The Securities (Disclosure of Interests) Ordinance currently requires disclosure of 'interests' in shares in Hong Kong-listed companies by directors of the relevant company and by any other person with an interest representing 10% or more of any class of the company's issued share capital. 'Interest' is widely defined, and requires aggregation of interests held by associated corporations and their controllers.
In some cases, entering into a long or short position in derivatives relating to a listed company's shares (or taking shares as collateral under a derivatives transaction, or dealing in shares, including stock borrowing, to cover a derivatives position) may trigger a disclosure requirement under the current provisions of the SDIO. However, this rarely arises in practice, for a number of reasons:
* only 'interests' in issued share capital are relevant, and not, for example, positions in subscription warrants or convertible bonds;
* a cash-settled derivative relating to the price of a listed company's shares does not create an 'interest' in shares;
* creating a short position by buying a put or writing a call does not create an 'interest' in shares;
* even where an interest in shares is created, for example as a result of hedging transactions, it would be unusual for the transaction, even when aggregated with any other 'interests' of the relevant person and its associated corporations, to reach the disclosure threshold of 10%.
In recent years, in addition to the development of exchange-traded derivatives relating to Hong Kong-listed company shares, such as listed warrants, stock options and futures, it has become common for listed companies or their substantial shareholders to enter into over-the-counter derivatives transactions with investment banks, relating to the listed company's shares. There is a range of economic reasons for such transactions and they can raise a number of legal issues. However, they can usually be effected without triggering disclosure requirements under the SDIO for either the bank or its counterparty.
In its consultation paper issued at the end of June, the Securities and Futures Commision proposes radical changes to the SDIO, which, among other things, would greatly enhance the need for disclosures in respect of equity derivatives, and the amount of information to be disclosed. Such disclosures would to some extent create greater transparency, but the proposals to require disclosure of both long and short positions, and cash-settled transactions, could well lead to a vast amount of information being disseminated, which would create more confusion than clarity for the listed company and the investing public. Such wide-ranging disclosure obligations would also make legitimate hedging activity much difficult and hinder the use of derivatives in the Hong Kong market altogether.
The main changes proposed by the SFC in relation to derivatives can be summarised as follows.
DISCLOSEABLE INTERESTS
The 'interests' requiring disclosure would be extended beyond interests in issued share capital. Interests in subscription warrants and convertibles also would be caught. The SFC proposes that, in calculating the percentage size of the interests, the existing issued share capital is used as the denominator, without taking account of the dilutive effect of the exercise of the warrants or conversion rights. This, coupled with the proposed reduction in the disclosure threshold to 5%, could mean that holdings of interests relating to unissued shares would easily trigger disclosure obligations.
The SFC paper is very unclear on a fundamental point relating to derivatives--whether it is intended to extend the definition of 'interests' to cover cash-settled products. The paper proposes that stock futures positions (which are invariably cash-settled) are to become discloseable, as if they were interests in unissued shares. It is not clear from the paper whether puts and calls providing for cash settlement (or providing for settlement in stock or cash at the election of one or both parties), or warrants for cash settlement, are also intended to be caught. However the SFC has subsequently confirmed that this is the intention.
SHORT POSITIONS
The SFC also proposes that short positions (the writing of calls, holding of puts and taking of short futures) should be included in the disclosure regime. If the objective is to give a true picture of a person's overall position, arguably long and short positions should be netted off, and only the balance disclosed. However, the SFC does not propose this approach. In summary, they propose either:
* to aggregate both long and short positions for disclosure purposes (so that a person who had written calls over 2.5% of the company's issued capital, and was holding puts in respect of the same percentage, would be treated as having a 5% interest requiring disclosure); or
* only to take long positions into account in determining whether the 5% disclosure threshold has been reached, but if a disclosure obligation does arise, all short positions also would need to be separately disclosed. The SFC's preferred approach is that a substantial shareholder would have to disclose movements in short positions crossing a 1% band, even if there had been no change in long positions triggering a need for notification.
INFORMATION TO BE DISCLOSED
Currently, a substantial shareholder does not need to identify in a notification under the SDIO how the interest in shares has arisen, or the capacity in which the interest is held. The SFC proposes much more detailed notifications, which in the case of derivatives would include the following
* identification of the number of shares the interest in which is derived from derivatives;
* the circumstances in which the interest arose e.g. on-exchange or off-exchange transaction, and the capacity in which the interest is held e.g. as a holder of convertible securities;
* the consideration paid or received in relation to acquiring or disposing of the interest in shares;
* in the case of an off-exchange transaction, copies of the contract or other document under which the interest arose or was disposed of (or a written memorandum of terms if the contract was not in writing).
In relation to OTC derivatives, some of this information is highly sensitive commercial information which banks and their counterparties would not be willing to release and which, if released to the market, could severely constrain the ability to effect hedging transactions. Also, the administrative burden of complying with the requirements should not be overlooked.
MATTERS NOT ADDRESSED IN THE SFC PAPER
The definition of Hong Kong listed company in the SDIO includes a company which has any securities listed on The Stock Exchange of Hong Kong. Therefore, an issuer of listed warrants (or debt securities) is within the scope of the legislation, requiring disclosure by its substantial shareholders, even though the shares are unlisted. This makes no sense, and an exemption is normally granted from compliance with the SDIO in these circumstances. However, the exemption must be applied for separately in respect of each issue, and there is a charge of HKD24,000 for each application, which adds to the cost of listing in Hong Kong compared to other exchanges. Although not dealt with in the SFC consultation paper it would be welcomed if the SDIO were to be amended so that it only applied in respect of companies whose shares were listed in Hong Kong.
This week's Learning Curve was written by Pauline Ashall, partner at Linklaters & Paines in Hong Kong.
