In the December 2007 issue of IFLR we discussed the difficulties presented by the Australian Takeovers Panel's proposed approach to the use of its powers. Its draft Guidance Note required the disclosure of a broad range of equity derivatives, regardless of whether or not a takeover was on foot. In early April, after a number of submissions by industry bodies and market participants, the Panel released its final Guidance Note. The result should be a relief for many participants in the equity derivatives market. The Panel has now adopted a regime that, although not perfect, is more workable than the regime originally proposed.

New position

The final Guidance Note states that the economic long position created in a company's shares under an equity derivative will need to be disclosed if the underlying company is the subject of a control transaction and the aggregate long position (without netting long and short positions and including any physical holding) is at least equal to 5% of the company's shares or, if that position has been disclosed, later changes by more than 1%. However, such a position will not need to be disclosed if the long position is held by a market-maker or the equity derivative is an index or basket trade (although there may be circumstances where a basket trade must be disclosed). In contrast with the previous draft, the new Guidance Note is written less as a formal set of rules and more as guidance. It specifically states that the Panel is not bound to follow the Guidance Note.

Unlike the previous draft, the new Guidance Note expressly recognises equity derivatives as valuable trading and risk management products. It states that the Panel does not want to interfere with the equity derivatives market as long as they are not used in ways that undermine Australian takeovers laws.

Market-makers

One concern with the draft Guidance Note published by the Panel was that, unlike the English Takeover Code, it did not contain an exemption for market-makers. Without that exemption, the market could be flooded with duplicate (and sometimes triplicate) disclosures, and the operational costs of market participants would increase.

In its final Guidance Note the Panel has recognised this concern. It will not require disclosure of a market-maker's short (or back-to-back long) positions, provided that the derivative is an arm's length transaction with a counterparty, which the market-maker is neither associated with (or acting with regarding the derivative's reference entity) nor acting for in a corporate advisory capacity (unless an effective Chinese wall is in place). The Panel describes a "market-maker" as a writer of equity derivatives who holds an Australian Financial Services Licence or its equivalent in another jurisdiction, and provides arm's length, professional intermediary services. The need for this exclusion was noted in a number of submissions made to the Panel in respect of its draft Guidance Note. Participants in the equity derivatives market should welcome the market-maker exemption warmly.

Control transactions

The Panel's draft Guidance Note applied the same disclosure obligations to investors taking a passive interest in a company that is not subject to a takeover bid, as it did to persons seeking control of or accumulating a position in a company subject to a takeover. But in its final Guidance Note, the Panel has clarified that it ordinarily will not expect disclosure of cash-settled equity derivatives written over shares in a company that is not the subject of a control transaction. The Panel has defined "control transaction" as a transaction that affects or is likely to affect control or potential control of a company, or the acquisition or proposed acquisition of a substantial interest in a company.

The Guidance Note states that the acquisition of a substantial interest is the acquisition of a parcel of securities of any size that "forms a step in the direction of takeover or change in corporate control" of a listed entity. These broad and somewhat vague concepts are derived from and consistent with the Panel's jurisdiction to declare unacceptable circumstances under the Australian Corporations Act.

There can be little doubt that a takeover bid or merger by scheme of arrangement would be a control transaction, but it is less clear what other circumstances will constitute such a transaction for triggering the disclosure requirement. Doubt may also arise about when a control transaction actually commences. In this regard, the Panel has said that it will consider a control transaction to have begun when a proposal that is likely to affect control or potential control of a company is announced, an acquisition of a substantial interest occurs (for example the acquisition of 3% of a company as part of a creeping acquisition), or a proposed acquisition of a substantial interest is announced.

The Panel has said that it is not concerned with deals that have little to do with control. In keeping with its statements that it is not bound by the final Guidance Note, the Panel has also said that it may examine situations in which a person holds a long position above 5% even though there is no control transaction.

Index and basket trades

The Panel has clarified that in most circumstances it will not require disclosure of equity derivatives in which the derivatives provide exposure to the performance of an index or a basket that includes shares in a company. However it remains concerned with basket trades that are not broadly based. For a basket trade to be exempt from disclosure, it must both be broadly based and not affect control or potential control of the securities comprising the basket. It is not clear how many entities must be included in a basket for a transaction to be considered broadly based. As an example, though, the Panel suggests a basket that includes the securities of five or more listed entities with no one security having a basket weighting of more than 30%.

Physically settled derivatives

The new guidance from the Panel does not change the law in relation to disclosing physical holdings or rights to the control of shares. If an equity derivative gives rise to a relevant interest in the underlying shares (because it gives the holder of the long position the right to control the disposal of, or voting on, the underlying shares) then the laws on disclosure set out in the Australian Corporations Act apply. These do not have exemptions for market-makers or particular types of derivative transactions. They apply whether or not a control transaction is in progress.

Physically-settled equity derivatives usually create a need to disclose a relevant interest in the underlying shares, although cash-settled equity derivatives can do this too. This does not mean that the Guidance Note applies only to cash-settled equity derivatives. The Panel has made it clear that physically-settled derivatives that do not require disclosure under the relevant interest provisions of the Corporations Act are within the scope of the disclosure regime set out in the Guidance Note. For example, exchange-traded options over shares in a listed entity do not have to be disclosed as a relevant interest until they are physically settled. The Panel considers that such an exemption does not place the buyer beyond the scope of the disclosure regime set out in the Guidance Note. It advises such buyers to disclosure their position as required by the Guidance Note.

What to disclose

The Panel has revised its approach to the information to be disclosed. It will now expect the content of the information to largely match that which a person with a physical holding of the relevant underlying securities would need to disclose. The counterparty to the derivative need not be disclosed, nor do the Isda terms (including those related to unwinding the derivative position). Nor does a hedging position that the counterparty puts in place need to be disclosed.

The Panel expects the identity of the taker (but not the writer) of the derivative to be disclosed. So should the relevant security, the price, including reference price, strike price and option price as appropriate. The entry date and number of securities to which the derivative relates should be disclosed, and the type of derivative – for example, contracts for difference, cash-settled put or call options. Material changes to information previously disclosed to the market should be provided, and information about the long equity derivative positions held by the taker and its associates, its relevant interests and its associates' relevant interests (and the identity of all the associates). The short-equity derivative positions that offset physical positions should be disclosed. Lastly, information about short positions of more than 1% that have been acquired after a long position is disclosed, whether by notice or substantial holding notice (the taker should update its disclosure with reference to the short position) should be provided.

The Panel has noted that if a derivative is entered into in multiple stages, disclosure may be required as it is progressively increased, regardless of when the formalities are completed. However, a taker is only required to disclose the exposure it has firm.

Netting

The Panel has not changed its view on the use of netting of long and short positions in determining the size of a buyer's holding of securities under an equity derivative, except where the offsetting positions are held through exchange-traded derivatives with precisely the same terms. As a result, the information to be disclosed will relate to the aggregate long position of a holder of physical and derivative exposure, without netting any short positions. In addition, the Guidance Note states that the information to be disclosed should include short positions that offset the long position that is the subject of the disclosure.

The new disclosure obligations commence now. However, the Panel says that for the next six months it will "bear in mind" in any application before it that disclosure systems may need to be changed, particularly in large organisations that do a lot of derivatives business. However, the Panel also says that the taker of a derivative is likely to be aware of its position – suggesting that new derivative positions taken where there is a "control transaction" must be disclosed from now on.

As far as undisclosed positions are concerned, the Panel recognises that disclosures may cause the taker some commercial disadvantage. But it goes on to say that if such a matter comes before it in the next six months, it will consider the steps the person concerned has taken to minimise adverse effects on the efficient, competitive and informed market for the relevant securities in the intervening period.

The Panel's position as set out in the Guidance Note is a welcome revision of the position described in its draft guidance. It presents a more manageable regime for participants in the equity derivatives market and one that does not place the Australian market wholly at odds with other leading financial markets. Still, it is not perfect. There will still be some grey areas where it is not clear whether the regime has been attracted or not.

Although the publication of the Panel's Guidance Note represents the Panel's settled position, it is likely that we will see further regulatory development in this area. On April 4 2008, the Australian Prime Minister announced that he has referred the topic of disclosure of equity derivatives for review by the Commonwealth Department of the Treasury. At the time of writing, the government had not published the terms of reference.

By Scott Farrell and Jeremy Green of Mallesons