[ Arundhati Barman Roy and Bhoomi Shah are final year student at NMIMS School of Law, Mumbai ]
Total Return Equity Swaps are over the counter derivatives generally seen been used in the Indian context by Foreign Institutional Investors for hedging their positions without actually owning the shares. A FII is sceptic to invest in India due to the lesser standards of corporate governance followed by the corporates in its promoter family driven environment, delays in transfer of ownership of securities and its registration process which in turn delays the receipt of dividends and entitlements- problems which TRESAs help to bypass. TRESA is also witnessed to be used by investors to bypass internal restrictions that may prevent direct investment in stocks due to trading permissions required, especially for China and India (i).
Consider a TRESA model where the bank is the short party and the long party is the client who is also a potential acquirer. If the share prices rise, the bank would have to transfer the gains that were made due to such rise in price of shares to the long party, but it would not have to do so from its own pockets but via the profits it has gained from the stock/ shares of the target company. Hence, TRESAs are excellent hedging instruments for the short party.
However, the issue with TRESA is that its application is just not limited to mere “hedging” but also takeovers. This is because the short party also has an option of transferring the ownership of the underlying asset to the long party on the maturity of the Total Return Swap Agreement.
The long party would have the equity upside on valuation increase from the initial price and would also receive dividends during the time period of the arrangement, which would be the same benefit it would have received in case of a profitable takeover transaction. In the event of maturity, if the TRESA is settled in kind, then the client would receive the reference shares too. Thus, the client would be able to do creeping acquisition for the takeover and receive benefits while at it by renting the bank’s balance sheet.
In case of negative returns, the client would have to pay the equity downside, however, that’s virtually the only downside for a potential acquirer. The client was able to test its acquisition without owning the shares and had an easy exit option because it was not obligated to actually own the reference shares at the termination of TRESA, which in case of a not profitable takeover would involve the additional hurdle of searching for potential buyers for the shares. This would also be beneficial for situations where the takeover could become hostile and would lead to the departure of the erstwhile management who played a key role in making the target desirable (e.g. L&T-Mindtree case). Hence, when a TRESA is used, the potential acquirer has comparatively multiple advantages like: not financing the entire purchase price of the underlying equity, retaining economic benefits without needing to own it and receiving dividends gross of any taxation unlike the scenario for takeover ownership.
Case Study of Hermes- LMVH takeover
In 2001-02, LVMH acquired 4.9% shareholding in Hermes through subsidiaries and 2007 onwards started purchasing equity swaps. Just like in India, in France a listed company’s acquisition of shares for five or more percent is required to be disclosed but equity derivatives are exempt. In 2010, LMVH finally announced to the markets that it had 14.2% shareholding in Hermes via the equity derivative channel which did not require any previous disclosure. The French equivalent of SEBI, AMF, however determined the 20% of stake of LVMH in Hermes with the help of equity derivatives not to be a product of financial investment as contended by it but a secret purchase of the shares and imposed a fine of $10 Million and ultimately led to LVMH divesting its shareholding in Hermes in 2014, which was valued at $7.5 billion then.
Schaeffler Group and Continental Tyres
In this case, the duty to disclose the changes in the shareholding of a public company was breached. In 2008, Schaeffler announced its intention of taking over Continental Tyres and informed the markets that apart from 2.97% of Continental AG shares it directly held with physically settled swaps of about 4.95%, it also held cash settled swaps which could be offered on termination to reflect about 28% shareholding. To bypass disclosure norms, Schaeffler engaged 9 banks as counterparties, 8 of which held reference shares just below the three percent threshold of German norms for disclosure, which ultimately resulted in a successful takeover.
CSX Corp v. The Children’s Investment Fund, 2011
In this particular case, a question with respect to ‘beneficial ownership’ was raised by the Applicants, where they claimed that on account of TCI being the long party in a Total Return Swap Agreement, they were the beneficial owners of the stock acquired by the short party. The 2nd Circuit Court of U.S. did not answer this question, however, it noted that the TCI was in violation of the provisions under 13.d of the SEC Act which carve out disclosure obligations. This is because, the acquisition of shares by the short party at this instance was done for the benefit of the long party, i.e. TCI, thus, they would be considered as group under SEC Act. This case was a landmark one as it directly discussed the implications of a TRESA on corporate control and the concept of ‘beneficial ownership’ arising due to such transactions became widely discussed.
What are the Regulations governing such Agreements in India?
As per Reg. 29 of the SEBI (SAST) Regulations, 2011, an acquirer is required to disclose his shareholdings when it reaches the 5% threshold, this threshold can be reached individually or with persons acting in concert with the acquirer. Further, under Reg. 30(1), it is mandatory for a party who has acquired more 25% of shares of a target company (standalone or with PAC) to make an Open Offer.
Often, it is witnessed that a TRESA is used to mask the actual holding of shares of the acquiring company in the target company. Here, say for example, the acquiring company holds 2% of shares of the target company and enters into a TRESA with a short party respect to 3% of the shares of the same company, it could be argued that effectively, the long party/ the acquiring party is controlling 5% of the share capital of the said company which would ideally trigger a disclosure requirement under the SEBI (SAST) 2011 Regulations. However, since such control over the 3% of shares is indirect in nature, no such requirement is triggered. This results in asymmetry of information in the market. Further, the target company or the shareholders thereof would remain unaware of such an arrangement since the disclosure requirement has been not triggered. The abovementioned case studies of Continental Tyres, LMVH and CSX Corp establish the use of TRESAs for such purposes.
Under the SAST Regulations the ambit of ‘Persons Acting in Concert’ is very wide. It is to be noted that it is necessary for the PACs that “there should be a common objective between two or more persons and that common objective should be substantial acquisition of shares pursuant to an agreement or an understanding, formal or informal”, as held by SAT in the case of Ketan Parekh v. SEBI. Such a definition can be applied to a short party in a TRESA; however, it is extremely difficult to prove that the party had the common objective of substantial acquisition of shares in concert with the long party.
In the case of Smt. Madhuri S. Pitti and Ors. v. SEBI, the SAT noted that, “Once an individual becomes part of the group acting in concert with the intention of acquiring shares, it loses its identity as an individual andtakes on the identity of the group as a whole. As per scheme of law as envisaged in the erstwhile SAST Regulations, 1997 an individual is no longer regarded as a separate entity of the group as he becomes an integral part of the entire unit as one cohesive structure.”
Using such a definition, it can be argued that in case the purpose of entering into a TRESA is for acquisition of shares by the long party, the short party would be considered as a Person Acting in Concert with the same. However, hedge funds or brokers would not be included in such a definition, since it is their profession to carry out such Agreements or transactions.
Apart from the Regulations under the Takeover Code as discussed above, there are no specific regulations dealing with the question of ‘beneficial ownership’ or ‘use of derivative instruments in carrying out hostile takeovers’ in India, due to the complex nature of such transactions. The lack of guidelines and laws surrounding transactions such as TRESAs causes information asymmetry in the market and could have a significant impact in the way Hostile Takeovers will be viewed in the future.
As mentioned previously, TRESA model can be used when there are regulatory hurdles for direct acquisitions, therefore even Chinese companies can exercise this option of testing takeover, against whom the Indian government has adopted a hostile stance.
------------------------------------------- (i) See Neil Schofield, Equity Derivatives: Corporate and Institutional Applications, in Equity Swaps 291 (2017).