Uk and Us Trends in the Treatment of Derivatives, Short Sales, and Contract for Differences

UK AND US TRENDS IN THE TREATMENT OF DERIVATIVES, SHORT SALES, AND CONTRACT FOR DIFFERENCES IN CONNECTION WITH BENEFICIAL OWNERSHIP DISCLOSURE AND MARKET MANIPULATION

June 30, 2008

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The current disclosure regimes in the U.K. and the U.S. generally do not require disclosure of derivatives related to registered/listed securities since the regulatory framework in both countries focuses primarily on direct or indirect control of voting rights (or in the case of the U.S., the power to control disposition of the voting rights). However, as the derivatives market has expanded, issuers and investors have raised concerns regarding the lack of disclosure of holdings of such derivatives and that such derivatives enable the holders to influence and increase stakes in companies or an undisclosed basis. The following memorandum covers the results of the recent case involving derivatives and the proxy fight involving a hedge fund and the railroad CSX, a proposal by the Financial Services Authority on how to treat contract for differences in counting beneficial ownership of the related shares, and short selling developments in the US.

US Court Finds Total Return Swaps to Confer Beneficial Ownership for Disclosure Purposes

The U.S. District Court for the Southern District of New York issued an opinion that affects the analysis of when an economic interest in publicly traded shares acquired through a cash-settled total return swap (TRS) will be considered to confer beneficial ownership for purposes of the filing obligations imposed by the U.S. securities laws on owners of more than 5 percent of a company's voting equity securities on the grounds that the counterparty may have to vote the shares as the other party wishes.

CSX argued in proxy fight litigation that the dissidents should have disclosed sooner the 12.3 percent stake that they maintained through equity swaps. The Children's Investment Fund (TCI) had started the swap arrangements in October 2006 and by January 2007, the swaps related to 10.5 percent of CSX's stock by January 2007. The SEC's opinion on the issue concluded that a swap arrangement between a hedge fund and a counterparty is not sufficient to trigger Schedule 13D obligations, but the court noted that the SEC is considering whether to propose a rule to address swaps.

The court agreed with CSX on the 13D claims but against both CSX and the funds on their assertions of proxy violations. The court held that TCI and 3G had failed to disclose that they had formed a group with respect to their holdings in CSX shares in February 2007, while their disclosure only occurred in December.

TCI and 3G swapped the right to receive the dividends and the increases in price movement on the CSX securities in exchange for the requirement by TCI/3G to pay the counterparty/short party the downside price movement on the securities plus an agreed interest rate on the value of the securities. According to the court, an investment firm or commercial bank swap counterparty almost always hedges a swap based on publicly traded securities by purchasing the underlying security and TRS market practices usually resulted in the long party's ability to obtain the securities at the termination of the swap, ensure that the short party held the securities, and ensure that the short party generally locked up the securities. The court also found that short parties are motivated, in order to attract business as a short party, to appear willing to vote hedging shares in a manner desired by the long parties and that, generally hedged counterparties have no economic interest in the shares to distinguish their views on voting the shares from those of the long party. Since the court's approach could implicate short parties that participate (knowingly or unknowingly) in schemes or groups to evade the long parties' disclosure requirements, short parties, for example the investment and commercial bank counterparties in this case, may wish to obtain representations from their TRS long parties that the holdings of the long party, with TRS interests included, do not exceed 5 percent of the issuer's shares.

The court found that TCI/3G(the long party) in a cash-settled TRS does not have the legal power to control either of voting or disposition of the securities,but determined, based on SEC pronouncements for the proposition that "control" exists, if the long party has influence on the voting or disposition. This approach differed from that of the SEC staff which argued that a swap arrangement between a hedge fund and a counterparty is not sufficient to trigger Schedule 13D obligations, but the court noted that the SEC is considering whether to propose a rule to address swaps.

Since Regulation 13D-G definition of beneficial ownership is used in other contacts, additional consequences may follow from a holding that TRS long parties hold beneficial ownership. Such as the triggering of state takeover statutory provisions, poison pills and other corporate charter, bylaw and contractual provisions.

Since the definition of beneficial ownership for 13D is used or read into other contexts, the court's ruling may affect the outcome on decisions of the SEC short swing profit rules, state takeover statutory provisions, poison pills, and corporate charter, bylaw and contractual provisions.

FSA Rules on Short Positions

The UK Financial Services Authority (FSA) has issued guidance with respect to its new rule on short selling in rights issues. Starting on 20 June 2008 the Code of Market Conduct will require disclosure of short positions representing an economic position of 0.25% of issued shares in stocks admitted to trading on prescribed markets which are undertaking rights issues.

- Long and short positions may be netted, and only a net short position of 0.25% or above must be disclosed.

- The net short position is calculated based on the number of shares prior to the rights offering.

- Derivative positions must be included in the calculation of net short position (even options that cannot be exercised during the rights issue period).

- Economic interest in a company held as part of a basket or index is disregarded for purposes of calculating the net short position.

- There is no obligation to update the initial disclosure when the short position increases or decreases.

- An intra-day short position of 0.25% or more need not be disclosed if it is unwound by midnight that same day.

- A fund manager with discretion over more than one fund should aggregate the positions over all of its discretionary funds to determine whether or not the 0.25% threshold is reached.

- The consequences of non-disclosure could include a fine or public censure.

FSA Consultation Paper of Contracts for Differences

A contract for difference (a CfD) is an arrangement made in a future contract, whereby differences in settlement are made through cash payment rather than the delivery of goods or securities.

The Financial Services Authority (the " FSA") issued a consultation paper, where the consultation process ended in February 2008, on disclosure obligations relating to economic interests in listed shares held through derivatives such as contracts for difference (CfDs). As of that time, the FSA Disclosure and Transparency rules only covered control of voting rights, but the Takeover Code required disclosure of dealings by holders of economic markets in 1% of target securities.

The FSA, therefore, proposes considering a CfD holder to have access to voting rights unless the CfD agreement (1) explicitly precludes the holder from exercising or seeking to exercise voting rights, (2) excludes further arrangements relating to the sale of underlying shares and (3) states the holder does not intend to use the CfDs for voting rights. CfDs that do not meet these three criteria would be aggregated with other interests in voting rights. The holder of aggregated voting rights above 3% must disclose under the FSA under the UK disclosure. Moreover, the proposal would authorize investigation to determine and disclose holder of economic interests above 5%. The FSA also is considering general disclosure requirements in relation to all economic interests above 5%.

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Short Selling Developments in the US

Although, short selling increases market efficiency, the SEC has sought to ensure that short selling is not used to manipulate markets.The SEC adopted Regulation SHO in January 2005, to help protect against manipulative short selling.

Regulation SHO requires (among other things) a broker to locate shares that can be lent to its customer before allowing the customer to sell short. Hedge funds who attempt to order short sales can be liable under theories of aiding and abetting, or causing, the broker's violation and failing to inform the broker of the absence of adequate borrow can constitute a violation by the

short seller of the securities laws' antifraud provisions.

Some hedge funds have allegedly sold securities short without the broker first determining that the shares are available to borrow. Congressional hearings have been conducted this past summer into whether or not hedge funds have been secretly arranging for independent research agencies to issue negative reports on a company based on false and misleading statements, shorting the stock in advance of the release of those negative research reports and then covering the short sales following a drop in the

company's stock price after the negative research was published.

In late 2007, the SEC prohibited any self-regulatory organization (SRO) from having a price test whereby short sales were allowed.

The SEC also took active steps to end instances of "naked shorting" in the market. Regulation SHO was enacted in part to reduce the frequency of "fail to deliver" positions. The regulation require, among other things, that a broker-dealer "close out" short positions (i.e., purchase securities of like kind and quantity) in so-called "threshold securities" (i.e., securities that

experience designated levels of "fails to deliver") if that broker-dealer has a "fail to deliver" position in a threshold security for thirteen (13) consecutive settlement days. Although the enactment of Regulation SHO significantly reduced the number of fail-to-deliver securities, certain threshold securities have remained on the threshold lists since the adoption of Regulation

SHO, prompting the SEC to seek the elimination of existing exemptions as a means of eliminating persistent fails to deliver.

Current Disclosure Regimes and Market Manipulation Rules Need Updating to Deal with New Financial Products and Practices

Court Treats Total Return Swaps as Conferring Beneficial Ownership on Long Party Under Circumstances Where Short Party Hedges with Underlying Security and Other Criteria Are Met

FSA RULES ON SHORT POSITIONS

FSA RULES ON CONTRACTS FOR DIFFERENCES

US DEVELOPMENTS ON SHORT SALES

Next Razor Alert: US Rating Agency Developments

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