Should equity derivatives be regulated and disclosed like shares? This is one of the possibilities raised in a new Treasury issues paper.
The paper, released on Friday, rehearses many of the arguments that surrounded the Austral Coal case in the Takeovers Panel back in 2005. This time, however, the outcome may be changes to the Corporations Act, rather than a Panel Guidance Note.
The issues paper looks at four types of derivative:
- options (over both issued and unissued shares)
- equity swaps/CFDs
Specifically excluded are index-linked derivatives and convertible notes.
What are the issues?
Essentially, the issues discussed in the paper are those which arose in the Austral Coal case and its aftermath: control and disclosure.
The paper identifies a number of potential control issues arising out of hedging by the issuer of a derivative:
- a possible expectation that the issuer of the derivative will transfer the hedge shares to the taker when the derivative matures, even if the derivative is written as cash-settled;
- the fact that, even if there is no physical delivery, hedging can remove shares from the market, which can prevent a takeover bid from succeeding;
- the possibility that the taker of the derivative may influence how the issuer votes its hedge shares.
Rather than assuming the worst, the issues paper asks for feedback on the extent to which these are real control issues in the market place.
The second part of the paper looks at the question whether, if these control issues are significant to the market, the Corporations Act should be amended to take account of them. Three possibilities are raised, two of which are focussed on disclosure.
The first proposal, which was extensively debated in the wake of Austral Coal, is whether, if derivatives do give rise to concerns about control, those concerns can be addressed by greater disclosure to the market. Specifically, the paper asks whether the substantial holder and beneficial ownership tracing provisions should be expanded to include equity derivatives.
The second, and most far-reaching, is whether Chapter 6 should be applied to equity derivatives.
"If substantial holder notice provisions were expanded to include equity derivative positions, should the law be amended so that positions over 20 per cent must also comply with the takeover provisions? Should the assessment consider whether the takeover provisions in the Corporations Act 2001 would benefit from an expansion to include equity derivatives holdings?"
However, the issues paper appears to take the view that such a step might not be necessary if improved disclosure would provide sufficient protection to investors:
"If the requirements for substantial holder notices are amended to incorporate equity derivative positions, it is arguable that this apparent gap in the takeover legislation may not be an issue because the market can be relied on to price in a control premium, thereby rewarding other shareholders with the premium that an acquirer of direct stakes normally has to offer in a takeover bid. Arguably, the Takeovers Panel could address such an issue when it arises in practice."
Finally, in the wake of last year's furore about disclosure of directors' margin loans, it is not surprising that there is a directorial angle to equity derivatives. The paper appear to favour the expansion of the disclosure requirements for directors' shareholdings to include equity derivatives over the company's shares: it describes the fact that derivatives are not currently disclosable as "a gap in the law".
Where to from here?
The issues paper is simply the first step in the reform process. It is possible (albeit not probable) that Treasury will conclude that the current law does not require amendment. It is more likely, however, that, at some point down the track, there will be a set of firm proposals or even a draft Bill issued for discussion. The extent and form of the changes will depend upon how Treasury assesses the responses to this issues paper and regulatory developments overseas.