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Disclosure of Derivative Positions Attracts Renewed Scrutiny


August 28, 2008

Recent pronouncements by a court in the United States, as well as regulatory activity in the United Kingdom, have highlighted the issue of whether rules requiring disclosure of beneficial interests in securities of public companies should extend to economic interests in securities held through derivative contracts. These securities include cash-settled total-return equity swaps (TRSs) and similar financial instruments. Under a TSR, an investor may acquire economic exposure to (but not legal ownership of) underlying securities. The debate resulting from these developments may have implications for Canada’s securities regulatory regime.

The CSX Decision in the United States

Considerable commentary has been published and debate waged since the June 11, 2008 decision of Judge Lewis Kaplan of the US District Court for the Southern District of New York in CSX Corporation v. The Children’s Investment Fund Management (UK) LLP et al. The defendants in this private securities law enforcement case — The Children’s Investment Fund Management (UK) LLP (TCI) and 3G Fund LP (3G) and their respective affiliates — are hedge funds that ultimately led a proxy fight to elect five directors to CSX Corporation’s (CSX) 12-member board.

Relying on anti-evasion provisions in beneficial ownership reporting rules under Rule 13d of the Securities Exchange Act of 1934, Judge Kaplan deemed TCI to be the beneficial owner of CSX shares that were the reference security for certain TRSs, and ruled that the defendants had failed to report their shareholdings in the manner required by US securities laws. Judge Kaplan thought the unique facts of the CSX case led to persuasive arguments for concluding that the TRSs held by TCI represented an actual beneficial ownership interest in the underlying CSX shares under Rule 13d-3(a). But he did not find it necessary to answer this question — instead relying on the anti-evasion provisions in the rule. Judge Kaplan clearly invited legislators to weigh in on the issue.

While the anti-evasion analysis in the CSX decision was heavily fact-dependent, the important implication for derivative instruments more generally was the obvious inclination of the judge to conclude, if necessary, that TRSs represent beneficial ownership of shares on their face. Even though it was not the basis for the decision of the case, this implication would represent a significant departure from the widespread view that owning economic interests in securities through cash-settled derivative contracts is not the equivalent of beneficial ownership of the reference securities.

At the CSX shareholders’ meeting, four of the five nominees of TCI and 3G were elected — at least for now — to the CSX board. Further developments are likely in this case as the CSX decision is currently under appeal. The Second Circuit Court of Appeals has agreed to hear an appeal by both parties on an expedited basis.

Developments in the United Kingdom

Prior to the CSX litigation, the Financial Services Authority (FSA) in the United Kingdom had begun a public consultation on the disclosure rules for holding contracts for differences (CfDs), which are the UK equivalent of TRSs.

Several alternatives had previously been proposed, but the FSA announced on July 2, 2008 that it has decided to implement a general disclosure regime for CfDs. This regime requires that CfDs be aggregated with ordinary share positions when investors are calculating the required disclosure threshold at the existing level of three per cent. Exemptions for market-makers and other appropriate intermediaries will be provided in order to reduce both unnecessary disclosures and the cost of implementing such disclosure.

Draft rules and a policy statement are proposed to be published by the FSA in September 2008, with final rules proposed to be published in February 2009 — and to be effective, at the latest, in September 2009. However, the FSA may try to advance that date.

Implications for Canada

The uncertainty arising from the CSX decision is not the first time Canadian regulators have had reason to consider the relationship between beneficial ownership reporting requirements and the use of equity swaps. The Ontario Securities Commission (OSC) examined this issue as part of its August 8, 2006 decision in Sears Canada Inc., which involved an insider takeover bid that was actively opposed by several hedge funds.

One of the issues litigated in the Sears case was the allegation that the opposing hedge funds had not properly complied with the reporting of their beneficial ownership interests in Sears Canada. The key aspects of this allegation were very similar to those made in CSX. The OSC determined there was insufficient evidence to conclude the hedge fund holding equity swaps that referenced Sears Canada shares had beneficial ownership or control or direction over the shares subject to those swaps — and therefore no disclosure obligations. However, the OSC did specifically note that circumstances could possibly arise where it would invoke its public interest jurisdiction under the Securities Act to find a different result.

In other words, even though Canadian early-warning reporting requirements do not contain the anti-evasion provisions on which Judge Kaplan relied in the CSX decision, the OSC has indicated that if sufficient abusive conduct exists, it might well use its public interest power to impose sanctions.

McCarthy Tétrault Notes:

The ongoing litigation with respect to CSX, and the recent and relatively strict proposal by the FSA in the United Kingdom to require reporting of equity swaps, will no doubt cause securities regulators in Canada to consider the early-warning disclosure obligations with respect to equity swaps at least in certain circumstances. Currently in Canada, only insiders of public companies are generally considered to be subject to disclosure obligations with respect to certain transactions involving derivatives pursuant to Multilateral Instrument 55-103 Insider Reporting of Certain Derivative Transactions (Equity Monetization) (MI 55-103). However, it may be possible to also characterize the total return component of any TRS having a physical settlement option as a convertible security for purposes of Canada’s early-warning reporting requirements, thereby requiring the counterparty that is long the total return component to file an early-warning report.

In addition to proxy battles, the consideration of disclosure requirements for equity swaps may have implications
for the takeover bid regime. Prospective bidders might consider using equity swaps to quietly establish "toeholds" prior to the launch of a takeover bid. A prospective bidder could also, by way of equity swaps, effectively park securities with a counterparty to a TRS in anticipation that those securities would be tendered to their bid.

The implications of these developments in the United States and the United Kingdom — and the OSC’s statements in the Sears case — suggest that legislators and regulators in Canada may soon consider taking action to enhance disclosure rules to ensure the public is informed of the true economic interest of various actors in underlying shares of public companies.

This will have implications for public companies, investors and intermediaries in derivative transactions.