The Case of Volkswagen

German legal aspects of Porsche’s recent VW dealings

Originally published in the November 2008 issue

The UK press has been dominated in recent weeks with events in Germany relating to the announced takeover of VW by Porsche and the hedge funds who have been caught short when it became obvious that, with only 5.9% of shares remaining in the free float (since the State of Lower Saxony controls 20%) and about 13% of shares sold short, a significant short squeeze was building up.

On 29 October, the Federal Financial Supervisory Authority (“BaFin”), the German financial regulator, revealed that it would look into the issue to decide whether it would open a formal investigation of the trading in VW stock to determine whether there was market manipulation or insider trading.

Cash settled call options and swaps explained
In its 26 October press release, Porsche stated that, at the end of the preceding week, it had held 42.6% of the VW ordinary shares and in addition 31.5% in so called cash-settled options relating to VW ordinary shares: “Upon settlement of these options Porsche will receive in cash the difference between the then actual Volkswagen share price and the underlying strike price in cash. The Volkswagen shares will be bought in each case at market price.”

Cash settled options do not require the actual delivery of the underlying security. Instead, the corresponding cash value of the underlying is netted against the strike amount and the difference is paid to the owner of the option. Examples of cash-settled contracts include most US-listed exchange-traded index options. However, options defined as cash-settled might still be physically settled on exercise if the parties agree.

In press articles it was speculated that a group of investment banks potentially would hold the actual VW shares at 2.999% each, thus preventing notification requirements on their own, in order to hedge the call options and potentially be able to deliver them to Porsche on exercise.

The German Transparency Directive Implementation Act does not cover cash-settled options
The Transparency Directive Implementation Act (“Transparenzrichtlinie-Umsetzungsgesetz”), which took effect on 5 January 2007, extended the notification duties to cover the holding of financial instruments entitling the holder to acquire shares to which voting rights are attached (“Financial Instruments”). Under the new aggregation rule in section 25(1) of the German Securities Trading Act (“Wertpapierhandelsgesetz – WpHG”), if a party holds a stake in a company consisting of both shares and Financial Instruments, all voting rights arising out of both positions are to be aggregated. However, cash-settled options do not fall under the Financial Instrument definition in this law or in the underlying Directive.

The recent Schaeffler Continental AG BaFin investigation showed no infringements
It is informative to look into BaFin’s Schaeffler Continental AG takeover investigation over last summer, where the agency found no breach of reporting requirements. In this investigation, BaFin had not been able to establish that Schaeffler committed any infringements of the reporting requirements of the German Securities Acquisition and Takeover Act (“Wertpapiererwerbs- und Übernahmegesetz – WpÜG”) or German Securities Trading Act (“Wertpapierhandelsgesetz – WpHG”) by means of a swap agreement with Merrill Lynch International (London).

Although Schaeffler, which before the announcement of the takeover bid already owned just under 2.97% of Continental’s shares, had built up a cash-settled total return equity swap with Merrill Lynch for around 28% of Continental’s shares between March and May 2008, this was a contract for difference, under which two parties bet on prices rising or falling. Such contracts are not intended to involve the actual delivery of shares but are settled by means of a cash payment of the difference. Shaeffler stated that it had the right to terminate the swaps at any time. After such a termination, the banks could tender the underlying shares into the offer.
The voting rights attached to the shares underlying the swaps could potentially have been attributed to Schaeffler under Section 22 (1)(1) number 2 of the German Securities Trading Act and its twin in Section (30)(1)(1) number 2 of the German Takeover Act. Shares held by a third party are attributed if they are held “for the account of the notifying party”. This rule is widely interpreted as requiring the notifying party (i) to bear the economic risks and benefits of the shares and (ii) to be able to influence the voting of such shares.

It is questionable whether the first test was met, because the banks were using the shares to hedge their own risk resulting from the swaps. Yet, there are good arguments to look through the banks to Schaeffler because the swaps mirrored the performance of Continental’s shares.

The second test asks whether the swaps conferred a facto influence on voting of Continental’s shares to Schaeffler.

The answer to these two questions is far from clear. Proponents of Continental’s view point to Article 10(g) of the EU Transparency Directive, on which the attribution rule in the German Securities Act is based. They argue that a narrowly construed rule facilitates the circumventions. Acknowledging that Schaeffler did not legally control the voting of any underlying shares, they maintain that Schaeffler’s termination rights increased its ability to buy the shares from the banks on maturity of the swap. In addition, they find that the swap scheme created a situation in which the participating banks were very likely to be strongly influenced by Schaeffler. The latter runs the risk of being interpreted as acting in concert, triggering an aggregation of Schaeffler’s and the banks’ positions pursuant to Section 30(2) of the German Takeover Act.

Not everybody is convinced by these arguments. Many, including BaFin, regarded Schaeffler’s strategy as perfectly legitimate. Others see a legal loophole which the legislator should close.

It is unclear whether a formal and more comprehensive investigation into the Porsche dealings that goes beyond the scope of the narrowly defined investigation, commenced on 29 October, related to recent dealings will be taken up by BaFin at this time and whether the findings will be similar to those in the Schaeffler case or not.

The new German Risk Limitation Act still won’t include cash-settled options
The new provision in Section 25(1) of the German Securities Trading Act on the aggregation of voting rights attached to shares and voting rights attached to financial instruments granting the right to purchase shares will only take effect as of 1 March 2009.

The “sneaking up” strategy (“Anschleichen”) employed by Schaeffler (Continental AG), Swiss Life (AWD) and Porsche (VW) has been discussed in the context of the legislative process leading up to the new bill and several observers are doubting whether they could have been prevented by the new law, which wasn’t designed to address this issue that only came up late in the process. German Finance Minister, Peer Steinbrück, has made clear that there will be no “Lex Conti”; the fact that Schaeffler sneaked up on Continental will not trigger new legislation in addition to the just-adopted Risk Limitation Act.

In the UK, the new proposed FSA rules which would come into force in September 2009 intend to require disclosure of cash-settled derivatives. Until then, they are only disclosable in certain cases under the rules of the UK Panel on Takeovers and Mergers. In contrast, in Germany, cash-settled options will still not trigger notification duties even in a takeover context as they do not carry an entitlement to acquire the underlying shares.

The UK thus plans to move beyond the current requirements of the Transparency Directive and it remains to be seen whether the European partners will follow suit and be inspired to mould this novel approach into a future directive. Until then, the “creeping takeover” strategy involving cash settled-settled equity swaps and options will, in all likelihood, continue to be used in other EU jurisdictions, including Germany.