The Securities and Futures Ordinance was enacted in March 2002 and is widely expected to come into force by April. The SFO is a major piece of legislation, consolidating and superseding 10 primary pieces of current legislation relating to securities and futures.
There are many regulatory changes introduced by the SFO which potentially effect derivatives players. However, arguably the area which may cause greatest change relates to the new disclosure of interests requirements.
Disclosure Of Interests
Part XV of the Securities and Futures Ordinance will replace the disclosure of interests regime under the Securities (Disclosure of Interest) Ordinance (Cap. 396) and introduces two parallel regimes: disclosures required of substantial shareholders (which relates to both corporates and individuals) and disclosures required of directors or chief executives of corporations with securities listed in Hong Kong. Part XV is an extremely detailed piece of legislation.
Here we attempt to provide an overview of features of the substantial shareholder disclosure regime of particular interest to the derivatives industry.
The new regime has three main components:
* disclosure of interests
* disclosure of short positions
* disclosure of changes in nature of interests
each of which is relevant when your aggregate interests in shares in a company with securities listed in Hong Kong reach or exceed 5% of the total issued share capital of that company. Disclosure has to be made to the company and the Hong Kong Stock Exchange.
There is no territorial limit: if you fulfil the criteria a reporting obligation will apply to you wherever you are located. The key feature for the derivatives industry is that equity derivatives which relate to shares in Hong Kong listed companies are a component in each of the three reporting areas (interests, short positions and changes in nature of interests).
"Interests" In Shares
Interests in shares are very widely defined to include interests "of any kind" (for example, a person who enters into a contract for the purchase of shares is taken to have an "interest" in those shares even before delivery and change in title), the limits being prescribed largely by the use of exemptions. In calculating his total aggregate interest, a person may also have to include interests attributed to him. For example, in the case of a corporate, the interests held by companies controlled by the first company. For this purpose, the ability to exercise one-third or more of voting power in a company is regarded as ability to control that company.
If your total aggregate interests, after taking account of exemptions, reach the 5% threshold for the first time or have crossed a percentage point above 5% (either increasing or decreasing) since the last disclosure, a disclosure obligation arises. Falling back down below 5% also triggers a disclosure. However, no further disclosures have to be made unless the 5% threshold is reached again.
One type of interest specifically identified is in relation to equity derivatives. The SFO goes much further than the previous disclosure regime which was, essentially, restricted to physically-settled equity derivatives relating to issued shares. Under the SFO the definition of "interests" specifically includes the interests of a "holder, writer or issuer" of "equity derivatives", who has (i) a right to delivery of the underlying shares or (ii) an obligation to deliver the underlying shares (these definitions cover equity derivatives which are physically-settled) or (iii) the right to receive an amount if the price of the underlying shares increases or (iv) the right to avoid/reduce a loss if the price of the underlying shares increases (these definitions cover most equity derivatives which are cash-settled). Therefore, a buyer of a cash-settled call or a seller of a cash-settled put will be treated as having interests in the underlying shares under the call/put for the purposes of the disclosure regime.
By way of example, one obvious area where interests under equity derivatives will have to be taken into account and were not relevant under the previous disclosure regime is in the area of cash-settled warrants linked to shares in Hong Kong listed companies. Holders and issuers will now have to analyse their positions in them in the context of the new disclosure requirements.
The second area of disclosure, and of particular relevance to derivatives practitioners, is that anyone who has interests at or above the 5% threshold also has to consider their aggregate short positions in the shares. If your short position exceeds 1% (the denominator being the number of shares of that company currently in issue), disclosure of that short position is required. For this purpose, netting of "interests" (long positions) and short positions is not permitted. The firm must file separate disclosures of long and short positions. Once the 1% short position threshold is reached, percentage increases and decreases of the short positions require further disclosure.
The definition of a "short position" relates only to positions a person has (a) by virtue of equity derivatives; and (b) as a borrower of shares under a securities borrowing and lending agreement.
In relation to physically-settled equity derivatives, a holder, writer or issuer has a short position when he has a right to dispose of shares underlying an equity derivative or an obligation to deliver underlying shares.
In relation to cash-settled equity derivatives, a holder, writer or issuer has a short position when he has a right to receive from another person an amount (or a right to avoid or reduce a loss) if the price of shares underlining an equity derivative declines. He is "short" the number of shares used in calculating the amount he may receive (or, as the case may be, to calculate the loss he may avoid or reduce).
Change In Nature Of Interest
The third area of disclosure is that anyone who has interests at or above the 5% threshold also has to consider changes in the nature of their interests. This expression, introduced by the SFO, is widely defined to include any change in the nature of "any of the person's interest whether legal or equitable in shares", and specifically includes any change in the persons' interests in the underlying shares of equity derivatives "on the exercise by, or against, him of rights under the equity derivatives". Thus, for example, the exercise of a physically-settled call will be regarded as a "change in nature of interest" of the option holder which has to be notified (assuming he has reached the 5% disclosure threshold).
"Equity derivatives" is very widely defined to include most types of equity derivatives, although the SFC has the power to exempt an applicant from disclosure requirements relating to any particular derivative. It does not matter whether the equity derivative is listed or over-the-counter, or whether the derivative is issued by the listed company or otherwise, all may be caught. Warrants, stock futures and depository receipts are specifically included.
In line with the inclusion of cash-settled derivatives, "underlying shares" are not limited to shares that may be physically delivered under an equity derivative; they include shares used to determine the price or value of an equity derivative.
There are a number of exemptions to the disclosure regime relating to various specific situations. Some exemptions are statutory and set out in the SFO; others are expected under subsidiary legislation and SFC rules to be published.
In the area of derivatives, there is an exception relating to basket products (whether physically or cash-settled): if the underlying shares are of five or more listed corporations, and no more than 30% of the value of the derivative is derived from the shares of any one of those listed corporations, the basket equity derivative is taken to have no underlying shares.
The new provisions were designed to achieve greater market transparency in Hong Kong marking a change from the philosophy of the previous disclosure regime which was designed to reveal stakebuilding. Under the SFO, even if a person's overall net economic position relating to the shares of a Hong Kong listed company may be minimal, he may nevertheless be obliged to disclose his dealings to the market in detail, so long as his aggregate interests (including attributed interests) in those shares amount to 5% or more of the issued share capital of that listed company.
It is clear that considerable administrative demands are being placed on market players to comply with the new regime, and the penalties for breach are onerous, including criminal sanctions for responsible officers.
This week's Learning Curve was written byJeremy Walter, partner, andTansy Tang, associate in the derivatives and financial markets group atClifford Chancein Hong Kong