Guidance for Directors on Cash-Settled Equity Derivatives

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Jul 14, 2010, 10:00 ET

NEW YORK, July 14 /PRNewswire/ -- The Conference Board released today guidance for directors of public companies to address or prevent situations where shareholders accumulate undisclosed equity stakes by means of cash-settled derivatives.

This guidance builds on the recommendations on shareholder activism, endorsed by a high-level committee of experts in the field, issued by The Conference Board Governance Center in April.

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.

"When used for this purpose, cash-settled derivatives have the potential to disrupt not only the internal governance and voting process of a corporation, but also the efficient operations of the financial markets," says Eugenio De Nardis, a corporate lawyer at Cleary Gottlieb and co-author of the report.

"Directors of European corporations should be aware of the risks and possible distortions caused by the undisclosed use of cash-settled derivatives," says Matteo Tonello, director of corporate governance research at The Conference Board and co-author of the study. "The danger is in having investors' public filings that only tell half the story about who actually owns the company. Also, when the transactions or stakes are eventually disclosed, markets might be unable to react promptly, giving rise to speculation and volatility."

The major recommendations included in the report:

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 report is the second in this year's Director Notes series on European corporate governance developments. Director Notes is a series of publications through which The Conference Board engages experts from several disciplines of corporate leadership in an open dialogue about topical issues of concern to member companies.

Source:
Know Your Shareholders: The Use of Cash-Settled Equity Derivatives to Hide Corporate Ownership Interests
Director Notes No. DN-009
July 2010
The Conference Board

About The Conference Board

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SOURCE The Conference Board