Going stealth with swaps

The stealth tactics of hostile bidders have attracted significant attention this year. French construction company Eiffage SA fended off a bid from Spanish rival Sacyr Vallehermoso SA by claiming that it conspired with dozens of other Spanish investors in an effort to seize control of Eiffage. In the U.S., CSX Corp. persuaded a federal judge that several activist investors violated U.S. Securities and Exchange Commission rules by plotting against the railroad without disclosing their intentions. And in Germany, Schaeffler KG, a family-owned maker of ball bearings, succeeded in taking control of Continental AG with a strategy that used specially designed derivatives.

Under German securities laws, shareholders don't have to disclose an equity stake of less than 5% in a company, although if the stake is between 3% and 5%, the shareholder may vote only up to 3% without disclosing its stake. Herzogenaurach-based Schaeffler skirted the rule, with the help of its adviser, Merrill Lynch & Co., by entering into swap agreements with banks that each held just under 3% of Continental's stock. The so-called cash-settled total return equity swaps allowed Schaeffler to take the economic risk and benefits of stock ownership while the bank counterparties held the actual shares.

Critically, the swaps allowed the banks to tender the underlying shares into an offer for Continental, which is not a market standard term in cash-settled swaps, according to Continental's lead lawyer, Christoph Seibt of Freshfields Bruckhaus Deringer LLP in Hamburg. The banks used Maximilian Schiessel of Hengeler Mueller in Düsseldorf, while Schaeffler tapped Hans Rolf Koerfer of Allen & Overy LLP in Düsseldorf and Hartmut Krause and Neil George Weiand of the firm's Frankfurt office. On July 14, Schaeffler went public with a €10.5 billion ($16.7 billion) offer worth €69.37 per share for Continental, a tire and automotive parts company. Schaeffler also disclosed that it and an affiliate had acquired 2.97% of Continental's stock, 4.95% in physically settled call options and 28% in cash-settled equity swaps.

At the time, Germany had separate reporting requirements for stock and physically settled (as opposed to cash-settled) call options, a loophole that's since been closed, according to an article in the International Financial Law Review by a team of lawyers from Debevoise & Plimpton LLP. More important, Schaeffler did not have to disclose the 28% of Continental over which the swaps arguably gave it control, and it also avoided triggering a German law that requires anyone who buys more than 30% of a public company to bid for the entire target. Because the banks that held Continental shares each owned less than 3%, they also had no disclosure obligations.

Had Germany's securities regulator (the Bundesanstalt für Finanzdienstleistungsaufsicht, or BaFin) found that Schaeffler broke its rules, the penalty would have been slight, the Debevoise lawyers note, since BaFin could have imposed fines of no more than €200,000 for the nondisclosure and €1 million for violating the mandatory bid rule. Schaeffler paid about €50 per share for the cash-settled swaps and ended up offering €75 for the Continental shares, implying a savings of €1.1 billion on the banks' combined 28% stake. And securities litigation in Germany against Schaeffler would be unlikely to succeed after BaFin rejected Continental's claims that the bidder had broken the law, Seibt says. BaFin found no proof of concerted action between Schaeffler and the banks.

The regulator reached the same conclusion in other cases where targets have appealed to it, most notably in an attack on Deutsche Börse AG by the Children's Investment Fund and other hedge funds in 2005 and in Porsche SE's successful takeover of Volkswagen AG. But Porsche used standard cash-settled options to build a little more than half of a 20% stake in Volkswagen, which was less aggressive than Schaeffler's strategy. The two automakers also have a relationship that dates to the early 1930s.

Continental in August allowed Schaeffler to buy up to a 49.9% stake at €75 per share. Schaeffler also promised not to break up Continental, fire workers or jettison its brand or Hanover headquarters. Continental CEO Manfred Wennemer, who resisted Schaeffler, resigned Aug. 31. Schaeffler's tactic, like Porsche's, has yet to raise the ire of German regulators and politicians, in large part because Schaeffler and Porsche are German companies. But if sovereign wealth funds or a company from a non-German-speaking country did something similar, political opposition might be more significant, Seibt says.

David Marcus is a senior writer at Corporate Control Alert.