Our last post discussed proposed Rule 10B-1, which would require significant public disclosures of security-based swap ("SBS") positions exceeding specified thresholds. Today, we’re going to take a look at the SEC’s recent proposal to expand Section 13’s “beneficial ownership” definition to include certain cash-settled derivatives.
As we noted, proposed Rule 10B-1 obliquely fills a gap in existing Rule 13d-3, which sets the ground rules for what derivatives constitute “beneficial ownership” for the purposes of Section 13. Rule 13d-3 has generally been interpreted to exclude cash-settled derivatives (such as total return swaps and options) that do not convey voting rights or disposition control in its threshold calculations. As a result, activists have been able to accrue significant synthetic exposure to public equity without triggering Section 13 reporting obligations. Unlike Rule 13d-3, proposed Rule 10B-1 captures many cash-settled derivatives in its scope. This means that certain transactions — for example, cash-settled total return swaps — that would not otherwise count towards Section 13 thresholds under Rule 13d-3 would count under proposed Rule 10B-1.
Conversely, however, we also pointed out that proposed Rule 10B-1 generally excludes non-SBS derivatives in its threshold calculations. This means that cash-settled non-SBS derivatives would generally be excluded both from proposed Rule 10B-1’s threshold calculations and Section 13’s threshold calculations. An activist using cash-settled options only would therefore be able to fly through Rule 10B-1’s net.
The SEC addressed this with proposed Rule 13d-3(e), which includes cash-settled derivatives other than SBS in Section 13’s beneficial ownership calculations to the extent such derivatives are “held with the purpose or effect of changing or influencing the control of the issuer.” This means that certain transactions — for example, cash-settled single-security options — that would not otherwise count towards Rule 10B-1’s thresholds would count under proposed Rule 13d-3(e).
If it sounds confusing, that’s because it is. The key is recognizing that all cash-settled equity derivatives are not treated the same way under the relevant regulations. While cash-settled swaps and cash-settled forwards referencing a single issuer’s shares will constitute SBS, cash-settled options referencing a single issuer’s shares will not.
In many circumstances, this won’t preclude disclosure. This is because under proposed Rule 10B-1, once a market participant accrues over $150 million notional of SBS referencing an issuer’s equity or SBS referencing more than 2.5% of a class of an issuer’s equity, that market participant will need to include its cash equity positions and non-SBS derivative positions in its threshold calculations. Depending on the issuer’s market capitalization, it might be very easy to exceed these thresholds. This will not always be the case, however. And either way, getting to the bottom of who owns what may require sifting through multiple forms of disclosure.
From the issuer’s perspective at least, these improvements are likely welcome regardless of any imperfections or complexities. But conceptually, if the goal of Section 13 modernization is to reverse course on the historical exclusion of cash-settled derivatives from the scope of “beneficial ownership”, then including cash-settled SBS motivated by activist intent may well make sense.
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