Disclosure of equity derivatives: amendments to Transparency Directive implemented in the UK

Amendments to the UK's Disclosure and Transparency Rules (the "DTRs") and the Financial Services and Markets Act 2000 ("FSMA") came into effect on 26 November 2015 in order to implement the Transparency Directive Amending Directive (Directive 2013/50/EU) (the "TDAD"). 

In our May 2015 briefing, we discussed the draft amendments set out in the Treasury and FCA joint consultation paper CP15/11.

In this briefing, we focus on the amendments, now in force, which affect disclosure of equity derivatives, stock lending and repo, together with the few key differences between the draft amendments discussed in our earlier briefing and the final amendments.

Background

The Transparency Directive (Directive 2004/109/EC) requires disclosure of voting rights held by a shareholder that reach or exceed 5% of the total voting rights of an issuer. The Transparency Directive originally applied only to physical shareholdings and instruments providing the holder with an entitlement to acquire shares on such holder's own initiative (such as physically-settled derivatives), which meant that it was possible to acquire through cash-settled derivatives an economic exposure to listed shares in excess of the thresholds without disclosure. The UK extended the scope of its disclosure regime in 2009, so as to require disclosure of long positions held through cash-settled derivatives, and some other member states had made similar changes before the TDAD came into force. This resulted in divergent rules on disclosure being applied across the EU. The TDAD seeks to bring national regimes into line on the rules for disclosure of cash-settled derivatives.

Key changes under the TDAD

As we discussed in our May 2015 briefing, the TDAD requires the following key changes in relation to equity derivatives:

• cash-settled equity derivatives are to be disclosable in all member states if relevant thresholds are reached or exceeded, in addition to physical holdings and physically-settled derivatives which are already disclosable;
• such disclosure of cash-settled equity derivatives is to be on a delta-adjusted basis (rather than using nominal positions);
• notifications will be required to include a breakdown by type of financial instruments held, distinguishing between physically-settled and cash-settled instruments;
• only long positions are to be taken into account, with no netting of long and short positions;
• existing exemptions for (i) clearing and settlement, (ii) market making activities, (iii) voting rights held in the trading book and (iv) asset managers also apply to cash-settled derivatives;
• a second notification will be required if an investor closes out a cash-settled derivative and acquires the underlying shares; and
• home member states are not permitted to impose more stringent disclosure requirements than those imposed by the Transparency Directive (as amended), except that they will be permitted to set lower or additional disclosure thresholds, to apply more stringent requirements for the timing and content of notifications and to apply laws, regulations or administrative requirements relating to takeover bids, merger transactions and other transactions affecting the ownership or control of companies. This provision is intended to limit "gold-plating" of the Transparency Directive in order to improve legal certainty, enhance transparency and reduce the administrative burden for cross-border investors.

Key changes to the DTRs

Since the UK regime already required disclosure of cash-settled derivatives if relevant thresholds were reached or exceeded, it has not changed greatly in this respect. There are various other amendments which have been made to the DTRs, however. Below we consider (a) these amendments in relation to equity derivatives, stock lending, and repo (in particular) and (b) the main substantive changes between the draft amendments set out in the consultation paper and the final amendments.

No stand-alone client-serving exemption

Perhaps the most notable amendment is the removal of the previous exemption for financial instruments held by a client-serving intermediary in a client-serving capacity. The TDAD required the European Securities and Markets Authority ("ESMA") to develop draft regulatory technical standards ("RTS") to specify, among other things, the cases in which the existing exemptions should apply to financial instruments held in order to fulfil orders received from clients or respond to a client's requests to trade otherwise than on a proprietary basis or to hedge positions arising out of such dealings. The final RTS provide that client-serving dealings and related hedging positions have the benefit of the existing trading book exemption but not a new stand-alone exemption.

As a result, the previous client-serving intermediary exemption has been removed by the deletion of DTR 5.3.1R(2)-(5) and related guidance. In place of the deleted provisions, the provisions from the RTS relating to client-serving transactions have been reproduced at DTR 5.3.2B. In addition, a new definition of "trading book" has been incorporated into the glossary to the FCA Handbook in order to reflect the TDAD.

It is important to note that, whereas the previous client-serving intermediary exemption was a complete exemption, the trading book exemption is capped at 5%. Therefore, cash-settled derivatives held in a client-serving capacity will need to be aggregated with the holder's other positions in cash-settled or physically-settled derivatives and/or the relevant shares, and all of the holder's positions will need to be aggregated with those of its subsidiaries. If the aggregated holding reaches or crosses the 5% threshold, it will have to be disclosed.

As a result of this change, there are likely to be more disclosures made by financial intermediaries which simply reflect client-serving activity or hedging of client transactions.

Financial instruments

As part of its concept of physically-settled and cash-settled financial instruments, the TDAD amends Article 13 of the Transparency Directive to set out a list of in-scope financial instruments, which comprises transferable securities, options, futures, swaps, forward rate agreements, contracts for differences and any other contracts with similar economic effects. Consequently, to assess whether a notification requirement exists, the new regime requires each financial instrument to be considered in the context of the wording of Article 13(1) of the Transparency Directive, DTR 5 guidance and ESMA's indicative list (which is periodically updated) of financial instruments that are subject to notification requirements. The previous DTR 5 guidance as to certain financial instruments that are exempt from disclosure requirements has been deleted. With respect to instruments related to unissued shares, such as nil-paid rights, the FCA refers, in policy statement PS15/26, to ESMA's final report on the draft RTS, which states: "for the avoidance of doubt, ESMA clarifies that only financial instruments relating to already issued shares have to be disclosed".

Notification of breakdown

Notwithstanding that holdings under financial instruments are to be aggregated with holdings of shares in order to determine whether relevant thresholds are crossed, under the TDAD a notification must include: (a) a breakdown of the number of voting rights attached to shares held directly or indirectly and voting rights relating to derivatives; and (b) a breakdown of derivative positions by physically-settled instruments and cash-settled instruments. A notification is required if there is a notifiable change in the percentage level of one or more of the categories of holdings, including if the overall percentage level of the aggregated holdings remains the same. DTR 5.7.1R has been amended and a new DTR 5.3.5R included in order to address these requirements.

In a change from the draft amendments set out in the consultation paper, a new DTR 5.7.1AR has been inserted to clarify that the notification requirements may apply where a person who has already notified voting rights relating to financial instruments subsequently acquires the underlying shares (reflecting Article 13a(2) of the TDAD).

In addition, the FCA plans to continue using existing TR-1 form but proposes implementing the new ESMA standard form in the future.

Notification of basket and index instruments

The previous guidance on financial instruments referenced to a basket or index of shares has been replaced by reproducing text from the RTS at DTR 5.3.3B. The RTS provide that, for the purpose of assessing thresholds in relation to such instruments, voting rights shall be calculated on the basis of the weight of the share in the basket of shares or index where either:

(a) the voting rights in a specific issuer held through financial instruments referenced to the basket or index represent one per cent or more of the voting rights attached to shares of that issuer; or

(b) the shares in the basket or index represent twenty per cent or more of the value of the securities in the basket or index.

These two conditions are in line with the previous guidance in the UK.

In addition, the RTS clarify that where a financial instrument is referenced to a series of baskets of shares or indices, the voting rights held through the individual baskets of shares or indices shall not be accumulated for the purpose of the thresholds.

Stock lending and repo

In addition to physically-settled derivatives, the financial instruments that are subject to notification requirements include, under the TDAD, certain repo agreements and the lender's right of redelivery commonly included in stock loans. Before the TDAD, the Transparency Directive did not directly address such rights of recall. Under the UK regime, the lender's position had been that where a stock lending agreement included such a right of recall, the stock loan did not constitute a "disposal" of shares for the purposes of the Transparency Directive and, therefore, did not require disclosure. The borrower's position had been that the borrowed shares were exempt from disclosure requirements provided that they were on-lent or otherwise disposed of by close of business on the next trading day and provided that the borrower did not declare any intention of exercising (and did not exercise) the associated voting rights.

The RTS specify that shares covered by such a right of recall should be subject to the disclosure requirements. Consequently, the DTRs have been amended so that (a) a stock loan which includes a right of recall will constitute a "disposal" of shares and (b) the right of recall will be notifiable as a financial instrument. Consequently, the total notifiable percentage of voting rights of the lender following the stock loan should be the same.

However, if a threshold, as set out in the DTRs, is reached or crossed in respect of one of the categories of voting rights (i.e. physical shareholdings or holdings through financial instruments), then a lender of shares would be required to disclose the change in the nature of its holding from owner of the shares to holder of a right of recall.

With regard to a borrower of shares, the DTRs have been amended so that voting rights attached to shares acquired by a borrower under a stock lending agreement are no longer disregarded for disclosure purposes. Accordingly, a borrower is required to disclose its ownership of the shares under a stock loan if a threshold is reached or crossed (provided that the borrower does not need to disclose such ownership if it disposes of the shares on the same day).

In addition, although it is not expressly stated in the Transparency Directive or the DTRs, it appears that the same treatment may apply to shares that are borrowed by a chargee under a right of use provided by an agreement creating security over shares, on the basis that it falls within the definition of a stock loan and the chargor would have a right of recall. It is not stated whether the same treatment would apply to repurchase transactions, although such transactions contain a similar right to recall the shares originally transferred (or their equivalent).

In the draft amendments set out in the consultation paper, the FCA had proposed that a stock lending transaction should be taken into account by each of the lender and the borrower in determining whether the EU minimum thresholds of 5%, 10% and higher thresholds are reached or crossed but disregarded for purposes of assessing the UK's super-equivalent thresholds. Following industry feedback, however, the FCA concluded that stock lending transactions will need to be treated in the same way as all other holdings and notified at the thresholds set out in the DTRs.

This new regime may be considered burdensome in the context of automatic stock lending programmes and certain rights of use that can be exercised without further notice to the owner of the shares (for example, under prime brokerage arrangements).

Investment managers

Previously, US and EEA investment managers benefited from an exemption which had the effect that they had to disclose only at the 5%,10% and higher thresholds but did not have to comply with the UK super-equivalent disclosure obligations, whereas other non-EEA investment managers did not have the benefit of this exemption. Since this created an uneven playing field, the FCA has extended the exemption in order that all investment managers (regardless of jurisdiction) disclose only at the EU minimum standard thresholds (5.1.5R (1)(a) and (2)).

Other changes to the DTRs

Various other changes have also been made to the DTRs, including: (i) a new exemption from disclosure for shares acquired for stabilisation purposes in accordance with the Buy-back and Stabilisation Regulation; (ii) changes to the definition of "issuer"; (iii) changes to the rules on home member states; and (iv) corrections to the transposition of the exemption in respect of non-EEA issuers from the obligation to publish the information contained in vote-holder notifications.

Changes to FSMA

The TDAD aims to create a minimum standard for member states' sanctions regimes in respect of breaches of the DTRs, including fines, in order to ensure that the sanctions are effective, proportionate and dissuasive. In order to implement the TDAD's requirements relating to sanctioning powers of the competent authority, a new Section 89NA has been added to FSMA. This gives the FCA the power to apply to the courts for an order suspending a person's voting rights where such person has committed a serious contravention of transparency provisions. The new section specifies factors the court may take into account in determining whether the contravention is sufficiently serious that it is appropriate to make such an order, including whether the contravention was deliberate and was committed despite warnings from the FCA, and the size of the shareholding to which the contravention relates.

Comment

There may be considerable benefit if the TDAD succeeds in achieving greater harmonisation across the EU, although it will still be necessary to check implementation in a relevant member state. Within the UK, however, the market may not regard as beneficial the removal of the client-serving intermediary exemption and the designation of the right of recall under a stock loan as a disclosable instrument, since these changes will increase the volume of notifications required, including where notifications may give excessive information or information that is not useful to the market.