A ‘Spiritual Document’ Gets Real

Takeover Panel Director General Richard Murley talks to the FT's Philip Coggan about the Panel's new disclosure regime

Philip Coggan
Originally published in the December 2005 issue

"We have absolutely nothing against hedge funds or hedge fund activity," says Richard Murley, director-general of the Takeover Panel. "We are simply saying that hedge funds should disclose what they are doing."

That philosophy is at the heart of the Panel's new disclosure regime during bid activity, a regime that may open hedge fund dealings to the full glare of public scrutiny. In particular, activity in derivatives such as contracts for difference (CFDs) will have to be announced on the following day.

Murley says the Panel needs to reflect changes in market practice. "In the past, investors dealt in shares and we regulated the disclosure of shares," he says. "Why did we do so? Because we are regulating the change in control of companies. What has increasingly happened is that trading has migrated to a significant extent to the derivatives market, specifically CFDs. As the market has moved on, so we have moved the regulatory regime."

The Panel had become concerned at the way that hedge funds had emerged to play the key role in a number of takeovers, notably the bid for Alvis from BAe systems and Philip Green's abortive bid for Marks & Spencer. "Alvis was a particularly striking example" says Murley. "Four derivative investors turned out to be holding the balance of power and effectively appeared from nowhere. they were able to deliver Alvis to BAe, much to the market's surprise. If they had been shareholders, we might have seen the market price at a different level."

Murley stresses that "The hedge funds were not doing anything wrong in our terms. They were under no obligation to disclose their positions and it was a legitimate use of their economic power. But we recognised the need to change the rules."

In the M&S case, a number of funds with long CFD positions tried to put pressure on the M&S board to grant Philip Green's bid vehicle access to the company's numbers for due diligence purposes. In November, it emerged that Polygon Investment Partners, a UK hedge fund group, had amassed a near-14% stake in Peacock, the discount fashion retailer planning a management buy-out. All three cases show that bid outcomes are no longer being decided by a handful of pension funds and big institutions. "There has been a shift in the economic power base from long funds to hedge funds" says Murley.

This matters not just to the Takeover Panel in terms of ensuring that control passes properly from one owner of a company to another but also in terms of price discovery, in ensuring that the market price reflects all available information. "We are well aware that hedge funds and other investors in CFDs are the drivers of marginal activity in the market" he says.

One thing that concerned the Panel was the power which CFD ownership provided. CFDs are typically structured as bilateral over-the-counter deals with banks. In theory, the banks retain control over the shares, including voting rights. In practice, that does not always seem to be the case. "What concerned us was the extent to which the investors had control over the underlying shares" says Murley. "If you look at the documentation of these deals, you would say there was no control; they have to be written that way, otherwise the investor would incur stamp duty. But in the real world, hedge funds often have their say over how the shares have voted."

Why does this happen? "Perhaps the banks ask the hedge funds how they would like to see the shares voted or perhaps the banks simply know what their clients would want" speculates Murley.

Another issue of concern is that these deals often give the hedge fund the right to close the CFD and get hold of the underlying shares. The key problem is that the existence of the derivative may lead to a change in control of the shares. Whether or not this always happens, the Panel had to amend the rules accordingly. Takeover rules had been adjusted in the past to take account of the widespread use of share options. One of the Code's key provisions, rule SAR 5, (relating to the requirement to make a bid if the holding breached 30%) already refers to ownership of shares or rights over shares.However, options were not treated as shares for the disclosure rules. An investor would not have had to disclose an interest of more than 1%, if it consisted entirely of options.

That is all changing now. All positions will be added together when determining whether an investor has a stake of more than 1%and is thus required to disclose all dealings. (The deadline for reporting has moved from noon on the following day to 3.30 to help with the new regime.) Murley says "There is a difficulty in defining derivatives. Once you get away from shares, there is no clarity about any of these terms." But for the new rules: "In terms of the big picture stuff, we are not making any distinction between options and CFDs."

Investors should note one important proviso, however. The Takeover Panel only regulates dealings when an offer period is deemed to be under way. The new rules will not apply to disclosures in non-offer periods, which are covered under the Companies Act. In theory, one could build up a 29% position in a stock through CFDs or options without reporting it (whereas a stake of more than 3% of the shares must be disclosed). Of course, hedge funds do not simply go long. One of the oldest ways of playing a merger situation has been to go long the shares of the prey and be short the shares of the predator. In terms of disclosure, dealings in the shares of the predator are subject to the Panel's rules only if the offer is a paper one. But what about a hedge fund that has gone long the CFD and also effectively gone short the same shares, perhaps by purchasing a put at a lower price? Should the rules be based on the hedge fund's gross or net position? Here the Panel had some tricky decisions to make.

Murley says the Panel has imposed a difference in disclosure depending on the trigger level. "If the investor's long position goes over 1%, then he must disclose all dealings including shorts. However, if he is only short of the stock, (or if his long position is less than 1%) he does not have to comply with the disclosure rules." Note, however, that the panel's definition applies to the gross long position, rather than the net. So a hedge fund with a 3%long position and 2.5% short would still fall foul of the rules.

Why are pure shorts exempt? The panel's rationale is that they are interested in control of the company. "If you are short, you don't have the potential for control" says Murley. "You can only do so when you're long."

There was an argument for requiring all long and short positions to be disclosed, to help with the process of price discovery. Murley says that, during the consultation on this point, the hedge funds said no while the long funds and the companies said yes. The panel eventually decided against. By exposing the position of investors with naked shorts, the panel worried that market liquidity could be impeded. "Making the requirement did not pass the panel's cost benefit analysis" says Murley.

Other tactics had to be considered. Some investors might take short positions to try and drive down the predator's share price and insure that the bid failed. Murley points out that, if those taking the short positions were associated with the offeree, then they would have to disclose their positions.

Another issue concerns the purchase of heavily out-of-the-money options, which are not likely to be exercised and thus are unlikely to have any influence on the outcome of the bid. The panel included them in the disclosure rules, says Murley, "because we couldn't see a logical point to draw the line between an option at the market price and one at three times the value of the bid. We have to operate on the basis of a clear approach. We cannot give determinations on absolutely everything."

The onus for making a disclosure falls on the investors. That might be a problem for the Panel since many hedge funds operate from centres that are a long way from the UK. Is the panel concerned about hedge funds avoiding the rules? "We have historically monitored market activity during offer periods" says Murley. "Since 1987, we have had access to all dealing on authorised markets. We have a good base of material and a dedicated surveillance unit to make sure people are disclosing properly. We will proactively inquire into any dealings which look large or are at an odd market price, long or short. It is true that hedge funds may be small, may be based offshore and so on. But derivatives have to be hedged. If someone deals in a derivative position, we are likely to come across it. All FSA-authorised people are obliged to answer our questions."

So although the onus of disclosure falls on the investor, the Panel can easily check up a position by getting at the banks. Crucially, they can ask who the banks' clients are and the banks must respond. The initial reaction of the hedge fund community, when the Panel launched a consultation document back in January, was negative. "They said this was a bad idea and they didn't agree with it. They believed they had the right to conduct their affairs in privacy" says Murley.

Some people were worried that they would be embarrassed by the public disclosure of their mistakes, for example, if they had taken abig position expecting a successful bid that had then fallen through. "But by the time we got round to actively explaining the detail, we found the hedge fund community had decided to move on and live with it" Murley adds.

The Panel has tried its best to sell the new rules. "We must have had 30-40 meetings with individual hedge funds" says Murley. "We have been very proactive in terms of the new regime, explaining it and being available for consultations".

The Panel has held seminars at Freshfields and Clifford Chance, two top city law firms. Will hedge funds change their behaviour as a result however? "Some have said to us that they might deal below the 1% rather than above it" admits Murley. But he adds that "We don't see hedge funds as victims. We are here to serve shareholders and we want to see hedge funds as insiders not outsiders. To the extent that our regulations serve shareholders well, they will benefit."

One sign that the panel is taking the hedge fund sector seriously is the addition of a hedge fund manager, Andrew Spokes of Noon Day Capital, to the Code committee. There are, however, some further details to sort out. The code committee is still waiting to decide whether in terms of the offer price, the reference point should be the strike price of any acquired options (this refers to the requirement that the bidder offers the highest price paid for any security over the last 12 months). That probably won't be decided till Easter. It could be an expensive rule where a bank is acting as principal but some other part of the organisation (eg the trading desk) has taken an out-of-the-money position.

Will hedge funds find a way to get round the new regime? Murley says the Code has advanced over 37-38 years to deal with changes in tactics. "The code is a spiritual document. The executive will be looking at the intent of actions." says Murley. In other words, hedge funds will need to observe the spirit, not the letter, of the code. If they want to avoid trouble, hedge funds need to bear that stipulation in mind.

Philip Coggan is Investment Editor of the Financial Times