Cash-Settled Equity Swaps and Market Distortions

Australia has a statutory framework that is advantageous to activist shareholders.  However, the common law has developed to constrain the ability for activists to bypass the directors and harness the members' meeting of a company to achieve their objectives.  This reduces the incentives of owning securities in the target of the campaign and has occasioned an environment in which alternative exposures can be held to effect change.  Equity derivatives have been utilised for this purpose.  Cash-settled equity swaps, however, are not captured by the substantial holding regime in the Corporations Act 2001 (Cth). 

I have recently published an article that delves into the way in which equity derivative positions are required to be disclosed to the market and tests the effectiveness of this regulation in the context of shareholder activism in Australia.  The Australian Takeovers Panel requires all long equity derivative positions, including cash-settled equity swaps, of over 5% to be disclosed to the listed company regardless of whether a control transaction has commenced.  However, non-disclosure of cash-settled equity swaps can only be sanctioned by the Takeovers Panel, which effectively places the onus on target companies to identify the activity, compel disclosure and if necessary apply to the Takeovers Panel to enforce disclosure and impose penalties.  Even if an application is made by a target, the Takeovers Panel may have limited enforcement options available.  This was demonstrated recently in the context of an activist campaign by British hedge fund Bell Rock Capital Management LLP.   

The Takeovers Panel does not require the investor to disclose the bank that is the writer of the equity derivative.  For this reason, even where the bank obtains a significant, or commensurate, hedging position and submits a substantial holder notice accordingly, there will be no information released to the market that explicitly links the respective interests.  The exception to this is where the investor and the bank are ‘associates’.  This is unlikely to arise if the relationship is limited to the bank writing and executing the relevant equity derivatives for the investor without more.  In the United States, the Securities and Exchange Commission (SEC) proposed reforms to overcome these challenges by classifying banks and investors as part of a ‘group’.  However, these proposed reforms did not ultimately form part of the final amendments that were released by the SEC in October 2023.

Since the publication of my article, the Australian Government has released an exposure draft in November 2024 on amending the substantial holding regime to apply to cash-settled equity derivative positions.  Under the regime, persons with relevant interests in voting shares of an entity amounting to 5% or more of the total votes that may be cast must disclose that they have a ‘substantial holding’.  Substantial holders must then report any subsequent movements in their interests of 1% or more, and are also compelled to disclose when they cease to have a substantial holding.  These market disclosure provisions are enforced by the Australian Securities and Investments Commission (ASIC) and the penalties for non-compliance are maximum civil penalties of 60 penalty units for individuals and 600 penalty units for bodies corporate and criminal offending carries a maximum term of imprisonment of two years for individuals and 2,400 penalty units for bodies corporate.  Consistent with my article, this will set a greater deterrent to market participants to disclose these positions and remove the burden on target companies to enforce disclosure through the Takeovers Panel.  These proposed reforms will also bring Australia into line with comparable jurisdictions, including Hong Kong, New Zealand and the United Kingdom.

Charles Nugent-Young is Special Counsel at Norton Rose Fulbright.