Lawyers continue to exploit loopholes
Like many sensible ideas, the EU Transparency Directive has an admirable goal. At its heart is the principle that all financial corporate information should be standardized so that regulated information can be disseminated quickly and clearly.
Whether you are a financial professional in the City, a Berlin housewife tracking investments online or an employee shareholder in Rotterdam, everyone gets the same access: old-style European socialist values of equality twinned with the free market. It could only have come from Brussels.
Despite its leaden title, the Transparency Directive, which came into force at the start of January 2007, is remarkably guidance-light. Its contents – which lay down a range of minimum reporting standards for all EU states, from interim management statements to information storage – total a mere 10 pages, giving plenty of room for EU states to tailor the advice to their own circumstances.
Since the introduction of the directive, many of the national European governments have worked hard at beefing up their corporate disclosure and transparency standards – and a number of countries have even gone well beyond the minimum disclosure levels set by the directive.
David Freedman, a partner at law firm Baker & McKenzie, says France switched into Transparency Directive mode-plus some time ago. ‘The directive was not a new issue for us in France,’ he explains. ‘We already had annual and half-year reporting, and all the major shareholding requirements already existed within French law. French corporate law allows issuers to insert a clause in their articles of association requiring disclosure as low as 0.5 percent of shares or voting rights. Most issuers have already done so.’
Freedman adds that the Autorité des marchés financiers, France’s equivalent of the Financial Services Authority in the UK or the SEC in the US, is typically ahead of most EU member states when it comes to adapting to and anticipating new financial regulations. Upcoming French legislation will deal with the disclosure of synthetic holdings, which will go well beyond the equity-linked instruments on which the Transparency Directive requires regulation.
This French progress on information disclosure is something to which more EU member states should aspire. Too often legislators lumber along behind market news events, plugging loopholes and gaps as clever lawyers prize open new crevices for clients to crawl through. For the moment, France is setting the pace.
Loopholes certainly remain, however. One example of a gap that many argue needs closing – and which the directive remains unable to deal with effectively – is the continuing Schaeffler crisis, which has shaken Germany to its engineering and industrial core.
Schaeffler is a family-owned German car parts maker that succeeded in a hostile takeover of German tire maker Continental, a DAX 30-listed company that is three times the size of Schaeffler. The deal was finessed by Schaeffler secretly building a 36 percent stake in Continental before finally pouncing on its far larger prey – or, as Continental put it, Schaeffler ‘secured access to 36 percent of Continental’s shares in an unlawful manner.’
Dr Manuel Lorenz, another Baker & McKenzie partner, says a loophole in German rules, which reflect the Transparency Directive’s focus on cash-settled instruments, allowed Schaeffler to build up a concealed position with little effect on its target’s stock price.
The story went like this. By the time Schaeffler launched the bid, it had already acquired nearly 3 percent of Continental’s ordinary shares and 4.95 percent in call options that had been physically settled. However, it had a much bigger chunk – some 28 percent – in the form of a derivative position in equity swaps, also known as contracts for difference. These were part of an agreement Schaeffler entered into with Merrill Lynch, backed by a group of other banks, most of which had just under 3 percent of stock apiece, avoiding their own notification requirements.
The agreement was for cash-settled equity swaps, with Merrill paying Schaeffler a sum equivalent to any rise in Continental’s stock price, together with any dividends it would have been entitled to if it had actually owned the stock. For its part, Schaeffler would pay Merrill the equivalent of any fall in the stock price as well as the amount Schaeffler would have had to pay in interest to Merrill if Merrill had lent it the cash to buy the stock.
It sounds like complicated stuff – and it’s arguably ownership by a different name – but derivatives are often a useful M&A tool for a bidder wanting to avoid the consequences of going public early on. ‘The stock price went up during the secret stake-building in Continental,’ observes Lorenz, ‘but this would arguably have increased earlier, and even more, if the market had been informed of the stake-building through threshold notifications.’
BaFin, the German supervisory authority, launched a probe into the affair but accepted that Schaeffler had not violated disclosure rules. After all, the Transparency Directive – along with the German regulations – does not require disclosure where derivative positions are settled in cash rather than shares. More than that, there was a clear precedent: Porsche had secretly increased its stake in Volkswagen by similar means, using cash-settled options, the year before.
The Schaeffler-Continental deal is now at risk of unraveling under the weight of €16 bn ($22 bn) of accumulated debt, which Schaeffler took on to finance the purchase. Continental’s share price has been decimated: last May its shares were trading at more than €82; currently it hovers around €13. ‘Ultimately, the market is confused about such transactions,’ says Lorenz. ‘There is a need to have more disclosure.’
Not the heaviest burden
For many countries the Transparency Directive hasn’t demanded too much change in terms of issues like annual reporting requirements. Italy still lags behind, says Kevin Desmond, director of the capital markets group at PricewaterhouseCoopers, but overall the directive’s loose modus operandi is welcome.
‘It doesn’t require quarterly reporting, and you can do interim management statements, which is what the UK chose to do,’ Desmond says. ‘The UK regulator hasn’t offered huge amounts of guidance on interims, which is quite right as there are wide variations in what is disclosed.’
However, Desmond makes the resonant point that the directive remains open to considerable interpretation, and therefore possible abuse. ‘What you don’t get is common interpretation and common application,’ he explains. ‘Some of the wordier bits, the need for a management report, could be interpreted differently depending on your existing market practice. However, the directive has accelerated the likelihood of pan-European regulation being more coordinated and regulated, or the creation of pan-European regulation.’
Meanwhile, there is disappointment in some on the regulatory side that the Transparency Directive is less luminous in practice for many investors than it should be. ‘One shouldn’t forget that one of the initial objectives of the directive was to make sure information was available in a widely used language such as English,’ says one observer close to the original project. ‘There is still nothing that is said or done under the directive to guarantee that every piece of regulated information put out by an issuer is systematically translated into English and disseminated to all investors.’
So it’s a mixed picture overall, and a success story up to a point. Although the directive’s framework originally laid out common standards, there remains considerable unevenness in its implementation. ‘The issue is also, don’t forget, about whether a company really desires to communicate well,’ argues corporate disclosure expert Mark Hynes of Transparency Matters.
‘The right thing in the current dark times is to look hard at how you tell your equity story using annual reports and other big communication opportunities, notwithstanding what the law says. It’s all very well complying with the directive, but explaining the culture of the board, which actually makes the decisions, is something else. Regulation should be a base, not a ceiling.’
That said, calls for transparency and openness need to be balanced against what can be reasonably expected from issuers, especially in harrowing economic conditions. One industry insider claims there’s a general feeling that EU bureaucrats are already pushing things to the limit, so maybe less is more – at least for now.
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