use of cash-settled derivatives as takeover instruments

1. CASH-SETTLED DERIVATIVES
AND TRANSPARENCY OF
CAPITAL MARKETS
Lex’Talk no. 12, 17 March 2015,
Danijel Stanković, LL.M. Finance

2. TOPICS FOR TODAY
• Takeover early warning system with emphasis on
notification duties under the Transparency Directive
• What are (cash-settled) derivatives?
• Secret stake-building and new takeover tactics – 3 case
studies
• 2013 amendment to the Transparency Directive

3. TAKEOVER EARLY
WARNING
SYSTEM

4. TAKEOVER EARLY WARNING SYSTEM
• the duty to disclose changes in the shareholdings in public
companies above and below certain thresholds
• the duty to submit a takeover bid after reaching a certain
threshold (so-called controlling stake) and to publish forthwith a
decision to launch a voluntary bid
• the duty to timely disclose the relevant price sensitive
information in order to prevent insider dealing, as well as not to
distribute any misleading information that would manipulate the
market
• aggregation of voting rights held in different positions (shares,
derivatives, decoupling of economic ownership)

5. TAKEOVER EARLY WARNING SYSTEM
• Directive 2004/109/EC of the European Parliament and of the
Council of 15 December 2004 on the harmonisation of
transparency requirements in relation to information about
issuers whose securities are admitted to trading on a regulated
market and amending Directive 2001/34/EC, OJ 2004 L 390/38
• Directive 2004/25/EC of the European Parliament and of the
Council of 21 April 2004 on takeover bids, OJ 2004 L 142/12
• Directive 2003/6 of the European Parliament and of the Council
of 28 January 2003 on insider dealing and market
manipulation (market abuse), OJ 2003 L 96/16

6. TAKEOVER EARLY WARNING SYSTEM
• General idea: anyone who intends to acquire control in a
listed company should make it public as soon as the decision
to acquire that control becomes final
• General goal: protection of the target company’s long-term
interests, minority shareholders, investors etc.

7. THE IMPORTANCE OF TAKEOVERS
INVESTORS
REGULATED
MARKETS
REGULATOR
SHAREHOLDERS
MANAGEMENT
CAPITAL MARKETS
TARGET COMPANY
(ISSUER)
MEMBER
STATES
LOCAL
COMMUNITIES
EMPLOYEES
OTHER STAKEHOLDERS
TAKEOVER EARLY WARNING SYSTEM

8. MAJOR ISSUES
• Management entrenchment v shareholder value (market for
corporate control – takeovers)
• Short-termism and hedge funds v long-term interests of the
target company (who’s hiding behind the hedges?)
• Decoupling of economic and legal ownership from voting
rights by means of financial instruments and other practices
TAKEOVER EARLY WARNING SYSTEM
OWNERSHIP VOTING RIGHTS ECONOMIC EXPOSURE

9. MAJOR ISSUES
• Economic ownership: economic returns associated with
share, i.e. dividends + appreciation
• Record date system vs. real-time verification of records –
who is your shareholder for the purpose of attending and
voting at the company’s general meetings?
• e.g. share loans used just to capture the record date
TAKEOVER EARLY WARNING SYSTEM

10. DISCLOSURE OF MAJOR SHAREHOLDINGS
A. If a shareholder acquires or disposes of shares of an issuer whose
shares are admitted to trading on a regulated market and to which
voting rights are attached (Art 9(1) Transparency Directive)
B. If a natural person or legal entity:
• is entitled to acquire, to dispose of or to exercise the voting rights
(Art 10), or
• holds, directly or indirectly, financial instruments that result in
an entitlement to acquire, on such holder’s initiative alone, under a
formal agreement, shares to which voting rights are attached,
already issued, of an issuer whose shares are admitted to trading
on a regulated market (Art 13), i.e. physically settled equity-based
instruments with in rem effect (mit dinglicher Übertragungs-
erklärung, § 22/1 WpHG)
TAKEOVER EARLY WARNING SYSTEM

11. DISCLOSURE OF MAJOR SHAREHOLDINGS
• Thresholds of 5%, 10%, 15%, 20%, 25%, 30%
(alternatively: 1/3), 50% and 75% (alternatively: 2/3) of
voting rights (Art 9(1),(3))
• Time-limit: not later than 4 trading days and the issuer has
to publish such notification within another 3 trading days
(Art 12(2),(6))
• Events changing the breakdown of voting rights (e.g.
cancellation of treasury shares, Art 9(2))
TAKEOVER EARLY WARNING SYSTEM

12. AGGREGATION OF VOTING RIGHTS
• Acting in concert – agreement to adopt, by concerted exercise of the voting rights, a
lasting common policy towards the management of the issuer in question (U.S.
group), Art 10(a) – a group of shareholders or investors
• Share loan, Art 10(b) – used for capturing the record date
• Share pledge, Art 10 (c) – who can exercise the voting rights: pledgor or pledgee?
• Life interest on a share, Art 10(d)
• Controlled undertakings, Art 10(e)
• Share deposit, Art 10(f)
• Holding on behalf, Art 10(g) – banks selling cash-settled options while holding the
underlying shares as a hedge
• Proxy, Art 10(h) – if it can exercise voting rights at its discretion
TAKEOVER EARLY WARNING SYSTEM

13. EXEMPTIONS
• shares acquired for the sole purpose of clearing and settling within the usual short
settlement cycle (max. 3 trading days)
• custodians holding shares in their custodian capacity, if they can exercise voting
rights only under written instructions
• acquisition or disposal of a major shareholding reaching or crossing the 5%
threshold by a market maker (i.e. up to 10%), if it neither intervenes in the issuer’s
management nor exerts any influence on the issuer to buy shares or back their price
• voting rights held in the trading book of a credit institution or investment firm not
exceeding 5% - if not exercised or otherwise used to intervene in the issuer’s
management
• buy-back programmes and stabilisation of financial instruments (NEW!) - if not
exercised or otherwise used to intervene in the issuer’s management
TAKEOVER EARLY WARNING SYSTEM

14. WHAT ARE
DERIVATIVES?

15. WHAT ARE DERIVATIVES?
• a type of financial instruments the value of which is
derived from and depends on the value of an underlying
asset
• an agreement between two parties (short party, the seller -
long party, the buyer) which is to be performed in future
with respect to the underlying asset and under the terms set
in advance
• settled either (a) physically/in kind, i.e. by delivery of the
underlying asset, e.g. transfer of shares, or (b) in cash

16. WHAT ARE DERIVATIVES?
• if settled in cash, any difference in the value between the agreed
price of the underlying (strike price or exercise price) and the
market value of the underlying on the day of the derivative’s
expiration/termination is paid in cash
• hedging of risk, speculation/arbitrage, takeover tactics
• traded either on exchange (EUREX, NYSE LIFFE) or over the
counter (OTC, i.e. off exchange, bilateral agreements)
• forwards, futures, options, swaps and their combinations
(structured products)

17. FINANCIAL INSTRUMENTS
Section C of Annex I to the Directive 2004/39/EC of the European Parliament and of the Council of 21 April 2004 on
markets in financial instruments, OJ 2004 L 145/1, − MiFID, as repealed by Directive 2014/65/EU with the effect
from 03/01/2017
• Transferable securities (shares, bonds, etc. excluding
instruments of payment − cheques, bills of exchange)
• Money market instruments (treasury bills, certificates of
deposit, commercial papers, excluding instruments of
payment)
• Units in collective investment undertakings (investment
funds, UCITS – undertakings for collective investment in
transferable securities)
• Derivatives

18. UNDERLYING ASSET
• all kinds of assets: shares, bonds and other securities,
commodities and currencies
• various economic variables: interest rates or yields,
financial indices (DAX, CAC 40) or financial measures
(ratios, ratings etc.), freight rates, inflation rates or other
official economic statistics
• climatic variables (e.g. wind harvest forecast for wind
farms) or emission allowances under the Kyoto Protocol
WHAT ARE DERIVATIVES?

19. FORWARDS AND FUTURES
• obliges the long party to buy the underlying asset at a future
date (settlement date, delivery date) at a price set today
(forward price)
• no payment today; requires payment only at the maturity
date
• futures = forwards traded on exchange
WHAT ARE DERIVATIVES?

20. OPTIONS
• entitle the long party to either buy (call option) or sell (put option) the underlying
in future
• no obligation on the part of the long party, it only pays a premium
• exercised if option is in the money (call – if market price is higher than the agreed
price; put – if market price is lower than the agreed price)
• an option is not exercised: (i) either the market price of the underlying is below the
strike price (“the option is out of money”) and (ii) the market price is equal to the
strike price (“the option is at the money”)
• European options − a specific maturity date; American options − can be exercised
throughout the whole period until their specified expiration date
WHAT ARE DERIVATIVES?

21. OPTIONS
CALL OPTION IS IN THE MONEY
• 1 Volkswagen share
• Today’s price € 216
• Agreed price € 250
• Maturity: 1 July 2015
• Price on 1 July 2015: € 350
• If settled in cash you get € 100 in cash
PUT OPTION IS IN THE MONEY
• 1 Volkswagen share
• Today’s price € 216
• Agreed price € 250
• Maturity: 1 July 2015
• Price on 1 July 2015: € 150
• If settled in cash you get € 100 in cash
WHAT ARE DERIVATIVES?

22. SWAPS
• parties exchange two independent cash-flows, thereby
assuming the risk of the other party’s cash-flow
• interest rate swaps, e.g. floating to fixed
• currency swaps
• total return swaps - contracts for differences - CfDs
WHAT ARE DERIVATIVES?

23. SWAPS EXAMPLE - CURRENCY SWAP
• Bank A granted you a 10-year CHF 100,000 loan in 2009
• You want to hedge you exposure to CHF
• Bank B (short party) accepts to pay your instalments in CHF
to Bank A while you will continue to pay instalments in EUR
to Bank B to repay the remaining EUR converted amount of
the principal plus an additional fee
WHAT ARE DERIVATIVES?

24. TOTAL RETURN SWAP
(U.K. Contract for Differences)
• exchange of the total return on any notional portfolio of assets
(i.e. specified number of reference bonds, stocks, etc.) in
consideration for interest on a notional principal (“virtual bond”)
• replicates the flow of the referenced asset as if you were owner
of that asset
• notional principal represents the amount agreed between the
parties, which is not paid out to the long party, but it only serves
as a reference amount for the calculation of interest owed to the
short party

25. EXAMPLE - TOTAL RETURN EQUITY SWAP
• You want to have economic exposure to a listed company and
benefit from its shares, but you do not want to own it.
• Total return includes dividend payments plus share price
appreciation on maturity or termination date, i.e. the upside
difference as compared to today’s price
• Your bank (short party) accepts to provide you that in return for
a regular fee calculated as interest on a notional amount plus
share price depreciation, i.e. the downside difference as
compared to today’s price

26. TOTAL RETURN EQUITY SWAP
WHAT ARE DERIVATIVES?
Total Return on
Reference Shares
(Dividends + Reference
Shares Appreciation)
Reference Rate + Spread
+ Reference Shares
Depreciation
Short Party Long Party
Total Return Payer Total Return Receiver

27. NEW TAKEOVER
TACTICS

28. NEW TAKEOVER TACTICS
• A company wants to take advantages of synergies from a business
combination with its competitor, but it does not want that its plan
becomes public
• Its bank offers cash-settled derivatives not entitling the long party to
acquire „on such holder’s own initiative alone” already issued shares
to which voting rights are attached (cf Art 13 Transparency Directive)
• The bank hedges its risks by buying the referenced shares or by
involving other banks to make all holdings fit to Transparency
Directive exemptions (5% threshold, trading book etc.)
• At maturity or termination date, the bank can offer shares in lieu of
payment of any of its outstanding financial obligations

29. CASE STUDIES
• Schaeffler v Continental AG (2008)
 no violation found
• Porsche v VW (2008)
 Criminal investigation
opened in 2014
• LVHM v Hermès (2013)
 EUR 8 million fine, no appeal submitted
NEW TAKEOVER TACTICS

30. SCHAEFFLER v CONTINENTAL AG
Source: D. Zetzsche: Continental AG vs. Schaeffler, Hidden Ownership and European Law – Matter of Law, or Enforcement? (SSRN No. 1170987)
Merrill Lynch – sole swap
counterparty
Probable hedging partners:
Commerzbank
Dresdner Bank
Credit Suisse
Royal Bank of Scotland
UBS
Landesbank Baden-Württemberg
UniCredit/HVB
NEW TAKEOVER TACTICS

31. SCHAEFFLER v CONTINENTAL AG
• BaFin (German Federal Financial Supervisory Authority) found no breach of
reporting duties:
http://www.bafin.de/SharedDocs/Veroeffentlichungen/EN/Pressemitteilung/2008/pm_08
0821_conti.html
„The shares underlying the swap agreement could [...] have been attributed to
Schaeffler only if BaFin had been able to prove the existence of further agreements
under which
 Merrill Lynch or third parties had held Continental shares on behalf of Schaeffler (section
30 (1) sentence 1 no. 2 WpÜG, section 22 (1) sentence 1 no. 2 WpHG);
 Schaeffler had been able to acquire Continental shares as a result of a declaration of intent
(section 30 (1) sentence 1 no. 5 WpÜG, section 22 (1) sentence 1 no. 5 WpHG);
 or voting rights were to be exercised jointly (section 30 (2) WpÜG, section 22 (2) WpHG).
BaFin was unable to find evidence of any such agreements.”
NEW TAKEOVER TACTICS

32. PORSCHE v VOLKSWAGEN AG
• In 2008, Porsche SE attempted to gain a 75%
stake in rival Volkswagen by accumulating
shares in stages, including through the use of
derivatives
• In October 2008, Porsche announced it held
42.6% of VW ordinary shares together with
31.5% in cash-settled options relating to VW
ordinary shares,
• VW share price soared from € 201 to € 1,005
per share what was, at the time (i.e. on 28
October 2008), the most expensive share
worldwide! (short squeeze – a situation where
there is not enough shares in the free float to
satisfy all short positions in that share)
Source: http://seekingalpha.com/article/291188-tesla-the-looming-short-squeezeSource: http://www.reuters.com/article/2008/10/28/us-volkswagen-idUSTRE49R3I920081028
NEW TAKEOVER TACTICS

33. PORSCHE v VOLKSWAGEN AG
• No decision by BaFIN at the time
• Various lawsuits have been filed against Porsche in Germany and the
United States by hedge funds
• In November 2014, former Porsche Chief Executive Wendelin
Wiedeking and his former finance chief Holger Haerter faced charges
of market manipulation, with possible financial implications for
Porsche.
Source: http://www.ft.com/intl/cms/s/0/108b3308-6a88-11e4-bfb4-00144feabdc0.html#axzz3RGlSoTJH
NEW TAKEOVER TACTICS

34. LVMH v HERMÈS
• During 2001 and 2002 LVMH acquired 4,9% in Hermès via two of its subsidiaries
(Luxembourg , Delaware)
• In the first half of 2008, LVMH entered into several swap agreements with Nexgen
Capital Limited, Société Générale and Crédit Agricole Corporate & Investment Bank
via its two subsidiaries in Hong Kong in relation to 12,37% of Hermès’ capital
• In December 2008, LVMH sold a portion of shares in order not to reach the 5%
threshold following the cancellation of certain treasury shares by Hermès
• On 23 October 2010, LVMH declared it held 14,2% of Hermès’ capital which
increased to 17,1% by 26 October 2010 and more than 20% by 21 December 2010
• On 25 June 2013, the French Financial Markets Supervisory Authority (Autorité des
marchés financiers) imposed a fine of € 8 million, and LVMH decided not to appeal.
Source: www.amf-france.org/technique/multimedia?docId=workspace://SpacesStore/f6d76d34-e619-4d93-ad47-6429cd3f9100_fr_1.0_rendition
NEW TAKEOVER TACTICS

35. 2013 AMENDMENT
TO THE
TRANSPARENCY
DIRECTIVE

36. DIRECTIVE 2013/50/EU
ART 13 OF TRANSPARENCY DIRECTIVE
NOW INCLUDES:
• financial instruments that, on maturity,
give the holder, under a formal agreement,
either the unconditional right to acquire
or the discretion as to its right to acquire
already issued listed shares to which voting
rights are attached, i.e. physically settled
equity-based derivatives now without the
need for a transfer statement having in rem
effect;
• all other financial equity-based
instruments with economic effect
similar to that of the financial
instruments, whether or not they confer a
right to a physical settlement, i.e. all other
cash-settled financial instruments (TRSs,
CfDs)
PREVIOUS WORDING:
• financial instruments that result in an
entitlement to acquire, on such
holder’s initiative alone, under a
formal agreement, shares to which
voting rights are attached, already
issued, of an issuer whose shares are
admitted to trading on a regulated
market

37. DIRECTIVE 2013/50/EU
• number of voting rights is calculated by reference to the full
notional amount of shares underlying the financial instrument
• If cash-settled, number of voting rights is calculated on a ‘delta-
adjusted’ basis, by multiplying the notional amount of underlying
shares by the so-called delta of the instrument
• Delta (Δ) is one of the ‘Greeks’ used in finance for pricing and
hedging of options. It is the ratio of the change in the price of an
option to the change in the price of the underlying share. It
changes over time. It can range from 0 to 1 for call options and
from 0 to -1 for put options (e.g. if a call option is deep in the
money it is closer to 1)

38. TRANSPARENCY VS. FLOOD OF INFORMATION
• Art 10(g) Transparency Directive:
voting rights held by a third party in its own name on behalf of
[another] person or entity.
• Art 2(1)(e):
‘shareholder’ means any natural person or legal entity governed
by private or public law, who holds, directly or indirectly:
(i) shares of the issuer in its own name and on its own
account;
(ii) shares of the issuer in its own name, but on behalf of
another natural or legal entity; [...]

39. TRANSPARENCY VS. FLOOD OF INFORMATION
• Too fact-specific provisions require more fact-finding
powers for supervisors – possibility for evasion
• Too many information can create false impression of an
imminent change of control making investors buy or sell
shares in the target thereby distorting the share price

40. FOR MORE INFORMATION
• D. Stanković: Challenges to the
Takeover Early Warning System in the
EU: The Case of Germany,
http://www.cyelp.com/index.php/cyel
p/article/view/184
THANK YOU FOR YOUR ATTENTION!