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Contracting out

Article by by Gareth Gore, Risk Magazine

Contracts for difference have caught regulators' eyes as being at the centre of possible market abuse scandals. Talk is brewing of a clampdown, with the UK regulator due to publish the results of a consultation paper this month. But are the fears justified? Gareth Gore reports

Surprise is always the favoured form of attack, not least when the strategy can save a company millions. But when defence and aerospace giant BAE Systems used a surprise weapon of its own in a takeover bid for the UK-based military vehicle manufacturer Alvis back in June 2004, some investors started to cry foul. Under the noses of Alvis shareholders, BAE had effectively sewn up the fate of a large chunk of the company behind closed doors - and with a group of investors that held not a single share between them

Since then, regulators have put equity derivatives known as contracts for difference (CFDs) under the microscope. CFDs are synthetic instruments that offer investors direct exposure to a company's share price, without the need to buy the stock itself. The payout is referenced to the stock's price movement during the contract's life, minus a fee of around 25 basis points

The regulatory scrutiny comes amid concerns that CFDs are being used to secretly accumulate large stakes in companies, as a result of hush-hush agreements between dealers and CFD investors. These agreements involve the dealer promising to sell the shares it has purchased to hedge its exposure from the sale of the CFD on to the investor once the contract expires - and that, say some, offers investors a back door to taking over a company

In fact, the regulators have already started to take action. Last year, the Panel on Takeovers and Mergers, which administers market requirements during periods of mergers and acquisitions in the UK, changed its rules, citing the Alvis takeover as one of its case studies. Now, any investor with an exposure to more than 1% of a company's stock - whether through shares or derivatives - must declare their interest during any takeover period

Later this month, the Financial Services Authority (FSA) will announce the result of its own consultation on CFDs, launched in March as part of new rules linked to the EU's Transparency Directive. Calls have been growing from some market associations and investment companies for the UK regulator to force all derivatives positions to be declared in the same way as shares - that is, to declare all positions above a fixed level of 3% of a company's stock

However, while greater disclosure was mooted in the consultation paper, the rules are unlikely to be changed - at least in the short term. A source at the FSA says the regulator will instead await a review of the new guidelines implemented by the Takeover Panel (see box) before deciding on its own course of action at some point next year. But the FSA official did not rule out a future change in the regulations, which is likely to anger both those who feel the current rules are adequate and those demanding immediate change

Indeed, many organisations have begun to voice their frustration with current regulations. "It is not right that long cash equity holders in a company don't know what's going on around a company they have invested in," says Peter Montagnon, director of investment affairs at the Association of British Insurers (ABI) in London. The organisation has a membership spanning some 400 companies or 94% of domestic insurance services sold in the UK, and those members are, in turn, estimated to account for almost 20% of investments in the London stock market

Montagnon says using CFDs to build up stakes behind the scenes has a major impact on the day-to-day workings of the market. "The disclosure regime we've got simply requires you to disclose long cash positions, but it doesn't give you the full picture of someone building up a contingent position, and that could have a big impact," he says. "It doesn't tell you about CFDs and it doesn't tell you about holdings that may have been acquired through borrowing of stock rather than paying for it. So when you look at current disclosures, you can't really tell who is in the driving seat."

The total notional outstanding of CFD contracts is hard to estimate, precisely because the products are traded over-the-counter. Nevertheless, the London Stock Exchange estimates that some 20% of all trading on the exchange can be attributed to dealers hedging CFD positions

Proponents warn that any changes to current rules could dramatically reduce demand for CFDs and, with it, the value-for-money trading strategies open to investors such as hedge funds. These contracts have become popular because they have two vital advantages over normal shares: they are exempt from stamp duty of up to 4% in the UK, meaning investors can take the view on the direction of a stock's price in a cost-effective way; and large positions don't have to be declared under company rules, meaning trades can be conducted in relative secrecy away from rival dealers.

The ABI wants derivatives positions to be subject to the same 3% rule as normal shares because of the apparent ease with which CFD investors can put side agreements in place that ensure they receive the physical shares the dealer had acquired to hedge the CFD position once the contract terminates. That means investors can build up large stakes in a company undetected and with relative ease. In its response to the FSA's consultation, the ABI argues that the costs of introducing such a disclosure regime would need to be seen in the context of increased market confidence, and calls for analysis to extend beyond the relatively straightforward consideration of direct costs and benefits.

However, the International Swaps and Derivatives Association hit out in June in its own response to the FSA consultation, arguing that measures to impose extra disclosure requirements on derivatives positions would be "fundamentally misguided" and "an unnecessary and unjustified burden".

"I think derivatives seem like an easy target for people who feel the financial system doesn't work in a way that's nice and cosy and predictable," says Richard Metcalfe, co-head of Isda's European office in London. He says the problem lies not in the derivatives contracts themselves, which often state the counterparty has no right to the underlying stock, but in informal side agreements entered into between dealers and their customers.

"We are facing an argument that is basically one of innuendo because it is suggesting that a cash-settled derivative must equate to some kind of side arrangement, whereas in fact any side arrangement by definition will be separate from what the derivative itself offers," says Metcalfe. He adds that Isda will stand firm on this issue. "That in essence is where we have been and where we will remain."

Nonetheless, concern about CFD holders obtaining physical shares from dealers is not without justification, and the Alvis acquisition is a case in point. At the time of the deal, BAE Systems already had a stake of 28.7% in the military vehicle manufacturer. Prior to affirming the acquisition, it reached agreement with investors holding a further 16.2% of shares to sell their stakes at a price of 320p.

In its official offer, BAE stated that it had also entered into irrevocable commitments with a number of hedge funds that held CFDs equivalent to some 7% of Alvis total stock. According to the BAE offer statement, the funds agreed to obtain physical shares from dealers "in accordance with market practice" before selling them on to BAE at a pre-agreed price. And with the Alvis share price leaping up by 14% in just one day following the announcement from 276p to 316p (see figure 1), investors say such 'market practice' is a breach of the FSA's current market abuse rules.

At present, the UK regulator has the power to heavily fine or ban from trading any market player that acts in a way likely to give a "regular user of the market a false or misleading impression", or in a way that could be "regarded by a regular user of the market as behaviour that would distort, or would be likely to distort, the market in such an investment". According to the Association of Investment Companies (AIC), a London-based trade organisation for the investment company industry, the FSA should, in fact, be using these current rules to clamp down on what it sees as market abuse.

The industry body favours forcing only those investors that may in future obtain physical shares through their CFD positions to disclose their interest at the outset of the contract - although that would rely on funds coming clean about side agreements in place with dealers. Nonetheless, the AIC says the regulator would easily be able to determine when investors had obtained shares through their CFD positions by monitoring trading volumes - if, on a single day, a fund acquired a large stake in a company without a surge in market volumes in that stock, it could indicate the shares had been acquired off-market, perhaps as part of a CFD side agreement.

According to Daniel Godfrey, the AIC's director-general in London, not only would this avoid investors having to declare innocent synthetic positions, but it would also prevent dealers trying to circumnavigate the 3% disclosure rule by developing new synthetic structures to allow their customers to keep trades secret. "In Hong Kong, where disclosure was written into company law, the rule book is just getting bigger by the day because people will pay clever lawyers to construct new instruments that fall just outside the definition that has been implemented," Godfrey says. "So we just gave up on company laws as being the right way to address this."

The UK regulator recognises the difficulty of policing such a regime, and part of its consultation involved asking participants whether further disclosure would in fact be justified in terms of cost and the sheer volume of data that would have to be collected. In a recent interview the FSA's head of market monitoring, Dilwyn Griffiths, admitted that the regulator was already struggling to follow all the leads generated by its Surveillance and Automated Business Reporting Engine - and many predict that disclosure of all CFD positions could lead to the FSA monitoring machine grinding to an abrupt halt.

No matter what course the FSA takes, intent will be very difficult to prove. Should a dealer that automatically sells the shares on a redundant CFD hedge to a customer that has just closed that CFD be viewed with suspicion? The FSA admits the area is unclear. "To the extent that CFD brokers have no real use for the stock held to hedge a CFD position, it is likely that they will be mindful of the wishes of their underlying clients (the CFD holders)," the consultation document states. "And even if there is no formal arrangement between the broker and holder, the latter would seem to be the obvious person to sell the underlying stock to (should he be willing) when the CFD and hedge transactions are unwound."

One CFD dealer at a large European bank says the issues coming out of the debate are peripheral to the CFD contracts in themselves and, although the bank always hedges directly with shares, CFD holders are never allowed to influence voting rights, nor does the bank have any kind of agreement - formal or informal - to sell on the shares once the CFD has expired. Indeed, many banks often separate out their hedging and equity sales books, he says.

"The sense we were getting very strongly from dealer firms when we were first generating responses to the Takeover Panel was that not only would firms categorically not enter into any such side agreements because of reputation issues and consequences, but they would take a dim view of anybody who asked them," says Metcalfe. "That doesn't mean it can never happen. It clearly could because you could have individuals that subvert firms' policy. But as a matter of industry policy, definitely not."

Although the difficulties of how to resolve the issue may leave regulators in a quandary, some believe failure to act now could lead to more scandals and, ultimately, a much more conservative response.

"We're not trying to do anything to kill the market - quite the contrary," says the ABI's Montagnon. "These are legitimate investment tools that are used legitimately by investors. The problem is that if you continue to operate at this level of obscurity, then the pressure is going to come for a more radical solution and that's something we want to avoid."

Redefining Interest

Last November, the Panel on Takeovers and Mergers became the first UK authority to impose disclosure rules on derivatives holders. Although investors are only required to fulfil this obligation during an official offer period for any UK-registered company, the rules are widely seen as an important redefinition of an investor interest in a company.

For the first time in the UK, if any investor has an interest in 1% of relevant securities of the company under offer during the official offer period, that interest must be declared fully to the panel. Previously, that had been restricted to long equity positions, but the November ruling also brought derivatives under scrutiny.

Under the rules, interests in securities arise when an investor has a long economic exposure to changes in the price of securities - crucially bringing contracts for difference within the remit of disclosure.

According to a high-ranking official at the panel, who spoke on condition of anonymity, monitoring investments in derivatives and equity linked to a company under offer is only practicable because of the relatively small number of firms under offer in the UK at any one time - usually around 50. The panel and FSA can ask any dealer to open their books on over-the-counter derivatives in the UK market, although it is unclear how this would encompass a CFD sold abroad with the dealer buying the shares in the UK.

"This has thrown light on a dark area," the panel official says. "One can say that plenty of people are dealing and disclosing, so it's not as if people are that afraid of the issue of disclosure. In fact, people have diligently turned their minds to complying with the rules. It has increased the disclosure level a bit, but not hugely. But no-one can ever be sure that something hasn't been missed."