Dealings in derivatives and options – changes to the Takeover Code

On 7 November Rule 8 of the Takeover Code was amended to require certain dealings in options and derivatives related to target shares to be disclosed to the market in the same way as dealings in actual shares.

Under the revised Rule 8.3 of the Code, a person who is directly or indirectly “interested” in 1% or more of any class of relevant securities of the target company or, if appropriate, the bidder (or who will be interested in 1% or more as a result of a transaction) must disclose publicly all “dealings” in such relevant securities of that company carried out during an offer period. A new definition of “interests in securities” provides that a person who has long economic exposure to changes in the price of securities (ie. essentially, he will benefit if the price rises) is treated as interested in them. Such an interest will be held by a person who owns or controls the actual shares, who has a call option or written put option in respect of them, or who has a long derivative referenced to them. But a person with a short position will not be treated as interested.

A new definition of “dealings” captures any transaction which results in an increase or decrease in the number of securities in which the person is interested or in respect of which he has a short position, including buying and selling securities, granting or exercising an option, subscribing for securities, and entering into, closing out or varying a derivative referenced to securities.

Previously, persons whose only interests were in the form of derivatives referenced to or options in respect of shares of a target company (or, if appropriate a bidder), no matter how large, had no obligation to disclose their dealings under Rule 8 as long as they were not also associates of the bidder or target. Further, while a counterparty to a derivative or option could acquire more than 1% of a company’s shares as a hedge, if the counterparty was a principal trader who was a recognised market-maker, it may have been exempt from the disclosure obligation by virtue of Rule 8.3(d).

For over a year the Panel has been concerned that investors may be able to take advantage of the economic rights conferred by options and derivatives that are referenced to company shares without having to comply with the obligations that would apply if the underlying shares were actually purchased.

For example, entering into a contract for difference (CFD) or spread bet referenced to the price of a share in Company X, multiplied by a specific number of shares, replicates to a large extent the economic exposure attached to actual ownership of the shares, particularly if the counterparty agrees to pass on to the investor the benefit of any dividends that are paid. Whilst the counterparty will usually hedge its exposure under the CFD, often by going out into the market and buying actual shares in Company X, unless the counterparty cedes control of those shares to the investor (e.g. under a voting rights agreement), the investor will not usually be obliged to notify Company X of its “interest” in the shares under section 198 of the Companies Act (obligation to notify interests of 3% or more).

This lack of transparency provides scope for a potential bidder to build a stake without having to reveal its hand, and also for investors to assist one of the parties to an offer without being identified as a concert party. It also makes it difficult for other market-users to understand why the price of a company’s shares may be moving in a particular direction.

In addition, because the investor invariably knows that the counterparty will usually buy actual shares in the market in order to hedge its exposure, and because the counterparty will often (although not always) deal with those shares in a manner that suits its client’s intentions (even if there is no express agreement to do so), the investor may exercise a significant degree of de facto control over the shares. If the counterparty is exempt from the disclosure obligations because it is a principal trader acting in that capacity, an investor may even be able to ‘surprise’ a company by closing out his position and acquiring the hedging shares from the counterparty at a single stroke.

For example, only a couple of weeks ago it was reported that Polygon, a London hedge fund, had secretly entered into CFDs in respect of 13.9% of the Peacock Group, which is subject to an offer by its management team. The existence of the ‘stake’ was only revealed when Polygon closed out its CFDs and acquired the actual shares previously held by the counterparty. Under the new Rule 8, entering into or varying any CFD referenced to Peacock shares once the company was in an offer period would be a ‘dealing’ that would have to be disclosed.

A contract for difference is a type of derivative. For further information see the note at the end of this article

Changes to Rule 8

Calculating the size of a person's interest

To establish whether a person is interested in 1% or more of any class of relevant securities, and therefore whether he is required to disclose his dealings, he must evaluate his holdings at midnight (London time) on the day of the dealing and on the previous business day. Any interests held by virtue of derivatives or options will have to be aggregated with any holdings of actual shares and with interests under other derivatives and options. Generally, a person’s percentage interest is taken to be his aggregate gross long exposure; but long positions can be netted off against short ones where the positions are in respect of the same security, the same investment product is used, and each is on the same terms and with the same counterparty.

Where the number of securities in which a person in interested is variable, he will normally be treated as interested in the maximum possible number of securities concerned. Where a person enters into a derivative by reference to the price of a number of securities, but subject to a multiplying factor, the Panel will have regard to the person’s gross economic exposure – ie. he will be taken to be interested in the number of reference securities multiplied by the relevant factor. If a derivative is not referenced to a particular number of securities, the investor will normally be treated as interested in the gross number of securities to changes in the price of which he has economic exposure.

Timing of disclosure and information required

Such dealings must be notified to the market by 3.30pm (London time) on the following business day using the Panel’s Rule 8.3 disclosure form. (By contrast, disclosures under Rules 8.1, 8.2 and 8.4 must be made no later than 12 noon on the business day following the date of the transaction.)

The obligation to disclose falls upon the investor, rather than the counterparty. However, the counterparty may have a separate obligation to disclose if, for example, it acquires actual shares as a hedge.

In the case of a derivative, the investor should disclose the number of securities to which the derivative is referenced, the maturity date or closing out date and the reference price, together with a description of the derivative instrument itself. In the case of an option, disclosure should include the number of shares under option, the exercise period or exercise date, the exercise price, any option money paid and a description of the option instrument. But in both cases, the identity of the counterparty need not be disclosed.

Any arrangement giving the investor control of the voting rights attached to the hedging shares, and any option for the investor to acquire those shares, must also be disclosed. If there is no such arrangement, this fact must be stated. Where such an arrangement is entered into after the derivative or option has been opened, this will be treated as a ‘dealing’ and must be disclosed.

Other changes into effect on 7 November

At the same time, the Panel amended various other Rules of the Code to require disclosure of derivatives and options in (particularly) Rule 2.5 announcements, offer documents, defence documents, and announcements of levels of acceptances.

PROPOSED FURTHER CHANGES TO THE CODE

Dealings in derivatives and options: control issues

When the Panel first proposed in January this year making changes to the Code to deal with derivatives and options, it divided the issues into ‘disclosure’ and ‘control’ issues. The disclosure issues have now resulted in the changes described above, which took effect on 7 November.

On 2 November the Panel published a further consultation paper (PCP 2005/3) containing its detailed proposals to amend various Rules which deal with obtaining control of a target. If these proposals are supported by the majority of market-users, they will come into effect as soon as the Panel publishes its Response Statement – which is likely to be towards the end of February or in March next year.

In general terms, the Panel proposes to adopt the same approach as for the disclosure issues – ie. as far as possible to treat long exposure under derivatives or options as equivalent to interests in actual shares. However, derivatives and options will not count towards a bidder’s acceptance condition under Rule 10.

Specifically, the main changes proposed are:

• Amend Rule 5.1 (Timing restrictions on acquisitions) to apply also to dealings in long derivatives referenced to shares carrying voting rights in a company, regardless of whether, or how, the counterparty hedges its position, by regarding a derivative referenced to such shares as equivalent to a “right over shares”. Irrevocable undertakings will continue to be taken into account for the purposes of Rule 5, but not for Rule 9.
• The exemption in Rule 5.2(a) for purchases from a single shareholder should continue to be construed narrowly. It should therefore not be available where an interest in shares is acquired by virtue of a derivative. (In any event, a derivative will often be entered into with a principal trader and Note 1 on Rule 5.2 states that a principal trader will not normally be considered to be a single shareholder for the purpose of that Rule.)
• Amend Rule 9.1 (Mandatory offers) to provide that if a person (together with his concert parties) acquires shares carrying voting rights, call options and written put options in respect of such shares, and long derivatives referenced to such shares, which in aggregate amount to 30% or more of a company’s voting rights, he will trigger an obligation to make a mandatory cash offer. Similarly, a person who, together with his concert parties, has an aggregate long position determined on this basis in respect of between 30% and 50% of a company’s voting rights will be required to make a mandatory cash offer if he increases that long position. In each case, a bid obligation will be triggered regardless of whether the derivative or option is cash or stock settled, whether it is in or out of the money, and whether (or how) the counterparty hedges its position.
• Various references to “shares” or “securities” will be changed to refer to “interests in shares” or “interests in securities” (which include derivatives and options), and various references to “purchases” will be changed to “acquisitions”. A large number of consequential changes will also be made.
• Acceptance condition: Although interests under derivatives and options will count towards the thresholds in Rules 5 and 9, they will not count towards an offeror's acceptance condition under Rule 10 (or Rule 9.3). This is because the Panel considers that offers should only become or be declared unconditional as to acceptances in circumstances where statutory control has passed. As at present, a person will only become free of the restrictions in Rules 5 and 10 on acquiring further shares once he has statutory control of the target.
• Price at which an offer is required to be made (Rules 6, 9.5 and 11): where the offeror, or a person acting in concert with it, has entered into long derivatives referenced to, or options in respect of, shares in the offeree company during the offer period or in the 12 months prior to its commencement, it will be treated as having purchased shares at the highest derivative reference price or option exercise price (plus any option money paid), whichever is appropriate. (The Panel does not favour an alternative proposal under which the offeror would have to offer the highest price at which the counterparty has acquired hedge shares during this period.)
• The introduction of a new status for certain trading desks, to be known as "recognised intermediary" status, under which interests in shares by virtue of derivatives or options held by a desk which is acting in that capacity will not be taken into account in determining the overall interests, for the purpose of Rule 9.1, of the group of which the desk forms part. The Panel proposes that recognised intermediary status should be used as the status for determining the applicability of the exception from disclosure in Rule 8.3(d).
• Amendment of the dealing disclosure requirements under Rule 38.5 for trading desks of connected exempt principal traders which do not benefit from recognised intermediary status.

Proposed abolition of the Substantial Acquisitions Rules (SARs)

On the same day, the Panel issued a separate consultation paper (PCP 2005/4) in which it proposes to abolish the majority of the SARs. Although this proposal is independent of those relating to derivatives and options, it was prompted by responses to the Panel’s previous consultations. Only those parts of the SARs that relate to tender offers will be retained (re-located as a new Appendix to the Code).

Background and purpose of the SARs

The SARs were introduced in December 1980 following a series of market raids on the shares of listed companies without any offer having been made. At the time, the Panel was principally concerned that:

• the premium paid by the potential acquirer in the market raid was made available only to a limited group of shareholders who were normally institutional investors; and
• the fact that the stake was acquired over a very short period of time meant that the board of the target company had no opportunity to respond to the development and to advise the company’s shareholders on how to proceed.

The SARs were therefore introduced in order to slow down the speed with which a person who has not announced a firm intention to make an offer can acquire shares or rights over shares that take his stake to between 15% and 30% of the voting rights of a company.

Panel's reasons for abolishing the SARs

Originally, in its consultations on dealings in derivatives and options, the Panel proposed to extend the scope of the SARs to dealings in derivatives referenced to, and options in respect of, shares carrying voting rights. However, for the following reasons (amongst others) the Panel has concluded that the SARs no longer serve a useful function:

• A person acquiring a stake is already required by s.198 Companies Act 1985 to disclose details of his interest to the target within 2 business days. Where a person’s aggregate interests are 1% or more, all ‘dealings’ during an offer period must be disclosed to the market under Rule 8. Rule 5 of the Code also restricts a person acquiring shares or rights over shares which take his and his concert party’s aggregate holding to 30% or more, and Rule 6 sets a floor on the price at which any offer must be made.
• Shareholders have the option not to sell their shares in a market raid and instead to hold out for a better price in subsequent purchases or in an offer.
• When SAR 3 was introduced, the period within which significant shareholdings in listed companies had to be disclosed to the market under the Companies Act 1985 was 5 days. With the reduction of the statutory limit to two business days, part of the rationale for this rule has disappeared.
• In general, the Panel’s approach to share dealings is permissive rather than restrictive, focussing on the consequences which should flow from particular dealings rather than seeking to prohibit them altogether, unless there is some overriding policy concern.

Tender offers

The Panel does, however, intend to retain those provisions of the Code and the SARs that relate to tender offers (principally SAR 4, which sets out the requirements for the conduct of a tender offer) and include them in a new Appendix 5 to the Code. The draft Appendix will largely replicate existing SAR 4 and Note 3 on Code Rule 36.3, although some amendments are proposed, including:

• a new provision under which the Panel's consent will be required for a tender offer;
• changes to take account of the amendments proposed in PCP 2005/3 (described above); and
• clarification that where a tender offer is for the shares of a company quoted on the London Stock Exchange, AIM or OFEX, it must be made by advertisement, although the buyer may also send a copy of the announcement to the target’s shareholders. In all other cases, the tender offer must be made by circular and be open for at least 21 days.

Timing of changes

This consultation closes on 27 January 2006 and, if the Panel’s proposals are broadly supported, they are likely to come into effect towards the end of February or in March next year.

If, following consultation, the Panel decides to retain the SARs, it proposes to publish a further consultation paper on amendments so that they apply to dealings in derivatives referenced to, and options in respect of, shares carrying voting rights.

Derivatives and contracts for difference (CFDs)

Derivatives are financial instruments whose price and value derive from the value of the underlying assets or other variables; these could an index such as the FTSE 100, individual shares or interest rates.

CFDs

A CFD is a type of derivative whose value is determined by reference to the price of an underlying security. In its simplest form, a CFD is an agreement where two parties agree to exchange the difference between the opening and closing prices of a particular share, multiplied by a specific number of shares, on pre-determined dates. Although a counterparty will often hedge its exposure by acquiring actual shares, sometimes it may do so by purchasing a balancing derivative.

Sometimes the counterparty may be prepared to enter into a voting rights agreement (or similar), under which the investor is given the right to control the exercise of votes attaching to the shares bought by the counterparty to hedge its exposure under the CFD and/or an option for the investor to purchase those shares.

Spread bets

A spread bet is a type of contract for difference. The glossary to the FSA Handbook defines a spread bet as:

"a contract for differences that is a gaming contract, whether or not section 412 of the Act (Gaming contracts) applies to the contract;

in this definition, "gaming" has the meaning given in the Gaming Act 1968, which is in summary: the playing of a game of chance for winnings in money or money's worth, whether any person playing the game is at risk of losing any money or money's worth or not."

The Code definition of derivative is deliberately wide and catches spread bets.

Other types of derivative

These include swaps (bilateral contracts where the parties agree for a period to exchange cash flows on future dates); options contracts (bilateral contracts between an option holder and an option writer who, in return for a premium, grants the option holder the right, but not the obligation, to buy or sell an agreed amount of an underlying asset at a fixed price on a future date); and forwards and futures (where the parties agree to buy and sell an underlying asset at a future date at an agreed price).

Derivatives can be traded on an exchange or over the counter (OTC) (ie. sold directly by seller to buyer). OTC derivatives have the advantage that they can be tailored to meet the requirements of a particular investor.

Futures and covered warrants

For the purposes of Rule 8.3, futures contracts and covered warrants that include the possibility of delivery of the underlying shares are treated as options; but if the terms do not provide for the underlying shares to be delivered, they are treated as derivatives.

Warrants to subscribe

A holding of warrants to subscribe for new shares will not amount to an interest in those shares for the purposes of Rule 8. But the holder will have an interest in the warrants as a class of security: if his aggregate interest in that class of securities amounts to 1% or more, he will have to disclose all dealings in relevant securities.

Panel Consultation Papers

All of the Panel’s Consultation Papers and Response Statements (including RS 2005/2 announcing the changes effective on 7 November) can be found on its website at http://www.thetakeoverpanel.org.uk/new/. Also available are the new Rule 8 Disclosure Forms, and (in the Code/SARs section) a summary of the (amended) provisions of Rule 8.