A Gathering Storm: The Market-Driven Unbundling of Equity

LONDON (HedgeWorld.com)--The head of contracts for difference at IG Markets Ltd. agrees with some of the U.K. regulators' concerns about the effects of the dramatic spread of CFDs in recent years.

Nick Saunders made clear that he was not speaking officially for the company as he spoke frankly about the subject in an interview.

The U.K.'s Panel on Takeovers and Mergers recently issued a consultation paper asking for comment on whether it ought to include the referenced equity of a CFD in calculating whether a party has passed the thresholds requiring that it declare its stake, or make a cash offer to all shareholders in a target company. The holder of a long CFD, the paper said, "is able in practice to exercise a significant amount of de facto control over the shares held by the counterparty to hedge its position".

IG Markets is a market maker in financial derivatives, especially CFDs, on both shares and indexes, so it's precisely the sort of counterparty of whom the panel was speaking. Mr. Saunders said that if anybody bought a CFD from IG, he or she would have no control at all over the shares. But there are, he said, "other companies that sail closer to the wind" in this respect, and it is right that if shares are likely to be voted in accord with a CFD holder's wishes, that holder should be "treated according to the same rules" as any other potential acquiring firm.

Market forces around the world are severing different aspects of corporate equity, complicating the very concept of stock ownership, and in the process changing both the alternative investment markets and the systems of regulation in several nations.

First-year law students in the United States take a property course that focuses in large part on real estate, and they learn that property isn't a thing or a plot of land but a "bundle of rights." Ownership of a plot of land is a bundle that includes the right to possess and occupy it, to make use of it, the right to exclude others from it, the right to sell it, etc. These rights can be unbundled with various results by contract, or by public policy. For example, every lease unbundles ownership from certain possessory rights.

Likewise, ownership of a share of stock is the right to cast a vote in a proxy fight, the right to tender that share, the right to receive a defined portion of the dividend stream, and the right to benefit (along with the risk of loss) if the market value of that stock increases (decreases) after one's purchase of it. These rights, too, can be unbundled with various results by contract, or by public policy.

Yet, on the other hand, that parallel doesn't quite work. The rights bundle of corporate equity has proven stickier, more resistant to division, because all the rights, and risks, of stock ownership can plausibly be thought to proceed from the same root--the owner of equity is the residual risk bearer. In the event of insolvency and court-supervised reorganization, equity investment is the first interest sacrificed. In any event short of that, the owners of equity vote in the board of directors and possess other rights at law intended to allow them a fair opportunity to avoid that contingency.

On the figurative third hand, perhaps the parallel does work. Markets around the world are moving toward an unbundling of equity, and they'll soon test the ability of legal and regulatory systems to adapt. A spokeswoman for the Alternative Investment Management Association Ltd., London, said recently that the AIMA as yet has no position with regard to the merger panel's paper on CFDs. She added that some members of AIMA have asked about what position it will take, and "we'll have to put our heads together and come up with something."

Consider, also, as an example of unbundling the growth of this market. In April 2004, the A&L Goodbody Tracker, a newsletter of a Dublin financial services company, noted that the covered warrants market in Ireland lay dormant due to the relative success of contracts for difference among that country's investors. It said that Investec, which was then the only institution licensed to sell covered warrants in Ireland, announced that it had no plans to do so. It said that the commission payable on covered warrants had made them unattractive compared to other derivative products, especially contracts for difference. It was not only commission, though, A&L commented, but the absence of a stamp tax, that have allowed CFDs to pre-empt any market for covered warrants in that country.

Consider, by analogy, the lawsuit that Carl Icahn filed against Mylan Laboratories Inc., Pittsburgh, Pa, and a hedge fund managed by Richard C. Perry.

Mr. Perry had an interest in a target company that Mylan sought to acquire, King Pharmaceuticals Inc., Bristol, Tenn. To advance that interest, he purchased stock in Mylan when a proxy fight over the wisdom of that acquisition seemed likely. Mr. Icahn's complaint, though, was precisely that Mr. Perry arranged his portfolio so as only to purchase the voting right, without becoming residual risk bearer or otherwise an economic stakeholder in Mylan.

That is to say, Mr. Perry was in effect selling a CFD to his broker, keeping the voting interest.

That lawsuit now seems likely to be dismissed as moot, because King has restated its financial results for 2002, 2003 and the first two quarters of 2004, and Mylan has taken the position that the restatement has resulted in a failure to satisfy a condition of Mylan's obligation to close the deal.

Mylan's vice chairman and chief executive, Robert J. Coury, said in a statement Jan. 12, "While our continued study may lead to a renegotiation of the existing merger agreement, there can be no assurance that a revised agreement will be reached or that any transaction will occur. Until a resolution is reached, Mylan intends to have no further comment on this situation."

CFaille@HedgeWorld.com

Contact Bob Keane with questions or comments at: bkeane@investmentadvisor.com.

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