Upcoming Mallesons seminarsHedge funds, investors, traders, fund managers generally, issuers of securities, issuers of CFDs, and other issuers and users of equity derivative instruments.
What do you need to do?Consider the necessity for an enhanced disclosure framework for equity derivatives and whether to make a submission by Friday 31 July 2009.
Damien Richard
Partner
Mark McFarlane
Partner
Michael Hung
Solicitor
Mark McFarlane
Partner
T +61 2 9296 2478
Damien Richard
Partner
T +61 2 9296 2296
The Federal Treasury has released an issues paper as part of the Government’s assessment of the existing ownership disclosure framework in light of the growing usage of both long and short equity derivative positions in the Australian financial markets. Any reforms which follow may have a significant impact on the Corporations Act substantial holding disclosure requirements as they apply to fund managers and others who enter into equity derivatives.
Since 2008, there has been market concern that the lack of an appropriate disclosure framework covering equity derivatives has:
- reduced transparency of ownership changes and takeover moves
- reduced the ability of companies to know who their effective owners are, and
- enabled hedge funds to outflank traditional institutional investors by using economic interests to influence companies.
The Government’s proposed assessment aims to close any gaps in the law that permit holders of equity derivatives to circumvent the disclosure of substantial holdings provisions in the Corporations Act. It also raises whether equity derivatives are adequately dealt with in the contexts of takeovers, tracing notices and directors acquiring or disposing of their interests.
The issues paper builds on Takeovers Panel Guidance Note 20 Equity Derivatives released in 2008. The Guidance Note requires market disclosure of all long equity derivative positions in the context of a ‘control transaction’ where the positions exceed five per cent of the underlying securities, alone or in combination with physical holdings (see our previous alert). It is also reflective of offshore developments, particularly the UK Financial Services Authority disclosure rules relating to contracts for difference (CFDs).
What are equity derivatives?
Equity derivatives are financial contracts whose value is derived from the underlying assets, which includes shares in companies, managed investment schemes or share indices. They are commonly acquired to manage risks associated with share trading or ownership, or are employed in speculative trading strategies. Equity derivatives broadly include instruments such as options, futures, forwards, CFDs, equity swaps and warrants. They include both over-the-counter (OTC) instruments and exchange-traded instruments, and those that are cash-settled and physically-settled. Index-linked derivatives and convertible notes are proposed to be excluded from the Government’s assessment.
The issues paper focuses on cash settled equity derivatives.
Disclosing substantial holdings
The Corporations Act requires investors with substantial holdings in listed companies and managed investment schemes to disclose their interests. ‘Substantial holding’ is defined as a relevant interest held by the person and its associates in securities representing at least five per cent of the total number of votes in a company or scheme. At present, cash settled equity derivatives generally do not provide a ‘relevant interest’ and are therefore not required to be disclosed under the substantial holding provisions. Cash settled derivatives typically grant an economic interest in the underlying securities, but do not provide voting rights or control over disposal of the underlying securities.
The issues paper questions whether this treatment of equity derivatives is appropriate on the basis that the derivative holder can have a significant degree of practical control over the underlying securities, because the issuer of the derivative typically takes a physical interest in the underlying securities to hedge its risk. In these circumstances it is suggested that:
- there is nothing preventing the derivative issuer from eventually selling the physical holding to the derivative holder at maturity
- the fact that the issuer buys the underlying securities as a hedge can have significant effects on the market in itself, and
- the derivative holder may also influence the voter in the exercise of voting rights attached to the underlying securities.
It is therefore suggested that non-disclosure can challenge the fairness and transparency of the market.
Further, the paper suggests that the use of equity derivatives may potentially allow the disclosure of substantial holdings provisions to be circumvented because they allow voting rights and economic benefits of holding securities to be separated. In long equity derivative contracts, it is said that the derivative holder, despite not holding voting rights, has real and effective control over the economic interests of the underlying shares; conversely, a short derivative position may lead to an ‘empty voting’ situation where the derivative holder is, through a physical holding, able to exercise voting rights despite holding a reduced or zero economic interest. The Government will consider whether disclosure should be made on the basis of economic interests, voting rights or the both together.
Other disclosure requirements
In the broader context, the Government proposes to consider equity derivatives in the context of a range of issues beyond substantial holdings:
- takeovers and within the market for corporate control - whether equity derivatives effectively allow a stake of greater than 20 per cent to be acquired without the same restrictions that apply to direct stakes
- tracing notices to detect ‘effective’ owners, and
- the need for director disclosure of equity derivative positions referenced to the relevant company’s securities.
Submissions
The Government is inviting submissions (including factual input) on the issues raised in the paper from all stakeholders, including investors, traders, issuers of securities, issuers of equity derivative instruments, industry groups, brokers and banks. All submissions are due on Friday 31 July 2009.
The issues paper can be accessed here.