Hedge Funds, Sovereign Wealth Funds and Cash-Settled Equity Swaps - New Controversies in Public M&A

Maximilian Schiessl - Hengeler Mueller

While global M&A markets have been negatively affected by the crisis in the financial markets, there is a worldwide debate about the role of hedge funds and sovereign wealth funds and whether and how their activities should be made more transparent and subject to tighter regulation.

Furthermore, cash-settled total return equity swaps have come under increased scrutiny after being used by hedge funds, and other potential bidders, to build up a stake in public companies without disclosure.

Whereas private equity funds have problems effecting transactions above the mid-cap segment due to the lack of debt financing, sovereign wealth funds have made substantial investments recently, in particular to rescue major banks. While their fresh capital is welcome and may soften the repercussions of the subprime crisis, many observers worry about the politically motivated influence such funds could exercise on major players in strategically important industries such as banking.

In Germany, there is broad political support to amend the Foreign Trade Act, which currently only applies to arms and defence-related industries, by extending its scope. Following strong criticism from business circles warning against protectionism, a revised draft bill was published on 11 July 2008. While the previous draft would have applied to all foreign acquirers, the revised draft will not apply to acquirers from EU countries and countries associated with the EU (Iceland, Liechtenstein, Norway and Switzerland). This change was necessary as restrictions on EU-resident buyers might have violated the rules on freedom of trade within the EU. As a result, the law applies to Russia and China, which concern the public and politicians; it also applies to major sovereign wealth funds based, for example, in Dubai, South Korea and Singapore, and to countries such as Australia, Canada and the US. The draft bill does not include a specified list of industries. Instead, the law could theoretically apply to any industry, provided that the direct or indirect acquisition of at least 25 per cent of the voting rights "endangers the public order or security of the Federal Republic of Germany". This is a very high threshold and there is widespread opinion that very few cases would be affected. However, this creates unwelcome uncertainty; for example, in auctions of companies that are borderline cases the bill could work to the disadvantage of a non-EU potential acquirer. For this reason, the new draft has introduced the possibility for each acquirer to apply for a preliminary clearance certificate.

The Risk Limitation Act, part of recent measures announced by the German government in response to market activities of certain financial investors such as hedge funds, was adopted by the German Parliament on 27 June 2008 and, following approval by the German Upper House on 4 July 2008, comes into effect in August 2008 (some provisions will become effective in 2009).

The German government proposed the draft bill of the Risk Limitation Act at the end of October 2007 as a reaction to the ongoing activities of hedge funds in Germany (eg, Cewe Color, Deutsche Börse, TUI) and is aimed, as a consequence, at impeding the unfriendly activities of such financial investors with regard to German-listed companies. The main focus of the new law is the enhancement of transparency, in particular with respect to the disclosure of acquisitions of voting shares in listed companies. The statutory thresholds for the public disclosure of voting rights remain unchanged. However, the basis for the calculation has been modified. Currently shares carrying voting rights and other financial instruments granting the right to acquire such shares are not aggregated for the purpose of determining whether the notification thresholds have been surpassed, thereby enabling an investor to acquire up to 2.99 per cent of the shares plus up to 4.99 per cent of call options or similar financial instruments without disclosure. Under the new law, shares and financial instruments will be aggregated, with the result that going over the 5 per cent threshold triggers disclosure requirements, regardless of whether or not shares or financial instruments granting a right to acquire shares have been acquired.

In addition, any investor acquiring 10 per cent or more of the voting rights will be required to disclose its objectives as well as the source of the funds used to acquire the stake within 20 trading days after having reached the 10 per cent threshold. These rules follow the model of the securities regulations in the US. In particular, the investor is required to disclose:
• whether it is pursuing strategic objectives or general profit-maximising objectives with the investment;
• whether it intends to acquire further voting rights in the next 12 months;
• whether it plans to influence the composition of the executive or supervisory board of the issuer; and
• whether it intends to materially change the capital structure of the issuer, in particular by changing the debt or equity financing of the issuer or the issuer's dividend policy.

Any change of the objectives during the course of the investment must be disclosed within 20 trading days.
A proposal to require the disclosure of any intention to acquire 30 per cent or more of the voting rights has not become law.
A further important change is a broadening of the definition of "acting in concert" by shareholders. Until now, case law has taken a rather restrictive approach, considering mainly the conduct of the shareholders at the company's shareholders' meeting. The new law defines "acting in concert" as joint conduct in the form of an agreement or by other means, either with regard to the exercise of the voting rights at the meeting or with the objective of permanently and substantially changing the issuer's business strategy. This comes as a reaction of the lawmakers to problems faced by the German regulator Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin) in proving acting in concert in cases such as Deutsche Börse. Another proposal to include the coordination of acquisitions of shares in the definition of "acting in concert" has not become law.

As a consequence of the above, "acting in concert" will have a broader scope of application, although the language originally proposed has been narrowed in the final law. The actual scope of the new definition is not sufficiently clear and it remains to be seen how BaFin will apply the new rules.

It should also be noted that the Risk Limitation Act amends the definition of "acting in concert" pursuant to the German Securities Takeover Act in the same way. If the shareholders acting in concert together hold 30 per cent or more of the voting rights, the mandatory tender offer rules will apply.

The past twelve months have seen cash-settled total return equity swaps rise to prominence in boardrooms worldwide. While such swaps are a commonly used product in the global derivatives markets, they have recently been used by hedge funds and other investors to prepare for the build-up of a stake in public companies. This has caused a worldwide debate regarding whether such swaps, which provide economic exposure to the share price development of the underlying shares but no beneficial ownership and no influence on the voting rights, should be subject to disclosure.

Typically, the investor enters into swap agreements with one or several banks. These banks, in order to hedge their position under the swaps, buy shares in the markets or enter into similar swap agreements with other financial institutions. As a result of the structure, a number of banks will hold substantial stakes in the public company. At maturity of the swap, the final price is determined and compared to the initial price that was taken at the initiation of the transaction. The banks unwind their hedge position and the swap is settled in cash.
While cash-settled swaps grant the investor no right to acquire the shares or influence voting rights as a result of the transaction, a large amount of the equity of a listed company might end up in the hands of banks, and the investor has the possibility of commencing the unwinding of the swaps at its discretion, thereby affording a ready supply of shares to the market. Therefore, many observers are concerned that the investor would have a real advantage in converting its exposure from swaps to physical shares, although the swaps are not unwound in kind.

There are already some countries that require cash-settled swaps to be disclosed. In England, such swaps are exempt from the filing obligations but must be disclosed in a takeover situation. In the United States, in CSX Corporation v The Children's Investment Fund, a New York court held in June 2008 that building up a stake with cash-settled swaps without disclosure may be a violation of section 13(d) of the Securities Exchange Act, although the Securities Exchange Commission had taken the opposite view in an amicus curiae brief.
In Germany, Schaeffler KG, which has launched a tender offer for Continental AG, disclosed in its announcements that it has entered into cash-settled total return equity swaps in the magnitude of 28 per cent of the share capital of the target. As a consequence, several German politicians have already requested further reform of the filing provisions in the German Securities Trading Act, although the Risk Limitation Act only recently amended these provisions.

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