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The consultation paper sets out thorough and detailed analysis of evidence, which shows how potential market failures could occur from using Contracts for Difference (CfDs) on an undisclosed basis to influence corporate governance and build up stakes in companies.

A CfD is a contract between two parties where the buyer will receive from or pay to the seller, the difference between the value of a company's share at expiry and its value at the time of the contract. The buyer could also have the option to buy the shares at the later date although the CfD does not confer a right to buy them. The holder of a CfD on a company's shares has an economic interest in the company, without direct ownership of shares in the company.

Voting rights

CfDs currently fall outside the scope of the Financial Services Authority’s (FSA) disclosure and transparency rules, unless they give access to voting rights attached to shares held as hedge by a CfD holder or a legal right to acquire the shares on expiration of the contract.

The takeover panel's current regime requires that if, during an offer period, a person has an interest, including an economic interest, in one per cent or more of any class of relevant securities of a company, then all dealings in any relevant securities, including long derivatives and options, of that company by that person must be publicly disclosed.

In 2006, the FSA consulted on the transparency directive for listed companies and explained that responsibility for overseeing the major shareholders notification regime (MSN) would move from the then Department for Trade and Industry to the FSA.

The FSA also said at the time that the then Companies Bill would give it powers to extend the regime beyond the disclosure of 'ownership' of significant equity positions to requiring more disclosure.

The FSA said that these failures, although not widespread, need to be addressed to ensure market confidence and efficiency are maintained.

Safe harbour

The paper proposes two alternative approaches to securing greater disclosure. The first approach would strengthen the current disclosure regime by requiring a disclosure of any CfDs written in reference to 3 per cent or more of total voting rights attached to a company's shares unless it was clear that:

• the CfD holder could not exercise or seek to exercise voting rights and had made a clear statement to that effect; and
• there were no arrangements or understandings in relation to the potential sale of the underlying shares by the CfD holder.

The majority of CfDs are expected to fall within this 'safe harbour', removing the need for disclosure.

In addition, this proposal would enable companies to request a notification if they believed a CfD holder had an economic interest of 5 per cent or more of the company's shares regardless of 'safe harbours'. It would also make clear the responsibilities of a CfD holder to ensure that any statements made about voting rights in a company are clear and not misleading.

The proposals would also make it harder for CfD holders to build up significant stakes in companies without disclosure. The cost of implementing such targeted disclosure is expected to be minimal.

The alternative approach is a general disclosure regime which would achieve the same objectives by requiring CfD holders to reveal all economic interest of stakes of 5 per cent or more in a company's shares. This would be broadly equivalent to extending the Takeover Panel's current regime in an offer period.

Not a clampdown

The total direct cost of implementation could be about £20-50 million with potential wider costs to the CfD and equity market as a whole. While this regime would cost more it would entail simpler rules.

Sally Dewar, FSA Director of Markets, explained that this is not a clampdown on CfDs but a means, following extensive research, of addressing the concerns about their use on an undisclosed basis. She said that, while the behaviour that concerns the FSA is not widespread, it is important enough to require a tightening of the existing regime to ensure fair and orderly markets.

"Our goal is to provide an effective and proportionate disclosure regime that works for all involved, and sustains market confidence and efficiency," Dewar said.

Any rule changes would only apply to CfDs relating to UK shares admitted to trading on a regulated or prescribed market. This includes shares admitted to the regulated markets of UK Recognised Investment Exchanges and the Alternative Investment Market (AIM).

The paper also details how the proposed changes would work with existing Takeover Panel rules on disclosure.

The consultation period will last for three months and end on 12 February 2008.

Related links

• Financial Services Authority
• CP07/20: Disclosure of Contracts for Difference