The Panel rules on cashsettled

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1 AUGUST 2005 MERGERS & ACQUISITIONS Inside: The recent Panel decisions throw some light on the use of cash-settled swaps in takeovers The Panel rules on cashsettled swaps Two recent Panel decisions shed some light on the use of cash-settled swaps in takeovers. Partner Cameron Price and Senior Associate Jonathon Mant report that there may be wider implications as even the validity of the Panel system is called into question. Over the past year, concerns have been expressed in Australian fi nancial markets over the use of cash-settled equity swaps 1 in Australian takeovers to acquire a pre-bid or a blocking stake without disclosure. While the substantial shareholding notifi cation provisions of the Corporations Act require disclosure when a person acquires fi ve per cent or more of a listed company, they arguably don t require exposure under a cashsettled swap to be counted toward the fi ve per cent. The issue arose earlier this year in relation to Cleveland Cliffs bid for Portman, and again in relation to BHP Billiton s bid for WMC Resources (although in this case, BHP Billiton s total exposure to WMC Resources shares was less than fi ve per cent). Your publication: If you would prefer to receive our publications in electronic format, please publications@aar.com.au Earlier this year, the press reported that the Takeovers Panel was preparing a draft guidance note on the issue. This followed a UK Takeover Panel paper in January that recommended tightening disclosure requirements over cash-settled equity swaps. However, before the Australian Takeovers Panel could get its draft guidance out into the market, along came Centennial s bid for Austral Coal and Glencore s use of swaps in relation to Austral Coal shares. The bid led to the Panel s decisions in Austral 02 and on review in Austral 02R. We look at those decisions and their implications. VISIT OUR WEB SITE TO READ ALL FOCUS EDITIONS 1. A cash-settled equity swap is a contract under which the parties agree to settle, in cash, the difference between a reference price (for example, the price of a reference share) at the date of the contract and the date of close-out, multiplied by an agreed number of shares. The swap holder usually pays the counterparty (commonly a broker or investment bank) a small deposit and the counterparty s fi nance costs. The counterparty may (and commonly does) take out a physical hedge against its exposure under the swap by buying the relevant number of shares, but it is not obliged to do so. 1

2 AUGUST 2005 The facts Centennial announced its bid for Austral Coal on 23 February In early March, Glencore acquired 4.9 per cent of Austral Coal on-market. Glencore then proceeded with cash-settled equity swaps with two banks for a further 7.4 per cent of Austral Coal, without disclosure. Glencore told both banks that it was considering a rival bid for Austral Coal. Glencore and the fi rst bank decided to proceed with the fi rst swap on 21 March, and immediately thereafter the fi rst bank began acquiring Austral Coal shares on-market to hedge its position. Glencore was aware and intended that the bank would do this. Glencore was also aware of the bank s progressive acquisition of the hedge shares. By 30 March, the fi rst bank had acquired 4.6 per cent of Austral Coal. The second swap was entered into on 29 March and, by 4 April, the second bank had acquired 2.5 per cent to hedge its position. Glencore only disclosed the swap arrangements to the Australian Stock Exchange (ASX) on 5 April, a fortnight after its combined holding (that is, the aggregate of its physical shareholding and the banks hedge shares) fi rst went through fi ve per cent. During the relevant period, Centennial declared its offer unconditional and moved from nine per cent to 34 per cent of Austral Coal, and approximately 13 per cent of Austral Coal shares had been traded on-market. Centennial subsequently increased its holding to 85 per cent, but has become stuck at that level and unable to achieve the 90 per cent compulsory acquisition threshold because the banks hold 6.5 per cent under the hedges and Glencore holds 7.32 per cent, and neither the banks nor Glencore have accepted the bid. On 3 June, Centennial applied to the Panel for orders requiring disclosure of the details of the swaps and orders that the banks sell their hedge shares into the Centennial bid. The legal issue The Corporations Act requires a person who acquires a substantial holding in a listed company to notify ASX and the company within two business days (or by 9.30 am on the next trading day if there is a bid on foot). A person has a substantial holding if the shares in the company in which they have a relevant interest, together with the shares in the company in which their associates have a relevant interest, exceed fi ve per cent of voting shares. A person has a relevant interest not only where they hold the share or have power to control the right to vote the share, but where they have power to control disposal of the share. A power to control disposal can be positive (for example, power to force the disposal of the shares) or negative (for example, power to prevent a person from disposing of shares except in certain circumstances). The term associate is also defi ned broadly in the Act, and includes where two parties act in concert to acquire a substantial interest in the company. Prior to Austral 02, the generally accepted legal view was that: A carefully drafted, 2 cash-settled equity swap would generally not give the holder a relevant interest in any hedge shares. This was so even where there had been a strong economic incentive for the counterparty to hedge the swap, and, if the holder had the right to close out early at the then market price, even though it was a market reality that the counterparty would sell the hedge shares to the holder or through the market upon close-out of the swap. The mere entry by a holder and a counterparty into a swap did not make them associates. However, it was always possible that this could change if they were knowingly working together to achieve a common purpose of acquiring a strategic stake. Even if there was no relevant interest or association, if the swap was entered into to secure a pre-bid or blocking stake immediately before or during a takeover, there was a real risk of the Panel making a declaration of unacceptable circumstances where the aggregate of the holder s physical stake and its derivative positions exceeded fi ve per cent and that fact was not disclosed to the market. Under the Act, the Panel can declare unacceptable circumstances whether or not the circumstances constitute a breach of the Act, and if the non-disclosure of the swap arrangements had materially impacted on an effi cient, competitive and informed market for control of the target, it was perceived that the Panel might make appropriate orders. 2. To achieve this result, the swap documentation would not require the counterparty to hedge, and would make it clear that if the counterparty did hedge by acquiring the reference shares, the holder had no right to vote or acquire or force disposal of those shares on close-out of the swap. 2

3 The Initial Panel decision The Initial Panel found that entry into the swap arrangements gave rise to unacceptable circumstances. It therefore made a declaration to that effect and orders. It found that the swap arrangements amounted to Glencore putting its foot on a strategic stake that it could use as a springboard for a bid for Austral Coal if it so chose, or as a blocking stake in relation to Centennial s bid, and that securing this strategic stake without timely disclosure meant that the market for Austral Coal shares had traded for some time in an ineffi cient and uninformed manner. The Panel found that Glencore knew and intended that the banks would acquire the hedge shares (there being no other effective hedge) and was in fact informed as the banks did so. In reaching its decision, the Panel found that it didn t need to reach any conclusions on relevant interests or associations. Instead, it considered the purpose outlined in section 602(a) of the Act, and of the substantial shareholding notifi cation provisions themselves, namely, that the acquisition of control over voting shares in a listed company take place in an effi cient, competitive and informed market. Having regard to that purpose, Glencore s actions were unacceptable. While the Panel did not consider it necessary to determine whether the control that Glencore exercised over the hedge shares met the legal test of being a relevant interest, it did say that in the circumstances of a takeover there was a strong economic incentive for the banks to hold the hedge shares during the swap, which gave Glencore a real degree of effective negative control over the disposal. Also relevant was Glencore s relationship with the banks, which led to inferences of control. The Panel noted that each bank may have become an associate of Glencore (but not the other bank). The Panel found that the banks knew that the swaps and connected transactions were designed to avoid disclosure of the combined holdings and in this knowledge proceeded to carry out the transactions required to give effect to Glencore s strategy. The Panel ordered that Glencore: immediately disclose the essential terms of the swaps to the market; offer to sell to any person who had sold Austral Coal shares on-market during the period from 9.30 am on 22 March (being the next trading day after Glencore s combined holding fi rst exceeded fi ve per cent) up until 5 April when Glencore made its ASX announcement, the same number of shares as were sold by that person on-market at the same price at which they sold on-market; and if it did not have enough Austral Coal shares to satisfy acceptances of those offers, could require the counterparty banks to sell suffi cient hedge shares to it. The Panel rejected Centennial s request for an order compelling the banks to sell into its bid, considering that Centennial had accepted the risk that it might not achieve compulsory acquisition when it waived its minimum acceptance condition on 23 March holding only nine per cent of the stock, and that Centennial s interests were not suffi ciently harmed by Glencore s lack of disclosure to warrant making that order. The Review Panel decision The Review Panel also found that there had been unacceptable circumstances but did not consider that it needed to make the detailed fi ndings of fact that the Initial Panel had made. Instead, it found that the banks acquisition of hedge shares was in practice highly likely, if not inevitable, as the shares were the only viable hedge, and that those purchases had signifi cantly reduced the free fl oat of Austral Coal shares without this being disclosed. Had the market known of the swaps, it would have assumed physical hedging and identifi ed Glencore as a potential bidder for Austral Coal or blocker of Centennial s bid. Shareholders would have reassessed their investment decisions in this light. While these fi nal conclusions were much the same as the Initial Panel, there was a strong anti-avoidance fl avour to the initial decision, in which the Panel was clearly infl uenced by Glencore deliberately entering into a strategy to accumulate a strategic stake of at least 10 per cent without disclosure. The Review Panel appeared less preoccupied with this aspect. The Review Panel did not continue the disclosure order (apparently because the market was now suffi ciently informed) and did not include the supplementary order that if Glencore did not have suffi cient shares to restore to shareholders, Glencore could acquire them from the banks. However, it made a similar order that Glencore offer to sell Austral Coal 3

4 shares to those Austral Coal shareholders who had sold on-market during the non-disclosure period at or below the sale price, and also ordered the banks not to sell their shares until it was clear whether Glencore would be able to discharge its obligations under the Review Panel s orders by reference solely to Glencore s direct shareholding. The implications The rules for disclosure of positions under cashsettled equity swaps will not be fully outlined until the Panel releases its guidance note. We understand that there will be a period for the market to comment once it is released. However, in the interim, we make the following observations in relation to the Austral decisions: The Austral decisions are limited to their facts and do not necessarily require that a cash-settled equity swap must be disclosed to the market where the aggregate of the swap holder s physical shareholding and the number of reference shares under the swap exceed fi ve per cent. The facts of Austral were special in the following respects: (a) Austral Coal was subject to a takeover bid at the time the swaps were entered into. This impacted on the liquidity in, and volatility of, the market for Austral Coal shares at that time and contributed to the Panel s conclusion that it was inevitable that the banks would hedge their exposure under the swaps. (b) Here, Austral Coal shares were the only effective hedge for the swaps. The Panel concluded that: there were no exchange-traded derivatives or similar products available to hedge exposure over Austral Coal shares; there were no indices or baskets of securities to provide effective hedging over Austral Coal shares; there were no other companies whose shares provided an effective hedge over Austral Coal shares (Austral Coal was a single-mine coal producer in fi nancial diffi culties); the above alternatives would not, in any event, provide a proper hedge where Austral Coal was subject to a takeover; and while the two banks might have hedged their exposure with back-to-back swaps with another bank, the third bank would clearly have not entered into the back-to-back arrangement without itself having acquired physical shares that it would retain for the life of the swap. (c) The Review Panel focused on the fact that it was therefore commercially highly likely, if not inevitable, that the banks would hedge the swaps by acquiring Austral Coal shares. (d) Glencore actually knew that the banks had acquired Austral Coal shares to hedge the swaps which, when combined with Glencore s existing physical shareholding, exceeded fi ve per cent of Austral Coal, and it still did not disclose that fact. In most cases, the swap holder would not be aware of the counterparty s action to hedge the swap position, or even whether the counterparty has hedged its position at all, although it might have either an intention or expectation about this. In light of the Austral decisions, it might be expected that the Panel s guidance note on cash-settled equity swaps will require disclosure by the holder where: the aggregate of the holder s physical holding in the reference company and the number of reference shares under the swap exceeds fi ve per cent; and it is commercially highly likely, if not inevitable, that the counterparty will hedge by acquiring physical shares in the reference company, or that the holder knows that the counterparty has hedged in this way. The holder would, however, need to bear in mind that the question of whether or not it was commercially highly likely that the counterparty would hedge by acquiring physical shares (or whether there was some real practical alternative) will be tested with the benefi t of hindsight if a bid is made and the matter is brought to the Panel. Whatever the position might be outside of a takeover context, the particular liquidity and volatility issues that arise during a takeover bid might mean that the Panel will be much more inclined in a bid scenario to conclude that physical hedging was likely. Practically, therefore, disclosure in the context of a takeover may in all but a few cases be necessary. Indeed, the Panel might extend this principle so that disclosure is always required when a bid is on foot, given that even the existence of a signifi cant economic exposure to a target company may be material information for the market in a control scenario, regardless of whether that position is actually or highly likely to be hedged by target shares. 4

5 It is not clear what details must be disclosed if disclosure of the swap arrangement is required. However, the disclosure order made by the Initial Panel in Austral required disclosure of the parties to the swap, its date, whether the swap was long or short, the reference price, the term of the swap and the number of reference shares. If a holder is required to disclose the swap within two business days (or by 9.30 the next morning if a takeover is on foot), the counterparty is unlikely to be prepared to enter into the swap unless it is confi dent that it will be able to hedge its position before that disclosure is made. Otherwise, it might need to pay a signifi cant premium for its hedge or even be unable to obtain the hedge. In practice, that means that a bank may not be prepared to enter into a swap until it has purchased its hedge portfolio (and, thus, may need to risk acquiring a signifi cant portfolio without being certain that the swap will proceed). Alternatively, the counterparty may wish to limit the number of reference shares to the number of shares that it knows it can acquire on-market in that two business day (or shorter) period without material price impact. Neither of the Panels in Austral found it necessary to decide whether the swaps gave rise to a relevant interest or an association. However, in the Initial Panel s decision in particular, there was a clear warning that a bank that knowingly helps a client acquire a stake of more than 10 per cent without disclosure runs a real risk of becoming an associate of the holder. If there is an association, the bank becomes subject to the substantial shareholding notifi cation provisions of the Act (as opposed to the requirements of Panel policy). Failure to notify in accordance with the Act can have civil and potentially criminal consequences, and the notifi cation must include not only the hedge shares but also any other shares held by the counterparty bank as a principal position or in any other capacity giving it a relevant interest. The information that must be disclosed also includes all agreements in connection with the association, which may require much broader disclosure than under Panel policy. A fi nding of association between the holder and the counterparty, if that were to occur, also has signifi cant consequences under the minimum-bid price rule and certain other provisions of the Act. It is not yet clear how the Centennial bid will pan out. During the non-disclosure period, Austral Coal shares traded in a range from $1.20 to $1.34 and were trading at $1.35 as at the date of the Review Panel decision. If suffi cient numbers of those former Austral Coal shareholders who sold on-market during the non-disclosure period require Glencore to sell them replacement shares and then sell into the Centennial bid, Centennial could still achieve compulsory acquisition. Alternatively, Glencore could presumably stand in the market for those shares. The outcome therefore remains uncertain. Postscript In time, the Austral case may be seen as having much wider ramifi cations even than those outlined above. On 27 July, Glencore initiated a judicial challenge to the Panel s decision. Glencore applied directly to the High Court, but its application was remitted to the Federal Court. Reportedly, there are two main bases for the challenge. First, that the Review Panel exceeded its powers under the Corporations Act and that it reached a decision which no reasonable Panel could reach. In other words, Glencore has apparently sought a judicial review of the Review Panel decision. Secondly, Glencore has reportedly alleged that the Panel system is inconsistent with the Australian Constitution. That allegation challenges the Panel s very existence. Since its inception fi ve years ago, there has been considerable debate among academics as to whether the Panel exercises judicial power and, because the Panel is not a court, whether the Panel system is consistent with the Constitution. It appears that this debate will soon be settled. One of the great strengths of the Panel system has been the decline in tactical litigation and the consequent extensive (and, from the perspective of target shareholders, unnecessary) delays in takeover bids. Another has been the Panel s ability to develop policy responses to new developments in takeovers practice in a much faster timeframe than Parliament could develop legislative responses, and without being constrained by black letter law. If a practice develops of seeking judicial review of Panel decisions or if the Panel system is ruled invalid by the High Court, these gains may well be lost. Watch this space. 5

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