While the use of cash settled equity swaps is an established part of the Australian securities market, their use in recent high profile takeovers in Australia has attracted much attention. In particular, this attention has focused on the use of swaps by bidders or potential bidders in target companies without disclosure.
Examples of cash settled equity swaps in recent takeovers include:
- BHP Billiton in its successful takeover of WMC Resources. BHP held cash settled equity swaps over 4.3 per cent of WMC. These were disclosed by BHP in its bidder’s statement at the outset of its bid.
- The recent takeover bid by Cleveland-Cliffs for Portman Mining, where Seneca (a US hedge fund) was reported to at one stage have held over nine per cent of Portman Mining (for practical purposes enough to block compulsory acquisition).
- The current takeover bid by Centennial Coal for Austral in relation to which Glencore International AG holds cash settled equity swaps over 6.49 per cent of Austral Coal (in addition to physically holding 7.42 per cent of Austral’s voting shares). Glencore’s holding of the swaps has now become the subject of a Takeovers Panel application.
What are they?
In essence, a cash settled equity swap is a contract referenced to an underlying parcel of shares pursuant to which the investor or ‘taker’ gives or receives cash payments from the swap counterparty or ‘writer’ equal to the decrease or increase in the underlying share price between the date of the agreement and maturity of the swap. In return, the taker agrees to pay a fixed return to the writer by way of a financing charge.
Ordinarily, the writer of the swap will hedge its position by acquiring the underlying shares, so that its economic return is equal to the financing charge. However, this need not be the case and the writer may take an unhedged or partially hedged position.
Why use them in takeovers?
A bidder or potential bidder may seek to use cash settled equity swaps:
- to lock in the acquisition price over a parcel of the target company’s shares equivalent to the swap shares, thereby hedging against target share price rises
- as a ‘de facto’ pre-bid stake—although the holder of a cash settled equity swap does not control the voting or disposal of any underlying shares which the writer may acquire to hedge its position, it may have the ability to buy such shares from the writer on maturity of the swap, and
- as a means of financing a pre-bid acquisition on a cost-effective basis.
Cash settled equity swaps usually do not, on their terms, confer a relevant interest in the target company’s underlying shares on the holder or make the holder an associate of the swap counterparty. If so, the advantage for a potential bidder is a swap in relation to more than five per cent of the company should not require disclosure by it under the substantial shareholding provisions of the Corporations Act. Conversely, if the swap counterparty acquired a physical shareholding in excess of five per cent, it would need to disclose it shareholding.
Can disclosure be avoided?
If disclosure of the cash settled equity swap under the substantial shareholding provisions is to be avoided, the swap must be structured such that:
- it is cash settled only (no option to settle physically)
- the holder has no power to control voting or disposal of the underlying shares
- the counterparty must not be acting in concert with or consistently with the wishes of the holder. The holder should consider using an independent third party (ie non-adviser) as the swap counterparty
- the counterparty should not be required to acquire shares in order to hedge its position, and
- there must be no ‘economic warehousing’—there must be no agreement, arrangement or understanding between the holder and the swap counterparty (whether or not enforceable) that the underlying shares would be available for purchase by the holder on maturity or unwind of the swap.
However, even if a swap is structured to avoid disclosure under the substantial shareholding provisions, this is not the end of the story. Failure to disclose the existence of the swap in respect of more than five per cent of the shares in a timely manner may give rise to ‘unacceptable circumstances’. This may be the case if it can be shown that the effect of the swap or the failure to disclose its existence infringes the Eggleston principles which, among other things, require that the acquisition of control over shares takes place in an efficient, competitive and informed market.
Is there a trend toward greater disclosure?
Recognising the widespread use of derivatives in the London market, the UK Takeover Panel issued a public consultation paper in May proposing amendments to the UK Takeover Code. This would require the disclosure of dealings in a target company’s relevant securities during the offer period where that person holds ‘long’ equity derivatives over one per cent or more of a target company’s relevant securities. The rationale for this extension included that:
- a significant element of market activity has moved from the cash market to the derivative market
- derivative holders may exercise a significant degree of de facto control over underlying securities (ie the swap counterparty will wish to obtain repeat business from the holder and therefore is likely to act in accordance with the holder’s likely wishes)
- swap counterparties will normally hedge by buying underlying shares equivalent to swap shares which they will not sell until swap is closed out. On the unwind, hedged shares then become available to be bought, including by the holder
- disclosure of dealings would enable target shareholders to better understand forces at work in the market and, in particular, reasons why prices of bidder or target securities may be moving in a particular direction, and
- market knowledge of swaps could have an impact on an efficient, competitive and informed market and that ‘desirably in a fully informed market, swap agreements should be disclosed’.
While the Australian Takeovers Panel and ASIC have been reported as considering the use of equity swaps in takeovers, there has not yet been any guidance on the matter. However, this is about to change.
The Takeovers Panel is currently considering an application brought by Centennial Coal alleging unacceptable circumstances in relation to the failure by Glencore International AG to make timely disclosure regarding equity swap arrangements entered into in relation to more than five per cent of Austral Coal.
These Takeovers Panel proceedings should provide some useful guidance on the use of cash settled equity swaps in takeovers, particularly with regard to the disclosure requirements. The decision may also be the precursor of a Takeovers Panel guidance note.
It will be interesting to see whether the Australian Takeovers Panel adopts an approach similar to that being proposed by the UK.
Future editions of this newsletter will provide an update on the results of the Panel proceedings and in respect of the issue of any guidance notes on the matter.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.