Disclosure of Equity Derivatives—Reminder of Consultation on Implementation of Amendments to Transparency Directive

The period for responses to the Treasury and FCA joint consultation paper CP15/11 closes on 20 May 2015. The paper sets out the changes proposed to be made to the Financial Services and Markets Act 2000 (FSMA) and the Disclosure and Transparency Rules (DTRs) in order to implement the Transparency Directive Amending Directive (TDAD).

Following the consultation, the changes will need to be implemented by 26 November 2015, which is the end of the two-year period given to EU member states to implement the TDAD.

In this briefing, we focus on the changes affecting disclosure of equity derivatives, stock lending and repo.

Background

The Transparency Directive (Directive 2004/109/EC) requires disclosure of voting rights held by a shareholder that reach or exceed five per cent 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 has 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 a previous briefing at the time of its publication, the TDAD (Directive 2013/50/EU) requires the following key changes in relation to equity derivatives:

• Cash settled equity derivatives will become 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 will 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 will 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 will 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 will not be permitted to impose more stringent disclosure requirements than those imposed by the Directive, 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 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 requires disclosure of cash settled derivatives if relevant thresholds are reached or exceeded, it will not, however, change greatly in this respect. The consultation paper sets out various other changes to be made to the DTRs. Below we consider these changes in relation to equity derivatives, stock lending, and repo (in particular).

No stand-alone client-serving exemption
Perhaps the most notable change is the removal of the current exemption for financial instruments held by a client-serving intermediary in a client-serving capacity. The TDAD required 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. On this issue, industry feedback to the ESMA consultation on the draft RTS, such as the joint AFME and ISDA response (on which Ashurst assisted the two trade associations), argued that the introduction of a separate and specific client-serving exemption, rather than a simple overlaying of the pre-existing exemptions, would be advisable and beneficial to the market in avoiding meaningless disclosures. However, ESMA ultimately concluded that the introduction of such a separate exemption would exceed its mandate. As a result, the final RTS (which were published in the Official Journal on 13 May 2015) provide that such client-serving dealings and related hedging positions would have the benefit of the existing trading book exemption but not a new stand-alone exemption.

As a result, the FCA propose that the current client-serving intermediary exemption be removed by the deletion of DTR 5.3.1R(2)-(5) and related guidance. In place of the deleted provisions, the FCA plans to reproduce provisions from the final RTS relating to client-serving transactions. In addition, a new definition of "trading book" will be incorporated into the glossary to the FCA Handbook in order to reflect the TDAD.

It is important to note that, whereas the current client-serving intermediary exemption is a complete exemption, the trading book exemption is capped at five per cent. 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 five per cent 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. Furthermore, ESMA is required to establish and periodically update an indicative list of financial instruments that are subject to notification requirements, which includes rights to recall loaned securities and repo transactions. Consequently, the FCA proposes deleting from DTR 5 current guidance as to certain financial instruments that are exempt from disclosure requirements, including nil paid rights received from an issuer during a rights issue and rights to apply for open offer shares.

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 derivatives positions by physically settled instruments and cash settled instruments. A notification would be required if there were 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. The FCA proposes to amend aspects of DTR5.7.1R and to include a new DTR5.3.5R in order to address these requirements but plans to keep the TR-1 form the same.

Notification of basket and index instruments
The FCA proposes to delete current guidance on financial instruments referenced to a basket or index of shares and to replace it by reproducing text from the final RTS relating to such instruments. 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:

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

The Final Report, however, specifies that shares covered by such a right of recall should be subject to disclosure requirements. In response, the FCA proposes a minimum harmonising approach to stock lending in order, it says, to balance the need to implement the TDAD correctly and achieve harmonisation across member states with the need to avoid over-reporting. Consequently, the FCA proposes that a stock lending transaction should be taken into account by each of the lender and the borrower in determining whether the five per cent, ten per cent and higher thresholds are reached or crossed, but disregarded for purposes of assessing the UK's super equivalent thresholds.

If the five per cent or ten per cent threshold is reached or crossed, 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. A borrower of shares would be required to disclose its ownership of the shares under a stock loan if the five per cent or ten per cent threshold is reached or crossed (however, the borrower would 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). However, it is welcome that the FCA will allow stock lending transactions to be disregarded except at the minimum standard thresholds of five per cent or ten per cent

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

Investment managers
Currently, US and EEA investment managers benefit from an exemption which has the effect that they have to disclose only at the five per cent, ten per cent and higher thresholds but do not have to comply with the UK super-equivalent disclosure obligations, whereas other non-EEA investment managers do not have the benefit of this exemption. Since this creates an uneven playing field, the FCA proposes to extend the exemption in order that all investment managers (regardless of jurisdiction) disclose only at the EU minimum standard thresholds.

Other changes
The consultation paper also proposes various other changes 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. The Treasury is consulting on implementation of this under the UK regime, including the power to apply to the courts to suspend voting rights for the most serious breaches.

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 beneficialthe 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.

Next Steps

The deadline for responses to the consultation is 20 May 2015. After that, the Treasury and the FCA will need to implement the changes by 26 November 2015.