February 18, 2011
On February 11, 2011, the German Parliament approved the bill for the so-called "Investor Protection and Capital Markets Improvement Act" (Anlegerschutz- und Funktionsverbesserungsgesetz) which is part of the ongoing legislative activity responding to the financial crisis. The bill is now referred to the second chamber of the Parliament and is expected to enter into force in April.
Apart from dealing with consumer-related issues such as (i) improving the protection of (retail) investors against wrongful advice by bankers and other professionals and (ii) stabilizing open-ended real-estate funds, the bill contains new disclosure obligations for stakeholders in public companies, e.g. holders of cash-settled options.
This highly relevant new disclosure rule is a reaction to the stealth takeover tactics that were, for example, employed by sports car maker Porsche it its attempted takeover of Volkswagen in the fall of 2008, but it may have a broader impact on the way public takeovers are done in Germany.
This alert focuses on the impact of the new bill on investments in and takeovers of public companies in Germany.
The Use of Cash-Settled Options
The use of cash-settled options as a means for hostile bidders to secretly secure a significant stake in the target without making any disclosures ("creeping in" or "stealth takeover") first became known in two very controversial headline cases, i.e. the hostile takeover of automotive supplier Continental AG by its competitor Schaeffler and the attempted hostile takeover of Volkswagen by Porsche.
In Germany, the current disclosure rules apply when an investor acquires at least 3% of the (voting) shares in a target or buys "financial instruments" granting the right to acquire at least 5% of the such shares. As cash-settled options do not confer upon the holder the right to acquire shares (but only the right to claim a cash-settlement), holding them does not — up to now — trigger any notification obligations. This is the widely agreed position of the German securities regulator BaFin as well as most legal commentators.
Although the letter of the law does not stipulate a disclosure obligation for holders of cash-settled options, reality showed that they can very well be employed as a useful tool to secure control over the target. In the Continental and Volkswagen cases, the facts can be summarized as follows: First, the bidder acquired cash-settled options from several banks. Had the bidder bought a similar number of shares (or options granting a claim for delivery of shares), it would have been obliged to make a disclosure because the relevant ownership thresholds were exceeded. However, by acquiring cash-settled options, the bidder was not required to disclose its position in the target. In order to hedge their economic risk, the banks in turn acquired a corresponding number of target shares when issuing the options, but each of the banks remained below the relevant disclosure threshold. At the end of the option period, the banks could sell the stock and settle the options in cash, but selling such large number of target shares would likely have compressed the share price, thereby exposing the banks to a loss. Therefore, it was — already at the time the options were issued — not unlikely that at the end of the option period, the banks would elect to sell the shares to the bidder, even though the bidder had no right to ask for such a sale.
This structure was widely perceived as a legal loophole which lead the legislature to amend the disclosure rules in the new bill.
The Revised Disclosure Rules
The bill establishes a new obligation of investors to make a disclosure if "they are holding financial instruments or other instruments which due to their structure enable their owner to acquire existing voting shares of an issuer domiciled in Germany, provided that they reach, exceed or fall short of a relevant threshold." Relevant thresholds are 5, 10, 15, 20, 25, 30, 50 and 75%. In such an event, the holder must immediately make the necessary notification to the issuer and BaFin.
The bill lists two examples where instruments "enable" the holder to acquire shares, i.e. (i) when the counterparty to the instruments could hedge or reduce its risk by holding the relevant shares or (ii) when the instruments include a right or an obligation to acquire the shares. Thus, the counterparty to a put-option will also need to make a disclosure.
In the annotations to the bill, the legislature provides some guidance. First, "other instruments" shall include all agreements which grant the right to acquire shares even if they are not financial instruments, e.g. the claim to return shares under a securities lending agreement or a "Repo" (Sale and Repurchase Agreement). The lawmakers aimed at including all arrangements that allow an investor to factually or economically acquire existing voting stock of the target. Specifically, cash-settled options or "contracts for difference" shall be subject to the new disclosure regime as well as "other transactions" in which — according to the economic purpose — the acquisition of voting stock is possible. Likewise, the rules shall also apply to financial instruments that refer to baskets or indices. The possibility to acquire shares exists regardless of whether the holder, the counterparty or a third party would need to take the initiative. In the case of options, one shall presume that they will be exercised.
Since the types of transactions representing "other instruments" under the new bill are not yet defined, the legislature suggested that BaFin may come up with a "non-exhaustive" list of transactions of "financial" or "other instruments".
In order to allow the market participants to prepare for the new disclosure rules, they will only enter into force nine months after the new bill has been formally enacted, i.e. most likely in early 2012.
Practical Evaluation of the New Disclosure Rules
The language in the bill was drafted broadly on purpose to avoid circumvention. Due to the broad scope and the economic approach, the new regime will indeed avoid creeping tactics as they were used by Schaeffler and Porsche and circumvention will become more difficult. However, the use of vague terms such as "enable" or "instruments" means that investors will have less legal certainty as some legitimate arrangements (e.g. irrevocable undertakings or conditional stock purchase agreements) may now need to be disclosed much earlier in the process, thereby making takeovers more risky.
The impact is mitigated by the fact that the new rules only apply once the 5% threshold is reached. The lawmakers wanted to avoid that day-to-day transactions would trigger complex reporting requirements if they are irrelevant in a takeover context. To determine whether a relevant threshold is met, all voting shares, financial instruments and other instruments held by an investor will need to be aggregated.
The practical implementation of the new rules will be key. It remains to be seen whether BaFin will mitigate the uncertainty by providing practical guidance.
While the goal to avoid creeping in tactics in public takeovers will most likely be achieved, lawmakers may have gone too far by reducing legal certainty and forcing early disclosure of structures that are generally considered legitimate. As a consequence, investors considering the acquisition of significant stakes in German issuers should be aware of the upcoming changes and carefully plan their steps in advance to avoid costly surprises.
Gibson, Dunn & Crutcher lawyers are available to assist in addressing any questions you may have regarding these issues. If you have any questions about these particular matters or would like additional information, please contact any of the following lawyers in the firm’s Munich office:
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