DISCLOSURE OF CONTRACTS FOR DIFFERENCES

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1 DISCLOSURE OF CONTRACTS FOR DIFFERENCES The United Kingdom Financial Services Authority ("FSA") has recently announced that its regime for disclosure of major shareholdings will be expanded to include contracts for differences ("CfDs"). The changes to the disclosure rules are intended to bring CfD positions in shares of UK companies listed on a UK recognised investment exchange (i.e. Main Market, AIM or PLUS) under the general major shareholder notification regime set out in Chapter 5 of the Disclosure and Transparency Rules. The proposed disclosure requirements for CfDs are expected to be finalised in February 2009 and come into effect in September This article examines these requirements and the rationale for them and also considers recent developments in this area in the United States, France and Germany. What is a Contract for Difference? A CfD in respect of a share is a derivative product that gives the parties to the CfD economic exposure to price movements in the underlying referenced shares. The parties to a CfD comprise a party, usually an investment bank, writing the contract (the "CfD writer") and an investor (the "CfD holder"). A CfD will usually not have a specified time period, and will be settled, in cash, on demand by the CfD holder. The CfD holder does not have a right to acquire the referenced shares, or benefit from any ownership rights, such as voting rights, in the underlying shares and therefore only has an economic interest in the share. If the CfD holder holds a long position in the referenced shares, on "closing-out" the CfD, the CfD holder will be entitled to payment from the CfD writer if the price of the referenced shares has gone up, and the CfD writer will be entitled to payment from the CfD holder if the price of the referenced shares has gone down. The CfD writer, as the counter party to the contract, will therefore hold a short position in the referenced shares. In order to cover any potential payment obligations under the contract, the CfD writer may hedge its position either by entering into a long CfD position or by acquiring a corresponding amount of the underlying shares in the market. In practice, there is the possibility that the CfD will be settled by the actual physical delivery of the shares rather than in cash, in which case the CfD holder will acquire full ownership rights in the shares, including any voting rights attached to them. Under the current major shareholder notification regime, the CfD holder is not required to disclose its position during the life of the contract. This allows CfD holders to build stakes through CfDs anonymously. There are a number of reasons for entering into a CfD in addition to the ability to build a stake in a company without disclosure, including: Leverage: A CfD holder will be required to pay an initial margin payment of only 5% to 10% of the value of the shares referenced in the CfD, which allows the CfD holder to gain economic exposure to price movements in the referenced shares at a fraction of the cost of acquiring the shares themselves. Stamp duty: No stamp duty is payable by the CfD holder when it enters into the contract and, where hedging is conducted by a CfD writer which is a "recognised intermediary", the hedging activity is also likely to be exempt from stamp duty. The pursuit of short/long trading strategies: CfDs can be written with the investor going short (i.e., benefiting from a fall in the price of the referenced share) in the 1

2 same way as it would by short selling the shares themselves, but without the corresponding obligation to deliver the shares to the counter party. Consequently, CfDs serve as an efficient way to pursue long/short trading strategies. In the United Kingdom the proposed changes to the disclosure rules are intended to bring CfD positions in shares of UK companies listed on the Main Market, AIM or PLUS under the general major shareholder notification regime set out in Chapter 5 of the Disclosure and Transparency Rules (the "DTR"). The proposed disclosure requirements, explained below, refer to gross long CfD positions. This means that in determining whether the disclosure thresholds have been triggered, the CfD holder must disregard any short positions held in the referenced shares. Why are long CfD positions being brought under the UK major shareholder notification regime? The FSA argues that there are certain 'market failures' which would be addressed by bringing long CfDs within the disclosure regime. The major shareholder notification regime is designed to focus on corporate ownership and voting rights. A CfD holder will not have a right to receive shares on closing out the contract and will not be entitled to direct the writer to vote any shares it holds as a hedge in accordance with the holder's instructions. Whilst CfDs are not a substitute for direct share ownership, the FSA concludes that in certain circumstances they can be used in ways "the intention of which the regulatory regime is designed to catch". Specifically, a survey of market participants found that CfDs are sometimes used by CfD holders to seek to influence voting and other corporate governance matters on an undisclosed basis. Also, the FSA has followed a number of recently reported cases where CfDs have been used to build up significant stakes in companies without prior disclosure. Under the UK Takeover Code, CfDs become disclosable during a takeover "offer period". The inclusion of CfDs in the major shareholder notification regime would also complement the Takeover Code requirements. What are the current disclosure requirements under the UK major shareholder notification regime? The United Kingdom major shareholder notification regime is set out in Chapter 5 of the DTR. DTR 5 applies to the shares of issuers if their home member state is the UK and such shares are admitted to the London Stock Exchange's Main Market, and the shares of UK-incorporated AIM and PLUS companies. For issuers from any other EEA member state, the rules governing major shareholder notifications in that state will be relevant (see below in relation to France and Germany). The UK regime currently requires any direct or indirect holding of 3% or more of the voting rights and every 1% change thereafter to be disclosed. Under DTR 5.3.1, any financial instrument which provides a party with a right to acquire shares is also subject to the disclosure regime as a 'qualifying financial instrument'. The DTR do not currently make any provision for the disclosure of a purely economic interest in shares. Therefore, a CfD would only fall within the current regime if it contains a contractual right to take delivery of the underlying shares and the relevant thresholds are crossed. What are the proposed amendments? The FSA has decided that CfDs should be brought into the scope of the current UK major shareholder notification regime, rather than being subject of a separate regime. 2

3 The amendments will apply in respect of UKincorporated companies whose shares are admitted to the Main Market, AIM or PLUS. Overseas companies whose shares are admitted to the Main Market, AIM or PLUS will therefore not be subject to the CfD disclosure requirements, but non-eea companies whose shares are admitted to the Main Market will continue to be subject to the major shareholder notification regime apart from these requirements. The proposed amendments include a change in the definition of 'qualifying financial instruments' for the purposes of DTR to include financial instruments which have a "similar economic effect to qualifying financial instruments" DTR 5.3.1(1)(b)(ii). A long CfD position gives the holder an economic interest in the underlying shares and so will be caught under the new disclosure regime. This definition will include any derivative instrument that has a 'similar economic effect' and should not be read as applying exclusively to long CfD positions. For example, cash settled options, total return swaps and other similar instruments will be covered by the regime. Under the amended regime, any long CfD positions (and long positions held through other similar derivatives) must be aggregated with any existing actual shareholdings for the purposes of assessing whether the relevant disclosure threshold has been reached. It is expected that an exemption will exist for CfD writers which act as intermediaries and are simply providing liquidity under a CfD. For example, an investment bank that writes a long CfD and hedges his payment obligations by acquiring the underlying shares in the market will not be required to make a disclosure under the DTR provided that the position is only held on the books for the purposes of providing liquidity and the voting rights or any other ownership rights are not exercised. The proposed amendments to the disclosure rules should be finalised in February 2009 and are expected to come into force in September What are the disclosures requirements for CfDs in other jurisdictions? United States Historically, absent special circumstances, CfDs (or cash-settled total return swaps) that are exclusively cash-settled are not required to be disclosed in the United States by a passive CfD holder. 2 The United States major shareholder notification regime, which is governed by the Securities Exchange Act of 1934 (the "Exchange Act"), focuses on "beneficial owners" of shares, and the disclosure rules do not currently deem a CfD holder to "beneficially own" the referenced shares, subject to certain exceptions. 3 However, the issue of whether a CfD holder "beneficially owns" the referenced shares underlying a CfD have been challenged in a recent federal court case. 4 As a result, the United States Securities and Exchange Commission (the "SEC") has announced that it is reviewing the rules and likely will propose changes to the definition of "beneficial 1 The full text of the consultation paper and the amended regulations can be found at 2 Special circumstances include situations where the CfD holder (in its own capacity or together with other collaborating shareholders) is already subject to the Schedule 13D disclosure regime in respect of the referenced shares or the CfD holder intends to use the CfD to influence the voting or corporate policies of the referenced shares' issuer. 3 Pursuant to Section 13(d) of the Exchange Act, a person is deemed to beneficially own a security if that person has or shares voting and/or investment power with respect to the security, including if the person has the right to acquire beneficial ownership of the security within 60 days, such as through the exercise of an option, warrant, right or through the conversion of another security. 4 CSX Corporation v. The Children's Investment Fund Management (UK) LLP, et al., 562 F. Supp. 2d 511 (S.D.N.Y. 2008); affirmed by 2008 U.S. App. LEXIS (2nd Cir. N.Y. Sept. 15, 2008). 3

4 ownership" in 2009 to include a CfD holder's interest in the referenced shares underlying its CfDs. If such a rule change were to be adopted, CfD holders would be required to file a Schedule 13D with the SEC (which is a publicly available electronic disclosure) when the total amount of the CfD holder's interests in the referenced securities (including direct holdings, holdings by affiliated parties, holdings by other members of a "group" (as defined in the Exchange Act rules) or interests attributable through CfDs) exceeds 5% of the issuing company's outstanding shares. 5 The disclosure requirement applies to the registered securities of U.S. public companies (i.e., companies that are subject to the periodic reporting requirements of the Exchange Act). Due to the current uncertainty of the disclosure regime, most CfD holders whose interests in a U.S. public company's securities (including through CfDs) exceeds 5% elect to disclose their ownership by filing a Schedule 13D as soon as they cross the 5% threshold. Europe The major shareholder notification requirements were substantively harmonised across Europe in early 2007 when most member states adopted the Transparency Directive 6. Under the Transparency Directive, member states are required to ensure that, where a shareholder directly or indirectly acquires or disposes of shares of a company whose shares are admitted to trading on an EEA 5 Once a Schedule 13D has been filed, the filer must promptly amend it to reflect any material changes in respect of the filer's interest in the referenced shares, including any greater than 1% change in its holdings, amendments to its CfDs, or the entry into new CfDs. See Commission Guidance on the Application of Certain Provisions of the Securities Act of 1933, the Securities Exchange Act of 1934, and Rules Thereunder to Trading in Securities Futures Products, Exchange Act Release No. 46,101, at Question 20 (June 21, 2002) d)); accord. Section 3A(b)(1) of the Exchange Act (excluding security-based swap agreements from the definition of "security"). 6 Directive 2004/109/EC. regulated market, and such shareholding exceeds or falls below certain prescribed thresholds, the shareholder will be required to notify to the issuer the proportion of voting rights that it holds. The Transparency Directive imposes minimum standards which must be incorporated into national law by members states. By focusing holdings of voting rights, CfDs are not covered in the major shareholder notification regime in the Transparency Directive and, to the extent that they wish to bring CfDs within the scope of their national regimes, member states will have to impose more stringent national requirements. The disclosure regimes for CfDs and other derivatives differs in each member state. Below is a brief outline of the current regimes in France and Germany. France The current French major shareholder notification regime requires any acquisition or disposal of shares resulting in the shareholder holding or ceasing to hold the requisite thresholds of voting rights (i.e., 5%, 10%, 15%, 20%, 25%, 33%, 66%, 90% and 95%) to be notified. In addition, on obtaining a holding of 10% or 20%, a holder is required to issue a statement of intent with respect to its holding over the next twelve months. The French securities regulatory authority, Autorité des marches financiers, has recently published proposals with respect to the notification of major shareholdings. The proposals recommend that, in line with the UK approach outlined above, equity swaps, CfDs and similar instruments should be aggregated with any other holding for notification purposes. It is likely that the proposals will be adopted into French law in early Germany The German major shareholder notification regime is set out in the German Securities Trading Act 4

5 (Wertpapierhandelsgesetz "WpHG"). Any acquisition or disposal of shares resulting in the shareholder holding or ceasing to hold the requisite thresholds of voting rights (3%, 5%, 10%, 15%, 20%, 25%, 30%, 50% and 75%) must be notified. In addition, the WpHG also provides for the disclosure of positions held as a result of certain financial instruments, provided such instruments entitle the owner to acquire already issued shares with voting rights. Cash-settled derivative instruments, such as CfDs, are therefore not taken into account when calculating the holdings of voting rights. 7 No proposed changes to the major shareholder notification regime have been announced by the German authorities even in the light of the fall-out from Porsche's use of cash-settled options in building a 74.1% stake in Volkswagen. Those transactions are, however, being scrutinised under the German market abuse rules. Conclusion CfDs and similar derivative instruments have drawn the attention of securities regulators in a number of jurisdictions. In Europe, even though the Transparency Directive has provided harmonised minimum requirements, CfDs are excluded from those requirements and individual member states will need to take specific legislative steps if they are to impose more stringent national requirements to provide for the disclosure of CfDs. 7 This position was recently confirmed by the German securities regulatory authority, BaFin, in the takeover of Continental AG by Schaeffler KG in 2008 ( 08/pm conti.html). 5