This update looks at the equity derivative used by DEXUS Funds Management (in its capacity as responsible entity of DEXUS Office Trust) (DEXUS) to secure a 14.9% stake in Commonwealth Property Office Fund (CPOF), and the dispute that arose in relation to the disclosure of hedging arrangements put in place by DEXUS. (1) Other recent examples of equity derivatives in action are Crown’s acquisition of an initial stake in Echo Entertainment Group (2012), Archer Daniels Midland Company’s acquisition of a pre-bid stake in GrainCorp (2012), and Air New Zealand’s “creep” up the register of Virgin Australia (2013).
STRUCTURE AND KEY COMMERCIAL TERMS
The equity derivative was structured as a forward contract and was written by Deutsche Bank (DB).
Set out below are the key commercial terms of the forward contract.
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Concurrently with execution of the forward contract, DEXUS entered into a zero-cost cash-settled collar over 350,000,000 units in CPOF (being equal to the number of sale units under the forward contract). The purpose of the collar was to hedge DEXUS’ exposure under the forward contract; it limits both the upside and the downside of the returns. Like the forward contract, it was written by DB.
In summary, the collar works as follows: if the VWAP of CPOF units over an agreed (and undisclosed) period is higher than $1.20 then DEXUS will pay DB the difference per unit; if the VWAP of CPOF units over that period is less than $1.02 then DB will pay DEXUS the difference per unit. Both the “ceiling” price and the “floor” price are subject to standard adjustments (e.g. for dividend payments by CPOF).
The collar has a 12 month term but can be terminated earlier in certain (undisclosed) circumstances whereas the forward contract has a term of 18 months but can be physically settled earlier at the election of DEXUS. We expect that the collar and the forward contract would be settled on the same date.
DISCLOSURE BY DEXUS AND LITIGATION BY THE CPOF RE
On the same day as entering into the forward contract and collar, DEXUS lodged a substantial holding notice which attached the full terms of the forward contract. It did not, however, attach or summarise the terms of the collar, but rather only included a brief reference to its existence.
The responsible entity of CPOF (CPOF RE) commenced proceedings in the Federal Court against DEXUS alleging that DEXUS failed to comply with relevant legal requirements by not disclosing the terms of the collar. DEXUS responded by releasing an announcement saying that it did not believe it had any legal obligation to disclose these terms.
Following discussions with the CPOF RE, DEXUS agreed to release a summary of the terms of the collar (on a without prejudice basis) and the CPOF RE agreed to discontinue the Federal Court proceedings.
It is interesting that the CPOF RE decided to go to the courts rather than the Takeovers Panel with its complaint about the disclosure made by DEXUS. The Federal Court would have been focused on the relevant provisions of the Corporations Act, which require disclosure of all written agreements contributing to the acquisition of a substantial holding. So we expect the relevant question before the Federal Court would have been whether the collar contributed to DEXUS acquiring a substantial holding in CPOF, or, alternatively, whether the forward contract was the only relevant agreement in this respect. The Takeovers Panel has its own guidance on disclosure of equity derivatives (Guidance Note 20), and whilst that guidance does not lend obvious support to the proposition that DEXUS should have disclosed the terms of the collar, the Takeovers Panel would be less constrained by the letter of law and so may have had more flexibility to reach the conclusion that disclosure should have been made.
In its initial substantial holding notice, DEXUS did not concede that it had a relevant interest in the 350,000,000 sale units under the forward contract, on the basis that it did not know whether DB held an interest in all or any of those units. Technically, DEXUS only has a relevant interest in those CPOF units in which DB has a relevant interest (up to 14.9%), so if DB did not hold an interest in 5% or more of the sale units (being the relevant threshold for disclosure of substantial holdings) then DEXUS would not have been required to lodge a substantial holding notice at that time.
Five days after DEXUS lodged a substantial holding notice, DB did the same, disclosing a relevant interest in 9.3% of the CPOF units, acquired pursuant to a number of securities lending agreements during the period from 26 March 2013 to 25 July 2013. Since then, DB has lodged three further substantial holding notices in respect of increases in voting power to 11.1%, 12.1% and 13.29% respectively, and DEXUS has made ‘technical filings’ reflecting that it shares the same voting power as DB by virtue of having a relevant interest in the CPOF units in which DB has a relevant interest (up to 14.9%).
It is common (and advisable) for the writer of an equity derivative not to disclose to the taker details of any physical stake it has acquired or intends to acquire for the purpose of performing, or hedging its position under, the derivative contract. A key reason for this is to manage the risk of the writer and the taker becoming associates, which can have unwelcome consequences such as requiring disclosure of the association and causing an aggregation of the writer’s and the taker’s interests for the purpose of determining their voting power.
Despite the cautiousness of some market participants when it comes to equity derivatives, they continue to be used as a means to acquire or increase control. However it remains true that care needs to be taken when using them as there are a range of legal/policy issues that require consideration, including relating to disclosure, insider trading and “control” implications.
If acquiring a physical stake is the desired outcome, then forward contracts can provide an increased level of certainty as compared to cash-settled equity swaps, not involving the same potentially complex unwinding process. The structure will ultimately be driven by strategic considerations having regard to disclosure obligations and the broader commercial objective, as well as market factors such as liquidity of the stock.
A collar can be used to further hedge price risk. Failure to adequately disclose hedging arrangements put in place in connection with an equity derivative may result in criticism (and even litigation).