The FSA's recent consultation paper on the disclosure regime governing contracts for differences highlights market concerns that "hedge funds may outflank traditional institutional investors by using economic interests to influence companies" (CP 07/20 Disclosure of Contracts for Differences). The view that funds holding large contract for difference (CFD) positions may influence management is widely held, particularly among traditional institutional investors. Yet there is no strong legal basis for it, and there is little evidence that CFDs are used for that purpose. So how should issuers deal with CFD holders?

Influence

In the UK, company directors have a duty to "promote the success of the company for the benefit of its members as a whole". A company is not obliged to look beyond its register of shareholders in identifying its members. As long as a company owes a duty to its members, that concept is limited to the legal owners of shares, recorded on the company's register. While directors need to have regard to the interests of stakeholder groups such as employees, there is no need for a company to look after the interests of the world at large. More specifically, a company does not have to take care of the interests of holders of CFDs.

Writers of long CFDs will often hedge their positions by taking an equivalent position in underlying securities. When a holder of a long CFD position can direct how the shares used to hedge the CFD are voted, or require physical settlement of the CFD, one could argue that its interest is akin to an equity interest and that management should recognise this and act on it. In these circumstances, directors may think that the interests of the shares' registered holder (that is, the CFD writer) are effectively the same as the interests of the CFD holder. Indeed, a board may be reluctant to ignore the demands of a CFD holder that controls a large proportion of the company's voting rights.

CFDs can be part of activist or takeover strategies, or attempts to avoid disclosure requirements, but they have other functions too. The stamp duty savings are beneficial. Crucially, CFDs are issued on the basis of up-front margin payments that are much less than the overall value of the position, allowing flexibility on funding and leverage. As the FSA's consultation paper points out, many CFD agreements do not enable the CFD holder to direct voting rights. They are cash settled. The holder has a purely economic and no proprietary interest in the shares underlying the CFD. The FSA's position in assessing changes of control in authorised firms is consistent with this analysis. Although the acquisition of a 10% equity holding in an authorised firm requires FSA approval, the FSA may not count a person's interest in certain CFDs when assessing whether that threshold has been breached. This is a valuable tool for bidders building stakes in an FSA-authorised target before a takeover offer is made. Pearl Assurance used the option recently when building its stake in Resolution. Still, the Takeover Code requirements and the regimes governing price sensitive information should be carefully considered.

When CFDs have no proprietary rights to the underlying shares, it is difficult to see why a board should feel obliged to act on the CFD holder's views – it is not a member and has no right to vote or to become a member. CFD holders often seek to influence management or the outcome of a takeover offer. If the CFD holder pursues an activist strategy, the directors may consider the issues the holder raises to be relevant, and may act on them, regardless of the company's legal obligations to that CFD holder; but that is different from the question of to whom the directors owe their legal duties.

Disclosure obligations

In formulating a response to a CFD holder's approach, a company should consider the extent to which the holder controls voting rights or is able to demand a physical settlement. If a fund manager wants to influence the board, it should incorporate control of voting rights in the CFD.

In the Hedge Fund Working Group's final report in January 2008, it acknowledged that many of its consultees want further discussion in this area. It stated "companies have a right to know who owns them or who has an ability to easily obtain significant voting power." If directors need to know the extent of the CFD holder's voting rights to see what their duties are to that holder, a mechanism should be in place to give them that information.

But because the legal relevance of the CFD holder's interest in a company depends largely on its access to voting rights, the company's knowledge should be limited to information about those with the ability to acquire shares or voting rights as a result of their interest in the CFD. Other holders simply don't own the company in the way that a shareholder does.

Although not expressed in those terms, the FSA's suggested approach, Option 2 in the consultation paper, endorses much of this rationale. Under Option 2, disclosure of a CFD position is not required when the CFD is structured so that the agreement with the writer prevents the holder from exercising or seeking to exercise voting rights; the terms of the agreement exclude further arrangements or understandings regarding the sale of the underlying shares; and the holder explicitly states that it does not intend to use its CFDs to seek access to voting rights.

But Option 2 goes further. It allows issuers to request disclosure of pure economic interests. This would arise when reasonable cause exists for the issuer to seek disclosure, and when the holding exceeds 5% of the economic interests in the issuer (and at 5% levels afterwards in accord with the Transparency Directive, or when an interest fell below those thresholds). This aspect of the proposal is likely to generate tension. Fund managers will be keen to keep their proprietary trading positions confidential when no effort is made to influence management or exercise voting control. On the other hand, issuers may wish to know the identity of the economic owners of their business. The tension is even more acute in the case of the FSA's Option 3: a general disclosure obligation regarding CFDs would be created, even when the position taken is a purely economic one. By contrast, the US imposes a disclosure obligation on CFD holders seeking to exercise voting control or influence management, and requires only limited annual disclosure of pure economic CFDs.

The framework for a contract for difference

No real agreement

Although the UK City Code on Takeovers and Mergers requires more general disclosure of economic interests in an offer period, that regime differs from the general need for disclosure because, as the Panel has stated, the distinction between those with control over the underlying shares and those who only have an economic interest in their price "is not easily drawn in the context of a takeover". The Panel's rationale for requiring disclosure of CFDs without reference to the CFD holder's economic interest was that:

"To draw a distinction between holders of "controlling CFDs" and holders of "purely economic CFDs", particularly in a market where CFDs are written "over the counter", would be over-simplistic in the context of a takeover where the price of a takeover stock is determined by the outcome or the likely outcome of the bid and where an interest in the price of a takeover stock is therefore an interest in the outcome of the bid."

The Takeover Code requirements and the proposed changes to the Disclosure and Transparency Rules can be reconciled, but at a fundamental level they do not agree. The Panel appears to have been willing to look beyond the form of CFD documentation when determining its view of CFD holders' controlling interests in relation to underlying shares.

EU role

Both the FSA and key players such as the Hedge Fund Working Group have acknowledged the need for a public debate about CFDs. CESR has also assessed the need for further consultation and potential harmonisation of regulators' stances on disclosure of derivative positions as part of its review of the implementation of the Transparency Directive. More work on the subject now seems likely at EU level.

It will be interesting to see whether the FSA takes a broader view of CFDs in the same way that the Takeover Panel has done, in this era of principles-based regulation. Fund managers will probably press for disclosure obligations to be limited to those seeking voting control or wishing to influence management. For now, the FSA seems to support a regime based on legal relations consistent with fundamental company law principles and the legal duties that the directors of issuers owe.

By partner Mark Geday and associate Stephen Newby at Herbert Smith. The firm advised the Hedge Fund Working Group on its best practice standards issued in January 2008