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ISDA to Takeover Panel: Don't Impede Merger Arb

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LONDON (–The International Swaps and Derivatives Association Inc. filed a response to a consultation paper issued in January by the United Kingdom’s Panel on Takeovers and Mergers, and ISDA contended that the takeover panel is working from a faulty presumption about the controversial equity derivatives known as contracts for difference.

The panel is concerned that the holder of a long CFD (typically either a hedge fund or the proprietary desk of a financial institution) is able to exercise a significant amount of control over the shares held by the counterparty–usually an investment bank or securities house–to hedge its position and that in exercising this control it acts in ways opaque to the statutory/regulatory structure that governs takeovers.

ISDA’s response, filed by email Feb. 28, sought to alleviate this concern. It said that there is a “well-established and reported market of activity in relation purely to price, which is particularly marked in relation to the stocks of companies involved in takeover bids.”

Such pure price plays, which don’t involve “what one would characterise as ‘real’ interest in the shares” are, according to ISDA’s response, a normal and harmless consequence of a market economy, and any reform ought to be carefully tailored so as to avoid penalizing merger arbitrage or other price plays.

Furthermore, the paper said that in ISDA’s experience the counterparties–those with title to the hedge shares–generally document with their customers the fact that those customers should not expect to claim any interest in those shares. In its 2002 ISDA Equity Derivatives Definitions, ISDA provided template language to just this effect, and those definitions are “the widely accepted basis for documenting a wide range of transactions.”

The panel’s consultation paper had expressed concern that, even in the face of such contractual waivers, the holders of CFDs might exercise de facto influence over how a counter-party votes such stock, because the counter-party would wish to cultivate the CFD holders as continuing customers.

ISDA’s response contended that this is too simplistic a view of market conditions.

“While a given investor might wish that certain shares could be voted in a particular way, dealer firms will have a range of customers across a range of services and will have a natural interest to avoid taking sides among such customers,” ISDA asserted

ISDA agrees with some of the panel’s concerns, though, and its response suggested that if a contract (or any “understanding” between the parties) does give a holder the right to influence, directly or indirectly, how shares are voted, the holder of that derivative should have an obligation to disclose the details of any trading in the derivative, subject to a 1% threshold.

The response also addressed what ISDA calls certain “technical considerations” that will arise in the event of any such reform. For example, in such a case the panel will have to establish a method to calculate when a holding of derivatives passes the threshold, since not all equity derivatives that may come within the scope of such a rule change would be “delta one” products–that is, products in which the size of the derivative position has a one-to-one relationship with the number of the underlying shares held as a hedge.

Contact Bob Keane with questions or comments at: [email protected].

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