Given the events of recent months and the resulting fragility of markets, the financial services industry is set for an extended period of regulatory change. Both the November 2008 G-20 meeting and the European Commission’s consultation on hedge funds confirm the intention to act quickly to tighten up regulations. Much of the focus will be on transparency, as some of the blame for market volatility has been attributed to poor oversight. Several recent situations have highlighted the gap between the sophistication of derivatives and synthetic finance, and the legislation supposedly governing it. For instance, a recent U.S. court battle concerning an issuer and two hedge funds holding derivatives with the issuer as underlier resulted in a decision that may yet redefine the concept of beneficial ownership—with potentially far-reaching consequences for the whole derivatives market.

Before detailing the case, one concept should be clarified. The concept of beneficial ownership, essentially the right to claim the benefits associated with a particular asset (e.g., dividends, votes), is central to understanding one of the cases mentioned. While the concept itself is relatively straightforward, and investment and voting powers are the criteria required for beneficial ownership under Section 13(d) of the U.S. Exchange Act, the actual holder of beneficial ownership is often clouded by issues that can arise from common derivative agreements, such as control and temporary asset ownership.

CSX Corporation (CSX) v. The Children’s Investment Fund (TCI) and 3G involves U.S.-based transportation/shipping firm CSX and the hedge funds TCI and 3G. In brief, the two hedge funds gained exposure to CSX through direct equity holdings and swaps. CSX sued the hedge funds in March 2008, arguing that TCI was the beneficial owner of the underlying CSX shares due to the fund’s influence over its swap counterparties. As such, CSX deemed TCI to be in breach of securities laws by not reporting its acquisition of more than 5% of CSX’s share capital. TCI held that it did not have beneficial ownership of the underlying CSX shares because it did not have any investment or voting rights.

The court ruled in CSX’s favour, agreeing TCI had the ability to “influence” its swap counterparties’ voting and investment, and thereby had beneficial ownership (and was therefore in violation of attendant reporting requirements). Interestingly, the court did not opine on whether entering into cash-settled, total return swaps, in and of itself, actually constitutes beneficial ownership.

This ruling presents several challenges and has wider impacts to investors and service providers, particularly on investment limits and disclosure. Without formally ruling on the matter, the court implied an extension—or at least a willingness to entertain a broader view—of beneficial ownership. Rule 13d currently holds a swap investor to be beneficial owner of the underlying securities if the investor can vote and has investing power. However, the court seemingly expands its interpretation to include the ability to influence voting and the investor’s intent.

If the wider interpretation becomes the new, enforced standard, then 1) investors might be afraid to engage in swaps due to concerns of being deemed beneficial owner; and 2) investors that might exceed the 5% threshold due to swaps would have to decide whether to follow the U.S. Securities and Exchange Commission’s position as affirmed in its amicus curiae letter to the court (i.e., that entering into a swap is not tantamount to beneficial ownership) or take a more conservative approach (i.e., deeming their swaps to be beneficial ownership).

Closer scrutiny of derivatives is not limited to the United States. The UK’s Financial Services Authority (FSA) previously provided guidance that a party holding a contract for difference (a cash-settled derivative position, or CFD) underpinned by a listed share did not have to disclose its interest if it did not have voting rights or rights to acquire the shares. However, after extensive consultation new rules will take effect from 1 June this year such that disclosure will be required if a combination of shares and complex derivatives results in an interest of more than 3%.

In addition, two cases in Germany highlight the impact swaps and derivatives are having on European financial markets. Porsche recently surprised the market by revealing that, via cash swaps, it had accumulated over 30% of outstanding Volkswagen shares, bringing its total holding to nearly 73%. VW shares soared sharply, impacting numerous hedge funds and distorting the market. Schlaeffler Group, a private ball-bearing manufacturer, engaged several banks to help it build a 36% stake in German tyre manufacturer Continental via cash swaps. Schlaeffler was able to gain control and make a surprise bid for Continental without paying a premium or being forced to adhere to mandatory takeover rules. While there is no question regarding the legality of Porsche and Schaeffler’s actions, they underscore derivatives’ ability to be simultaneously market-distorting and clandestine, resulting in calls for a reexamination of disclosure rules in Germany and more widely.

If the interpretation of beneficial ownership changes, then the way in which investors are taxed and the systems, processes and reporting surrounding complex investment holdings and strategies are also likely to change. For instance, if a broader interpretation stands, then third-party providers will face a larger technological burden stemming from tallying and keeping abreast of a wider range of ever-changing holdings. Requirements for enhanced disclosure seem to be in the works in numerous jurisdictions. The implication for investors, administrators and market counterparties could be a requirement to disclose more information about their positions—as well as their intentions—than ever before. These developments will continue to be closely monitored by our Product Management and Industry Initiatives teams; but perhaps the real challenge lies in ensuring that whatever regulatory change emerges is proportionate and, crucially, workable.