Tuesday, November 13, 2007

UK Regulators Propose a Rule

The UK's Financial Services Authority published a "consultation paper" yesterday -- that is, a request for public comment on a proposed new regulation.

The subject of the proposal is an instrument known as a "contract for difference." This is a contract in which a party is paid when an underlying asset increases in value or perhaps pays out money when the asset falls in value (takes the long side), or vice versa (for the opposite party of course takes the short side). The significance of the CFD is that the speculator -- typically a hedge fund -- never acquires title of the underlying asset, so the transaction unbundles title from economic risk.

The FSA is concerned that undisclosed CFDs can mess up the system of corporate governance. Consider, for an easy case, a corporation's stockholder who has sold CFDs to a hedge fund. The hedge fund has the "long" position -- it has an interest in an increase in the value of that stock. The stockholder now has a "short" position -- it will receive money if the stock price falls. The stockholder still has title to the stock, though, and accordingly still has a vote in proxy contests.

Will the stockholder exercise that vote in such a way as to sabotage efforts of corporate management, or to help install an incompetent board, so as to benefit from the difference, the price fall, that will result?

That's an easy problem to imagine, but not the FSA's central concern. After all, look at the matter from the point of view of the hedge fund that bought the long position. It wouldn't be likely to do so if it thought the stockholder was about to sabotage the company so blatantly. Or, at least, it wouldn't make the same mistake twice. Can't the contracts between the long and short parties be trusted to ensure that the economic interest and the voting interest remain in some alliance?

Now we get to the real regulatory concern. The contracts can do that job all too well. The FSA is worried that hedge funds and others with CFD, but without titles to the stock, are exercising informal control over how the stock is voted, and that this makes the corporate governance system too opaque -- management and the other shareholders don't know who is pulling what strings.

Accordingly, the FSA's proposal focuses on disclosure. In essence, they want managements to be able to flush out all CFD holders with an economic interest of 5% of more of their equity.

There is a tax angle to this, too. CFDs are a flourishing part of the UK equity market, accounting for 30% of all trades, because in Britain there's a 0.5% stamp duty levied by the government on the sale of the actual shares, the underlying asset. CFDs are a way of playing the market without paying the tax, and the "unbundling" of votes from economic interest is more of a side effect than a positive benefit of these instruments.

The bottom line though is that if you want to comment on the FSA proposal, you've got three months. The clock is ticking.

No comments: