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— Analysis —
Unfortunately, it came too late to save many hedge funds from becoming a case study in how big the "problem" could be. Three days later, on a Sunday, Porsche AG, under CEO Wendelin Wiedeking, shocked the market when it said it had built a 74.1% stake in fellow German carmaker Volkswagen AG. The surprise came because 31.5% of the shares were held through cash-settled options, meaning Porsche did not have to declare that part of its holding. With a further 20% of the company in the hands of the German state of Lower Saxony, Porsche's purchases meant a little less than 6% of the company remained in free float.
The problem for the hedge funds (and perhaps some banks) was that they had been betting on VW's value tumbling, building a combined short position of about 12% of VW's equity. When markets opened the following Monday, funds scrambled to cover their short positions. By Tuesday, shares in VW were soaring, and the company briefly became the world's most valuable business. Hedge funds were nursing losses estimated at between €20 billion and €30 billion ($26 billion and $39 billion). "I feel for the guys who have been stung, and from what I am hearing, there will be casualties," says one London-based fund manager who asked not to be named. "But that's the game." The rules of the game are changing, though, in ways that could redefine how merger battles are won and lost. The U.K. and France are rewriting laws governing derivatives, Germany is under pressure to take some action to address swaps, and everywhere the world's 10,000-odd hedge funds are scrambling to boost portfolio returns (or at least minimize losses) in the hopes of surviving a looming shakeout of the $1.9 trillion industry. In Britain, France and Germany, Europe's three biggest equity markets, shareholders now must disclose only those shares they actually own. Derivatives, such as cash-settled options, contracts for difference and equity swaps, circumvent this rule by leaving shares in the hands of the derivative seller, even though the derivative holder effectively controls them. That differs from U.S. regulation, which puts the onus of declaration on the "beneficial owner," effectively grouping both equity and derivative holdings, though only where derivatives are exercisable within 60 days. European regulators are aware of the deficiencies of their system, and nowhere more so than in Germany. In 2007 Porsche used exactly the same maneuver to build its initial stake in VW. Earlier this year Schaeffler KG, a German ball bearings maker, used derivatives to amass 33% of a 36% stake in German tiremaker Continental AG before launching a bid. But it is Britain and France, where the use of derivatives to build covert stakes has been less marked, that are moving to close the loophole. The U.K.'s Financial Services Authority, or FSA, will publish new rules in February 2009 that would demand disclosure of any stake of more than 3% in a company, even where the stake was held through contracts for difference, known as CFD. The rules are due to take effect next September. France's AMF is consulting on a similar proposal as part of a review that would introduce as many as 20 changes to disclosure rules, probably by next year. Still, the clamor for greater disclosure of derivatives in both the U.K. and France is hardly deafening. "I am not sure that it will have a big effect," says Pierre Servan-Schreiber, co-head of the Paris office of law firm Skadden, Arps, Slate, Meagher & Flom LLP. "Derivatives have certainly been used in creeping takeovers, and I know because I have advised clients on their use, but it is not widely used." Instances of the use of derivatives in creeping takeovers were rare enough in France that the AMF was forced to draw on examples from foreign markets. The report cited a 2007 case in Italy involving the acquisition of a 30% stake in Fiat SpA by Exor Group SA, an investment vehicle controlled by the Agnelli family, and a March 2008 case in Switzerland where investment fund Laxey Partners Ltd. built an undeclared stake of about 25% stake in Implenia AG using contracts for difference. In the U.S. it noted a June 2008 ruling by a New York court against the Children's Investment Fund Management (UK) LLP and 3G Capital Partners Ltd. The ruling found that they had violated SEC rules by using derivatives to amass a 14% stake in railroad company CSX Corp. That ruling was partially overturned on appeal on Sept. 15. It is perhaps no coincidence that the three examples all identify investment funds as protagonists of their morality tales. France and Germany, in particular, are prone to handwringing about the actions of investment funds, remaining less offended by the actions of industrial actors. German regulator Bundesanstalt für Finanzdienstleistungsaufsicht, or BaFin, has shown little evidence of concern about Porsche's short squeeze and the huge potential losses that ensued. Porsche said it had notified BaFin of its actions as it built its stake and maintains it has done nothing wrong to raise the ire of the regulator. "The applicable capital market laws have been complied with at all times," the carmaker said in a statement. Some funds and commentators have chosen to see complicity in BaFin's sanguine response. Indeed, it is difficult to shake the suspicion that if a large hedge fund had used derivatives to squeeze VW or Porsche in the same manner, then the official response would have been far more critical. If that is the case, then hedge funds should welcome efforts to improve disclosure of derivatives stakes, because they would, at the least, level the playing field. |
The warning was clear enough. The use of derivatives "poses problems in terms of information to other shareholders, to the business concerned and to the market," said France's market regulator, the Autorité des Marchés Financiers, or AMF, in a report published Oct. 23. 
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