1.3.0 Introduction

The over-the-counter equity derivatives market has grown exponentially over the last decade, with an estimated notional amount as high as $10.2 trillion at the end of June 2008 — more than half of which was accounted for by derivatives of European shares.1 Equity derivatives are regularly used by hedge funds to leverage their exposure.2 Yet, there have been instances where hedge funds, as well as hostile bidders, have used derivatives to influence corporate control, without fully disclosing their interests.

Although the terras of cash settled derivative contracts such as options and contracts for differences (Cfd) inherently do not stipulate a transfer of the reference shares, such contracts may, as a practical matter, involve shares.3 The reason is that the short party, usually an investment bank, will typically hedge its position by acquiring the reference shares. This raises two potential issues. First, the bank may be inclined to exercise the voting rights attached to the reference shares according to the preferences of its counterparty, for example a hedge fund. The bank will generally be indifferent to the voting rights, while the fund has an economic interest in the shares. The bank will thus have a commercial incentive to accommodate the fund's wishes regarding the exercise of the voting rights. Yet under existing rules, the fund may be able to avoid disclosure of its ability to influence control, resulting in a lack of transparency.

Second, cash settled derivative contracts, despite their terras, may be physically settled. Once a contract has expired, the bank will have to unwind its position by disposing of the reference shares. If it concerns a substantial stake, the bank may not be able to sell the shares in the market without depressing the share price. By instead transferring the shares to the counterparty if so requested, the bank can simultaneously avoid lower proceeds and accommodate its client. Again, under existing rules, the fund may be able to avoid upfront disclosure of its ability to eventually acquire the shares, resulting in a lack of transparency.

These two issues have materialized, for example, in the context of a high profile battle between activist hedge fund TCI and CSX, a major U.S. railroad company. TCI had amassed a significant stake in CSX partly through total return swaps (TRS), the U.S. equivalent of Cfd, which it had not immediately disclosed.4 CSX felt this had enabled TCI to ambush CSX in the run-up to a proxy contest, and sued TCI for violation of U.S. securities laws. The case focused on whether TCI qualified as beneficial owner of the reference shares; if so, it would have been subject to a disclosure obligation.5 The key question was whether TCI had a "significant ability" to affect how voting power or investment power with respect to the reference shares would be exercised.6

As to investment power, the court observed that TCI had significantly influenced its counterparties to purchase or sell CSX shares.7 This conclusion was based on the facts that (1) it was inevitable, due to the "very nature" of the TRS, that TCI's counterparties would hedge the TRS by purchasing CSX shares, (2) this is what TCI contemplated, and (3) the counterparties did in fact hedge their positions.8 This also explains why TCI limited the size of its TRS with individual counterparties: to avoid triggering a disclosure obligation on their part.9 Moreover, the court observed that the fact that TCI had the ability to agree to unwind the swaps in kind meant that the hedge positions "hang like the sword of Damocles over the neck of CSX."10

As to voting power, the court found there was reason to believe that TCI was in a position to influence the exercise of voting rights by its counterparties, especially Deutsche Bank.11 This finding relied primarily on the fact that while TCI had initially entered into TRS with multiple banks, it had subsequently concentrated its TRS in Deutsche Bank. In doing so, TCI was motivated by the belief that it could influence how Deutsche Bank voted its CSX shares.12 Remarkably, Deutsche Bank next recalled the shares, which it had lent out, in order to be able to vote them at the shareholder meeting where the proxy battle would be decided. Whether it did so pursuant to an explicit or implicit agreement with TCI was, in the court's view, a "close one."13

Ultimately, the court did not hold that TCI directly qualified as beneficial owner, but merely that TCI should be deemed beneficial owner, because it used the swaps to evade the disclosure obligation. Still, the decision went further than the decision by German regulator BaFin in a recent case concerning the takeover of automotive company Continental by Schaeffler. Before Schaeffler announced its unsolicited offer in the summer of 2008, it had built up a stake comprising just below 3% of shares, just below 5% of call options and approximately 28% of cash settled equity swaps.14 Yet, while it essentially held a 36% stake, the composition of the stake had enabled Schaeffler to refrain from making any prior disclosure. Consequently, both the market and Continental were caught by surprise. Despite public outcry, BaFin concluded there had been no violation, since it had been unable to find evidence of agreements that would have triggered disclosure obligations.15

These are not unique cases. Hu and Black, who have coined the term "hidden (morphable) ownership" to describe the combination of undisclosed economic ownership plus probable informal voting power, have identified a number of cases across the globe.16 These have changed the political economy and spurred lawmakers into action. Both the UK Takeover Code and the Irish Takeover Code now require economic interests to be disclosed during offer periods,17 and the scope of the general UK disclosure regime has recently been expanded along the same lines.18 Similar regulatory developments have occurred in France, Switzerland, Australia and Hong Kong.19 In other jurisdictions, such as Canada and the Netherlands, regulators are contemplating amending the rules.20 Courts have also addressed the issue, for example in New Zealand and Italy.21 Nonetheless, the issue has only marginally received attention at the European level thus fat