Use of derivatives in the market for corporate control
What is the issue?
Australia has a relatively good system for regulating the market for corporate control. Minorities, with some noticeable exceptions, are generally protected by a system which usually generates an equitable control premium for all shareholders.
The 20% takeover threshold, combined with the 3% creep provision every six months, make it difficult for a predator to get control of its takeover target without making a full bid.
One ongoing flaw in the system is the increasing use of derivatives to subvert the disclosure regime around substantial shareholding when control is in play. Ironically, control transactions, especially when a “blocking stake” under 20% is involved, are precisely when the value of substantial shareholding disclosure is greatest.
Properly administered, the Australian rules dictate that any shareholder that acquires more than 5% of a company’s shares (or any subsequent 1% increment) should make a disclosure to the ASX within 2 business days of purchase. The intention is that the regularity of the disclosure informs the market that an acquirer may be acquiring a blocking stake or a material parcel in anticipation of a full bid. Sellers can make an informed assessment if they are being adequately compensated for the control implications of selling or lending into an open market where a substantial shareholder is actively acquisitive.
What should be a simple regime has been made complex by the emergence of ‘swap’ transactions which means the rules are very easy to side-step. Substantial shareholders are not required to disclose anything if they hold an interest in a ‘swap’ – an instrument that guarantees payment to a third party that has acquired shares on its behalf, if that shareholder ‘elects’ to receive them. So instead of telling the market that you have acquired 10%, you simply go to a couple of investment banks and get them to acquire 5% each pursuant to a ‘swap’ and the market is none the wiser! Once upon a time this behaviour was regarded as ‘warehousing’ but the involvement of the transaction industry, notably investment banks, has institutionalised this loophole to the extent that it is now regarded as commonplace and ‘savvy’ behaviour.
The history of this goes back to BHP Billiton’s 2005 acquisition of WMC Resources, when it launched a counter-bid to Xstrata’s offer but had already emerged with a 4.3% exposure through an arrangement with Deutsche Bank, its corporate advisor on the deal.
The UK regulators sorted out this issue a decade ago by declaring that exposures through derivatives must be disclosed with each 1% change of interest. Australia has a higher 5% threshold for the initial disclosure but isn’t mandating disclosure of derivative exposures above this level.
Unlike UK regulators, Australia is yet to act and we think it is beyond time.
The purchase of ordinary shares is harder to conceal because targets can issue tracing notices, as Brambles famously did to Asciano in August 2007, prompting this unusual ASX announcement by Brambles.
In light of this embarrassment for Asciano, you can understand the attraction of dealing through a third party investment bank to retain the element of surprise and lower the average cost of entry, but such tactics mitigate against a fully informed market.
The derivative arrangements with investment banks are opaque and difficult to regulate. There may be conflicts of interest where banking conglomerates with corporate advisory relationships either take principal positions or deal with clients as brokers, prime brokers or facilitate the ‘acquisition’ of shares pursuant to the swap via securities lending transactions. The delivery of ‘borrowed’ shares under swap transactions is becoming increasingly frequent in Australia when control is at stake.
Why should a selling or lending institution receive a lower price than others in the market for corporate control, just because the derivative arrangement allowed the predator to remain invisible to the market?
We believe that Australia should adopt a version of the UK rules such that any interest under a derivative arrangement should be added to shares already owned.
If the combined interest is greater than 5% (and any subsequent 1% interest), timely disclosure should be made.
BHP & WMC Resources
BHP Billiton launches $9.2 billion cash bid for WMC Resources, disclosing that it already has a 4.3%exposure through an arrangement with its corporate advisor on the transaction, Deutsche Bank.
Bruce Gordon & Ten Network
Shortly after achieving board representation, Bruce Gordon, the largest shareholder in Ten Network Holdings increased his holding through a derivative arrangement with Deutsche Bank which the substantial shareholder notice observed didn’t technically need to be declared.
Dexus & CPA
Dexus emerged with a 14.9% blocking stake in CPA through a derivative arrangement with Deutsche Bank (involving borrowed securities) just one day after the Commonwealth Bank announced its intention to exit the property management business.
Crown & The Star
Crown announced it had secured 10% of Echo through an arrangement with Deutsche Bank (involving borrowed securities) at the same time as it launched a proposed joint development of a new casino at Barangaroo.