FSA Adopts New Disclosure Regime for Hedge Fund Derivatives Positions

In an effort to prevent hedge funds and other market participants from using contracts for difference to influence corporate governance and build up undisclosed stakes in companies, the UK Financial Services Authority will require disclosure of interests in a company’s shares held through derivatives, such as contracts of difference. The new rules will make it harder for derivatives holders to build up significant stakes in companies without disclosure. The new disclosure regime will provide greater transparency for issuers and for the market at least in terms of who holds economic interest in them and therefore who their potential shareholders are.

The disclosure threshold will be set at 3 percent, in line with the existing disclosure rules. The FSA will develop an exemption for contracts for difference writers who act as intermediaries, which will be similar to the Takeover Panel’s recognized Intermediary exemption.

The FSA will publish a Policy Statement in September 2008, along with draft rules to implement this position. Although the position has now been finalized, the FSA will accept technical comments on the new rules to ensure that they are workable. Final rules will be issued in February 2009.

A contract for difference is a share in a derivative product giving the holder an economic exposure to the change in price of a specific share over the life of the contract. Hedge funds are the typical holders of contracts of difference, which allow them to take an economic exposure to a movement in the referenced share at a small fraction of the cost of securing a similar exposure by acquiring the shares themselves. Essentially, the hedge fund or other holder of such a contract has an economic interest in the company without direct ownership of shares in the company. Currently, contracts for difference fall outside the FSA’s transparency and disclosure rules.

Although hedge funds maintain that what is seen as a lack of transparency is in effect a legitimate factor underlying their trading strategies, the FSA believes that hedge funds may outflank traditional institutional investors by using economic interests to influence companies. Thus, some investors may be disadvantaged by investing in a market where others may have better information, such as who holds significant undisclosed economic interests.

The rules will allow companies to verify claims by hedge funds as to their holdings. Currently, companies approached by individuals claiming to have an economic interest in their shares have no way to verify such claims. The disclosure will allow companies to make appropriate enquiries into such claims and then disseminate the conclusions to the market. In turn, said the FSA, such a verification process will reduce the number of misleading statements being made in respect of significant holdings.