The Board’s report cites anecdotal evidence – including cases involving Continental, Fiat, and Volkswagen-Porsche – that cash-settled derivatives are increasingly being used by investors and strategic bidders to discreetly expand ownership positions in European listed firms.

When used for this purpose, cash-settled derivatives can disrupt a company’s internal governance and voting process and the efficient operations of markets, argued the report’s co-author, Eugenio De Nardis, a corporate lawyer at Cleary Gottlieb.

“Directors of European corporations should be aware of the risks and possible distortions caused by the undisclosed use of cash-settled derivatives,” added Matteo Tonello, director of corporate governance research at the Board and the other author of the study.

“The danger is in having investors’ public filings that only tell half the story about who actually owns the company. Also, when the transactions or stakes are eventually disclosed, markets might be unable to react promptly, giving rise to speculation and volatility.”

Chief among the Board’s recommendations for corporate managers is closer monitoring of trading activities. It suggests directors maintain sound procedures in monitoring all securities holdings, including derivative instruments where the company’s securities are the underlying instrument. At a minimum, it suggests companies should regularly review public filings by investors and available shareholder lists.

Talk to investors

Investor dialogue with major shareholders should be improved as well, the report argued. The Board says this will allow a firm to learn early on about potential shareholder concerns and critical changes in its ownership base, such as information on group voting arrangements and other understandings among shareholders. It also suggests regular outreach to investors can help management recognise perceived valuation gaps between a company’s stock price and its intrinsic value.

Board members should then be provided with regular reports on this intelligence, the report suggests, including updates on abnormal shareholder activity or changes in company ownership, profiles of any private pool of capital with investments in the company’s securities and information on any prospective strategic acquirer in the marketplace.

Finally, the body suggests companies should seek to understand the intentions of investors resorting to hidden ownership schemes, and remain open-minded when reviewing significant requests around corporate strategy, industry benchmarks, analyst reports, and investor profiles.

The report concludes that directors must take it upon themselves to notify the market and regulators of situations where there is evidence of shareholders operating under an undisclosed understanding with investors or other market participants or dealers, and in any case where there appears to be a violation of applicable securities regulation.

Continental raid

Continental, the German tyre and car parts maker, was bought in July 2008 by family-owned manufacturer Schaeffler Group, along with a consortium of five banks. Schaeffler managed to build up a 36% stake without any regulatory disclosure.

Of this, 28% of the capital was held through cash-settled derivatives, the Conference Board found, which did not trigger any disclosure obligations under German law.

Another 2.97% of Continental’s capital was held in shares, when the threshold triggering disclosure was 3%. Similarly, 4.95% was held in physically settled derivatives, for which the threshold was 5%.

Car wars

Back in 2005, Fiat’s holding company maintained control of the firm without triggering disclosure by amending a cash-settled derivative with underlying Fiat shares to require physical settlement concurrently with the expiration of a convertible loan. Consob, the Italian regulator, has already sanctioned the parties involved for providing misleading information to the market.

In the still more complex Porsche-Volkswagen case, the luxury carmaker announced in October 2008 that it had built up a 72% stake in VW, almost half of it undisclosed. Porsche held about 30% of VW’s share capital through cash-settled derivatives. Some of the parties involved are, however, under investigation in connection with violations of market abuse rules, the study notes.

To date, such moves are still allowed under German law. In May, the Bundestag began debating a bill – the “Act on strengthening investor protection and improving the functionality of capital markets” – which will, among other considerations, attempt to establish concrete disclosure requirements for long equity holdings.

According to the report, the draft bill would set a 5% holding benchmark – including cash-settled futures – for triggering disclosure requirements. The Conference Board report suggests it is unlikely any new legislation will come into effect before 2011.

On a pan-European level, the EC’s most recent Transparency Directive on disclosure requirements was adopted in December 2004. The Committee of European Securities Regulators recently recommended that the directive’s scope be extended to include the disclosure of derivatives positions, regardless of whether the relevant instruments are settled physically or in cash.

Tom Osborn +44 207 779 8361 tosborn@fow.com