Unclear transparency

Like many sensible ideas, the EU Transparency Directive (TD) has an admirable goal. At its heart is the principle that all financial corporate information should be standardized so that regulated information can be disseminated quickly and clearly. Despite its leaden title, this directive, which came into force in January 2007, is remarkably guidance-light. The document – which dictates minimum reporting standards for all EU states, from interim management statements to information storage – totals just 10 pages, giving plenty of room for EU states to tailor the advice to their own circumstances.

Since then, many national European governments have worked hard at beefing up their disclosure and transparency standards. A few have even taken the guidance beyond the minimum disclosure levels set by the directive.

‘The TD was not a new issue for us in France – we already had annual and half-year reporting, though quarterly information was not as deep as the directive stipulates on the issuer side,’ says David Freedman, a partner at law firm Baker & McKenzie. ‘But all the major shareholding requirements already existed within French law, which allows issuers to insert a clause in their articles of association requiring disclosure as low as 0.5 percent of shares or voting rights.’

Freedman adds that the Autorité des Marchés Financiers, France’s financial regulator, is typically ahead of most EU member states when it comes to adapting to and anticipating new financial regulations. Upcoming French legislation will deal with the disclosure of synthetic holdings, which will go well beyond the equity-linked instruments the TD seeks to regulate.

Such French progress on information disclosure should surely be applauded. One could also argue it’s something to which more EU member states should aspire. Too often legislators lumber along behind market news events, plugging loopholes and gaps as clever lawyers skilfully pry open new crevices for clients to crawl through.

Stealthy stake-building
Loopholes certainly continue to be present, however. One example is the continuing Schaeffler crisis, which has shaken Germany to its engineering and industrial core. A German family-owned car parts maker, Schaeffler succeeded in a hostile takeover of German car tire maker Continental, a DAX 30 company and three times the size of Schaeffler.

The deal was finessed by Schaeffler secretly building a 36 percent stake in Continental before pouncing on its far larger prey. Or, as Continental put it, Schaeffler ‘secured access to 36 percent of Continental’s shares in an unlawful manner.’

It happened like this: by the time Schaeffler launched its bid, it had already acquired nearly 3 percent of Continental’s ordinary shares and 4.95 percent in call options that had been physically settled. But it had a much bigger chunk – 28 percent – in the form of a derivative position in equity swaps, also known as contracts for difference (CFDs). These were part of an agreement Schaeffler entered into with Merrill Lynch, backed by a group of other banks, most of which had just shy of 3 percent apiece, avoiding their own notification requirements.

The agreement was for cash-settled equity swaps, with Merrill paying Schaeffler a sum equivalent to any rise in Continental’s stock price, together with any dividends it would have been entitled to if it had actually owned the stock. For its part, Schaeffler would pay Merrill the equivalent of any fall in the stock price as well as the amount Schaeffler would have had to pay in interest if Merrill had loaned it the cash to buy the stock.

It sounds complicated – and it’s arguably ownership by any other name – but derivatives are useful M&A tools for bidders wanting to avoid the consequences of going public early on. ‘The stock price went up during the secret stake-building in Continental, but this would arguably have increased earlier, and by more, if the market had been informed of the stake-building through threshold notifications,’ says Dr Manuel Lorenz, another Baker & McKenzie partner.

BaFin, the German supervisory authority, investigated the affair but accepted that Schaeffler had not violated disclosure rules. Neither the TD nor German regulations require disclosure where derivative positions are settled in cash. There was also a precedent: Porsche secretly increased its stake in Volkswagen by similar means, using cash-settled options, the year before.

Market confusion
As it happens, the Schaeffler-Continental deal is now at risk of unraveling under the weight of €16 billion ($22.3 billion) of accumulated debt that Schaeffler took on to finance the purchase. And Continental’s share price has been decimated: last May its shares traded at more than €82; currently it hovers around €13.

‘Ultimately, the market is confused about such transactions,’ says Lorenz. ‘There is a need for more disclosure. The German government has beefed up the rules for certain derivatives but there are always efforts to close loopholes when you have financial engineers and legislators who simply try to play catch-up.’

Away from the horrors of ongoing boardroom battles, for many countries the TD hasn’t demanded too much change in terms of issues like annual reporting requirements. Italy still lags behind, according to Kevin Desmond, director of PricewaterhouseCoopers’ capital markets group, but overall the TD’s loose modus operandi is welcome. ‘It doesn’t require quarterly reporting; and you can do interim management statements, which is what the UK chose to do,’ he notes.

However, Desmond adds that the directive remains open to considerable interpretation, and therefore possible abuse. ‘That means what you don’t get is common interpretation and common application,’ he says. ‘Some of the wordier bits, like the need for a management report, could be interpreted differently depending on your existing market practice. The TD has accelerated the likelihood of pan-European regulation being more coordinated and regulated.’

UK chancellor Alistair Darling is thought to be against a Europe-wide regulatory body, but Desmond reckons more noise will build for something stronger than the current single-state arrangements as the credit crunch deepens.

Investor clarity – to a point
Meanwhile, there is disappointment in some regulatory quarters that the TD is less luminous in practice than it should be. ‘One shouldn’t forget that one of the initial objectives of the directive was to make sure information was available in a widely used language such as English,’ says one observer close to the original project. ‘There is still nothing that is said or done under the TD to guarantee that every piece of regulated information put out by an issuer is systematically translated into English and disseminated to all investors.’

It’s a mixed picture overall. Although the directive’s framework originally laid out common standards, considerable unevenness in implementation remains. ‘The issue is also about whether a company really desires to communicate well,’ argues corporate disclosure expert Mark Hynes of Transparency Matters. ‘The right thing in the current dark times is to look hard at how you tell your equity story so you can tell it effectively, notwithstanding what the law says. It’s all very well complying with the directive, but explaining the culture of the board is something else. Regulation should be a base, not a ceiling.’

Calls for transparency and openness, however, need to be balanced against what can be reasonably expected from issuers, especially in harrowing economic conditions. One industry insider claims there’s a general feeling that EU bureaucrats are already pushing things to the limit, so maybe less is more – for now.