Canada: Use Of Derivatives By Shareholder Activists

Last Updated: April 26 2011
Article by Patricia A. Koval

In recent years, hedge funds and other activist investors have relied on equity derivatives strategies to accumulate economic interests in potential takeover or proxy contest targets. So-called stealth accumulations have seemingly increased in both Europe and North America. In Europe, LMVH amassed more than a 20% holding in Hermes, largely through the use of equity derivatives, and in the United States, hedge funds acquired significant economic positions in this manner in Fortune Brands and J.C. Penney, allegedly with a view to exerting control or influence. Such transactions have brought these strategies to the forefront of attention of both activist investors and securities regulators in 2011. In the United States, the Securities and Exchange Commission is actively studying modernizing its reporting requirements to take into account the use of equity derivatives strategies in connection with takeover bids; we understand that the Canadian securities regulators are also considering this.

Typically, these equity derivatives strategies involve cash-settled total return equity swaps or similar vehicles, including, as they are known in Europe, "contracts for differences" (CFDs). In these contracts, while no actual purchase or sale of underlying securities occurs between the purchaser of the swap (the "long" party) and the counterparty, the counterparty will typically hedge its risk by purchasing the underlying securities. The long party will not receive the power to vote the underlying securities or to compel the counterparty to dispose of them. As a practical matter, however, the swap may be "closed out" and "converted" into a direct holding by the long party by cash-settling the swap and using the proceeds to acquire the securities from the counterparty.

Under Canadian and U.S. securities laws, the prevailing view of cash-settled total return swaps has historically been that, absent specific evidence to the contrary, these swaps do not provide the long party with actual or beneficial ownership of, or control or direction over, the underlying securities. Therefore, a party acquiring an economic interest in an issuer under an equity swap of more than 10% of the outstanding equity or voting securities of a class of a Canadian issuer has not typically filed an early warning report or an insider report relating to that interest (although a party that is already an insider as a result of beneficial ownership of such securities would be required to disclose its acquisition of an economic interest under an equity swap on an insider report under National Instrument 55-104, Insider Reporting Requirements and Exemptions). On its face, a party can, in this manner, accumulate an economic interest of virtually any size (including actual beneficial ownership of up to 9.9% of the issuer's securities) in an issuer without making disclosure. A party that is already an insider can increase its economic interest using an equity swap without filing an early warning report or being subject to the associated purchase moratorium on the underlying securities; rather it can simply disclose the position on an insider report filed five days after the transaction (and that report is not required to contain any statement about the party's intentions). In the United States, similarly, a long party would not typically file a report under Section 13(d) of the Securities Exchange Act of 1934 (the 1934 Act) after acquiring an economic interest under a total return swap in 5% of the common stock of an issuer.

In 2006, the Ontario Securities Commission considered the use of equity derivatives and reporting requirements in the Sears Canada transaction. Although the OSC was unable to conclude on the evidence that cash-settled equity swaps gave a hedge fund beneficial ownership or control or direction over the subject Sears Canada shares, the OSC indicated that the use of swaps to deliberately "park" securities and avoid reporting obligations in the context of a takeover bid could constitute abusive conduct. Subsequently, in 2008, in the proxy contest for CSX, the United States District Court for the Southern District of New York (affirmed on appeal) found that two hedge funds used cash-settled total return swaps and other arrangements to obtain significant economic power over CSX, without disclosure, before launching a proxy contest for seats on the CSX board of directors. Although the Court declined to go so far as to say that a typical cash-settled total return swap creates beneficial ownership, the Court found that, in the circumstances, the conduct of the hedge funds was sufficient to have deemed them to have acquired beneficial ownership; the hedge funds had, according to the Court, entered into these arrangements for the purpose of avoiding their disclosure obligations.

In an effort to protect themselves from stealth acquisitions, some U.S. issuers have included derivativebased long positions in the definition of "beneficial ownership" in their shareholder rights ("poison pill") plans. In both the United States and Canada, however, these efforts are largely chilled by the position of influential proxy advisory firms. For example, the 2011 voting guidelines of ISS recommend voting against approval of a plan that refers to derivatives contracts in the definition of "beneficial ownership."

The use of equity swaps to acquire economic toeholds or positions of influence has attracted regulatory scrutiny and recent reform outside North America. In the United Kingdom, the Financial Services Authority implemented new rules in June 2009, which contemplate a general disclosure regime requiring aggregation of physical share and long CFD holdings. In Australia, the Australian Takeovers Panel issued an Equity Derivatives Guidance Note that requires disclosure of positions taken in equity derivatives when there is, or can be expected to be, a "control transaction" by purchasers who have a combined long and actual physical position exceeding 5% of the underlying stock. Hong Kong has enacted similar rules to require disclosure of positions taken by way of cash-settled equity derivatives. Germany is expected to enact similar rules in 2011.

Perhaps not surprisingly, the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd- Frank Act) in the United States did not ignore this issue. It will add Section 13(o) to the 1934 Act to provide that beneficial ownership of a security will be deemed to have been acquired on the basis of the purchase or sale of a security-based swap to the extent that the SEC deems it to do so by rule. With the July 2011 enactment of this section looming, the SEC is being encouraged to amend the concept of beneficial ownership for purposes of Section 13(d). For example, Wachtell, Lipton, Rosen & Katz formally petitioned the SEC on March 7, 2011 to reformulate the definition of "beneficial ownership" for this purpose to encompass ownership of any derivative instrument that includes the "opportunity, directly or indirectly, to profit or share in any profit derived from any increase in the value of a subject security" (a formulation similar to "economic interest in a security" found in Canadian securities legislation). On March 17, 2011, in Release No. 34-64087, the SEC reaffirmed that where a security-based swap is used with the purpose or effect of divesting or preventing the vesting of beneficial ownership as part of a plan to avoid the beneficial ownership requirements, the party concerned may be deemed to have beneficial ownership of the subject securities; the SEC also announced that its staff is engaged in a project to modernize reporting under Section 13(d).

In Canada, the Canadian Securities Administrators, through a consultation paper published in November 2010, commenced a project intended to create sweeping transformational regulation of the Canadian OTC derivatives market; that consultation paper, however, did not address this issue. In Ontario, the December 2010 amendments to the Securities Act did expressly extend the prohibition on insider trading with material undisclosed information to related derivatives (including cash-settled derivatives). No amendments have yet been proposed, however, to the early warning reporting rules, but this issue is understood to be under study.

Taken together, these developments are expected to prompt further regulatory scrutiny of the use of equity swaps in contests for corporate control. Canadian securities regulators might be expected to revisit the early warning rules in this context.

Torys has offices in Toronto, New York and Calgary*

The content of this article does not constitute legal advice and should not be relied on in that way. Specific advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on

Click to Login as an existing user or Register so you can print this article.

In association with
Related Video
Up-coming Events Search
Font Size:
Mondaq on Twitter
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
Email Address
Company Name
Confirm Password
Mondaq Topics -- Select your Interests
 Law Performance
 Law Practice
 Media & IT
 Real Estate
 Wealth Mgt
Asia Pacific
European Union
Latin America
Middle East
United States
Worldwide Updates
Check to state you have read and
agree to our Terms and Conditions

Terms & Conditions and Privacy Statement (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

Use of

You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these terms & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.


Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.


Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.

Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

If you do not want us to provide your name and email address you may opt out by clicking here .

If you do not wish to receive any future announcements of products and services offered by Mondaq by clicking here .

Information Collection and Use

We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to with “no disclosure” in the subject heading

Mondaq News Alerts

In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.


A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

Log Files

We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.


This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

Surveys & Contests

From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.


If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.


This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to

Correcting/Updating Personal Information

If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to

Notification of Changes

If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

How to contact Mondaq

You can contact us with comments or queries at

If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at and we will use commercially reasonable efforts to determine and correct the problem promptly.