Laying Your Cards on the Table – Equity Derivative Positions in Australia Exposed by Crown and Echo Entertainment

The issue of disclosure to the market of interests held through equity derivatives has been brought to the fore by the attention that the media has given to James Packer-backed Crown's recent equity derivative holdings in Echo.

What is an equity derivative?

In general terms, an equity derivative, such as an equity swap or a contract for difference, is a contract whose value is referenced to an underlying asset (for instance, shares in a company).

For example, the writer (that is the person who "provides" the derivative, such as the investment bank) of the equity derivative might agree to deliver $5 million worth of Echo shares to the holder of the equity derivative in exchange for $5 million cash at a predetermined future time plus interest at an agreed rate.

A cash-settled equity derivative is settled by the exchange of cash rather than the exchange of the underlying shares. It is common in the case of a cash-settled equity derivative for the writer of the derivative to hedge its position by acquiring the underlying shares, but there is usually no obligation to do so.

What is the issue?

Persons with a substantial holding (a 5% or higher relevant interest) in a listed company are required to disclose their interests under section 671B of the Corporations Act 2001 (Cth) (Corporations Act) by way of a substantial holder notice to the company and ASX. Holdings of equity derivatives which give rise only to an economic interest but do not give the holder of the derivative a right to acquire the underlying shares (for instance, a cash-settled equity derivative) are arguably not required to be disclosed under the substantial holding provisions of the Corporations Act¹.

In the Crown-Echo affair, Crown announced in June 2011 that it held an economic interest of 4.9% in Echo, acquired prior to the Tabcorp demerger, by way of cash-settled equity derivatives.

On 24 February of this year, Crown further disclosed that it held a 10% interest in Echo by way of a derivative that was to be settled by the physical delivery of 68.8 million Echo shares. The cash-settled equity derivative that Crown announced in June 2011 had been terminated. As at 24 February, Crown had not lodged a substantial holder notice in relation to this 10% interest. The market was, at that time, also not informed that Deutsche Bank was the writer of the derivative. According to media reports, Crown's chief financial officer said at that time that Crown was not a substantial holder of Echo for the purposes of the Corporations Act and therefore had no obligation to lodge a notice^{2, 3}.

One of the focal points of the discussion surrounding the Crown-Echo affair relates to the impact on an informed market if holdings of equity derivatives are not disclosed, particularly in the context where such products are used to acquire a pre-bid or blocking stake in a company without disclosure.

Some background

In 2005, this issue was considered by the Takeovers Panel (Panel) in the Austral Coal matters. The circumstances giving rise to these matters were that, against the backdrop of a takeover bid by Centennial Coal for Austral Coal, Glencore entered into cash-settled equity swaps in relation to shares in Austral Coal which were not disclosed in a timely manner to the market. Although the Panel decided that Glencore's failure to disclose its economic interest under the swaps was unacceptable, Glencore successfully challenged the jurisdictional basis of the Panel's findings in the Federal Court.

Following the Federal Court's decision in the Austral Coal matters, the concept of "substantial interest" was introduced into the Corporations Act in 2007. The Corporations Act now provides that if circumstances, which have or are likely to have on the acquisition or proposed acquisition by a person of a substantial interest in a company, appear to the Panel as being unacceptable, the Panel can make a declaration of unacceptable circumstances⁴. Section 602A(1) of the Corporations Act clarifies that a "substantial interest" in a company is not limited to a relevant interest in securities in the company, a legal or equitable interest in the securities, or a power or right in relation to the company or its securities.

Additionally, in June 2009, Treasury released a paper entitled, "Improving Australia's Framework for Disclosure of Equity Derivative Products" (Treasury Issues Paper), which sought submissions on whether there should be law reform to increase transparency in disclosure of equity derivatives. Some of the questions raised by the Treasury Issues Paper for consultation included:

• whether substantial cash-settled equity derivatives transferred significant effective control over shares;
• if there was physical hedging by the writer, how common was it for the holder to be aware of this hedging; and
• whether in practice, counterparties in equity derivative contracts typically issued voting instructions to the direct holder of the referenced shares, or seek to influence voting in any way.

As far as we are aware, no amendments to the law were proposed following from the Treasury Issues Paper.

Takeover Panel's guidance

Although the provisions introduced into the Corporations Act in 2007 do not expressly state that a "substantial interest" encompasses an economic interest, the Panel has issued Guidance Note 20 (GN20) to assist market participants to understand the Panel's approach to disclosure of equity derivatives.

Disclosure in the context of a control transaction

GN20 states that the Panel considers that equity derivatives may be a substantial interest (being a parcel of securities, of whatever size, that forms a step in the direction of takeover or change in corporate control) even though they give rise only to an economic interest. Where there is a control transaction, the Panel expects all long positions of 5% or more, either alone or when combined with the holder's physical position, to be disclosed.

A "control transaction" is considered by the Panel to have commenced when:

• a proposal that is likely to affect control or potential control of a company is announced;
• an acquisition of a substantial interest occurs; or
• a proposed acquisition of a substantial interest is announced.

Whether or not a "control transaction" exists in a particular set of circumstances could be subject to much contention.

Disclosure by a substantial holder notice is not required

Disclosure of an economic interest is not required to be made by way of a formal substantial holder notice (unless otherwise required because of a relevant interest in the underlying shares) and can be by written notice to the company. However, it should be noted that in deciding whether the level of disclosure gives rise to unacceptable circumstances, the Panel will take into account whether certain types of information, a list of which is set out in GN20⁵, has been disclosed.

In the case of Crown, it appears that the view taken by Crown was that it had no relevant interest in the Echo shares the subject of the equity derivative until Crown's subsidiary gave notice of settlement of the derivative on 2 March 2012 and therefore, the substantial holding provisions of the Corporations Act did not apply as at 24 February 2012 (and disclosure at that time was not required to be made in the form of a substantial holder notice).

When a substantial holder notice may be required

Although GN20 states that it is not concerned with disclosure required under the substantial holder notice requirements of the Corporations Act, it also provides that a holder of a cash-settled equity derivative may obtain a relevant interest in the hedge securities (and therefore, if that interest constitutes a substantial holding, will need to be disclosed in the form of a substantial holder notice) if the holder:

• acquires any right or obligation (formal or informal) to have them transferred (e.g. at settlement or otherwise);
• acquires any voting or disposal right in them; or
• makes any agreement, arrangement or understanding restricting the writer's ability to deal with or vote them.

Another consideration in determining whether a substantial holder notice is required is whether the holder and writer of the derivative are associates (for instance if they are acting in concert in relation to the affairs of the company). If they are associates, the relevant interest of the writer in any hedge securities will be counted in determining whether or not the holder of the derivative has a substantial holding in the company.

In the case of a writer of equity derivatives who is an Australian Financial Services Licensee authorised to provide arm's length, professional, intermediary services, the Panel takes the view that non-disclosure of an equity derivative by the writer is unlikely to give rise to unacceptable circumstances if:

• the equity derivative is written at arm's length;
• the equity derivative is written for a client who is not an associate; and
• the writer is not acting for the client in a corporate advisory capacity, or if there are effective Chinese walls in place between relevant divisions.

However, GN20 makes it clear that the above does not address disclosure obligations of a writer under the substantial holding provisions of the Corporations Act in relation to a physical hedge. In other words, if a writer of an equity derivative acquires the underlying shares (or acquires a relevant interest in those shares, for instance through a securities lending arrangement) to hedge its position, then the writer will need to disclose its interests via a substantial holder notice if its interest is 5% or more.

What are the gaps in the current law?

If it is accepted that there are market integrity and efficiency arguments in favour of requiring substantial economic interests derived from long equity derivative positions to be disclosed to the market, it appears that there are gaps in the current law which may need to be addressed.

One of these is that although the Panel has the ability to declare non-disclosure of such long positions as unacceptable circumstances, it will generally only consider the issue where there is a control transaction. There will be situations when substantial derivative positions are taken where a control transaction has not yet commenced (and does not ever commence). In such situations, the market integrity and efficiency arguments appear to be no less relevant.

Another gap may be that there is no prescribed form for disclosure of an economic interest held via an equity derivative. This is unlike disclosure of a substantial holding which is made via the prescribed form of a substantial holder notice.

In light of the increased attention on this issue as a result of the Crown-Echo affair, ASIC's deputy chair, Belinda Gibson, has been quoted in the media as saying that ASIC has been talking to the market informally about whether derivatives are being used to transfer control without the protection of the Corporations Act and the takeover provisions⁶. It may be that regulation may be introduced to more clearly mandate the disclosure of such equity derivative positions.

Footnotes

¹ Note, however, that market traded options and rights to acquire issued shares given by a derivative are likely to give the holder a relevant interest in the underlying shares for the purposes of the substantial holding provisions of the Corporations Act (see section 671B(7) of the Corporations Act).
² Durie, J 2012, 'Packer punts on murky derivative', The Australian, 1 March, viewed 29 March 2012, Factiva Database.
³ It is noted that:

• on 2 March 2012, Deutsche Bank lodged a substantial holder notice indicating that it became a substantial holder of Echo on 1 March 2012; and
• on 5 March 2012, Crown lodged a substantial holder notice indicating that it became a substantial holder of Echo on 2 March 2012 (which is the date on which Crown's wholly-owned subsidiary, Pennwin Pty Limited, gave notice of early settlement of the equity derivative).

• the price (including reference price, strike price, option price etc as appropriate);
• entry date;
• number of securities to which the derivative relates; type of derivative;
• long equity derivative positions held by the holder and its associates, its relevant interests and its associates' relevant interests (and the identity of its associates);
• short equity derivative positions that offset physical positions; and
• short positions of more than 1% that have been acquired after a long position is disclosed, whether by notice or substantial holder notice.

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.