CANADIAN IR PRACTITIONER PERSPECTIVE

It is becoming increasingly difficult for IROs to identify their companies’ shareholders and affect ownership through good communication. In addition to the lack of transparency caused by beneficial shareholders holding ownership through brokerages, there is a growing trend by activist firms to use synthetic derivative tools to boost their ownership in a company, yet remain hidden from sight.

Synthetic derivatives are derivative instruments that utilize puts and calls in various fashions (e.g. straps, straddles and strips), creating a costless insurance policy against price volatility. However, puts and calls were actually created to hedge commodities or a security with insufficient liquidity. The intention was not to provide synthetic control of a company’s stock, but this is how they are being utilized by activist and arbitrage firms.

Firms can obtain call and put options on a stock, providing them with the ‘right’ to ownership in a company through calls (rather than cash), although they technically don’t have over 10% ownership. Since the ownership is ‘synthetic’, the IRO often cannot identify the firm as a holder. Trading of puts and calls can be tracked, but is not as transparent as stock trading, since there are no reporting requirements. This is a regulatory loophole that needs to be addressed. CIRI is trying to get the regulators to lower the early warning threshold from 10% ownership to 5%, but this will have no effect on synthetic ownership, since firms trade derivatives behind the scenes.

Synthetic ownership tactics are a significant issue for the IRO, making shareholder identification difficult. As synthetic owners don’t actually purchase the stock, companies can be blindsided when a firm comes forward with its own agenda.

Real Life Examples in Canada

In the past 18 months, there have been several companies that have been affected by synthetic ownership in Canada and the U.S. Following are two examples from Canada that hit close to home.

In early 2012, TELUS Corporation proposed a transaction that would eliminate TELUS’ dual class share structure, simplifying its share structure to advance good governance. Shortly thereafter, Mason Capital, a New York hedge fund, rapidly acquired TELUS’ common shares – eventually holding 33 million shares of this class – while shorting an almost equivalent number of non-voting shares and common shares. Essentially, the fund obtained a ghost position through the use of synthetic derivatives. While Mason had less than a 0.25% net economic interest in the company due to its short trades, it controlled almost 19% of the common share votes through derivatives. Mason then issued a dissident proxy circular seeking to defeat TELUS’ proposal for its own short-term profit, at the expense of other shareholders.

As per TELUS’ releases, Mason was “attempting to disrupt the proposal in order to widen the gap in price between TELUS’ share classes and thus profit from its short position in TELUS’ Non-Voting Shares”. Glass Lewis stated that it was “troubled by the brief period in which Mason has been invested in the Company as well as its outstanding short position which, in our opinion, call into question the Dissident's motives for opposing the conversion.”

In May 2012, TELUS withdrew its proposal when it became apparent that the vote would not succeed. Mason Capital was voting $1.9 billion worth of TELUS’ common shares with only a $25 million net economic stake. If Mason’s shares were factored out, the proposal was on track to be approved with 92% of voted shares in favour. In August 2012, TELUS reintroduced the proposal with democratic voting of both voting and non-voting shares. Mason attempted to challenge the validity of the proposal through the B.C. Courts, which subsequently ruled in TELUS’ favour. The resolution passed in October 2013 with 81% of total shares voting in favour.

Talisman Energy Inc. experienced a similar synthetic ownership situation in October of this year through tactics used by shareholder activist Carl Icahn to lever his interest in the company. The Globe and Mail reported that Icahn’s firm used “put and call options to amass a stake in Talisman – a tactic designed to rake in enormous profit if the stock rallies.” At that time, Icahn’s equity stake in Talisman was reported at less than 1%, but he controlled approximately 6% through rights from synthetic derivatives. He utilized a straddle of puts and calls – with calls providing voting power and the option to purchase more shares at a lower price, and puts providing protection should the price fall.

In October 2013, Icahn stated that he may “seek talks with management on strategic alternatives and board seats.” In December 2013, Talisman reached an agreement with Icahn to place two of Icahn Capital’s representatives on the company’s Board of Directors. In exchange, Icahn agreed to not initiate a proxy battle and promised to vote his shares in support of the Board’s slate of director nominees at the 2014 AGM.

In both cases, the companies couldn’t see the activist’s ownership on their radar screens, and were possibly surprised when they came forward with their stock ownership and control. Bear in mind that it is debatable whether activists using derivatives in this manner are doing so in the companies’ and shareholders’ best interests.

What Can an IRO Do?

How does this growing trend affect the IRO’s role and ability to do what needs to be done? It is difficult, but there are a few actions available to try to identify such tactics. First of all, monitor puts and calls on the company’s stock. While these trades lack transparency, an increase in volume (especially if from one house) may indicate that an activist is using synthetic derivatives to his or her advantage and increasing a ‘hidden’ position. Also, when greater trading in shares occurs, start talking to major shareholders to see if they have been approached by any activist firms and to ensure existing shareholders are sympathetic to management. Finally, the IRO should leverage relationships with the trading desks to get information on trading in stock or derivatives. There may be rumours or information that will surface.

Overall, be aware of this growing trend and watch the outcomes at companies that face the challenge. Knowing how the issue has been handled may help your company react more quickly and effectively if you find yourself in this situation.