Lex'Talk 12

CASH-SETTLED DERIVATIVES AND TRANSPARENCY OF

CAPITAL MARKETSLex’Talk no. 12, 17 March 2015, Danijel Stanković, LL.M. Finance

TOPICS FOR TODAY

• Takeover early warning system with emphasis on notification duties under the Transparency Directive

• What are (cash-settled) derivatives?

• Secret stake-building and new takeover tactics – 3 case

studies

• 2013 amendment to the Transparency Directive

TAKEOVER EARLY WARNING SYSTEM


• the duty to disclose changes in the shareholdings in public companies above and below certain thresholds

• the duty to submit a takeover bid after reaching a certain threshold (so-called controlling stake) and to publish forthwith a decision to launch a voluntary bid

• the duty to timely disclose the relevant price sensitive information in order to prevent insider dealing, as well as not to distribute any misleading information that would manipulate the market

• aggregation of voting rights held in different positions (shares, derivatives, decoupling of economic ownership)


• Directive 2004/109/EC of the European Parliament and of the Council of 15 December 2004 on the harmonisation of transparency requirements in relation to information about issuers whose securities are admitted to trading on a regulated market and amending Directive 2001/34/EC, OJ 2004 L 390/38

• Directive 2004/25/EC of the European Parliament and of the Council of 21 April 2004 on takeover bids, OJ 2004 L 142/12

• Directive 2003/6 of the European Parliament and of the Council of 28 January 2003 on insider dealing and market manipulation (market abuse), OJ 2003 L 96/16


• General idea: anyone who intends to acquire control in a listed company should make it public as soon as the decision to acquire that control becomes final

• General goal: protection of the target company’s long-term interests, minority shareholders, investors etc.

THE IMPORTANCE OF TAKEOVERS

INVESTORS

REGULATED MARKETS

REGULATOR

SHAREHOLDERS

MANAGEMENT

CAPITAL MARKETSTARGET COMPANY

(ISSUER)

MEMBERSTATES

LOCAL COMMUNITIES

EMPLOYEES

OTHER STAKEHOLDERS


MAJOR ISSUES

• Management entrenchment v shareholder value (market for corporate control – takeovers)

• Short-termism and hedge funds v long-term interests of the target company (who’s hiding behind the hedges?)

• Decoupling of economic and legal ownership from voting rights by means of financial instruments and other practices


OWNERSHIP VOTING RIGHTS ECONOMIC EXPOSURE

MAJOR ISSUES

• Economic ownership: economic returns associated with share, i.e. dividends + appreciation

• Record date system vs. real-time verification of records – who is your shareholder for the purpose of attending and voting at the company’s general meetings?

• e.g. share loans used just to capture the record date


DISCLOSURE OF MAJOR SHAREHOLDINGS

A. If a shareholder acquires or disposes of shares of an issuer whose shares are admitted to trading on a regulated market and to which voting rights are attached (Art 9(1) Transparency Directive)

B. If a natural person or legal entity:• is entitled to acquire, to dispose of or to exercise the voting rights (Art 10),

or• holds, directly or indirectly, financial instruments that result in an

entitlement to acquire, on such holder’s initiative alone, under a formal agreement, shares to which voting rights are attached, already issued, of an issuer whose shares are admitted to trading on a regulated market (Art 13), i.e. physically settled equity-based instruments with in rem effect (mit dinglicher Übertragungs-erklärung, § 22/1 WpHG)


DISCLOSURE OF MAJOR SHAREHOLDINGS

• Thresholds of 5%, 10%, 15%, 20%, 25%, 30% (alternatively: 1/3), 50% and 75% (alternatively: 2/3) of voting rights (Art 9(1),(3))

• Time-limit: not later than 4 trading days and the issuer has to publish such notification within another 3 trading days (Art 12(2),(6))

• Events changing the breakdown of voting rights (e.g. cancellation of treasury shares, Art 9(2))


AGGREGATION OF VOTING RIGHTS

• Acting in concert – agreement to adopt, by concerted exercise of the voting rights, a lasting common policy towards the management of the issuer in question (U.S. group), Art 10(a) – a group of shareholders or investors

• Share loan, Art 10(b) – used for capturing the record date

• Share pledge, Art 10 (c) – who can exercise the voting rights: pledgor or pledgee?

• Life interest on a share, Art 10(d)

• Controlled undertakings, Art 10(e)

• Share deposit, Art 10(f)

• Holding on behalf, Art 10(g) – banks selling cash-settled options while holding the underlying shares as a hedge

• Proxy, Art 10(h) – if it can exercise voting rights at its discretion


EXEMPTIONS

• shares acquired for the sole purpose of clearing and settling within the usual short settlement cycle (max. 3 trading days)

• custodians holding shares in their custodian capacity, if they can exercise voting rights only under written instructions

• acquisition or disposal of a major shareholding reaching or crossing the 5% threshold by a market maker (i.e. up to 10%), if it neither intervenes in the issuer’s management nor exerts any influence on the issuer to buy shares or back their price

• voting rights held in the trading book of a credit institution or investment firm not exceeding 5% - if not exercised or otherwise used to intervene in the issuer’s management

• buy-back programmes and stabilisation of financial instruments (NEW!) - if not exercised or otherwise used to intervene in the issuer’s management


WHAT ARE DERIVATIVES?


• a type of financial instruments the value of which is derived from and depends on the value of an underlying asset

• an agreement between two parties (short party, the seller - long party, the buyer) which is to be performed in future with respect to the underlying asset and under the terms set in advance

• settled either (a) physically/in kind, i.e. by delivery of the underlying asset, e.g. transfer of shares, or (b) in cash


• if settled in cash, any difference in the value between the agreed price of the underlying (strike price or exercise price) and the market value of the underlying on the day of the derivative’s expiration/termination is paid in cash

• hedging of risk, speculation/arbitrage, takeover tactics

• traded either on exchange (EUREX, NYSE LIFFE) or over the counter (OTC, i.e. off exchange, bilateral agreements)

• forwards, futures, options, swaps and their combinations (structured products)

FINANCIAL INSTRUMENTSSection C of Annex I to the Directive 2004/39/EC of the European Parliament and of the Council of 21 April 2004 on markets in financial instruments, OJ 2004 L 145/1, − MiFID, as repealed by Directive 2014/65/EU with the effect from 03/01/2017

• Transferable securities (shares, bonds, etc. excluding instruments of payment − cheques, bills of exchange)

• Money market instruments (treasury bills, certificates of deposit, commercial papers, excluding instruments of payment)

• Units in collective investment undertakings (investment funds, UCITS – undertakings for collective investment in transferable securities)

• Derivatives

UNDERLYING ASSET

• all kinds of assets: shares, bonds and other securities, commodities and currencies

• various economic variables: interest rates or yields, financial indices (DAX, CAC 40) or financial measures (ratios, ratings etc.), freight rates, inflation rates or other official economic statistics

• climatic variables (e.g. wind harvest forecast for wind farms) or emission allowances under the Kyoto Protocol


FORWARDS AND FUTURES

• obliges the long party to buy the underlying asset at a future date (settlement date, delivery date) at a price set today (forward price)

• no payment today; requires payment only at the maturity date

• futures = forwards traded on exchange


OPTIONS

• entitle the long party to either buy (call option) or sell (put option) the underlying in future

• no obligation on the part of the long party, it only pays a premium

• exercised if option is in the money (call – if market price is higher than the agreed price; put – if market price is lower than the agreed price)

• an option is not exercised: (i) either the market price of the underlying is below the strike price (“the option is out of money”) and (ii) the market price is equal to the strike price (“the option is at the money”)

• European options − a specific maturity date; American options − can be exercised throughout the whole period until their specified expiration date


OPTIONS

CALL OPTION IS IN THE MONEY

• 1 Volkswagen share

• Today’s price € 216

• Agreed price € 250

• Maturity: 1 July 2015

• Price on 1 July 2015: € 350

• If settled in cash you get € 100 in cash

PUT OPTION IS IN THE MONEY

• 1 Volkswagen share

• Today’s price € 216

• Agreed price € 250

• Maturity: 1 July 2015

• Price on 1 July 2015: € 150

• If settled in cash you get € 100 in cash


SWAPS

• parties exchange two independent cash-flows, thereby assuming the risk of the other party’s cash-flow

• interest rate swaps, e.g. floating to fixed

• currency swaps

• total return swaps - contracts for differences - CfDs


SWAPS EXAMPLE - CURRENCY SWAP

• Bank A granted you a 10-year CHF 100,000 loan in 2009

• You want to hedge you exposure to CHF

• Bank B (short party) accepts to pay your instalments in CHF to Bank A while you will continue to pay instalments in EUR to Bank B to repay the remaining EUR converted amount of the principal plus an additional fee


TOTAL RETURN SWAP (U.K. Contract for Differences)

• exchange of the total return on any notional portfolio of assets (i.e. specified number of reference bonds, stocks, etc.) in consideration for interest on a notional principal (“virtual bond”)

• replicates the flow of the referenced asset as if you were owner of that asset

• notional principal represents the amount agreed between the parties, which is not paid out to the long party, but it only serves as a reference amount for the calculation of interest owed to the short party

EXAMPLE - TOTAL RETURN EQUITY SWAP

• You want to have economic exposure to a listed company and benefit from its shares, but you do not want to own it.

• Total return includes dividend payments plus share price appreciation on maturity or termination date, i.e. the upside difference as compared to today’s price

• Your bank (short party) accepts to provide you that in return for a regular fee calculated as interest on a notional amount plus share price depreciation, i.e. the downside difference as compared to today’s price

TOTAL RETURN EQUITY SWAP


Total Return on Reference Shares

(Dividends + Reference Shares Appreciation)

Reference Rate + Spread + Reference Shares

Depreciation

Short Party Long Party

Total Return Payer

Total Return Receiver

NEW TAKEOVER TACTICS


• A company wants to take advantages of synergies from a business combination with its competitor, but it does not want that its plan becomes public

• Its bank offers cash-settled derivatives not entitling the long party to acquire „on such holder’s own initiative alone” already issued shares to which voting rights are attached (cf Art 13 Transparency Directive)

• The bank hedges its risks by buying the referenced shares or by involving other banks to make all holdings fit to Transparency Directive exemptions (5% threshold, trading book etc.)

• At maturity or termination date, the bank can offer shares in lieu of payment of any of its outstanding financial obligations

CASE STUDIES

• Schaeffler v Continental AG (2008) no violation found

• Porsche v VW (2008) Criminal investigation

opened in 2014

• LVHM v Hermès (2013) EUR 8 million fine, no appeal submitted


SCHAEFFLER v CONTINENTAL AG

Source: D. Zetzsche: Continental AG vs. Schaeffler, Hidden Ownership and European Law – Matter of Law, or Enforcement? (SSRN No. 1170987)

Merrill Lynch – sole swap counterparty

Probable hedging partners:

CommerzbankDresdner BankCredit SuisseRoyal Bank of ScotlandUBSLandesbank Baden-WürttembergUniCredit/HVB


SCHAEFFLER v CONTINENTAL AG

• BaFin (German Federal Financial Supervisory Authority) found no breach of reporting duties:

http://www.bafin.de/SharedDocs/Veroeffentlichungen/EN/Pressemitteilung/2008/pm_080821_conti.html

„The shares underlying the swap agreement could [...] have been attributed to Schaeffler only if BaFin had been able to prove the existence of further agreements under which

Merrill Lynch or third parties had held Continental shares on behalf of Schaeffler (section 30 (1) sentence 1 no. 2 WpÜG, section 22 (1) sentence 1 no. 2 WpHG);

Schaeffler had been able to acquire Continental shares as a result of a declaration of intent (section 30 (1) sentence 1 no. 5 WpÜG, section 22 (1) sentence 1 no. 5 WpHG);

or voting rights were to be exercised jointly (section 30 (2) WpÜG, section 22 (2) WpHG).

BaFin was unable to find evidence of any such agreements.”




PORSCHE v VOLKSWAGEN AG• In 2008, Porsche SE attempted to gain a 75%

stake in rival Volkswagen by accumulating shares in stages, including through the use of derivatives

• In October 2008, Porsche announced it held 42.6% of VW ordinary shares together with 31.5% in cash-settled options relating to VW ordinary shares,

• VW share price soared from € 201 to € 1,005 per share what was, at the time (i.e. on 28 October 2008), the most expensive share worldwide! (short squeeze – a situation where there is not enough shares in the free float to satisfy all short positions in that share)

Source: http://seekingalpha.com/article/291188-tesla-the-looming-short-squeeze Source: http://www.reuters.com/article/2008/10/28/us-volkswagen-idUSTRE49R3I920081028


http://seekingalpha.com/article/291188-tesla-the-looming-short-squeeze

http://seekingalpha.com/article/291188-tesla-the-looming-short-squeeze

http://www.reuters.com/article/2008/10/28/us-volkswagen-idUSTRE49R3I920081028








PORSCHE v VOLKSWAGEN AG

• No decision by BaFIN at the time

• Various lawsuits have been filed against Porsche in Germany and the United States by hedge funds

• In November 2014, former Porsche Chief Executive Wendelin Wiedeking and his former finance chief Holger Haerter faced charges of market manipulation, with possible financial implications for Porsche.

Source: http://www.ft.com/intl/cms/s/0/108b3308-6a88-11e4-bfb4-00144feabdc0.html#axzz3RGlSoTJH


http://www.ft.com/intl/cms/s/0/108b3308-6a88-11e4-bfb4-00144feabdc0.html#axzz3RGlSoTJH






LVMH v HERMÈS

• During 2001 and 2002 LVMH acquired 4,9% in Hermès via two of its subsidiaries (Luxembourg , Delaware)

• In the first half of 2008, LVMH entered into several swap agreements with Nexgen Capital Limited, Société Générale and Crédit Agricole Corporate & Investment Bank via its two subsidiaries in Hong Kong in relation to 12,37% of Hermès’ capital

• In December 2008, LVMH sold a portion of shares in order not to reach the 5% threshold following the cancellation of certain treasury shares by Hermès

• On 23 October 2010, LVMH declared it held 14,2% of Hermès’ capital which increased to 17,1% by 26 October 2010 and more than 20% by 21 December 2010

• On 25 June 2013, the French Financial Markets Supervisory Authority (Autorité des marchés financiers) imposed a fine of € 8 million, and LVMH decided not to appeal.

Source: www.amf-france.org/technique/multimedia?docId=workspace://SpacesStore/f6d76d34-e619-4d93-ad47-6429cd3f9100_fr_1.0_rendition


http://www.amf-france.org/technique/multimedia?docId=workspace://SpacesStore/f6d76d34-e619-4d93-ad47-6429cd3f9100_fr_1.0_rendition

















2013 AMENDMENT TO THE TRANSPARENCY DIRECTIVE

DIRECTIVE 2013/50/EU

ART 13 OF TRANSPARENCY DIRECTIVE NOW INCLUDES:• financial instruments that, on maturity, give

the holder, under a formal agreement, either the unconditional right to acquire or the discretion as to its right to acquire already issued listed shares to which voting rights are attached, i.e. physically settled equity-based derivatives now without the need for a transfer statement having in rem effect;

• all other financial equity-based instruments with economic effect similar to that of the financial instruments, whether or not they confer a right to a physical settlement, i.e. all other cash-settled financial instruments (TRSs, CfDs)

PREVIOUS WORDING:

• financial instruments that result in an entitlement to acquire, on such holder’s initiative alone, under a formal agreement, shares to which voting rights are attached, already issued, of an issuer whose shares are admitted to trading on a regulated market

DIRECTIVE 2013/50/EU

• number of voting rights is calculated by reference to the full notional amount of shares underlying the financial instrument

• If cash-settled, number of voting rights is calculated on a ‘delta-adjusted’ basis, by multiplying the notional amount of underlying shares by the so-called delta of the instrument

• Delta ( ) is Δ one of the ‘Greeks’ used in finance for pricing and hedging of options. It is the ratio of the change in the price of an option to the change in the price of the underlying share. It changes over time. It can range from 0 to 1 for call options and from 0 to -1 for put options (e.g. if a call option is deep in the money it is closer to 1)

TRANSPARENCY VS. FLOOD OF INFORMATION

• Art 10(g) Transparency Directive:voting rights held by a third party in its own name on behalf of [another] person or entity.

• Art 2(1)(e):‘shareholder’ means any natural person or legal entity governed by private or public law, who holds, directly or indirectly:

(i) shares of the issuer in its own name and on its own account;(ii) shares of the issuer in its own name, but on behalf of another natural or legal entity; [...]

TRANSPARENCY VS. FLOOD OF INFORMATION

• Too fact-specific provisions require more fact-finding powers for supervisors – possibility for evasion

• Too many information can create false impression of an imminent change of control making investors buy or sell shares in the target thereby distorting the share price

FOR MORE INFORMATION

• D. Stanković: Challenges to the Takeover Early Warning System in the EU: The Case of Germany, http://www.cyelp.com/index.php/cyelp/article/view/184

THANK YOU FOR YOUR ATTENTION!

http://www.cyelp.com/index.php/cyelp/article/view/184









Lex'Talk 12

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