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CSA Proposes Changes to Early Warning Requirements

March 14, 2013

On March 13, 2013, the Canadian Securities Administrators ("CSA") published for comment a number of proposed changes to Canada's early warning regime (the "Proposal"). Currently, investors are required to issue a press release and file an early warning report when their share ownership reaches 10% or more of the outstanding voting or equity securities of a Canadian public company, and again every time an additional 2% is acquired. There is an alternative monthly reporting regime available to certain passive institutional investors. The purpose of the early warning regime is to ensure the market is advised on a timely basis of accumulations of significant blocks of securities that may impact control or voting outcomes, signal a takeover bid or affect a company's public float.

The Proposal addresses a wide range of changes to the early warning regime and the alternative monthly reporting system for passive investors.

Threshold Changes

There are three principal changes proposed to the basic early warning requirements:

  • The reporting threshold would be reduced from 10% to 5% of the outstanding voting securities. This would bring the Canadian threshold in line with the Schedule 13D filing threshold in the United States, though the time for filing in the U.S. is longer.

  • Investors would be required to report 2% decreases in ownership (not just 2% increases in ownership, as is currently the case). In the request for comments, the CSA has asked for input regarding whether reporting should be required for 1% changes, rather than 2% changes.

  • Investors would be required to report when their ownership stake drops below 5%. Currently, reporting is required only when the investor goes over the threshold, not when the investor's stake later drops below the threshold.

Currently, once a reporting threshold is reached, the investor cannot acquire additional securities until one business day has elapsed after the early warning report is filed (unless the investor holds 20% or more of the shares of the class). Under the Proposal, this trading moratorium would apply starting at 5% ownership, rather than 10% ownership, but the CSA has flagged for input the appropriate threshold for application of the moratorium, which may be higher than the threshold for early warning reporting.

Impact of Derivatives

For some time there have been concerns regarding the impact of "hidden ownership" and "empty voting". Hidden ownership occurs when an investor uses equity swaps or similar derivative arrangements to accumulate a significant economic position in a public company without public disclosure. Empty voting occurs when an investor, through securities lending arrangements or derivatives, holds voting rights (and thus can impact voting outcomes) but not the related economic interest in voting securities.

Hidden Ownership and Total Return Swaps

In the case of hidden ownership, accumulations occur without public disclosure. This can significantly undermine the early warning system because an investor may have de facto access to securities held by the derivative counterparty but avoid a disclosure obligation. In addition, the investor can generally convert the derivatives into voting securities and thereby influence the outcome of a shareholder vote or a change of control transaction.

The Proposal would require an investor to include "equity equivalent derivatives" in calculating its share ownership for the purpose of the early warning requirements. Equity equivalent derivatives would capture derivatives that substantially replicate the economic consequences of ownership. Examples include total return swaps and contracts for difference, and other derivatives that provide the investor holding the notional "long" position with an economic interest that is substantially equivalent to the economic interest the investor would have if it held the securities directly. The Proposal indicates that a derivative will be considered to be an equity equivalent security if the counterparty that took the notional "short" position on the derivative could substantially hedge its obligations under the derivative by holding 90% or more of the number of underlying securities.

Importantly, under the Proposal partial-exposure instruments, such as options and collars, that provide the investor with only limited exposure to the relevant securities would not be considered equity equivalent derivatives, though the CSA has requested input on this policy decision.

Empty Voting and Securities Lending Arrangements

In the case of empty voting, shareholder voting outcomes may be skewed as a result of the separation of voting rights and economic interest. Securities lending arrangements ("SLAs") are the primary mechanism by which empty voting occurs. In a SLA, securities are temporarily transferred from the lender to the borrower for a fee. Although often described as a loan, SLAs often involve a transfer of title to the underlying securities. The borrower, as the new owner of the securities, would be entitled to vote and receive any dividends. However the economic benefits of ownership will remain with the lender, including the borrower generally being required to make payments to the lender equivalent to the dividends paid. As a result, the borrower is an "empty voter" because the borrower holds the voting rights but not the equivalent economic interest in the securities. If the lender wants to vote the securities, it may have the right to recall them from the borrower.

The Proposal will clarify the application of the early warning reporting obligations in connection with SLAs and require greater transparency. (In the Proposal, the CSA indicates it is their view that the existing early warning regime applies to SLAs, even in the absence of the Proposal.)

The Proposal clarifies that the borrower of securities under a SLA must include the borrowed securities in calculating its share ownership for purposes of the early warning requirements.

In addition, the Proposal clarifies that the lender of securities under a SLA must include the lent securities in calculating its share ownership for purposes of the early warning requirements. However, the CSA has indicated that it is considering an exemption from the requirement to report decreases in ownership of securities for lenders in a SLA where the lender has the unrestricted ability to recall the securities before a meeting of securityholders. The CSA has requested input on this policy item.

Changes for Institutional Investors

The early warning regime includes alternative monthly reporting for passive institutional investors. Presently, institutional investors who solicit or intend to solicit proxies are eligible for alternative monthly reporting. Under the Proposal, such institutional investors would not be considered to be passive, and would be subject to the traditional early warning regime, rather than alternative monthly reporting.

Enhanced Disclosure

The Proposal includes a number of changes to the required content of an early warning report designed to elicit more useful disclosure. The principal changes include the following:

  • Currently, an early warning report is required to include information about the investor's purpose in carrying out the relevant transaction. The CSA has noted that the disclosure is often inadequate, regularly consisting of boilerplate language that provides little useful information to the market. In an effort to address this concern, the new early warning requirements would specify the type of information the CSA expects to be reported about the purpose of the transaction giving rise to the reporting obligation.

  • The early warning report would:

    • include details regarding the existence and material terms of any SLA, including the duration and any recall provisions;

    • identify if the transaction triggering the report involved an equity equivalent derivative, including details regarding the underlying securities; and

    • include disclosure of any transactions that have the effect of altering the reporting investor's economic exposure to the issuer.

    Request for Comments

    The Proposal's comment period expires on June 12, 2013. In addition to the proposed changes, in the request for comments the CSA identifies a list of 15 specific policy questions related to early warning disclosure (some of which are noted above) and invites market participants to comment on those policy items as well.

    Conclusion

    The changes set forth in the Proposal will improve the level and quality of information available about the shareholder profile for Canadian companies. Public companies and investors will have much better information about the company's shareholder base. Also, prospective acquirors will have greater insight into the identity and intentions of large blockholders, which can assist in takeover bid planning. On the other hand, if these changes are implemented, they will have a material impact on the size of a toehold position that a bidder can accumulate before having to publicly disclose its acquisition intentions.

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