The Takeovers Panel is seeking input on whether holders of long equity derivative positions in listed companies should be required to disclose those interests.
Investment banks writing equity derivatives, their clients, and market participants generally, should take note. Submissions on the Panel’s proposals are due by 5 October 2012.
The Panel is concerned that, under current law, a person may, in effect, accumulate undisclosed equity positions in listed companies through the use of equity derivatives, particularly in the period leading up to a takeover offer.
What are equity derivatives?
Equity derivatives (common types of which include futures, options or swaps) are synthetic contractual instruments which enable a party to gain economic exposure to price movements in a given security, without the need for that party to actually hold the underlying security.
Long equity derivatives (in which the client “purchasing” the derivative will benefit from an increase in the price of the underlying security) incentivise the investment bank that is typically on the other side of the derivative to hedge its exposure. Banks typically will do this by purchasing, at the time the derivative is entered into, a sufficient number of the underlying securities such that, if the price of the underlying security increases during the term of the derivative, the bank will be able to offset its loss on the derivative by selling its holdings in the underlying security for a corresponding gain.
In practice the securities held by the investment bank as a hedge are often available to be purchased by the derivative counterparty when the derivative is unwound (cash-settled), as the counterparty is often the natural buyer.
This raises the concern that equity derivatives can be used as a method of warehousing an undisclosed position in a listed company, given that the underlying physical securities held as a hedge will in all likelihood be available for purchase at the counterparty’s option.
Long equity derivatives are not currently disclosable
The Court of Appeal’s 2004 decision in Ithaca (Custodians) Limited v Perry Corporation, which involved an undisclosed long equity derivative position in Rubicon, established that the present substantial security holder disclosure regime does not require the disclosure of long equity derivative positions, per se.
The Court found that the likelihood that the underlying securities held as a hedge would be available to be purchased by the derivative counterparty was simply a market reality, which in the absence of any actual agreement or understanding between the parties to the derivative was not enough to create a relevant interest. There being no relevant interest, disclosure was not required.
The Panel’s proposals
The Panel’s preferred option is to change the securities disclosure regime to include a requirement for the ongoing disclosure of long equity derivative positions, in much the same way as relevant interests must now be disclosed under the substantial security holder regime.
If adopted by the Government, this would likely be implemented through supplementary amendments to the Financial Markets Conduct Bill now before Parliament, after the Bill has been reported from the Commerce Select Committee (currently scheduled for 7 September).
Long derivative positions would be aggregated with relevant interests held in the issuer’s securities. To take an example - a direct holding in 4% of an issuer’s ordinary shares, and a long derivative position in an additional 2% of those shares, neither of which would meet the 5% disclosure threshold by itself, would be aggregated, resulting in a combined holding of 6% that would need to be disclosed.
These new disclosure requirements would apply to all persons at all times and not merely in circumstances relating to takeovers.
Two other options presented in the consultation paper for comment, but not favoured by the Panel are:
- do nothing – on the basis that there is little evidence equity derivatives are having a negative effect on the New Zealand takeovers market, or
- amend the Code to provide for the disclosure of long equity derivative positions in takeover offer documents and target company statements.
Chapman Tripp comments
The concerns raised by the Panel are not new. The decision in the Perry case prompted an earlier effort to require the disclosure of equity derivative positions by expanding the relevant interest test to include "market practices", an effort which was abandoned.
The use of equity derivatives in New Zealand does not appear to be widespread. Nor is there clear evidence that equity derivatives have been used by bidders to warehouse shares in advance of a takeover. For this reason one could take the view that the Panel’s resources would be better spent pursuing other, more pressing issues.
On the other hand, an absence of evidence is not evidence of absence. As the Perry case demonstrated, equity derivatives are a feature of the New Zealand capital markets, although to what extent is uncertain. Much of this uncertainty can be attributed to the fact that disclosure is currently not required.
Also, as the law currently stands, a bidder could use equity derivatives to secretly warehouse securities prior to launching a takeover bid – which would be inconsistent with the objectives of the Code and the policy behind requiring the disclosure of substantial holdings in listed companies.
Other jurisdictions, including Australia and the United Kingdom, have recently made changes to their regime to require additional disclosures of equity derivative positions, particularly during a takeover.
For these reasons the Panel’s proposals should at least be considered. The Panel’s efforts in this area could be regarded as good housekeeping. Not all law reform efforts need to be prompted by immediate threats. Indeed, attempting to address potential issues before they become real problems seems to us to be good regulatory practice.