On July 14, 2008, family-owned conglomerate Schaeffler KG announced its voluntary takeover offer for Continental AG, a German DAX 30 company, at an offer price of EUR 70.12 per share. With targeted annual sales of more than EUR 26.4 billion in 2008, Continental is one of the top automotive suppliers worldwide.
When its bid was announced, Schaeffler already held 2.97 percent of Continental’s shares and another 4.95 percent in physically settled call options. In addition, Schaeffler had entered into cash-settled equity swaps with an investment bank backed by other investment banks for approximately 28 percent of Continental’s shares. These cash-settled equity swaps could be terminated by Schaeffler at any time, in particular during the acceptance period of the tender offer. In general, the risks under the swap agreement are hedged by entering into corresponding hedging positions (i.e., either by the counter party purchasing shares by itself or by entering into derivative contracts with third parties). After the swap agreement was terminated, the investment bank was obliged to dissolve the position in Continental shares in a commercially reasonable manner (including the acceptance of the tender offer by Schaeffler).
Continental’s CEO rejected Schaeffler’s unsolicited bid in unusually harsh words, alleging that Schaeffler had, with the help of banks and derivative positions, “secured access to 36% of Continental’s shares in an unlawful manner” in contravention of reporting and notification requirements. Continental characterized the methods used by Schaeffler, namely the entering into swap agreements, as a clear infringement of the reporting and notification provisions of the German Securities Trading Act (Wertpapierhandelsgesetz) and Securities Acquisition and Takeover Act (Wertpapiererwerbs und Übernahmegesetz). Continental demanded that the Federal Financial Supervisory Authority (Bundesanstalt für Finanzdienstleistungsaufsicht, or BaFin) take measures to redress this situation.
Schaeffler responded that its takeover strategy fully complied with the law. Germany’s BaFin decided to launch a probe and, after consideration, concluded that Schaeffler did not violate its reporting and notification obligations.
This incident sparked an intense public debate in Germany regarding the use of cash-settled equity derivatives and similar financial instruments to build up stakes prior to a takeover bid without notifying BaFin and the issuer. Similar takeover approaches are being discussed and evaluated in other European countries.
The legal treatment for Schaeffler’s first two positions (i.e., 2.97 percent of Continental’s shares and another 4.95 percent in physically settled call options) is as follows: The German Securities Trading Act requires any party that acquires 3 percent or more of the voting rights of a German issuer to notify the issuer company and BaFin within four trading days. Notification must also be made when a party holds other financial instruments that give it the right to acquire at least 5 percent of the voting rights. The term “financial instrument” is broadly defined and includes physically settled equity derivatives. At the time when Schaeffler announced its takeover offer, shares and financial instruments triggered separate reporting requirements. Thus, with both positions falling below the reporting requirement, Schaeffler did not trigger any notification obligation. However, the new Risk Limitation Act (Risikobegrenzungsgesetz), which came into effect on August 19, 2008, closed this loophole. Under the new law, if a party holds a stake in a German issuer consisting of both shares and financial instruments, all voting rights arising out of both positions are to be aggregated. This new aggregation rule is intended to make it more difficult to acquire a significant position without triggering the notification requirements.
Even so, the cornerstone of Schaeffler’s strategy was its use of cash-settled equity swaps. Cash-settled equity swaps are contracts referenced to an underlying bundle of shares pursuant to which the investor gives or receives cash payments from the swap counterparty equal to the decrease or increase in the underlying share price and dividend payments between the date of the agreement and maturity of the swap. In return, the investor agrees to pay a fixed return by way of a financing charge. Generally, the swap counterparty will hedge its position by acquiring the underlying shares. In this case, Schaeffler entered into swap agreements with the investment bank, backed by a number of other investment banks, the majority of which held 2.999 percent each of the underlying Continental shares in order to avoid the banks’ own notification requirements. Schaeffler stated in its offer document that it was not legally entitled to purchase the underlying shares, but it had the right to terminate the swaps at any time. After such a termination of the swaps, the banks would be obliged to dissolve the position in Continental shares in a commercially reasonable manner, including the tender of the underlying shares into the tender offer.
The conclusion and/or dissolution of cash-settled equity swaps does not trigger disclosure obligations under the German Securities Trading Act. Financial instruments only result in a disclosure obligation if they “entitle the bearer to acquire, on one’s own initiative alone and under a legally binding agreement, shares in an issuer.” Thus, Schaeffler did not have to disclose its cash-settled equity swaps.
More difficult to answer is the question of whether the voting rights attached to the shares underlying such swaps had to be attributed to Schaeffler under the German Securities Trading Act and the German Takeover Act. Shares held by a third party are attributed if they are held “for the account of the bidder.” This rule requires that the bidder (i) bears the economic risks and benefits of the shares, and (ii) is able—at least on a de facto and limited basis—to instruct the third party how to exercise the voting rights of such shares.
It is unclear in this case whether the first condition was satisfied, since the banks were using the shares to hedge their own risk resulting from the swaps. However, since the swaps mirrored the performance of Continental’s shares, there may be support to look through the banks to Schaeffler. And the second condition is even harder to determine whether or not it is satisfied in this case. Did the swaps really confer such a de facto influence to Schaeffler?
Supporters of Continental’s view argue that Schaeffler did have voting control over the shares pursuant to Article 10(g) of the EU Transparency Directive, on which the attribution rule in the German Securities Act is based, and take the position that a narrow reading of the attribution rule will make circumventions easier. Acknowledging that Schaeffler did not legally control the voting of any underlying shares, Schaeffler’s termination rights did, however, increase its ability to buy the Continental shares from the investment banks on termination of the swaps. In addition, the swaps may have created a situation in which the participating investment banks were inclined to follow Schaeffler’s instructions. Moreover, most swap agreements contain provisions under which the banks are excluded from exercising the voting rights resulting from the underlying shares.
Nevertheless, despite its critics, Schaeffler’s takeover strategy in using cash-settled options was viewed as legitimate. The German Finance Minister has also made it clear that there will be no “Lex Conti”—the fact that Schaeffler’s “creeping takeover” of Continental will not trigger new legislation, in addition to the recently adopted Risk Limitation Act.
In fact, a similar takeover strategy was used by Porsche in its “creeping takeover” of Volkswagen. It remains to be seen whether creeping takeovers using swap transactions will occur more frequently in the future. Since BaFin has confirmed that Schaeffler’s strategy was legitimate, we will most likely see similar approaches in hostile takeover situations, in particular where a bidder would like to avoid its intention being revealed by mandatory disclosures under the German Securities Trading Act, which might lead to higher share prices in anticipation of the takeover offer. Although the Risk Limitation Act has made it more complicated to build up secretive stakes, using this strategy still might save a lot of money for flexible bidders.