The Canadian Securities Administrators (CSA) have proposed important changes to existing "early warning" disclosure obligations, designed to improve transparency of investor interests and voting rights in the securities of reporting issuers. These proposals are intended to respond to increased shareholder activism, more frequent proxy battles and concerns regarding "empty voting" and "hidden ownership" arising from the use of equity derivatives and securities lending arrangements. The recommended changes would, among other things:
- align Canada's threshold for early warning disclosure to match the 5% threshold applicable in the U.S. and several other major foreign jurisdictions
- require disclosure of decreases (in addition to increases) of ownership, based on changes of 2% or more compared to the previously filed report
- include economic interests held through "equity equivalent derivatives" in determining whether disclosure is required
- enhance the transparency of the disclosure regarding the nature and extent of investors' voting interests and investors' intentions in holding securities
- expand the circumstances in which an investor will not be eligible to access the alternative monthly reporting framework
Early Warning Reporting Thresholds
Currently, if a person acquires beneficial ownership of, or control or direction over, voting or equity securities of any class of a reporting issuer that would constitute 10% or more of the outstanding securities of that class, the person must issue and file a press release promptly and file an early warning report within two business days. The CSA have proposed a reduction of this early warning threshold from 10% to 5%.
The proposed 5% threshold aligns Canada's reporting regime with requirements applicable in the U.S. and several other major foreign jurisdictions. In explaining its rationale for lowering the threshold, the CSA highlight increasing shareholder activism and that early warning disclosure can be relevant for purposes beyond signalling a potential take-over bid, such as alerting issuers and other market participants to a potential proxy battle. The 5% threshold is also consistent with the level at which, under certain corporate statutes, an investor may requisition a shareholders' meeting. Other benefits noted by the CSA include giving reporting issuers more time to defend against a potential offeror or activist shareholder, as well as facilitating greater communication among shareholders.
Under Canada's existing rules, a person who has filed an early warning report needs to report subsequent ownership increases of 2%, but not decreases (except if the investor were to conclude that the reduction represented a change in a material fact contained in an earlier report). The CSA indicate that the current reporting regime provides incomplete insight into changes in ownership interests and accordingly propose that investors who have previously filed an early warning report also be required to disclose reductions of ownership of 2% or more of a class of securities. Disclosure would also be required if the investor's ownership percentage were to decrease to less than 5%.
"Hidden Ownership": Disclosure of Equity Equivalent Derivatives
The CSA's proposals move to require early warning disclosure beyond beneficial ownership, direction and control of securities, to include initial and ongoing disclosure of economic interests held through certain types of equity derivatives. This proposal is the next step on the path toward treating synthetic positions assumed through derivative instruments as changes in ownership of underlying securities for reporting purposes. The approach is akin to changes made to insider reporting requirements starting in 2004, which currently require insiders and others to look through their derivatives positions and integrate their effect when interpreting certain provisions of securities law.
The CSA believe that changes to early warning disclosure to address "hidden ownership" are required "in order to ensure proper transparency of securities ownership in light of the increased use of derivatives by investors." The CSA are concerned that sophisticated investors could use derivatives to accumulate a significant economic interest in an issuer without having to disclose it, and then potentially convert that interest into voting shares in time to exercise a shareholder vote. The commentary suggests that the CSA perceive an indirect, tacit linkage to voting rights under cash-settled derivatives, based on the "strong incentive [of the counterparty/dealer] to hedge its obligations under the arrangement through holding reference securities and [that the counterparty/dealer] may decide to vote in accordance with its client's wishes or to make the securities available to the client on request".
In response to these concerns, the CSA propose to revise both the manner of determining when an investor is required to disclose its interest in a reporting issuer and the nature of the disclosure required. In particular, the CSA have proposed that "equity equivalent derivatives" be counted in determining whether the investor has met the applicable early warning threshold trigger. Equity equivalent derivatives would capture derivatives that substantially replicate the economic consequences of ownership and include instruments such as total return swaps, contracts for difference and other instruments that provide an investor with a notional "long" position having an economic interest that is substantially equivalent to that of the underlying securities. The CSA's commentary suggests that an "equity equivalent derivative" for a specified quantity of underlying securities would be considered to exist if the short position under the derivative could be "substantially hedged" by holding 90% or more of that specified quantity of underlying securities. This quantitative approach will no doubt raise many interesting practical considerations. Instruments that provide the holder with only partial exposure to the underlying securities, such as options, would not necessarily be considered "equity equivalent derivatives", although the CSA have included a reminder that they have public interest jurisdiction to respond to partial exposure instruments where the CSA perceive their use to be abusive. Under the CSA's proposal, "equity equivalent derivatives" would be counted only for the purpose of determining whether an investor has triggered the early warning disclosure requirements, but not for certain other purposes, such as whether the 20% take-over bid threshold has been triggered.
The CSA also propose to expand the scope of information required in early warning disclosure to include the actual or notional number or principal amount of securities underlying an equity equivalent derivative as well as the existence and material terms of any related financial instruments in which the investor has an interest.
The CSA anticipate that an investor could, through the use of derivatives or securities lending arrangements, be able to influence the outcome of a shareholder vote without having a significant economic interest in the issuer. In such instances, while the investor's ownership interest may be disclosed, its true economic interest may remain undisclosed.
Securities lending arrangements are a common practice in which securities are transferred from a lender to a borrower in exchange for a fee, subject to the borrower's obligation to return identical securities on agreed terms and conditions. To provide a more complete understanding of an investor's actual economic and voting interest in a reporting issuer, the CSA have proposed expanding the scope of information required in early warning disclosure to include a description of any securities lending arrangement applicable to the investor's interest in the issuer. Once the early warning disclosure threshold is crossed, the proposed changes would reveal where securities are acquired by an investor under lending or other arrangements that provide the holder the ability to exercise the votes attached to securities without having an economic interest in the securities and the terms of such arrangements. The disclosure would include disclosure of securities lending arrangements in effect at the time of a reportable transaction even if that transaction did not itself involve a securities lending arrangement.
As the proposed amendments would require disclosure of reductions by 2% or more of previously reported ownership interests, absent an exemption, securities lending arrangements would impose disclosure obligations on securities lenders in applicable circumstances. The CSA are considering providing an exemption from the early warning disclosure requirements for securities lenders in the case of securities loan arrangements that include an unrestricted ability of the securities lender to recall the borrowed securities prior to a meeting of security holders. The CSA are not considering a corresponding disclosure exemption for borrowers.
Enhanced Disclosure of Intentions
An investor is currently required to disclose the purpose of an acquisition as part of its early warning news release and report. However, in practice such disclosure is often generic, providing little additional information to the market. The CSA's proposal requires more detailed disclosure of an investor's intentions.
Limitations on Alternative Monthly Reporting
Certain institutional investors are exempted from the standard early warning requirements if they adopt a prescribed monthly reporting regime. The policy rationale underlying this alternative framework is that eligible institutional investors are passive investors who would not be seeking to influence control over the reporting issuer. Currently, institutional Investors are disqualified from relying on this alternative reporting regime in respect of securities of an issuer if they make, or intend to make, a take-over bid, or propose, or intend to propose, a reorganization, amalgamation, merger, arrangement or similar business combination with the reporting issuer if the institutional investor would obtain a controlling interest in the reporting issuer. The list of disqualifying circumstances does not currently include investors who solicit, or intend to solicit, proxies from security holders of the issuer. The CSA noted that this is inconsistent with the intent of the alternative reporting regime and propose to include in the list of disqualifying events proxy solicitation in connection with the election of directors or a reorganization, amalgamation, merger, arrangement or similar transaction.
The proposed changes would result in the amendment of National Instrument 62-103 – The Early Warning System and Related Take-Over Bid and Insider Reporting Issues, Multilateral Instrument 62-104 – Take-Over Bids and Issuer Bids and National Policy 62-103 – Take-Over Bids and Issuer Bids, and, in order to allow the substance of the proposed amendments to apply in Ontario, amendments will be required to the Securities Act (Ontario) and Ontario Securities Commission Rule 62-504 – Take-Over Bids and Issuer Bids. The CSA requested comments on the proposed changes during a 90-day comment period, with comments being due by June 12, 2013. The CSA have posed 15 specific questions regarding the proposals, which commenters are invited to address in their responses.
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