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The Harvard Law School Forum on Corporate Governance and Financial Regulation, September 12, 2010 posting



Using Cash-Settled Derivatives to Hide Corporate Ownership

Posted by Scott Hirst, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Sunday September 12, 2010 at 10:58 am

Editor’s Note: This post comes to us from Matteo Tonello, Director of Corporate Governance for The Conference Board, Inc., and is based on a recent paper published by the Conference Board, which is available here.

In a recent paper, Know Your Shareholders: The Use of Cash-Settled Equity Derivatives to Hide Corporate Ownership Interests, The Conference Board offers guidance for directors of public companies to address or prevent situations where shareholders accumulate undisclosed equity stakes by means of cash-settled derivatives.

Derivatives are an important class of financial instruments that has taken center stage in today’s capital markets. The reason for their increasing popularity is that they offer risk protection while also allowing innovative investment strategies. In particular, in a regulatory environment where disclosure requirements are triggered by voting rights rather than economic interest, derivatives can be used to conceal equity ownership of a public company—a practice generally known as “hidden ownership.”

The new report by The Conference Board cites anecdotal evidence—including the most notable recent cases regarding Continental, Fiat, and Volkswagen-Porsche—that cash-settled derivatives are increasingly being used by investors and strategic bidders to discretely expand their ownership positions in business corporations listed on European stock exchanges.

The major recommendations included in the report are:

Monitor trading activities

Directors should ensure that the company relies on a sound process to monitor securities holdings, including derivative instruments, where the company’s securities are the underlying instrument. At a minimum, the company should regularly review public filings by investors and available shareholder lists. However, the thoroughness of the monitoring process should be elevated based on market indicators of abnormal shareholder activity that may signal situations of hidden ownership.

Obtain insights from large investors

Through investor dialogue, the company can learn early on about potential shareholder concerns and critical changes in its ownership base, such as information on group voting arrangements and other understandings among shareholders. Cultivating proactive relations with the investment community can prove helpful with larger institutions such as pension funds and mutual funds.

Commission perception studies

Regular outreach to investors can help management recognize a perceived valuation gap between the stock price and the company’s intrinsic value, which is often the impetus for the recourse to hidden-ownership accumulation strategies. If such a valuation gap exists, the board may consider commissioning a perception study to gain better insight into the issues causing the discrepancy.

Expect regular reporting from management

The board should be provided with regular reports on important shareholder intelligence, such as abnormal shareholder activity or a change in company ownership. Directors should meet with executives to discuss the implications and recognize possible hidden ownership.

Compile profiles of investors and prospective strategic bidders

The board should expect management to maintain profiles of any private pool of capital with investments in the company’s securities, as well as any prospective strategic acquirer in the marketplace.

Notify enforcement agencies

Directors must ensure that any material information on shareholdings is promptly communicated to the market and regulators in accordance with applicable laws. Enforcement agencies should be notified in situations where there is evidence that a shareholder or a group of shareholders are operating under an undisclosed understanding with investors or other market participants or dealers and, most important, in any case where there appears to be a violation of applicable securities regulation.

Understand the intentions of hidden owners

A company should not assume that investors resorting to hidden ownership schemes always pursue a hostile intent or a merely speculative agenda. Instead, directors should remain open-minded and review significant requests made by such shareholders in light of the company’s current strategy, industry benchmarks, analyst reports, and the investor profile and track record.

The full paper is available here.


© 2010 The President and Fellows of Harvard College




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