U.K. hedge fund face greater disclosure under new CFD rules

FSA calls for greater disclosure of Contracts For Difference (CFDs) Proposes either three percent or five percent disclosure thresholds Hedge funds no longer able to covertly acquire large shareholdings

The U.K. Financial Services Authority (FSA) has called for greater disclosure of shares held through derivatives such as Contracts For Difference (CFDs).  CFDs are widely used by hedge funds as it allows them to gain exposure to stock at low cost - typically five to ten percent of the value of the underlying share.  CFDs also enable investors to go short, avoid paying stamp duty (0.5 percent of a transaction), and maintain secrecy (very few jurisdictions require disclosure of purely economic interests).  According to the FSA, 30 percent of all equity trading in the UK is “in some way” driven by CFD transactions.

Until now, CFDs have been largely outside the scope of the FSA’s Disclosure and Transparency Rules (DTRs), the only requirement (since November 2005) being that CFD holders must declare economic interests of more than one percent in a target company once a formal offer is announced.

One of the criticisms made of the current regime is that it enables hedge funds to suddenly acquire a large stake in a company by converting CFDs into the underlying equity and in doing so take the market by surprise. (It could not do so through a direct holding as once its shareholding exceeded three percent, it would have to be disclosed).  CFDs also allow hedge funds to exert influence on a company’s management, with the company being unable to verify the CFD holder’s true position.

In response, the FSA has suggested two possible ways to secure greater disclosure of CFDs.  Its first approach would be to strengthen the current regime by requiring disclosure of CFDs equivalent to three percent or more of a company’s shares, but only in situations where the CFD holder planned to exercise voting rights or sell the shares. Under this approach, a company would also be entitled to ‘request a notification’ if it believed an investor held an economic interest of five percent or more.

Alternatively, the FSA suggests a ‘comprehensive’ regime requiring all CFD holders to reveal any economic interest of five percent or more in a company’s shares.

Both options, say the FSA, will provide greater transparency, enabling companies to identify who holds an economic interest in their shares, and therefore, who their potential shareholders are.

The FSA consultation period will end on 12 February 2008.  For more information, see the consultation paper:
Disclosure of Contracts for Difference.