Securities and Exchange Commission Director John White last month asked a gathering of U.S. securities attorneys for insights about unwieldy new financial instruments activist hedge fund managers are using as part of their pressure-cooker campaigns at corporations.
White told the lawyers at an American Bar Association meeting in New York that the SEC is weighing what kind of disclosure to require for short positions, equity swaps and other derivatives. One place White might look is across the Atlantic Ocean.
The Financial Services Authority in London, Britain's securities market regulator, is expected this month to set in motion a process that will require activist investors employing derivatives investments -- particularly, cash-settled equity swaps -- to report those stakes as if they were equivalent to real shares.
The move, which will take effect in February with a grace period, could have a major impact on how activist fund managers operate. Such swaps, known in the U.K. as contracts for differences, or CFDs, don't involve real shares but are agreements between investors and bank derivatives dealers where one party pays the other for virtual shares based on the performance of the underlying stock price.
The FSA is concentrating on shares that are "matched" -- in which a derivatives dealer at an investment bank hedges his exposure to a swap by holding real shares in the same company to offset any loss. Typically, brokers will sell their hedged shares on the expiration date of their cash-settled swap or earlier if a settlement is reached. The FSA contends that derivatives dealers, in some circumstances, have been willing to sell the shares directly to the insurgent once they settle up their swap contract or vote their matched shares to support an activist's insurgency agenda as part of the quid pro quo of the swap. "You're going to vote the shares the way the activist wants you to, or that's the last time the activist will use that dealer," says Barry Genkin, partner at Blank Rome LLP.
Corporate executives in the U.S. and U.K. argue that the swaps help activists secretly accumulate a large economic position or additional voting rights, all the while they formally avoid government disclosure thresholds. There, in the shadows, they can gain the support of like-minded investors, many of whom have quietly accumulated similar, secretive stakes. By the time the activists take their campaign public, CEOs have to scramble to find support. "The swaps help an activist in their Pearl Harbor sneak attack that comes as late in the game as possible," Genkin says.
The FSA's draft regulations will require insurgents at U.K.-listed companies to disclose whether their combined physical shares and synthetic swap investment exceeds a 3% stake. For non-U.K. companies listed on the London Stock Exchange, that threshold is 5%. Both the 3% and 5% levels are the historic disclosure threshold for physical shares under the U.K.'s Disclosure and Transparency rules.
The measure is the latest by U.K. companies as part of a campaign to rein in the influence of insurgent investors. U.K. raider fund Children's Investment Fund Management (UK) LLP, or TCI, and its large-scale activism drew the ire of U.K. regulators last year. Responding to the fund, the FSA issued guidelines for hedge fund market manipulation. One principle: Hedge funds that acquire shares to help another activist avoid breaching a disclosure threshold could be sanctioned by the FSA.
In fact, a cacophony of complaints from London Stock Exchange-listed companies has been driving the FSA swap disclosure initiative. Embattled British lender Northern Rock plc was targeted by activist funds QVT Financial LP of New York and SRM Master Global Fund LP of Monaco, both of which acquired large CFD positions as part of their purported strategy to put the embattled bank in play. That effort failed after the British government nationalized the retail bank.
U.K. activist real estate investor Robert Tchenguiz in May settled a significant portion of his CFD positions in pub operator Mitchells & Butlers plc held through his Violet Capital Group Ltd. investment vehicle and immediately picked up the matched shares, presumably sold by derivatives dealers at banks, making him the largest shareholder in the chain with a 29.88% stake, including the 3% real shares he already owned. In 2006, Tchenguiz made a 550 pence ($10.17) per share bid to buy the pub operator that was rejected. His next move is now being eagerly awaited.
Mitchells & Butlers spokeswoman Kathryn Holland says relations with Tchenguiz are friendly and she and others at the chain were aware of his CFD investments. But, she adds, the overall experience has made company officials more enthusiastic about the new FSA disclosure requirements. "From an investor point of view, knowing who is on the investor registry, knowing who owns what, is very important," Holland says.
A panoply of other U.K. companies have been targeted by investors employing CFDs, including British gambling companies Ladbrokes plc and Rank Group plc. Last year, British food group Greencore Inc.'s chairman, Ned Sullivan, lashed out at CFDs, arguing that better disclosure requirements were necessary.
In the U.S., the battle between railroad operator CSX Corp. and TCI is at the center of the cash-settled swap storm. In October 2007, TCI disclosed it owned a 4.1% physical equity stake in CSX. Not until December did TCI concede that it held an additional 11% economic stake through cash swaps. A Federal District Judge Lewis Kaplan found TCI had violated SEC disclosure rules when it indicated to CSX executives that it could convert its swaps at any time into votes or shares, thereby hiking its equity position significantly. CSX appealed the ruling to the U.S. 2nd Circuit, which heard oral arguments Aug. 25.
"In reality, even someone who has a pure economic interest often could have the ability to exert influence on the person who is holding the shares and gets to vote them," says Jeremy Jennings-Mares, a partner at Morrison & Foerster LLP in London. "The FSA has concluded that the scope for abusing this is too broad."
Draft U.K. rules expected this month will probably give companies, investors and derivatives brokers at banks a six-month transition period, until February, to get used to the new rules. Derivatives dealers -- those brokers on the other end of the cash-settled contract -- anticipate an exemption from the rules as part of an effort by regulators to make sure investors with no activist or control-related intentions are not discouraged from allocating funds to swaps.
At the SEC, White says he may consider changing the agency's Schedule 13D filing requirements to account for swaps when they account for 5% or more of a company's shares. He doesn't expect his unit to have a proposal for six to 12 months. By then, the agency will know how the appeals court rules in the CSX case, and how investors in London have reacted to the U.K. rule. "This project is new enough that I haven't been out there talking about it yet, and it definitely falls into the category of longer-term projects," White says.
That left many corporate attorneys fuming. Genkin says that while SEC Chairman Christopher Cox has tried to identify himself as someone who's focused on disclosure by using technology changes to add transparency, he's done nothing about this monumental problem. "Why is it that this disclosure issue is standing out like a sore thumb?" he asks.