations Act are followed. Any shares repurchased are automatically cancelled. The Corporations Act procedures relating to a share repurchase (or ‘share buy-backs’ as referred to in the Corporations Act) include a requirement to give 14 days’ notice to ASIC of the proposed share buy-back and disclosing all information relevant to the buy-back. If the buy-back relates to shares other than ordinary shares, or offers to buy back were made to specific shareholders only, the shareholders must approve the buy-back by special resolution with voting restrictions imposed on the persons whose shares are proposed to be bought back (or, alternatively, a resolution being passed at a general meeting by all shareholders of the issuer). These procedures do not easily accommodate repurchasing shares by way of a derivative. If the issuer is listed, the Listing Rules of the Australian Securities Exchange (ASX) also require the issuer to make certain announcements to ASX concerning the share repurchase.

An issuer must not be in possession of inside information if it wishes to repurchase shares and, provided that the buy-back is a genuine transaction and not implemented for a purpose outside the interplay of genuine market prices, ought not fall foul of the market misconduct prohibited under Part 7.10 of the Corporations Act, including market manipulation, creating a false or misleading appearance of active trading and artificially creating or maintaining a trading price of financial products (which includes shares and derivatives over shares).

What types of risks do dealers face in the event of a bankruptcy or insolvency of the counterparty? Do any special bankruptcy or insolvency rules apply if the counterparty is the issuer or an affiliate of the issuer?

Generally speaking, the risks faced by a dealer in a counterparty insolvency scenario involving equity derivatives are similar to the risks faced by a dealer in the same scenario involving derivatives generally.

There are three main types of insolvency proceedings applicable to an Australian company (other than certain regulated bodies such as authorised deposit-taking institutions (ADIs) and insurance companies that in addition are subject to specific regulation) that may become relevant - liquidation (or winding up), voluntary administration (a procedure to appoint an independent person to take control of and investigate the affairs of the company whose future is decided by its creditors resolving to accept an arrangement, end the administration or place the company in liquidation) and receivership (where a secured creditor appoints a receiver to realise the secured assets).

In a liquidation, a liquidator will also have certain rights to make claims in respect of voidable transactions, including unfair preferences and uncommercial transactions. An unfair preference will generally involve a transaction between the company and an unsecured creditor within six months prior to the commencement of the liquidation (but while the company is insolvent), which results in the creditor receiving more from the company than if it had claimed in a liquidation for the debt. An uncommercial transaction will generally involve a transaction of the company (usually while it is insolvent), which a reasonable person in the company’s circumstances would not have entered into.

In the case of an insolvent liquidation, if the derivatives transactions are subject to a close-out netting arrangement (such as an International Swaps and Derivatives Association, Inc (ISDA) Master Agreement), then a dealer may have protection under the Payment Systems and Netting Act 1998 (Cth) (the Netting Act) to close out its derivatives transactions to manage its credit risk exposure. If protection is not available under the Netting Act and the dealer seeks to rely on any contractual set-off provisions, such contractual set-off will be subject to the application of mandatory set-off provisions under the Corporations Act, which require mutuality to exist between the parties.

In the case of a voluntary administration, a dealer as a creditor may be subject to the imposition of a moratorium (automatic stay) upon certain enforcement actions. However, if the derivatives transactions are subject to close-out netting protection under the Netting Act, then generally speaking the dealer can still close out its derivatives transactions to manage its credit risk exposure.

In the case of a receivership, priority of a dealer’s security interest becomes more important. Where the Personal Property Securities Act 2009 (Cth) (PPSA) applies, the dealer will need to have perfected its security interest under the PPSA to have priority over other competing security interests.

There are special legislative regimes applying to ADIs and insurance companies in financial difficulty that need to be considered, including in the case of ADI, stays on certain close-out rights against such entities.

In September 2017, Australia enacted legislation relating to ipso facto rights that provides for the stay on enforcement of certain rights as a result of the occurrence of certain insolvency events. The legislation commenced on 1 July 2018. A right contained in a contract, agreement or arrangement that is, or is directly connected with, a derivative, or in a close-out netting contract under the Netting Act, is exempted by regulations from the stay on enforcement.

What types of reporting obligations does an issuer or a shareholder face when entering into an OTC equity derivatives transaction on the issuer’s shares?

See questions 14 and 26 in relation to the obligation to file substantial holding notices with the ASX and in relation to derivative transaction reporting obligations applicable to domestic and foreign entities, respectively.

Are counterparties restricted from entering into OTC equity derivatives transactions during certain periods? What other rules apply to OTC equity derivatives transactions that address insider trading?

The insider trading prohibitions in the Corporations Act (which apply generally to transactions involving financial products and not just OTC derivatives) will prevent a counterparty, if they are in possession of inside information in relation to an issuer, from entering into an OTC equity derivative in respect of an issuer’s securities or procuring another person to enter into an OTC equity derivative in respect of an issuer’s securities.

‘Inside information’ is information that is not generally available, and if it were, a reasonable person would expect it to have a material effect on the price or value of securities.

What additional legal issues arise if a counterparty to an OTC equity derivatives transaction is the issuer of the underlying shares or an affiliate of the issuer?

See questions 6 and 7. As noted in question 6, under Australian law an issuer may not enter into an OTC derivative to sell its own shares.

What types of taxation issues arise in issuer OTC equity derivatives transactions and third-party OTC equity derivatives transactions?

The Australian tax law does not contain specific rules dealing with the tax treatment of equity derivatives, although there are a number of specific provisions that deal with the tax consequences of transactions that commonly affect equity derivatives (eg, exercise of options, conversion or exchange of convertible or exchangeable instruments, etc).

As such, the tax treatment of equity derivatives is determined under the general provisions of the Australian tax law, including, where relevant, the specific rules mentioned below and, where applicable, the ‘taxation of financial arrangements’ rules in the tax law (which is a comprehensive ‘code’ governing the tax treatment of certain types of financial instruments for certain classes of taxpayers).

The specific types of taxation issues that arise for issuers and holders of equity derivatives depend on the particular type of equity derivative involved. Some of the taxation issues that commonly arise include (but are not limited to):

• classification of the instrument under the debt or equity rules;
• assessability or deductibility of payments made or received under the instrument;
• capital gains tax consequences of acquiring, holding and disposing of the instrument; and
• taxation consequences of exercise, conversion and exchange of instruments.

For the purposes of Australian goods and services tax (GST, the Australian equivalent of VAT), dealings in interests in equity derivatives and securities will usually be classified as ‘financial supplies’. Financial supplies are one of the main categories of input taxed (exempt) supplies in Australia. This means that no GST is payable on the supply but both the supplier and the acquirer may not be entitled to claim full input tax credits for the GST incurred on any costs associated with the supply (eg, legal fees, accounting fees, etc). Certain acquisitions (eg, brokerage) that relate to making input taxed financial supplies or acquisitions may qualify for a reduced input tax credit (broadly equal to 75 per cent of the GST amount or 55 per cent for certain expenses of funds and trusts in certain cases).

As the rules applicable to equity derivatives are complex and varied, specific advice should be obtained regarding the relevant rules and their application in the circumstances of the particular transaction.

Describe the liability regime related to OTC equity derivatives transactions. What transaction participants are subject to liability?

In addition to liabilities that can arise for derivatives transactions generally (eg, liabilities arising under contract, tort, equity or statutes), OTC equity derivatives transactions can also give rise to liability if there is a breach of the prohibitions against insider trading or other types of market misconduct (see questions 7 and 10) or, if the derivative transaction gives the taker a relevant interest in the underlying securities (of a listed company) in excess of 20 per cent of the company’s voting securities, in breach of the takeover provisions of the Corporations Act.

What stock exchange filings must be made in connection with OTC equity derivatives transactions?

A shareholder of the issuer will have an obligation to file a substantial holding notice with the issuer and the ASX if, as a result of entry into the OTC equity derivative, the shareholder:

• begins to have, or ceases to have, a substantial holding; or
• has a substantial holding and the OTC derivative transaction results in a movement of at least 1 per cent in their holding.

A shareholder will have a substantial holding if they (together with their ‘associates’) have a relevant interest in voting shares carrying 5 per cent or more of total votes of the issuer. Certain OTC derivatives that confer on a party a right to acquire the underlying shares will result in that party acquiring a relevant interest in those shares.

Under the Corporations Act, it is possible for an issuer to acquire a ‘relevant interest’ over its own shares (this being a concept different from having a legal interest in the shares) and therefore in certain circumstances the above filing obligation can apply to the issuer itself.

If an OTC derivative over the shares of an ASX-listed company is cash-settled only and does not give the taker the right to physical settlement, entry into the OTC derivative would not ordinarily require the taker to file a substantial holding notice (even if it relates to 5 per cent or more of the company’s shares). This is because a cash-settled equity derivative would not ordinarily give the taker any relevant interest in the underlying shares unless it gives the taker any right to control the voting or disposal of the underlying securities.

However, if the listed company is the subject of an announced control transaction or a potential control transaction, the expectation of the Takeovers Panel is that all long positions that already exist, or that are created, over that company’s shares are disclosed unless they are under a notional 5 per cent (Takeovers Panel Guidance Note 20). At the time of writing (May 2019), the Takeovers Panel is seeking to broaden this policy such that all long positions over a listed company’s shares exceeding a notional 5 per cent should be disclosed regardless of whether or not there is an announced control transaction or a potential control transaction.

What types of documents are typical in an OTC equity derivatives transaction?

In the Australian market for OTC equity derivatives, parties typically enter into a confirmation under an ISDA Master Agreement to document an equity derivatives transaction. The confirmation will typically incorporate the relevant equity derivatives definitions, such as the 2002 ISDA Equity Derivatives Definitions. Depending on the nature of the security arrangement, parties may document their security arrangements using the ISDA Credit Support Annex or other tailored security documentation such as a specific security deed. In the case of margin loans, it is not uncommon for parties to use the Asia Pacific Loan Market Association documentation or other bespoke forms of documentation.

For what types of OTC equity derivatives transactions are legal opinions typically given?

As with derivatives transactions generally, a dealer typically obtains legal opinion comfort on close-out netting and collateral enforceability from industry published opinions. A dealer may also request capacity and authority opinion from the counterparty. For OTC equity derivatives transactions that are more structured in nature, additional legal opinions (such as opinions on contractual enforceability and security interest) may also be sought.

A dealer may sometimes require detailed legal advice on corporate law issues, such as for OTC equity derivatives transactions used in a mergers and acquisition context as part of the strategy to acquire a substantial equity stake, to ensure that the specific requirements that may arise in this context are identified, including in relation to the prohibition against insider trading (see question 10), acquisition of relevant interests in the underlying securities and disclosure of substantial holdings (see question 14). If the taker is a foreign person, requirements under the Foreign Acquisitions and Takeovers Act 1975 (Cth) will also need to be considered.

May an issuer lend its shares or enter into a repurchase transaction with respect to its shares to support hedging activities by third parties in the issuer’s shares?

As an issuer is not entitled to hold its own shares under Australian law (see question 6), it will not be able to lend its own shares in any circumstance.

As noted in question 7, while an issuer may enter into a repurchase transaction with respect to its shares, there are procedures that must be followed under the Corporations Act. Under these procedures, the shares are automatically cancelled on repurchase. In addition, the issuer would need to consider insider trading and market manipulation provisions.

What securities registration or other issues arise if a borrower pledges restricted or controlling shareholdings to secure a margin loan or a collar loan?

Generally, where a security interest granted over shares is subject to the PPSA, the lender will want to ensure that appropriate steps under the PPSA are taken to protect that security interest. This might include registration of a financing statement on the Personal Property Securities Register.

If a borrower pledges shares in a listed company for the benefit of a lender, the lender will need to consider whether the creation of the security interest causes the lender to acquire a ‘relevant interest’ in those shares. The Corporations Act prohibits, subject to certain exceptions, the acquisition of a relevant interest in shares where doing so will cause a person to have an interest in 20 per cent or more of a listed company. Furthermore, if the relevant interest relates to 5 per cent or more of the listed company’s shares, a substantial holding notice obligation will arise (see question 14).

An exception to the creation of a ‘relevant interest’ exists for commercial lenders if the lender has acquired a security interest over shares in the ordinary course of the business of lending, and the acquisition is on ordinary commercial terms. This exception operates so that no relevant interest arises at all if the exception applies, and therefore the lender would not be required to file a substantial holding notice even if the security interest is over more than 5 per cent of the shares. For this exception to apply, however, the lender and the borrower must not be associates - for instance they must not be parties to (or propose to enter into) an agreement for the purpose of controlling or influencing the composition of the listed company’s board or its affairs.

If the lender taking security interest over shares is a foreign person or entity, the lender should also consider the application of the Foreign Acquisitions and Takeovers Act 1975, which requires that certain forms of acquisitions of interests over shares (that can include the circumstance where shares are pledged in favour of a lender) be notified to the Treasurer before being undertaken.

If a borrower in a margin loan files for bankruptcy protection, can the lender seize and sell the pledged shares without interference from the bankruptcy court or any other creditors of the borrower? If not, what techniques are used to reduce the lender’s risk that the borrower will file for bankruptcy or to prevent the bankruptcy court from staying enforcement of the lender’s remedies?

A margin loan lender to an Australian company borrower that becomes subject to certain types of Australian insolvency proceedings may in some circumstances be prevented from enforcing the security against the secured assets without consent or court leave. To address this, a lender may look to structuring techniques that engage the protection under the Netting Act, which will apply despite other law imposing restrictions on security enforcement. A lender may structure the security as a title transfer arrangement (which relies on close-out netting for enforceability) that is protected as a close-out netting contract under the Netting Act. Alternatively, as a result of amendments to the Netting Act in 2016, a lender may also structure a grant of a security interest over financial property in respect of obligations of a party to a close-out netting contract that satisfies certain Netting Act requirements such that protection would be afforded to the enforcement of the security interest.

What is the structure of the market for listed equity options?

• Listed options (over unissued shares) are issued by the ASX-listed entity, entitling the option holder to subscribe to additional shares in the entity upon exercise of the option. Such options may be quoted or unquoted on the ASX and, if they are quoted, are traded on the ASX in the same manner as shares in the issuer.
• Exchange Traded Options are equity options over ASX-approved companies that are traded via the ASX. The ASX permits the trading both of call and of put options.
• Warrants are issued by banks and other financial institutions over a range of various underlying instruments, including shares, exchange-traded funds or a basket of different securities. While the terms of the warrant differ depending on their series, warrants typically give holders the right to buy or sell the underlying instrument to the warrant issuer for a particular price according to the terms of issue, or entitle holders to receive a cash payment relating to the value of the underlying instrument at a particular warrant.

Describe the rules governing the trading of listed equity options.

Listed options are governed by the ASX Listing Rules and the ASX Settlement Operating Rules. Exchange traded options are governed by the ASX Operating Rules. Warrants are also governed by the ASX Operating Rules, in particular Schedule 10 (Warrant Rules). These rules provide ASX with broad powers to take action in the interests of maintaining fair and orderly markets, including the ability to suspend trading, impose position limits or exercise limits and terminate open contracts. Similarly, regulatory authorities such as ASIC may give directions to ASX or ASX Clear (which operates the clearing facility for exchange traded options), for example to suspend dealings in products.

Trading of listed equity options on ASX must also comply with the Corporations Act, including its insider trading and other market misconduct prohibitions.

Types of transaction

What categories of equity derivatives transactions must be centrally cleared and what rules govern clearing?

At the time of writing, interest rate derivatives denominated in certain currencies only are subject to mandatory clearing in Australia, and equity derivatives are not subject to the Australian mandatory central clearing regime.

What categories of equity derivatives must be exchange-traded and what rules govern trading?

There are no categories of equity derivatives that are required to be exchange traded. However, in practice the main equity derivatives that are exchange traded are options, warrants, futures contracts and contracts for difference. The relevant rules are the ASX Operating Rules, the ASX 24 Operating Rules (and associated clearing and settlement rules) and the various ASIC Market Integrity Rules.

Describe common collateral arrangements for listed, cleared and uncleared equity derivatives transactions.

In the case of OTC equity derivatives in the Australian market, collateral arrangements are more relevant for uncleared transactions (noting that equity derivatives are currently not subject to mandatory clearing in Australia). For uncleared equity derivatives transactions entered into under an ISDA Master Agreement, parties commonly document their collateral arrangement using an ISDA Credit Support Annex under a title transfer approach. Parties may also structure the collateral arrangement using a security interest approach although that has not been as common as the title transfer approach.

In the case of exchange-traded equity derivatives where there is a potential exposure for the clearing house, the relevant clearing house will generally call for margin from the relevant clearing participant, who will in turn call for margin from the relevant client. This may be cash or acceptable securities (subject to a haircut).

Must counterparties exchange collateral for some categories of equity derivatives transactions?

Prudential Standard CPS 226 (CPS 226) sets out the margining requirements for non-centrally cleared derivatives, including OTC equity derivatives transactions. CPS 226 imposes both variation margin requirements and initial margin requirements. These margining requirements can apply directly to an ‘APRA covered entity’, which includes entities such as an ADI (including a foreign ADI), a general insurer, a life company and a registrable superannuation entity. These margining requirements can also apply indirectly to a ‘covered counterparty’ if the covered counterparty is trading with an APRA covered entity directly subject to CPS 226. An entity will be a ‘covered counterparty’ if it is a ‘financial institution’, subject to certain exclusions. CPS 226 in turn defines ‘financial institution’ fairly broadly, which may include entities such as hedge funds, trading firms and foreign deposit-taking institutions.

Please see question 24 for more on exchange-traded equity derivatives.

Liability and enforcement

What is the territorial scope of the laws and regulations governing listed, cleared and uncleared equity derivatives transactions?

In respect of derivatives transaction reporting, the ASIC Derivative Transaction Rules (Reporting) 2013 apply to reporting entities, which may in practice be domestic or foreign. However, in practice the obligations would apply only to a foreign entity to the extent it had brought itself within the scope of the Australian regulation by obtaining an Australian licence, authorisation or exemption (or that it had registered or provisionally registered as a swap dealer with the US Commodity Futures Trading Commission in accordance with the Commodity Exchange Act 1936 (US)).

What registration or authorisation requirements apply to market participants that deal or invest in equity derivatives, and what are the implications of registration?

An entity that deals in equity derivatives on behalf of Australian clients will generally be required to either obtain an Australian financial services licence or rely on a relevant exemption.

In respect of exchange-traded derivatives, becoming a participant of the ASX or ASX 24 markets will result in an entity becoming subject to extensive regulation by the relevant market operators and ASIC.

See question 24 in respect of OTC derivatives and the scope of reporting requirements.

What reporting requirements apply to market participants that deal or invest in equity derivatives?

As noted in question 3, Australia has a derivatives transaction reporting regime that gives effect to G20 commitments made in 2009. The regime imposes reporting obligations on entities referred to in question 26.

ASX and ASX 24 participants are also subject to various reporting obligations.

What legal issues arise in the design and issuance of structured products linked to an unaffiliated third party’s shares or to a basket or index of third-party shares? What additional disclosure and other legal issues arise if the structured product is linked to a proprietary index?

The characterisation of the structured product and whether or not it is being offered to retail investors will determine whether, and if so, what type of disclosure document is required (eg, a prospectus or product disclosure statement). If a disclosure document is required, the content requirements are prescribed by the Corporations Act, but if, for instance, the product is also a warrant there will be additional disclosure requirements under the warrant rules. If the product is offered only to wholesale, there are no disclosure requirements prescribed by the Corporations Act and disclosure tends to be more limited. In this context the disclosure must not be misleading or deceptive.

Structured products that are linked to other indices (proprietary or otherwise) may give rise to certain intellectual property considerations in relation to the use of those indices.

Describe the liability regime related to the issuance of structured products.

The issuance of structured products in Australia must be made under a disclosure document in compliance with the Corporations Act. The Corporations Act also contains a liability regime for the issue of structured products under a disclosure document where the issue of the disclosure document or the disclosure document itself is misleading or deceptive or the disclosure document is defective.

A investor who invests in a structured product under a disclosure document and suffers loss because of a defective disclosure document, or misleading or deceptive conduct, may recover the amount of the loss or damage from any person involved in the contravention. In certain circumstances, such conduct may constitute an offence under the Corporations Act punishable by imprisonment or a large fine.

What registration, disclosure, tax and other legal issues arise when an issuer sells a security that is convertible for shares of the same issuer?

Unless the issue is being made to sophisticated or professional investors, the issue of securities that are convertible into shares of the issuer will ordinarily require a prospectus or other disclosure document to be prepared under Chapter 6D of the Corporations Act, lodged with ASIC and the ASX and provided to the persons to whom the offers to issue the securities are made.

Such a disclosure document may also be required for secondary sales of such securities, if a prospectus was not prepared at the time of their initial issue, the securities were not quoted and the secondary sale takes place within 12 months of their issue.

There is no requirement for the convertible security to be registered; however, if the security is intended to be tradeable on the ASX, it will need to comply with the ASX listing rules and the terms of the security will be reviewed by the ASX.

The main tax issue with a convertible instrument is typically whether the instrument is characterised as a debt interest or an equity interest for Australian tax purposes (see question 12). This will depend on the terms of the instrument, although notes that are mandatorily convertible or are convertible at the option of the issuer would normally be equity interests while notes that are convertible at the option of the holder would normally be debt interests. However, specific advice should be obtained to confirm the correct characterisation from an Australian tax perspective.

From the holder’s perspective, the conversion of a convertible interest into shares of the issuer may give rise to an immediately taxable gain or may be disregarded (that is, any gain or loss on the conversion is not immediately recognised but is deferred until realisation of the shares into which the instrument is converted). Whether the gain is immediately taxable or is disregarded depends on the terms of the instrument and whether the instrument is characterised as a ‘traditional security’ for tax purposes (broadly, a debt security issued without a significant discount). Where the gain is taxable, it is generally taxable as income (and not capital gain).

From an Australian GST perspective, the sale and conversion of the security will usually be an input taxed (exempt) financial supply. This means that no GST will be payable on the supply but the issuer and the holder may not be entitled to claim full input tax credits for any GST incurred on costs associated with the supply (eg, legal fees, accounting fees, etc). Certain acquisitions may qualify for a reduced input tax credit of 75 per cent or 55 per cent of the GST amount.

The issue of convertible notes or conversion of a convertible interest into shares of the issuer can potentially give rise to Australian landholder stamp duty. This will depend on a number of factors, including whether the issuer is a listed entity or an unlisted entity, whether the issuer holds, directly or indirectly, any interests in land in any state or territory of Australia with a market value exceeding certain thresholds, and the proportionate interest in the issuer (together with that of any associates, or as part of an associated transaction) that the holder (together with associates) acquires upon conversion. For example, if the issuer is an entity listed on the ASX or other recognised exchange, a liability to landholder duty generally does not arise unless the holder’s convertible interest in the issuer amounts to an entitlement on a notional winding up of the issuer to property of the issuer representing an interest of 90 per cent or more.

What registration, disclosure, tax and other legal issues arise when an issuer sells a security that is exchangeable for shares of a third party? Does it matter whether the third party is an affiliate of the issuer?

See question 31. Broadly similar legal considerations apply to exchangeable securities and to convertible securities.

The main tax, GST and stamp duty issues with an exchangeable instrument are broadly the same as those that arise for a convertible instrument, as summarised in question 31.

Update and trends

Are there any current developments or emerging trends that should be noted?

See question 14 where we note that, at the time of writing (May 2019), the Takeovers Panel is considering broadening its policy in respect of disclosure of long positions over a listed company’s shares exceeding a notional 5 per cent. The proposed new policy is that all long positions should be disclosed regardless of whether or not there is an announced control transaction or a potential control transaction.