7

Strategic Equity Derivatives in Mergers and Acquisitions

This chapter examines examples of entities that have used equity derivatives in an M&A situation. In some circumstances the use of equity derivatives has greatly impacted corporate control contests. In this chapter I have tried to analyze the most common uses of equity derivatives in M&A situations by covering real cases. As we will see, in M&A there is no such thing as the perfect strategic equity derivatives solution for a specific situation. The interpretation of securities laws for a specific equity derivatives transaction is quite subjective. Regulators often have differing interpretations regarding the same transaction. To make it more challenging, securities regulations change over time and differ from country to country. However, I think it is useful to learn from past experiences to devise more robust M&A strategies.

Numerous are the motivations behind the use of equity derivatives in M&A situations. A common thread would be an insurgent shareholder and/or a potential bidder accumulating a block of stock to gain shareholder approval for his/her proposals. The temptation to buy a pre-offer block is very strong because it may help the insurgent shareholder and/or potential bidder to lock in attractive share acquisition prices, to increase voting rights, to avoid disclosure requirements and/or to avoid public offer requirements. There are other motivations for using equity derivatives, more unusual – for example, securing a block of shares during a standstill period.

Locking in Acquisition Prices

When an acquirer's intentions become public knowledge, the target company's stock price will rise significantly to incorporate the offer price and the likelihood of a deal being consummated. Therefore, a potential acquirer has a strong incentive to buy as much stock as possible prior to an offer to lock in pre-offer acquisition prices.

Moreover, in an active merger market a third party may join the contest, making a more attractive counter-offer for the target company. In this situation the original potential acquirer could find itself a loser in a bidding war, having to pay expensive legal and investment banking advisory fees. Acquiring stock in the market at pre-offer prices may offset the incurred expenses and may even provide the losing bidder with a net profit on the transaction.

A public offer is usually financed with a bridge loan, which would later be replaced by a mix of syndicated loans and public bonds. Often when the acquirer has made the decision to purchase a pre-offer block, the bridge financing has not been agreed yet. Strategic equity derivatives may help to acquire a pre-offer block without a substantial financial commitment.

Increasing Voting Rights

A sizable block of a target company stock can also provide valuable leverage in an eventually contested shareholders’ meeting (i.e., a proxy contest). For example, by acquiring a large block of the target company's stock, a bidder can launch an accelerated proxy fight. Fundamentally, a proxy contest is defined by a date and set of proposals to be voted in an extraordinary general (shareholders’) meeting (an “EGM”). An EGM date formally determines when shareholders will gather to vote on the various proposals. The term “proxy” is used because many shareholders – rather than attending the meeting in person – vote in absentia, granting a right, or proxy, to someone else who then votes the shares. A shareholder will generally give its proxy either to the management or the insurgent, depending on which side the shareholder favors.

Typically, there are four main forms of proxy contests:

• Contests for seats on the board of directors of the target. An insurgent shareholder may use this means to replace opposing directors. The directors can normally count on a certain percentage of votes to support their position. Some of these votes might be through management's own stock holdings.
• Contests to clear the way for a tender offer. Many modern takeover defenses, such as the poison pill, can only be removed through a shareholder vote.
• Contests to approve a merger or acquisition. The target directors may oppose a merger and an insurgent shareholder may be in favor.
• Contests to approve changes in the target company strategic plans. For example, an insurgent shareholder may seek the disposal of a strategic asset with the proceeds paid to shareholders by means of a special dividend. Another common situation would be an insurgent shareholder seeking the approval of an aggressive buyback program.

The bidder can benefit from the voting power associated with the shares it owns. Such voting power can prove critical at various stages of a fight for control. By entering into equity derivatives transactions, an insurgent investor may obtain additional voting rights, helping him/her:

• To increase the likelihood of approval/rejection of resolutions voted in an AGM/EGM.
• To be able to call an EGM. For example, a 10% shareholding may entitle an investor to call a shareholders’ meeting. This threshold is usually defined in the company articles of association (i.e., the certificate of association or bylaws).
• To be able to submit resolutions to an AGM/EGM.

Avoiding Disclosure Requirements

Disclosure and regulatory approval requirements can be a barrier to secret pre-announcement accumulation. Equity derivatives may help to gain de facto control over a substantial amount of the target's shares before the transaction is disclosed or regulator approval is obtained, circumventing the restrictions to a direct acquisition. These restrictions can take different forms:

• Disclosure requirements of a significant shareholding in public (i.e., listed) companies. These requirements try to make the market aware of an interest in a company in excess of a specified limit, to avoid takeover abuses. The stock market regulator, and often the target company, must be notified of the direct or indirect acquisition or disposal of a “qualifying holding”. A qualified holding is a holding which represents at least a certain percentage (e.g., 5%) of the share capital or voting rights of a listed company.
• Regulatory approvals before the acquisition of a stake. For example, the acquisition of substantial shareholdings in banks and insurance institutions will, in most countries, require a notification to, or consent of, the relevant banking/insurance regulatory authority. The regulator, generally, has several months to oppose the intended transaction if, “in view of the need to ensure sound and prudent management” of the target, it is not satisfied as to the suitability of the purchaser.
• Antitrust authorities may require approval before the acquisition of a stake. For example, an antitrust authority may take months before assessing whether an M&A transaction can create or strengthen a dominant position as a result of which competition would be significantly and lastingly eliminated or reduced.

Avoiding Mandatory Offer Requirements

Equity derivatives may avoid mandatory takeover bids if the relevant thresholds are exceeded. The acquisition of a shareholding above certain thresholds may trigger a requirement for a public offer for a part of the company. Typically, if a shareholder has more than 50% of the voting rights of a listed company, he/she is required to make a mandatory takeover bid for all the outstanding shares. In some countries, the ownership of more than 30% of the share capital of a company may trigger a partial takeover bid. Equity derivatives may help to gain de facto control over a substantial amount of the target's shares without triggering a mandatory offer.

7.1 KEEPING VOTING RIGHTS IN PROXY CONTESTS

The first type of M&A situations analyzed in this chapter involves keeping the voting rights in a proxy contest. As we saw earlier, a proxy contest is a voting process in which a single shareholder or a group of shareholders require a company to make a certain decision through the use of the mechanism of corporate voting.

7.1.1 Case Study: Montalban Partners' Disposal of Gold International

This transaction shows a fictional example of how a single shareholder may attempt to use his/her voting rights to garner support for the disposal of a subsidiary. It is common that a shareholder cannot vote any resolution on any relationship between the company and the shareholder, not pertaining to the company's bylaws. This case shows how a shareholder parked its voting rights in a proxy contest and the potential legal implications for the participating parties.

In January 20X0, Montalban Partners -- a private equity firm -- was interested in selling its fully owned subsidiary -- Gold International -- to Precious Metals Inc. for USD 3 billion. Montalban Partners was Precious Metals' largest shareholder, owning 10% of its common stock (see Figure 7.1). The offer was going to be voted in an EGM to take place on 15 February 20X0. Precious Metals board of directors strongly opposed the offer.

Ahead of the EGM, Montalban Partners decided to enter into a derivative in order to transfer its voting rights to another other shareholder. Thus, Montalban Partners entered into a cash-settled equity swap and direct sale with a bank -- Gigabank -- (see Figure 7.2). The notional of the equity swap represented 10% of Precious Metals. Gigabank had to buy Precious Metals shares to hedge its market exposure under the equity swap. Thus, Gigabank put in place its hedge by acquiring 10% of the share capital of Precious Metals from Montalban Partners. The equity swap included a clause allowing Gigabank vote at its complete own discretion and to ignore any voting recommendations from Montalban Partners.

Right after entering into the equity swap, Montalban Partners in a regulatory filing informed Precious Metals' stock market regulator that it no longer held a stake in Precious Metals. Simultaneously, Gigabank disclosed that it held a 10% stake in Precious Metals. Following this announcement, Precious Metals board of directors moved to bar Gigabank from voting, arguing that Montalban Partners and Gigabank had a conflict of interest. According to the stock market law, a shareholder could not vote on issues involving a “relation”, existing or to be created, between the company and that shareholder. Montalban Partners argued that it had no agreement with Gigabank on how it will vote.

On 15 February 20X0, the acquisition offer was submitted for approval to Precious Metals' EGM. 60% of the submitted votes voted in favour and 40% against it.

Designing the Transaction

When designing the transaction, the participating parties have to carefully take into account the following issues:

Firstly, the equity swap confirmation has to be written in such a way as to avoid any suspicion of the parties acting in concert. The confirmations had to state that Gigabank would be voting independently. As an example, the confirmation of the equity swap between the company (i.e., Montalban Partners in our case) and the bank can include the following representation: “Gigabank will freely exercise, in its entire discretion, in any general shareholders' meeting of Precious Metals, the voting rights attributable to all the shares of the Precious Metals that it may hold at all times in order to hedge the transaction”.

It is advisable to go even further by adding to the representation that the company will not instruct the bank to exercise in any general shareholders' meeting of the Precious Metals the voting rights attributable to all the shares of the Precious Metals that the bank may hold at all times to hedge the transaction. Moreover, in the event that the bank receives any instruction from the company that affects the exercise of such voting rights, the bank will ignore any such instruction.

Secondly, in implementing this sort of transaction, the parties have to assess what are their disclosure requirements. Montalban Partners had to disclose the sale of its stake. The optimal scenario would have been the bank not disclosing its stake in Precious Metals. However, Gigabank was obliged to disclose at inception of the transaction its 10% stake in Precious Metals because according to the stock market regulations any shareholder had to disclose an ownership exceeding the 5% and each multiple of 5% thresholds. That meant that placing more than 5% with a bank would make the market aware of the sale of the stock to the bank. In our case Montalban Partners could have entered into two equity swaps with two banks, each on 4.99% of Precious Metals share capital, and in theory these banks could have avoided a disclosure obligation because their percentage of the underlying stock did not exceed 5% of the voting rights.

Usually derivatives do not need to be disclosed unless they lead to a change in the attribution of voting rights. In our case, Montalban Partners was not required to disclose the execution of the equity swap because it only allowed for cash settlement.

In some jurisdictions, all transactions entailing a transfer of voting rights, or of attributed voting rights, involving a member of the board might need to be disclosed, even though their size represent less than the legal disclosure thresholds.

Conclusions

In my view, transactions aimed at keeping voting rights in a proxy contest are likely to backfire. Although the sound design of the equity swap agreement in regard to the voting rights of the underlying shares prevented the derivative parties from being sued by other Precious Metals shareholders or its board of directors, there was a substantial reputational risk. If the transaction was detected by, for example, Precious Metals board of directors (remember that it opposed the transaction) it was very likely that they would try to have the stock market regulator rule that Montalban Partners still controlled 10% of Precious Metals' voting rights even after it sold its stake. If such claim was confirmed by the stock market regulator, the EGM's chairman would prevent Gigabank from voting at the EGM. A public relations fight may endure and other previously indifferent shareholders might vote against the proposal.

What about Gigabank's position? Gigabank made an attractive profit consisting in the floating amount spread that accrued over the life of the equity swap. The bank was not exposed to market risk, being otherwise exposed to Montalban Partners's credit risk. However, participation in M&A related strategic equity derivatives is a two sided sword. On one hand, Gigabank enhanced its relationship with Montalban Partners, being uniquely positioned to participate in other future highly confidential transactions with the company. On the other hand, Gigabank worsened its position to attract future business from Precious Metals, unless this company's board of directors were replaced.

7.2 SUBMITTING RESOLUTIONS TO AN AGM

The second type of M&A situation analyzed in this chapter involves using strategic equity instruments to increase voting rights with the objective of being able to submit proposals to an AGM and increase the likelihood of approval of these proposals.

7.2.1 Case Study: Laxey's Stock Lending Transaction

This case shows how a hedge fund entered into a stock lending transaction to increase its influence in the decision-making of a company. The stock lending transaction allowed the fund to obtain a substantial stake in a company and to include its own proposals in the company's AGM agenda.

In April 2002, Laxey Partners Ltd (“Laxey”), a closely held British fund, owned 2% of the third largest British real estate company, British Land plc. British Land shares were trading at a discount of about 30% to its net asset value. Other real estate companies were taking the opportunity to acquire back some of their own stock. At that time, British Land's chairman – John Riblat – said that although buybacks were not generally in the board's agenda, the company could consider such a transaction if it couldn't foresee other attractive investment opportunities.

Laxey wanted British Land to offer shareholders the chance to vote on a share buyback plan. Laxey proposed that British Land buy 10% of its outstanding shares for a minimum 700 pence per share if, in the four weeks prior to the end of the first six months of the fiscal year and the full fiscal year, its shares traded at a discount in excess of an average 15% of its net asset value. Laxey also wanted the company to propose the potential purchase of an additional 20% of its shares every year. Laxey proposed the two resolutions to be put to the 2002 annual general meeting (AGM) to take place in July 2002. Laxey added a third resolution requesting British Land to hire advisers to help manage property investments.

Just prior to the AGM, Laxey raised its stake in British Land to 9% by borrowing shares to gain voting rights. Shares on loan generally cannot be voted by their lender unless the shares are recalled. Stock borrowers, on the other hand, can vote the borrowed shares.

On 16 July 2002, British Land's AGM took place and its shareholders voted against Laxey's three resolutions.

The Stock Borrowing Transaction – Flows at Inception

At inception, the following processes took place (as shown in Figure 7.3):

• The securities lending and borrowing agreement was agreed and signed by Laxey and the stock lender on 7% of British Land's share capital.
• The 7% of British Land's share capital was transferred from the lender custody account to the Laxey's custody account. Legal title passed to Laxey, so it could disclose its ownership and vote the stock.
• Collateral was posted by Laxey, to reduce the lender's credit exposure to Laxey. Commonly, the stock borrower has to post cash or other liquid securities. The market value of the collateral posted was probably 105% of the market value of the stock borrowed.

The Stock Borrowing Transaction – Flows during its Life

During the life of the stock lending and borrowing agreement, the following processes took place (as shown in Figure 7.4):

• Laxey paid the borrowing fee to the lender.
• The lender paid interest to Laxey on the cash collateral. The interest was calculated on a daily basis.
• Laxey paid to the lender an amount equivalent to the dividends distributed to the borrowed shares – a manufactured dividend.
• Collateral was readjusted on a daily basis, so the market value of the collateral posted was 105% of the market value of the stock borrowed.

The Stock Borrowing Transaction – Flows at Maturity or upon Early Termination

At maturity of the agreement, or upon early termination, the following processes took place (as shown in Figure 7.5):

• The stock was returned from Laxey's custody account to the lender's custody account.
• Posted collateral was returned by the lender to Laxey.

Other Comments

The use of stock lending transactions is a legal and cost-efficient way to increase voting rights in a shareholders’ meeting. However, this strategy faces several constraints.

First, the building of a position is not trivial as it is often difficult to borrow a large number of shares. This is especially the case if the potential gains of having resolutions approved or rejected are substantial and powerful hedge funds and arbitrageurs enter the fray. Hedge funds may borrow the shares to benefit from a potential large fall in the company's stock price if a resolution is approved (or rejected). In the case of proxy fights, in which a takeover is voted, an active presence of arbitrageurs may make it difficult to borrow a substantial number of shares. In a stock-for-stock merger, arbitrageurs typically buy the target's shares and sell short the acquirer's shares. In our case, Laxey could only build a 9% stake, a position that proved insufficient to change the voting results.

Second, a stock borrowing transaction may require substantial resources to implement. Laxey had to post collateral to the stock lenders, to reduce their credit exposure to Laxey, in the form of cash or other liquid assets. Sometimes stock borrowers do not have such resources available.

Third, if a stock borrowing strategy is unveiled, the credibility of the shareholder behind the strategy may be undermined. Under this strategy a shareholder does not bear the economic risks and benefits of holding the borrowed shares. In our case, British Land's board exposed Laxey's strategy, giving the impression that Laxey was a pure speculator without any interest in the long-term success of the company.

Finally, a majority of the stock lenders can recall the lent shares at any time. The stock borrower may be required to return the stock before the shareholders’ voting takes place, obliging the stock borrower to replace the recalled shares.

7.3 INCREASING LIKELIHOOD OF SUCCESS OF A MERGER ARBITRAGE POSITION

In this section I will cover a real case in which a hedge fund's merger arbitrage position was enhanced by the use of derivatives. In a way the case covered in this section is similar to the previous two cases because all of them used derivatives to increase voting rights in a proxy contest.

7.3.1 Case Study: Perry's Equity Swaps with Bear Stearns and Goldman Sachs

This case shows how a hedge fund increased its likelihood of profiting from a merger arbitrage position linked to the Mylan–King merger, by entering into an equity derivatives transaction with Bear Stearns and Goldman Sachs.

In order to increase the likelihood of consummation of the Mylan–King merger, Perry purchased Mylan shares in order to vote the shares in favor of the merger. At the same time, in order to avoid the economic risk of owning Mylan shares, Perry entered into a series of equity swaps designed to fully hedge its financial exposure to Mylan's stock price.

Merger Arbitrage

A merger arbitrageur tries to profit from a stock-for-stock merger by entering into the so-called risk–arbitrage spread trade. A risk–arbitrage spread trade is a transaction designed to take advantage of an arbitrage spread opportunity. An arbitrage spread opportunity is created when, as a result of a merger announcement, the stock of the acquiring company (“the acquirer”) trades at a higher adjusted price than the shares of the company it seeks to purchase (“the target”). The adjusted price refers to the stock price of the acquirer adjusted for how many shares of the acquirer the target's shares will convert to in the stock-for-stock merger. This pre-completion spread between the adjusted price of the acquirer's shares and the price of the target's shares reflects market uncertainty about deal consummation, i.e., whether the premium offered to the target company will be realized. Thus, the pre-completion spread widens if there are indications that the merger will not be completed. Conversely, the pre-completion spread narrows as confidence grows that the merger will be completed.

A risk–arbitrage spread trade is established by acquiring shares of the target and selling short a corresponding number of shares of the acquirer. When the merger is completed, the shares of the target become shares of the acquirer, and these shares can be used by the arbitrageur to cover its short sales of the acquirer's stock. If the merger is not completed, no profit is realized from the risk–arbitrage spread and a substantial loss may result.

Chronology of the Transaction

Perry, a New York-based investment adviser, had invested in King intermittently from October 2001. Beginning in March 2004, Perry had built a significant position in King. On 23 July 2004, Perry had accumulated a total of 4.34 million shares of King at an average cost of USD 15.08 per share. Because King's share price declined between March and July 2004, Perry sustained a paper loss of USD 20.4 million.

On 26 July 2004 Mylan, an American manufacturer of generic pharmaceutical products, announced an agreement to acquire King, an established brand-name pharmaceutical company. The agreement provided that King shareholders would receive 0.9 shares of Mylan common stock for each outstanding share of King stock. Pursuant to the terms of the agreement, consummation of the merger was subject to the approval of both Mylan and King shareholders. On the day of the merger announcement, King's stock price went up almost 25% and Perry could have sold its King shares then and recouped a portion of its trading losses.

Following the merger announcement, Perry tried to maximize its profits by converting its long position in King in a risk–arbitrage spread trade through the short sale of a corresponding number of Mylan shares. In the five days immediately following the merger announcement, Perry sold short 3.8 million shares of Mylan and adjusted its King position in order to establish its risk–arbitrage spread position, the profitability of which was contingent upon a successful completion of the merger. If the merger had been completed at that time, Perry's existing risk–arbitrage spread position would have resulted in a gain to Perry of approximately USD 14.4 million, offsetting much of its paper loss on King. Perry also continued to increase its King position, such that as of the close of business on 13 August 2004, Perry held 5.2 million shares of King, representing 2.1% of King's share capital.

On 18 August 2004, a prominent activist investor and certain entities he controlled (collectively, the “activist investor”) received approval from the relevant authority, the Federal Trade Commission, to purchase between USD 100 million and USD 500 million worth of Mylan shares, representing between 2.4% and 11.9% of Mylan's share capital. On 7 September 2004 the activist investor disclosed that it had acquired 6.8% of Mylan's stock and that it opposed the Mylan–King merger and intended to solicit proxies against it. The activist investor filing signaled that winning Mylan shareholder approval of the merger would be difficult and the market reacted swiftly. Between 7 September 2004 and 17 September 2004 the activist investor increased his position to 8.9% of Mylan's stock. As a consequence, the risk–arbitrage spread widened by 59%, from USD 3.26 to USD 5.19. The risk–arbitrage spread reflected market uncertainty as to whether the merger would succeed in the face of the activist investor's opposition, particularly given that there was no indication that any other large Mylan shareholder supported the merger. If the activist investor succeeded in blocking the merger, Perry would lose its anticipated profit from its risk–arbitrage spread trade.

Following the activist investor's disclosure of his position, Perry began exploring various ways of acquiring Mylan voting rights without economic risk and without public disclosure. Perry wanted to obtain Mylan stock in order to vote in favor of the merger and thereby counter the activist investor's votes, but did not want to take on the economic risk of owning Mylan shares. In addition, because Perry wanted to profit from a wider risk–arbitrage spread, Perry did not want the market to be aware that Perry was building a position to vote in favor of the merger. Had the market known that he was acquiring Mylan shares sufficient to offset the activist investor's position, the spread would have narrowed to reflect the increased likelihood that the merger would be completed, thereby reducing Perry's potential profits on its risk–arbitrage spread trades. As a result, Perry researched possible mechanisms to purchase or transfer Mylan stock without making the market aware of his intentions and eliminating Perry's economic exposure to Mylan's stock. Perry had never before engaged in a similar strategy.

Starting on 8 September 2004 and ending on 24 September 2004, Perry acquired 26.6 million shares, or 9.9% of Mylan's share capital, to vote in favor of the Mylan–King merger and to counter the activist investor's opposition. Perry purchased 5.6 million of these Mylan shares in regular open-market transactions, all of which shares were offset by short sales Perry had already in Mylan. Although an investor typically would cover a short position and close out the short (and stop paying financing fees to the bank through whom it was executing the short), Perry kept both positions open – long Mylan and short Mylan – thereby paying financing fees to its prime brokers for its existing short position while retaining the right to vote the shares purchased to cover the short.

Perry acquired the remaining 21 million shares of Mylan from, and engaged in a series of equity swap transactions with, two banks – Bear Stearns and Goldman Sachs – that gave Perry voting rights to Mylan shares while eliminating Perry's economic risk of holding the shares.

On 19 November 2004, the activist investor announced that he intended to make a USD 20 per share tender offer for Mylan. Shortly thereafter, at the end of the day on 22 November 2004, a news article was published that speculated that Perry and other hedge funds had taken positions in Mylan to vote in favor of the merger and capture the significant risk–arbitrage spread, without having any economic interest in the company or exposure to Mylan's stock price.

On 23 November 2004, Perry consulted with counsel at a law firm, who opined that Perry should disclose its position in light of the activist investor's tender offer. The law firm opined that because of the tender offer, Perry now could be said to hold its Mylan shares with the purpose or effect of changing or influencing the control of Mylan. On 29 November 2004, Perry disclosed its Mylan position, more than two months after Perry had acquired more than 5% of Mylan shares.

The Mylan–King merger was not completed for reasons unrelated to the above described trading. On 8 December 2004, King announced that it would have to restate earnings for 2002, 2003 and the first six months of 2004. On 27 February 2005, Mylan and King announced that they had mutually agreed to terminate the proposed merger because they were “not able to agree upon terms for a revised transaction”.

Anatomy of the Transaction

The transaction through which Perry obtained voting rights on 21 million shares of Mylan had three different parts, as shown in Figure 7.6.

Firstly, Bear Stearns and Goldman Sachs borrowed 21 million Mylan shares from the stock lending market. The banks posted collateral to the stock lenders. The transfer of the shares from the stock lenders who previously owned them to the banks were not reported to the market as a whole, keeping the stock lending transaction hidden from the market.

Secondly, the two banks sold to Perry 21 million shares of Mylan stock. Perry took several steps to ensure that the purchase transactions would be hidden from the market. The acquisition was executed in blocks of 1 million to 2 million shares, which Perry purchased in foreign markets or in the New York Stock Exchange (NYSE) after hours. At that time, NYSE over-the-counter trades made between 6:30 p.m. and midnight were reported to the relevant exchange on the next trading day and marked “as of”. Trades reported in this way were not disseminated to the market as a whole. By contrast, trades that took place during regular business hours were immediately publicly disseminated. By structuring the transaction in this way, these trades were not reported by any volume-reporting or other public dissemination services, even though on many days Perry's share purchases eclipsed the total volume of all Mylan shares reported to have been purchased through all reporting exchanges. Thus other market participants were unaware that Perry was obtaining a very large voting interest in Mylan that could be used to counter the activist investor's opposition to the merger.

Thirdly, at the same time as it was acquiring its long position in Mylan through short sales by the banks, Perry was executing cash-settled equity swap agreements with the banks tied to the underlying Mylan shares Perry was purchasing from the banks. Through the cash-settled equity swaps Perry agreed to reimburse the banks for the difference between the price at which the banks short sold the Mylan shares to Perry and the market price at the time the transaction was unwound. If the market price at that time was lower, the banks agreed to reimburse Perry for the difference between the price Perry paid for the stock and the market price at the time the transaction was unwound. Conversely, if the market price at that time was higher, Perry agreed to reimburse the banks for the difference between the market price at the time the transaction was unwound and the price Perry paid for the stock.

The cash-settled equity swap agreements effectively eliminated any economic risk Perry had from owning, and the banks from short selling, Mylan shares. As a result of the combination of the purchase/sale of stock and the equity swap transactions, neither Perry nor the banks were at risk of any movement in the price of Mylan stock.

• Because the banks sold the Mylan shares to Perry, they were short the stock. Therefore, the banks were at risk if the price of Mylan stock was up at the time the banks needed to cover their short positions. Under the equity swaps, the banks benefited from a rise and were exposed to a fall in Mylan's stock price. Thus, the combination of the stock sale and the equity swaps mitigated the bank's market risk to Mylan stock.
• At the same time, Perry – which was long the 21 million shares – was at risk if the price of Mylan stock was down, and benefited if Mylan's stock price was up, at the time Perry wished to unwind its position. Under the equity swaps, Perry benefited from a fall and was exposed to a rise in Mylan's stock price. Thus, the combination of the stock sale and the equity swaps mitigated Perry's market risk to Mylan stock.

Additional Comments

The main drawback of this type of transaction is the substantial resources needed to implement it. However, in this case Perry was able to acquire its 9.9% stake in Mylan without making a significant financial outlay. Perry financed its purchase of Mylan stock through an extension of its existing margin line of credit at its prime broker. For each purchase of Mylan stock, in the three days between trade date and settlement date, Perry drew upon its margin account to have enough cash deposited into its cash account to satisfy payment for the long position. The funds were then transferred to the banks by the settlement date. In total, Perry paid less than USD 7.2 million to its prime broker to finance the purchase of the 26.6 million Mylan shares, worth approximately USD 492 million. Perry also earned interest on its short positions and on the collateral it gave to the banks for the equity swaps. As a result, accounting for all of Perry's costs and also the interest it earned on its various positions, Perry paid only USD 5.76 million to acquire voting rights to almost 10% of Mylan's shares.

In my view, it would have been easier just to implement a stock borrowing transaction between the two banks and Perry. However, as we saw in an earlier case, the main drawback of a stock borrowing is that Perry could be seen as an “unreal” shareholder, undermining the credibility of its position.

Perry unlawfully failed to disclose its position when it exceeded the 5% ownership threshold. US securities law required any person who has acquired beneficial ownership of more than 5% of the voting class of equity securities to report such acquisition within 10 days after such acquisition. However, as an alternative, the rules allow the use of short-form disclosure statements with differing timing requirements under certain conditions. Under this alternative, certain qualified institutional investors may file a short-form statement within 45 days after the end of the calendar year in which they made the triggering acquisition, so long as the institutional investor acquired the securities “in the ordinary course of his business and not with the purpose nor with the effect of changing or influencing the control of the issuer, nor in connection with or as a participant in any transaction having such purpose or effect”. Perry claimed that it was eligible to file a short-form statement within 45 days after the end of the calendar year because it acquired the shares in the ordinary course of business and not with a view toward, or as part of a plan having the purpose or effect of, changing or influencing control of Mylan. Perry claimed that the deal was a reverse triangular merger, with a subsidiary of Mylan merging into King, and that there would be no change in the Mylan board as a result of the merger. The SEC claimed that Perry was not entitled to defer filing and instituted legal proceedings to impose remedial sanctions against Perry. In the end, Perry paid USD 150,000 to the SEC to settle the accusations and, as a result, the SEC ceased the proceedings.

7.4 AVOIDING MANDATORY OFFER RULES

7.4.1 Case Study: Agnelli Family Equity Swap with Merrill Lynch

This case provides a real-life example of a transaction aimed at avoiding future dilution without triggering a full mandatory offer. The Agnelli family, the founders of Fiat Group S.p.a. (“Fiat”), controlled Fiat through a cascade of companies (see Figure 7.7). Fiat was one of the largest car and truck manufacturers in Europe. Giovanni Agnelli & C, a privately held partnership, owned 100% of the investment company IFI, as well as another holding company called Exor Group. IFI owned 63.6% of the listed company IFIL, which in turn owned 30.1% of Fiat. IFIL was the largest shareholder of Fiat.

In October 2002, Fiat signed a EUR 3 billion mandatory convertible facility with a consortium of banks for the purpose of providing it with the financial resources to implement a restructuring plan. The facility had a term of three years, expiring on 10 October 2005. Fiat could elect to repay the facility in cash at any time prior to maturity on condition that its credit rating remained at least equal to the investment grade level. Any residual liability for principal would be repaid with common stock of Fiat, which the lending banks agreed to underwrite and offer pre-emptively to all shareholders. The conversion price of the facility would be the average of EUR 15.5 and the average stock price of Fiat in the last three or six months, depending on the case, preceding the repayment date.

In April 2005, after Fiat's poor performance, it was becoming clearer that the mandatory convertible facility would not be repaid, and thus, would be converted into Fiat's common stock. If the banks converted their facility into Fiat shares on 20 September 2005, they would get 24% of Fiat's share capital, diluting IFIL's ownership to 23%. IFIL was interested in keeping its stake at 30%. In principle, IFIL had two alternatives:

• To wait until 20 September 2005 to acquire an additional 7% of Fiat, being exposed to a future higher stock price.
• To acquire the 7% immediately, taking advantage of the then depressed Fiat's stock price (see Figure 7.8). However, this alternative would cause IFIL to exceed the 30% statutory threshold to launch a mandatory offer in cash for the remaining stock of Fiat. A mandatory full bid would require a huge investment, an unrealistic commitment even for the Agnelli family.

The Agnelli family opted for the first alternative, but hedged its exposure to a future higher stock price of Fiat by making its Luxembourg-based subsidiary Exor Group enter into a cash-settled total return equity swap with Merrill Lynch (“Merrill”). As a result, on 26 April 2005 Exor and Merrill entered into an equity swap with the following terms:

Exor's Cash-settled Total Return Equity Swap Terms
Party A	Exor Group
Party B	Merrill Lynch
Trade date	26-April-2005
Termination date	26-October-2008
Early termination	Party A may partially or totally terminate the transaction early at any time by providing a termination notice to Party B
Underlying currency	EUR
Equity amount part
Equity amount payer	Party B (Merrill Lynch)
Equity amount receiver	Party A (Exor Group)
Shares	Fiat common shares
Cash settlement	Applicable
Number of shares	90 million
Initial price	The volume-weighted average at which Party B puts in place its initial hedge. The initial price was set at EUR 5.50
Equity notional amount	EUR 495 million Number of shares × Initial price
Settlement price	The volume-weighted average at which Party B unwinds its hedge of the transaction during the month (“the final period”) following a termination notice. Party B can extend such final period at its own discretion to assure a smooth execution of its hedge unwind
Settlement date	Three trading days after the last day of the final period
Floating amount part
Floating amount payer	Party A (Exor)
Notional amount	The equity notional amount
Payment dates	At the end of each quarter
Floating rate option	EUR-Euribor
Designated maturity	3 months
Spread	Plus 50 bps (0.50%)
Floating rate day count fraction	Actual/360
Dividend amount
Dividend amount	100% of the paid amount
Dividend payer	Party B (Merrill Lynch)
Dividend receiver	Party A (Exor)
Dividend period	The period commencing on, and including, the third scheduled trading day preceding the effective date and ending on, and including, the valuation date
Dividend payment date	The date of the payment of the dividend by the issuer of the shares
Independent amount	Party A shall post on the trade date EUR 10 million, and at all times shall post a EUR cash amount equal to 10% of the equity notional amount

The underlying number of Fiat shares of the equity swap was 90 million, representing 7% of Fiat's voting capital. The equity swap only allowed for cash settlement. Exor paid quarterly Euribor 3-month plus 0.50% on a notional of EUR 495 million. Exor posted a EUR 10 million collateral on trade date and gradually increased this amount, in coordination with Merrill's implementation of its initial hedge, to equal 10% of the equity swap notional. As a result, after the initial hedging period Exor posted EUR 49.5 million cash collateral to Merrill. In order to hedge the transaction, Merrill gradually acquired 90 million Fiat shares in the market in the period between 26 April and 7 June at an average price of EUR 5.50. This price became the initial price.

The same day, 26 April 2005, Fiat announced that it would not repay the USD 3 billion mandatory convertible facility, therefore obliging the facility lenders to automatically convert the facility into stock in September 2005.

On 15 September 2005, Exor and Merrill agreed to modify the terms of the equity swap to allow Exor to elect between cash and physical settlement for up to 82.25 million shares. The remaining 7.75 million shares continued to allow only for cash settlement. The physical settlement feature required disclosure of the equity swap to the Italian stock market regulator. Besides the equity swap disclosure, Merrill disclosed its 7% stake in Fiat.

In September 2005, the mandatory convertible facility was extinguished by its conversion to Fiat's common stock. The conversion took place on 20 September 2005. As a result, Fiat issued 291.8 million shares at a price of EUR 10.28.

On 20 September 2005, simultaneously to the execution of the facility's conversion, Exor gave notice for the partial early termination of the equity swap for 82.25 million shares, opting for physical settlement. As a result, Exor received 82.25 million shares of Fiat from Merrill in exchange for EUR 461 million. Exor paid EUR 5.60 per share, the EUR 5.50 initial price plus EUR 0.10 of interest and broken funding costs. Concurrently, Exor sold the 82.25 million shares to IFIL at a price of EUR 6.50 per share. As a result, Exor realized a significant capital gain of EUR 74 million. Exor continued to have exposure to a residual 7.75 million Fiat shares through the remaining equity swap.

The transaction triggered an investigation by the Italian stock market regulator. Three issues were investigated: (i) if the transaction breached Italy's mandatory bid rules; (ii) if the transaction should have been disclosed at inception; and (iii) if the profit generated by the sale of the shares by Exor to IFIL was legal. Let us discuss these issues next.

Mandatory Bid

The transaction legally avoided a mandatory bid if the parties could prove that they were not acting in concert. In my view, it could help to justify the absence of joint exercise of the political rights if Merrill Lynch did not make available to Exor the voting rights associated with the 90 million underlying shares, or if the equity swap terms included a clause preventing Merrill from voting. The Italian stock market regulator ruled that no breach of the Italian mandatory bid rules occurred.

Disclosure of the Transaction

A second issue was the need to disclose the equity swap on its trade date. The cash-settlement feature made the transaction more robust from a legal standpoint. According to the Italian law, the cash settlement feature avoided the need to disclose the transaction. However, at the beginning Merrill did not disclose that it owned 7% of Fiat. By 7 June 2005, Merrill exceeded the 5% Italian legal threshold and it should have disclosed this fact.

The amendment to the equity swap to allow for physical settlement obliged the parties to disclosure equity swap. A big question remains if the change to the equity swap terms was planned from the start. If so, the temporary cash-settlement feature would have been a subterfuge to avoid informing the market. The existence of the equity swap was very relevant because it would have hinted to the market about the upcoming conversion of the mandatory convertible facility.

In my view the difference between cash settlement and physical settlement is rather subtle. In both cases, Merrill would need to sell 90 million Fiat shares to unwind its hedge.

• In a physically settled equity swap, Merrill would sell the shares directly to Exor.
• In a cash-settled equity swap, Merrill would sell the shares onto the market. However, Exor could always acquire the 90 million shares through the stock exchange in coordination with Merrill's sale.

Therefore, under a cash-settled equity swap Exor could have acquired the underlying shares without taking a large price risk.

The Italian stock market regulator found Exor guilty of market manipulation, ruling that Exor should have disclosed the position in Fiat. It fined IFIL and Giovanni Agnelli & C EUR 7.5 million, and fined and suspended two directors from serving on boards of public companies.

Market Abuse

The sale by Exor of the 82.25 million Fiat shares to IFIL also raised some legal questions. Exor sold the shares to IFIL at EUR 6.50, a price notably higher than its EUR 5.50 acquisition price. IFIL's minority shareholders wondered whether this transaction amounted to a diversion of their funds to the Agnellis. Exor argued that the EUR 6.50 execution price was the result of a negotiation between Exor and IFIL and that the price took into consideration the size of the block and the average VWAP of Fiat's stock during the previous three and six months (EUR 6.90 and EUR 6.10 per share). The board of directors of IFIL obtained a fairness opinion that confirmed the adequacy of the EUR 6.50 price.

7.5 INCREASING LIKELIHOOD OF SUCCESS OF A TAKEOVER

7.5.1 Case Study: Unipol's Takeover of BNL and Call/Put Combination with Deutsche Bank

This case provides a real-life example of an equity derivatives transaction aimed at increasing the likelihood of a merger taking place. The case also shows how derivatives can secure the acquisition price of a stake before obtaining authorization to acquire it.

In April 2005 BBVA, Spain's second largest bank, announced its interest in acquiring full control of Banca Nazionale del Lavoro S.p.A. (BNL). BBVA already controlled 15% of BNL's ordinary share capital. BBVA offered EUR 2.72 for each BNL share. The offer soon appeared to have hit strong opposition when the governor of the Bank of Italy (BoI), Antonio Fazio, was openly opposed to the offer and when a group of BNL's core investors declared their refusal to sell their 25% stake in BNL to BBVA. As the different parties searched for a compromise, a new suitor, Unipol Assicurazioni S.p.A (Unipol), appeared.

At the end of the first half of 2005, within the limits authorized by the BoI, Unipol held 9.95% of BNL's ordinary share capital, consisting of a direct holding of 155 million shares, or 5.12%, whilst the remaining 4.83%, or 146,320,000 shares, were acquired through its subsidiary Aurora Assicurazioni.

On 1 July 2005, Unipol and Deutsche Bank entered into a converse transaction on 75.5 million shares of BNL. Under the converse Unipol acquired a European call and sold to Deutsche Bank an American put, both with strike price EUR 2.9173 per share and expiry date 18 July 2005.

On 15 July BoI authorized Unipol to raise its shareholding in the ordinary share capital of BNL to 14.99%. On 17 July Unipol's board of directors authorized its chairman and vice-chairman to continue the negotiations underway with top international and Italian banks, financial operators and other partners aimed at achieving potential business and/or company partnerships.

On 18 July 2005, Deutsche Bank exercised its put and Unipol acquired the underlying 75.5 million shares of BNL at EUR 2.9173 per share. Also on 18 July 2005, Unipol acquired from Bayerische Hypo und Vereinsbank A.G. and from Dresdner Bank 50 million and 25 million shares of BNL respectively. In total, Unipol acquired 150.5 million BNL shares for a total counter value of EUR 437.8 million. On conclusion of these acquisitions, Unipol held 14.92% of BNL's ordinary share capital. As it was deemed to be significant under Italian stock market law, BNL disclosed the stake to the Italian stock market regulator CONSOB.

On 18 July 2005 Unipol signed with a group of core shareholders of BNL, all grouped under the name “pact members”, a shareholders’ agreement (“the shareholders’ agreement”) including a consultation and block agreement, relating to the shareholdings owned by Unipol and the pact members in BNL, amounting to 30.86% of the BNL share capital. The shareholders’ agreement was intended to enable Unipol and the other partners to lump their BNL holdings together, in order to identify common company and business strategies that would boost BNL operational capabilities. The shareholders’ agreement included a lock-up period on the BNL shareholdings conferred by the pact members, in which they committed to not transferring the syndicated shares until the 30th day following the closing of the offer, and the granting to Unipol of the right of pre-emption, an option right for Unipol to purchase from the pact members either totally or partially their BNL shares at EUR 2.70 per share on the 30th day following the closing of the offer, the terms and conditions for the launching of the mandatory tender offer and the commitment not to take part in the BBVA public exchange offer. Unipol, moreover, granted some of the pact members the right to sell to Unipol the BNL ordinary shares held by them in the event of some specific conditions.

Concomitantly, Unipol signed with Credit Suisse First Boston (CSFB) an agreement (“the CSFB agreement”) relating to: (i) the procedures to be followed in the event of transfer of the BNL shareholding owned by CSFB; (ii) the pursuit of commonly shared commercial and financial plans; and (iii) the terms and conditions for the launching of the mandatory tender offer. Furthermore, Unipol signed a separate agreement with CSFB regulating a call option for Unipol and a put option for CSFB, both with a strike price of EUR 2.70 per share, of CSFB's shareholding in BNL, representing 4.18% of BNL's ordinary share capital, and which could be raised up to 4.50%. These options could be exercised subject to some specific conditions.

Concurrently with the signing of the shareholders’ agreement and the CSFB agreement, Unipol also subscribed agreements with other parties (“the other parties”) which, inter alia, granted Unipol the right to purchase at EUR 2.70 per share the BNL shares held by them, representing in all 6.6% of the BNL share capital, and also establish the reciprocal assumption of further commitments, such as a lock-up period, the prohibition on the purchase of further BNL shares and the commitment not to take part in the offer launched by the BBVA. Unipol, moreover, granted some of the other parties the right to sell to Unipol the BNL ordinary shares held by them in the event of some specific conditions.

The signing of these agreements by Unipol, the pact members, CSFB and the other parties implied the joint obligation of these parties to launch a tender offer on the totality of the BNL ordinary shares, representing 59.24% of BNL's ordinary share capital. This joint commitment was to be economically fulfilled solely by Unipol, which would uphold all related costs, including the payment of the amount due for the BNL shares involved in the offer, thus keeping indemnified the pact members, CSFB and the other parties from these obligations. Unipol agreed to pay each shareholder adhering to the offer the cash amount of EUR 2.70 for each share. This unitary amount, calculated taking into account the price of the exercise of the call/put options also, was above the minimum price derived from the application of the criteria of the Italian takeover law in so far as Unipol decided to pay out a premium of 5.7%. To those taking part in the offer, such a price represented a premium equal to 25.4% of the daily arithmetic weighted average of the official quotations of BNL ordinary shares over the previous 12 months or a premium of 0.4% on the closing price of ordinary shares on 15 July 2005. Subject to obtaining the authorizations prescribed by the then current regulations, the offer was expected to be launched in September 2005. In the event of full completion of the offer, Unipol would own up to around 64.83% of the fully diluted ordinary share capital of BNL. At the time of the offer, Unipol's market value was less than half that of BNL.

In theory, the total counter value of the public tender offer was EUR 4.96 billion. In practical terms, Unipol anticipated that the maximum expenditure would drop to a figure of no more than EUR 4.53 billion, with the Deutsche Bank and Credit Suisse First Boston shareholdings in BNL not included as part of the mandatory public tender offer (accounting for 4.88% and 0.31% of the ordinary share capital respectively), since they were the subject of option call contracts in favor of Unipol. In addition, assuming that the Banca Popolare dell’Emilia Romagna shareholding in BNL (amounting to approximately 3.87% of BNL's ordinary share capital) could be deemed to be stable, consequently it was not expected that it would accept the bid. In this case the actual maximum expenditure anticipated by Unipol would drop still further to a total of EUR 4.2 billion.

Also on 18 July 2005, Unipol subscribed with Deutsche Bank A.G. London (“Deutsche Bank”) two converse agreements on a total of 151.157 million BNL shares, or 4.99% of the BNL share capital. Deutsche Bank, furthermore, committed itself not to sell or tender BNL shares involved in the derivative agreements to BBVA's takeover bid. The agreement did not prevent Deutsche Bank from entering into other transactions linked to BNL shares as part of its normal banking activity. The two agreements included a clause in which Deutsche Bank committed itself not to take part in the offer launched by the BBVA. Unlike the rest of the terms of the two transactions, this clause was not disclosed to avoid the impression that Deutsche Bank was not considered as acting in concert in Unipol's tender offer.

• Under the first converse, which Unipol called “the sport hedge”, Unipol purchased from Deutsche Bank an American call option, with a strike price of EUR 2.70 per share, to be exercised during a period of six months starting on the termination date of the offer, and Deutsche Bank purchased from Unipol a European put option which would expire at the earliest of (i) the exercise date of the call option and (ii) the third anniversary of its trade date. The put option had a strike price of EUR 2.70 to be adjusted upwards to take into account the time value of money and to be adjusted downwards by any dividend distributed to the underlying shares. Both options were on 65.281 million shares, or 2.15% of BNL's ordinary share capital, and had a strike price of EUR 2.70 per share.
• Under the second converse, which Unipol called “the put & call hedge”, Unipol purchased from Deutsche Bank a European call option, with a strike price of EUR 2.70 per share, to be exercised on 18 January 2006, and Deutsche Bank purchased from Unipol a European put option which would expire at the earliest of (i) the exercise date of the call option and (ii) the third anniversary of its trade date. The put option had a strike price of EUR 2.70 to be adjusted upwards to take into account the time value of money and to be adjusted downwards by any dividend distributed to the underlying shares. Both options were on 85.876 million shares, or 2.84% of BNL's ordinary share capital, and had a strike price of EUR 2.70 per share.

On 22 July 2005, BBVA withdrew its offer for BNL.

On 4 August the request for authorization to acquire a controlling stake in BNL was submitted to the BoI, and on 8 August the request for authorization to acquire full control of BNL Vita S.p.A., BNL's insurance subsidiary, was submitted to the Italian insurance regulator ISVAP. On 16 August a communication containing the essential elements of the public tender offer and the draft offer document was submitted to CONSOB, in accordance with Italian law. At the same time a press release with the essential elements of the mandatory public tender offer was issued.

On 12 August 2005, Unipol acquired from Deutsche Bank an American put, which Unipol called “the contingent put” that gave Unipol the right to sell to Deutsche Bank a number of shares of BNL equal to the difference, if positive, between (i) the number of shares tendered and (ii) the difference between the total number of shares object of the offer and 65,281,000 shares. The option could be exercised during the 15 calendar days following the closing of the offer.

On 29 August an EGM of Unipol authorized the board of directors to increase Unipol's share capital by up to EUR 2.6 billion. The EGM also passed the motion to cease indicating the nominal value of the shares and to amend the company's by-laws accordingly. In this respect it should be mentioned that on 12 August 2005 the holding company Finsoe paid EUR 896 million on account for the future capital increase and that subscription to the remaining amount would be guaranteed by an underwriting bank syndicate consisting of leading Italian and foreign banks. The capital increase was intended to partially finance the mandatory public tender offer. Another objective of the capital increase was to strengthen Unipol's equity in order to keep equity ratios in line with the relevant laws and regulations. The capital increase was expected to be carried out in the fourth quarter of 2005. The offer was also to be financed by Unipol issuing subordinated debenture loans and/or other sources of long-term funding for a maximum of EUR 1.4 billion and releasing own funds, mainly through asset disposals, amounting to approximately EUR 0.8 billion.

On 31 August CONSOB approved the publication of the offer document relating to the mandatory public tender offer for BNL shares.

On 6 September 2005, Italy's antitrust authority resolved not to open a preliminary investigation into the operation to acquire control of BNL by Unipol, since it did not create or strengthen a dominant position as a result of which competition would be significantly and lastingly eliminated or reduced. The antitrust authority also approved the wording of a communication to be sent to the Bank of Italy containing its opinion on the impact the operation in question would have on banking markets, specifying that it “did not significantly affect markets involving bank deposits and lending”.

On 12 September 2005 the board of directors of Unipol, availing itself of the powers conferred by the EGM of 29 August 2005, resolved to propose to shareholders a share capital increase of up to EUR 2.6 through a rights issue.

On 15 October Deutsche Bank bought 40,000 BNL shares for EUR 2.755 per share related to a trading activity unrelated to the offer.

On 21 October 2005, BNL rejected Unipol's takeover offer. BNL did not consider Unipol's offer price to be fair.

On 2 November 2005, Unipol announced the successful conclusion of its right issue, raising EUR 2.58 million.

On 3 November 2005, Unipol and Deutsche Bank modified the terms of the puts part of the “spot hedge” and the “put & call hedge” agreements to include the possibility of cash settlement election by Unipol. This change was aimed at reducing Unipol's financial commitment were Deutsche Bank to exercise any of its puts.

On 19 December Antonio Fazio, the governor of the Bank of Italy, stepped down after his conduct in the battle for BNL and in other takeover fights came under investigation by the European Commission. Mario Dragui became the new governor.

On 23 December 2005, CONSOB deemed the options contracts between Unipol and Deutsche Bank to be shareholders’ agreements and that, as a result of these agreements and the fact that in the middle of October Deutsche Bank had acquired more BNL shares at EUR 2.755 per share, the bid price should have been increased to EUR 2.755 per share. As a result, CONSOB forced Unipol to increase the offer to match the price it paid to other investors.

On 28 December 2005, Unipol raised its offer for BNL by 2% to EUR 2.755. This increase implied that Unipol would spend EUR 84 million more, a small impact. That increased the size of the offer to EUR 5 billion from EUR 4.9 billion.

On 10 January 2006, Unipol's bid was rejected by the Bank of Italy, ending the insurer's six-month attempt to take over BNL. The Bank of Italy stated that the conditions for complying with the requirements of prudence relating to the capital adequacy required for the acquisition of the control of BNL to be authorized had not been met. It definitively confirmed this opinion on 3 February 2006.

On 4 February 2006, Unipol's board of directors approved an agreement with the French bank BNP Paribas, to sell the BNL shares held by it and by its financial partners. This agreement, which could not be implemented until the required authorizations were received, provided for payment of EUR 2.925 per share. The sale resulted in a total capital gain for Unipol of approximately EUR 81 million, which enabled most of the costs incurred in launching the bid to be offset and the put options on BNL shares held by the principal financial partners in the operation to be terminated.

Conclusions

This case highlights how Unipol increased its chances of success with its offer for BNL by entering into two equity converse transactions with CSFB and Deutsche Bank, prior to raising the offer financing. At the end the Bank of Italy did not approve the takeover, but otherwise the converses would have notably helped Unipol to achieve its objective.

One interesting fact of the transaction was that Unipol had to improve the offer as a result of Deutsche Bank's tiny purchase of shares in the market during the offer period. This could have been a very costly mistake. According to CONSOB, Deustche Bank's undisclosed written commitment to not tender any BNL shares related to the converses limited the transfer of shares and was considered as acting in concert in Unipol's tender offer. The fact that the commitment was not disclosed greatly weakened Deutsche Bank's reply to CONSOB because it gave the impression that Deutsche Bank and Unipol were interested in hiding this parasocial agreement. In my view, its undisclosure did not make sense. The transaction was not substantially different from the disclosed converse transaction signed between Unipol and CSFB.