iflr...iflr international financial law review april 2008 private equity and venture capital review...

IFLRInternational financial law review

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April 2008

Private equity and venture capital review

Set up a renminbi fund The secret to investing in China

Regulators: don’t overreact Sovereign wealth should not be feared

When to disclose derivativesThe UK’s new rules on building stakes

www.iflr.com PEVCR from IFLR 1

ContentsPrivate equity and venture capital review

News analysisMac clauses come to Asia; Hedge fund listings to flood London; Japan creates new, 4unregulated poison pill; China private equity is running out of ideas; Year of the Spacs?

ChinaYou need local funds to succeed 6International private equity houses operating in China should create locally denominated funds to invest successfully.

Sovereign wealth fundsDon’t overreact 9Whatever you do, don’t panic. Sovereign wealth funds have been around for a while and are nothing to fear.Regulators are thankfully realising this and are ignoring politicians

Sovereign wealth fundsCanada’s position 12Although Canada has set out its views on foreign state buyers, its guidelines offer insufficient guidance

GermanyA complicated victory 13The rules that protected VW stock are now illegal. But that doesn’t necessarily help shareholders, it just makeseverything more complicated

United KingdomContrary views on disclosure 15Should holders of contracts for difference have to disclose their positions, even if they have no access to votingrights? The debate is raging at UK and EU level

Private equity awardsWe are proud to celebrate innovation 17Details of the private equity winners from the recent IFLR awards in Hong Kong, London and New York

BermudaNurturing business 23Natasha Scotland and Neil Horner of Attride-Stirling & Woloniecki explain how government regulation supportsBermudian business

BrazilAttend your meetings online 25Private equity buyers in Brazil should be aware that shareholders’ meetings can now be carried out on the web.Gyedre Oliveira, Denise Moretti and Ricardo Freoa of Souza, Cescon Avedissian, Barrieu e Flesch investigate

British Virgin IslandsThe needs of the BRIC markets 27Offshore structures have a role to play in emerging markets and BVI legislation facilitates them. But their popu-larity means that this may be a good time for dialogue according to Leonard A Birmingham, partner at Harneys

Cayman IslandsPartnership rules 30Cayman Islands exempted limited partnerships are popular. Iain McMurdo of Maples and Calder explains howto draft them


GermanyA new set of rules 32Jens Hörmann and Dr Frank Thiäner of P+P Pöllath + Partners argue that a new Act will change German M&A.But it may not go far enough

LuxembourgSuccess for SICARs and SIFs 35The growth of specialised funds for sophisticated investors confirm Luxembourg’s position as a centre of innova-tion, says Marc Meyers of Loyens & Loeff

MexicoParadigm shifts in PE law 37Private equity investment has always been complex. Lawyers from Kuri Breña, Sanchez Ugarte y Aznar explainwhy Investment Stock Corporations are better than the traditional tailored solutions

United KingdomUndervalued service 39Can third party expert valuations be challenged? David Wallis, Andrew Harrow and Anna Cope of Dechert LLPinvestigate


Now you can check outIn the past, investors in permanent capital sometimes felt like they were at theHotel California. They could check in, but they couldn’t check out. Well nowthey can call the bellboy and hail a cab. And Special Purpose AcquisitionCompanies (Spacs) are the reason why.

The equity vehicles for one-off acquisitions are proving popular – Wall Streetearned $770 million in 2007 from the sale of shares in 64 Spacs. Investors areattracted by the entrepreneurial records of the people setting up the fund. Andthe risks are minimal. Typically, a Spac has 18 to 24 months to find a suitabletarget. Once it has, 80% of its shareholders have to approve the target. If thevote succeeds and an investor voted against it, it can withdraw and take itsmoney back.

But things can be even easier.Euronext Amsterdam is rapidlybecoming the place to listEuropean Spacs. Unlike inLondon, Spac shares on theDutch exchange are not sus-pended from trading when apotential acquisition isannounced.

So Spacs can make a call on whether their shareholder vote will succeed or failbased on an analysis of the share price, and whether it rises or falls. More impor-tantly, investors that see their Spac shares spike, but feel the proposedacquisition is wrong, can sell directly over the exchange. For a profit.

This benefits the Spac too as it means that the shareholder vote is more likelyto go through and have a percentage mandate in the high nineties.

London changed its rules to allow permanent capital onto its exchanges lastyear. It will have to amend them again to allow shares to continue trading whena Spac acquisition is announced. Otherwise all the European Spac investors willbe checking in and out whenever they please in Amsterdam.

Nicholas Pettifer

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“Now private equityinvestors can call thebellboy and hail a cab”


NEWS ANALYSIS

MW Tops’ plan to list in London due toa rule change is set to spark a flurry ofsimilar moves in the market.The e1.4 billion Marshall Wallace feeder fund

listed on Euronext Amsterdam in December 2006because of a restriction on the listing of singlestrategy hedge funds in London.

But to ensure it doesn’t lose out, Londonchanged its rules on March 6. An overhaul of thesystem means that, among other things, feederfunds can now undertake a primary listing underchapter 15 of the UK listing rules. MW Tops isthe first fund to take advantage of this shift.

“There are definite benefits for funds due to thischange. For example, there is greater liquidity forshares as London is a broader and deeper market.Also, being listed in London means the chance ofbeing included on the FTSE index thus openingup funds to tracker products,” said Nigel Farr ofHerbert Smith, advisor to Marshall Wallace.

“There aren’t that many other funds onEuronext, but they are big. There’s got to be achance that they will follow. It’s not particularlyexpensive or difficult to do.”

The rule changes are being seen as a general lib-eralisation of policy. For example, thesuper-equivalent requirement that fund managersmust have “sufficient and appropriate” experienceto list has been scrapped. Also, quarterly disclosureof significant holdings is no longer needed.

In an issue more specific to MW Tops, the rulethat directors of feeder funds had to make up themajority of the directors of the master fund hasbeen relaxed. LR15.2.6 is the key to allowing feed-er funds to list. It states that if an investment entityprincipally invests its capital in another company’sfund, it must control the policy of that entity. Thisis still a restriction, but it is more liberal and prin-ciples-based than its predecessor.

Pressure on London to change its listing rulesbegan in earnest when KKR opted to list its $5billion offering in Amsterdam in May 2006. Thedebate was ramped up when single strategy hedgefunds such as MW Tops started to list inAmsterdam later in the same year. This led to aUK Listing Authority (UKLA) announcementthat chapter 14 didn’t ban overseas investmentcompanies from a secondary listing. BrevanHoward tested this by listing its feeder fund BHMacro for $1.1 billion in March 2007. ThirdPoint and Ashmore Global soon followed suit.

This outraged the Association of InvestmentCompanies and the Treasury Select Committee asforeign investment entities were listing with fewerrequirements. As result, a rewrite of the listingrules was agreed. As of March 6, chapter 15 hasbeen liberalised, but the chapter 14 route will beshut for investment entities.

Hedge fund listingsto flood London

Just months after the last spate of poi-son pills, Japanese companies appearto have come up with another scheme for blocking hostile bids. The new

measures are poison pills by name, butnothing like the ones buyers and theircounsel are reluctantly used to.

The new style of defence measures areembedded in financing schemes whichcombine loans with warrants. If exercisedthe warrants would dramatically dilute thestakes of shareholders and defend againstunwelcome bidders.

Two Sumitomo Group companiesrecently raised funds by taking out loanswith warrants. Sumitomo Realty raisedY120 billion ($1 billion) this monththrough a subordinated loan fromSumitomo Banking Corp (SMBC). Theloan has warrants that have a moving strikeprice. In response to a takeover bid, SMBCcould exercise its right to the underlyingshares, creating a problem for the bidder.

Sumitomo Realty denied the scheme wasdesigned to defend against takeover bids.However, it is not clear what other uses itcould have.

“Apparently this [new structure] is areality. And what else are the companies inquestion going to use it for?” said PaulO’Regan, head of Clifford Chance’s corpo-rate group in Tokyo. To make mattersworse, related party transactions and non-pro rata allotments of shares are notregulated, either by law or the Tokyo StockExchange.

“These warrants are designed to dilutethe shareholding of an unwanted suitor,but also dilute that of a normal sharehold-er. Where else in the world could thathappen, at least without shareholderapproval?” said O’Regan.

Loans with warrants attached are notnew. Banks have been using them forfinancing private equity-backed leveragedbuyouts, granting them a portion of theupside. “But this has obviously beenlatched onto as a scheme that can fulfilanother purpose,” said O’Regan.

The news comes just weeks after Japan’sFinancial Services Authority released areport outlining plans to strengthen thecountry’s financial markets, which includ-ed a promise to improve regulation andallow competition. TY

Japan creates new, unregulated poison pill

Buyers and their counsel in Asia arelearning lessons from the US, asmaterial adverse change (Mac) claus-es have begun to appear in M&Adocumentation.

Although the clauses have traditionallybeen rare in public deals in Asia, they areincreasingly being used in both Hong Kongand Singapore.

A survey carried out by Stamford Law hasfound that three out of five public HongKong deals in 2007 included Mac clauses, asharp rise from previous years.

Mac clauses aim to give the buyer theright to walk away from an acquisition afterit is announced, but before it closes, if cer-tain events occur that are detrimental to thetarget company.

With financing so readily available untillast summer, the clauses have traditionallybeen either accommodating to the seller, dueto the pressure of rival buyers, or absent alto-gether. This has changed, though perhapsnot purely because of the credit crunch.

“There has certainly been an increase over

the last couple of years – but I haven’t seen asudden surge in the last few months due tothe situation in the US,” said Barbara Mok,partner of Jones Day’s Hong Kong office.

The US buyer’s tendency is to incorporategenerally worded clauses to allow them aswift exit.

“As a Hong Kong lawyer, I’m more accus-tomed to UK, common law techniques. Butwe’re starting to see the influence of US Macclauses,” said Mok, adding that Hong Kongcourts nevertheless tend to be more protec-tive of the seller.

Under the Hong Kong system, the buyercan only rely on the Mac clause if the changeis such that it frustrates the purpose of theagreement or strikes at the heart of the deal.In short, it favours the seller.

And in Hong Kong especially, generalchanges to market conditions or those affect-ing the industry sector in which the targetcompetes aren’t thought to be enough towarrant a Mac clause – though bidders areincreasingly pushing for such clauses whennegotiating takeovers in the US. TY

Mac clauses come to Asia


NEWS ANALYSIS

As the financial worlddives deeper into a bearmarket, SpecialPurpose Acquisition Companies(Spacs) look to be replacing per-manent capital listings.

“Spacs have had a pretty pro-found transformation in the last18 months. The type of man-agers involved has improved, ashas the involvement by the

bulge bracket firms,” saidQuentin Nason, managingdirector for equity capital mar-kets at Deutsche Bank.

Indeed, December saw BearStearns dip into the Spac marketfor the first time by underwrit-ing MVC Acquisition for $200million.

The initial public offering(IPO) of Liberty Acquisition

Holdings was the first of thesepublicly traded buyout compa-nies to break the $1 billion markwhen it listed on the AmericanStock Exchange in November.

And last week saw Spacs moveto Europe when LibertyInternational Acquisition raised€600 million ($880 million) onEuronext Amsterdam. This hasprompted talk of a trend.

“Spacs are a bear marketproduct and this bear marketreally has its teeth into us. Itlooks like Spacs will step up tothe plate,” said Nason.

Spacs are designed to raisemoney via public a publicoffering before they look for asuitable target. Typically, Spacsare sold at $6 each for one shareof common stock and two war-rants for the purchase ofadditional shares. Most Spacshave a two-year time limit tofind a target and funds arereturned to investors if thislapses.

In terms of fees, investmentbanks usually take around 10%and if a bid is successful, themanagement team takes 20% ofthe acquired company’s profits.The shareholders get ownershipon the acquired company.

In 2007, Wall Street earned$770 from the sale of shares in64 Spacs, which helped count-er the reduction of earningsoverall for IPOs. In 2006 therehad only been 36 Spac offer-ings on Wall Street. Europeanexchanges will be hoping thatLiberty InternationalAcquisition will spark a similarturnaround.

However, one private equitypartner at a magic circle firm inLondon is not convinced:“There are lots of Spacs in thepipeline, but I heard similar pre-dictions of growth in Europelast year and not much materi-alised. Considering today’senvironment, I am not sure thatthese vehicles will be somethingthat people will invest intoblindly.”

While it is true that Spacsraise funds via a blind pool anddon’t specify a target until afterthe IPO, there are other featuresthat may attract investors in tur-bulent markets.

First, 70% of shareholderstypically have to agree to theacquisition target before the bidprocess commences. Moreimportantly, most Spac fundsare held in trust. So even if asuitable business for purchasecan’t be found, investors are like-ly to at least break even. NP

I nvestors in China arerunning out of structuresto take over local compa-nies, it emerged at this year’sIFLR M&A Forum in HongKong.

A senior figure at one pri-vate-equity house, speaking atthe conference, complainedthat the traditional methods ofinvesting in targets werebecoming harder, due to acombination of protectionistregulators and dwindling tar-gets.

“From January to Marchthis year, we have attempted16 deals in China, but noneof them are still alive,” hesaid.

Three of the deals involvedthe target having an offshoreholding company in HongKong – a traditional way tobypass the approval of the

country’s Ministry ofCommerce (Mofcom), beforelisting the company on a for-eign stock exchange.

However, according to thespeaker, two of the three tar-gets with such a structurewere “abysmal”, indicatingthat desirable targets with off-shore holding companies arerunning out.

Other failed bids wereonshore investments, a tech-nique where the foreigninvestor forms a joint-venturewith a China partner, beforeallowing that partner toinvest in the onshore compa-ny, again bypassing foreigninvestment approval.

But the nature of foreign-invested enterprises makesonshore investments difficult.In the US, for example,investors have access to both

preferred and common classesof stock. China has only oneclass of equity. This removespreferential rights associatedwith private equity invest-ments, like preferentialpayment of dividends and liq-uidation proceeds. Thesedeals were failing too, said thespeaker.

The remaining targetsinvolved offshore investorsinvesting into onshore com-panies with no assets, andinvestors purely having accessto the cash flows of the target.This option was also provingunpalatable.

The comments came during‘The China Factor in GlobalM&A’ at this year’s Asia M&Aforum, co-hosted by Inter-Pacific Bar Association andIFLR at the Island Shangri-Lain Hong Kong. TY

China private equity is running out of ideas

2008: year of the Spacs?


CHINA

Private equity lawyers advising oninvestment into China are at a loss.Although investors are keen to makedeals happen, many are collapsing due toprotectionist regulation and a fall in thenumber of adequate targets.

Typically, Chinese targets would have aholding company based in Hong Kong.But investors are finding such companiesthin on the ground. As described in thenews analysis section (‘China privateequity is running out of ideas’), formingjoint-ventures with a Chinese partner toinvest is also failing. Bypassing foreigninvestment approval is getting harder.

Kathleen Ng is the managing directorat the Centre for Asia Private EquityResearch, which analyses and packagesdata for the industry. She highlights thepopularity of renminbi-denominatedfunds in China.

IFLR: Foreign private equity is facing alot of protectionism in China. They trynew structures, but still face strong oppo-sition. Will this change?

Kathleen Ng: Not immediately. One ofthe most important developments inChina has been the introduction of thegovernment’s active support of renminbi-denominated funds. This is actuallychanging the whole landscape of privateequity. When you have a vast pool oflocal denominated money available forinvestment, it is only natural for the localcompanies to come to you. They speakthe same language. Also, it only takes twoweeks to get approval from the central

government as to whether it will invest ornot. With foreign funds, it can take sixmonths or longer. There is no guaranteethat the government would approve thetransaction either.

So if you are a company seeking toraise funds, why would you opt for thelatter? There will be trend of foreign pri-vate equity houses beginning to look athow they can launch a locally denominat-ed fund to access this sort of bankablecompany and keep the deal flow going.

By hiring local people and so developinga stronger relationship with the clientbase?

Exactly. So the trend will continue, andthis is very much what Beijing wants tosee. For a long time, a lot of the gravy hasbeen earned by foreign private equitypeople. Profit is ok, but the governmentwants the locals to have a share.

Will the Chinese government allow aflood of foreign private equity houses toset up these funds?

The locally denominated funds onlystarted setting up a year ago, so it is veryearly days. I don’t think the governmenthas ever thought about what would hap-pen if large numbers of foreign fundscome in and set something similar up.Obviously there would be a lot of regula-tory hurdles to overcome, but thepotential is there for a lot of funds todevelop. Some foreign investors have toldme that this is the way to go. They needto work in the local way in order toaccess local deals and recruit local people.If this trend continues, it is going toreshape the whole of the private equityindustry in Asia. Historically privateequity has been dominated by dollar-denominated funds with the players inEurope and the US dominant. Now youhave local renminbi funds being launchedand the market is very different. It isgoing to be very interesting to see howBeijing shapes future development.

My feeling is that the government islooking to use private equity and venturecapital to help local industries to grow, toimprove management, governance and soon. On the other hand, they don’t wantforeign private equity to absolutely domi-

nate. This was the premise behindlaunching the locally denominated funds.

How many of these funds are there?Last year there were four or five local

funds in China and they raised at least$10 billion. One was launched over ayear ago, called Bohai IndustrialInvestment Fund. The total fund size wasover $1.2 billion. Every single fund thatthey launch is at least at the $1 billionmark.

Does India follow a similar model?India hasn’t launched a locally denomi-

nated fund of any substantial size that weare aware of. It is feasible, but therehaven’t been any large ones. There are alot of foreign investors though – India forone reason or another is the first port ofcall for lots of technology investors. A lotof them are raising the funds specificallyfor India too. But all of these funds aredenominated in US dollars.

But both China and India are the hotcountries for private equity?

Yes. In 2007 for the first time bothChina and India overtook Japan. For along time Japan dominated the Asian pri-vate equity scene in terms of fresh capitalinvestors and transaction volume.Because of the sheer size of Japan’s econo-my, invariably it attracted very largefunds. It was also the hub for buyouts.

Also, the emerging markets in Asiahave consolidated their position. In 2006,Australia was a very hot market in terms

“When you have avast pool of localmoney, it is only natural for localcompanies to cometo you”

“This will reshapethe whole of the private equity industry in Asia”

You need local funds to succeedInternational private equity houses operating in China should create locally denominatedfunds to invest successfully. Kathleen Ng from Asia Private Equity Research discusses why


CHINA

of buy outs. If I remember correctly,Australia topped the markets with over$14.1 billion of transactions. In 2007this dropped dramatically.

The investment figures in Australia andJapan have dropped, so two of the devel-oped economies in Asia that weredominating the buyout scene havebecome less prominent. Instead Chinaand India are in charge.

Why do you think this has happened?It is probably because of the growth

potential of both countries. They are soenormous that you a lot of private equityinvestors are deploying capital. A lot ofthis capital has been taken away fromdeveloped countries.

For example, the failure of the consor-tium of investors to take over Qantas inAustralia was a defining deal. At the time,the board was recommending the offer tothe shareholders and said that the Qantasshares would drop if they didn’t take upthe proposal. It didn’t happen that way.Qantas shares continued to climb afterthe buyout deal failed. The shareholderswere really questioning the board. I thinkthe board failed to win the confidence ofshareholders. A lot of them were unsureand didn’t believe that the board’s advicewas in their best interests. Since then wehave seen a sea change in the sharehold-ers of target companies themselves. A lotof them have opposed buyouts.

Why has investment moved from Japan toIndia and China?

The Japanese economy improved inlate 2005 and in 2006. A lot of the com-panies were able to raise money from thestock market. Also, there has been a trendof Japanese companies discouraging buy-outs from parties that they don’t know.That together with the improved stockmarket led to a slip in the transactionvalue of buyouts.

On the other side, investors are justpouring money into India and China. Inaddition, investments in China and Indiathat were made in the early years of theindustry are beginning to show veryhandsome rewards. This is extremelyimportant because for a long time peoplethought that Asian private equity was ablack hole. Especially in China – youcouldn’t get any return. This theory hasbeen quashed. Both India and Chinahave been able to demonstrate that theycan consistently provide returns toinvestors. And some of the returns havebeen extremely enticing. This gives peo-ple the impetus to invest.

Moving onto other jurisdictions, areother emerging markets easing theirstance on private equity?

I think that Taiwan is opening up toforeign private equity. The valuation ofcompanies is much more attractive com-pared to China. The multiples that thecompanies in China are asking areextremely high because of the growthpotential. Private equity investors are verysimple – you find a place where you canby at low multiples. You have to have anattractive entry price.

We have actually seen private equityinvestors happily going into Taiwan andthis will accelerate with the new politicalregime in the latter part of next month.The new regime headed by Ma Ying-jeouwill advocate a lot more of the economicties between China and Taiwan, ratherthan the stand-offish policy of the lastgovernment. We see the tension betweenthese two markets relaxing. This monththe first group of property developersfrom China is actually going to visitTaiwan. This is a landmark event – peo-ple from China are investing in Taiwan.A situation like this gives people a hugelevel of confidence.

Taiwan was one of only two Asian mar-kets in 2007 that had a consistentlyincreasing surge of capital from investors.Overall, Asian private equity sloweddown, but Taiwan increasingly attractedmoney from private equity. We will seemore activities there. There is no doubtabout it.

Are other Asian jurisdictions showinggrowth?

Private equity is beginning to focus onsouth-east Asia. In particular, Vietnam isseeing a lot of movement. A lot of fundsare being raised there too.

There is always some early movementin Cambodia. This is almost a repeat of1996 – just before the Asian financial cri-sis – when a lot of people were very keenabout these south-east Asian markets. On

top of that we also see a lot of very stronginvestment into Malaysia. Some of thedeals by foreign private equity investorsare very substantial too. So even thoughMalaysia has currency controls, peopleare finding ways to hold assets.Principally because of the fact that youcan also sell your asset at a very profitablereturn.

The south-east Asia market, which hasbeen in a slump since the 1997 financialcrisis, is now able to show that it can pro-duce a very handsome return. Havingsaid that, the only market that is findingit hard to attract investment is Indonesia.Investors are still trying to digest how theeconomics there work. We don’t see asurge of interest in Indonesia yet. But Ibelieve a lot of people are looking at it,and if the government can maintainpolitical and economic stability, they maybe able to convince some to go backthere.

What do you forecast for 2008/2009?It splits into two distinct areas. The

avalanche of capital coming into themarket from abroad will continue. Asiais the growth centre of the world – therewill be no respite. More funds will belaunched.

On the investment side, deals will bevery competitive because there is only adefined number of quality companies.In Asia we simply do not have a suffi-cient pool of quality companies forthose coming into the market. So yousee increased competition for deals.

Also, there could be growth in thebuyout industry. Last year was a bad onefor buyout investors – they just didn’tseem able to close deals. But given thevolatile stock market, I think that somepeople will be talking to buyoutinvestors and looking to offload some oftheir non-core assets. There will be aslight increase in buyout activities, butnot a great deal. Certainly not like itwas in 2003/2004.

“We have seen a sea change in the shareholders of target companies themselves. A lot of them have opposedbuyouts”

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SOVEREIGN WEALTH FUNDS

IFLR’s journalists in London, New Yorkand Hong Kong all agree: people areoverreacting to sovereign wealth funds.

These controversial investment vehicleshave become increasingly political since theturn of the year. French President NicolasSarkozy spoke out against them and GermanChancellor Angela Merkel reinforced herstance against them. Even in the midst of theUS race for President, Hillary Clinton tried toturn the topic into a vote winner.

But lawyers all round the world say the samething: sovereign wealth funds are old news,there is no need to panic and any reactionneeds to a considered one.

At the moment, it is estimated that the topsovereign wealth funds hold around $2.5 tril-lion in assets. By 2015, this is expected to haverisen to $12 trillion. China InvestmentCorporation can already afford to buy MorganStanley four times over. Imagine what it couldpurchase by the middle of the next decade.

After the whirlwind of speculation at theturn of the year, the inevitable regulation ofsovereign wealth is starting to take shape.Lawyers were worried that a regulatoryresponse could turn into protectionism, but itlooks like action will not be as over zealous asmany feared.

Europe outlines regulationThe European Commission (EC) is pressingahead with a voluntary code of conduct forsovereign wealth funds.

At the end of February, EuropeanCommission president José Manuel Barrosoissued a statement during his official visit toNorway. While admitting that sovereignwealth is “not a big bad wolf at the door”, he

drew upon the transparency of Norwegianfunds as a paradigm for other funds in Europe.

“A code of conduct has been inevitable sincethe furore over sovereign wealth started at theturn of the year,” said a funds partner at oneUS law firm. “But that doesn’t mean it wasrequired. This will just quieten political panicand make it look like serious action is beingtaken.”

But Barroso justified his statement by sayingthat a level playing field will benefit Europe asa whole: “We will propose a commonapproach at European level, avoiding distort-ing the single market with incompatiblenational responses. This EU approach shouldbenefit both investor and recipient countries.”

Barroso’s plans were confirmed later in thesame week in Commission proposals released,which were designed to direct discussions ofEuropean leaders at the spring EuropeanCouncil on March 13 and 14.

The proposals called for the leaders to agreeto a voluntary code of conduct. In particular, ithoped this would encourage some “opaque”funds to disclose the value of their assets,investment objectives and the nature of theirrisk management systems.

Ironically, these proposals may have prevent-ed stronger regulation. By calling for a code ofconduct the Commission has stumbled acrossa middle ground. European leaders such asGerman Chancellor Angela Merkel andFrench President Nicolas Sarkozy will havefound it hard to get backing for legislation witha more moderate proposal on the table.Neither has publicly declared their desire forheavy regulation, but their stance has beenobvious from anti-sovereign wealth statements.

Indeed, the Commission’s proposals seemedto strike a chord with the Economic andFinancial Affairs Council (ECOFIN) who meton March 4 to discuss sovereign wealth fundsto prepare the discussion of the full councilnine days later. As a result, the presidency con-clusions from the mid March meeting inBrussels said:

“The European Council agrees on the needfor a common European approach taking intoaccount national prerogatives, in line with thefive principles proposed by the Commission,namely: commitment to an open investmentenvironment; support for ongoing work in theIMF and the OECD; use of national and EU

instruments if necessary; respect for EC Treatyobligations and international commitments;proportionality and transparency.

“The European Council supports the objec-tive of agreeing at international level on avoluntary code of conduct for sovereign wealthfunds and defining principles for recipientcountries at international level.”

But opponents to sovereign wealth regula-tion should not rest easy. Any voluntary codeof conduct could be hardened at a later date.This was a lesson learnt by the private equitycode of conduct in the UK last year.And Barroso refused to rule out further action:“We will not propose European legislation.Though we reserve the right to do so if we can-not achieve transparency through voluntarymeans.”

Australian regulationBut sovereign wealth fund regulation started inthe southern hemisphere in February. Australiaissued specific international guidelines on gov-ernment-backed investors before the ECannouncements.

The country unveiled a set of screening cri-teria governing sovereign wealth fundinvestments, which will be used by regulatorsto judge foreign, namely sovereign wealthfund, bids. Among the six guidelines iswhether the investors “are independent fromthe relevant foreign government,” includingthe extent to which they operate at arm’s lengthfrom its government and whether they are con-trolled by a foreign government, includingfunding arrangements.

Others include whether the fund followscommon standards of business behaviourshowing clear commercial objectives and goodcorporate governance practices.

As a member state of the OECD, the bodyresponsible for designing a code of conduct forrecipient countries, it is likely that Australia’sset of six principles will be similar to the organ-isation’s final suggestions. And although theannouncement is the first solid piece of regula-tion on the matter, the six principles are littlemore than official statements on current prac-tices.

“This seems to be the beginning of a verylong process for sovereign wealth fund regula-tion. The Australian government appears to besaying that this isn’t the last word but thebeginning of the conversation,” said StephenHarder, a China partner at Clifford Chance.“Also, calling them six principles makes themsound more tangible than they are. We have toremember that [the Australian government] isreiterating several powers that it already has,”said Harder.

Harder also believes that through a cumula-tive process of failed and successful bidsinvestee countries and the corresponding for-

Don’t overreactWhatever you do, don’t panic. Sovereign wealth funds havebeen around for a while and are nothing to fear. Regulatorsare thankfully realising this and are ignoring politicians

“Don’t overreact,don’t over-regulate,don’t over-control,don’t over-legislate”Angel Gurria,

OECD secretary general



eign sovereign wealth funds will develop analmost common law-style set of precedents forwhich types of transactions go forward andwhich do not. “But once we start seeing reallylarge investments, very few countries will notreserve the right to consider political issuesraised by the target’s new ownership structure,”he added.Europe: stop panicking

In January, IFLR’s journalists broughttogether the opinions of lawyers world wide onthe issue of sovereign wealth. The overwhelm-ing message was: “don’t panic”.

For example, Standard Chartered claimedthat sovereign wealth funds are potentially“irresponsible participants in the world econo-my.” This was an overreaction, according toUK counsel.

In an interview in mid-January, the bank’schairman Mervyn Davies called for a code ofconduct to create more transparency. This wassignificant given that Temasek, the Singaporestate fund, holds an 18% stake in StandardChartered.

One UK corporate partner reacted by say-ing: “I don’t understand all this fuss aboutsovereign wealth funds. Qatari funds have beenactive in London since the early nineties andno one has ever made a big deal about it.

“The national papers have suddenly latchedonto them in much the same way that they didwith private equity last year. It’s pure scare-mongering.”

But it was exposure in the media and publicpressure that led to Sir David Walker draftinga private equity code of conduct in Novemberlast year.

The focus on sovereign wealth funds can beattributed to the governments of Kuwait,Singapore and South Korea providing most ofthe $21 billion lifeline to Citigroup andMerrill Lynch earlier in January. The mediasunk its teeth into this and it is unlikely to letgo easily.

“A code of conduct would only serve to qui-eten people who are panicking for littlereason,” the UK corporate partner continued.“No one was concerned about transparency ofsovereign wealth funds before, why shouldthey start now?”

Lessons should also be learned from lastyear’s UK private equity code. People quicklyrealised that the code was merely a sop to theirconcerns and there is now pressure to strength-en it. If a similar code is drawn up for sovereignwealth funds, it will have to have more weightto it.

Some at an international level are also argu-ing that policy makers need to avoidover-zealous regulation that could smack ofprotectionism. The day after Davies’ com-ments, secretary general of the OECD AngelGurria issued a warning to regulators.

“The OECD is saying buyers have to havetransparency, abide by market rules. But sellers:don’t overreact, don’t over-regulate, don’t over-control, don’t over-legislate. They are helpinginvestments, solving some of the problems, likeglobal imbalances. They could become sover-eign development funds,” he said.

US: It’s a liquidity boostLawyers in the US also say that sovereignwealth should not be feared. Indeed, it willhelp improve liquidity.

“One factor is their huge dollar surplus,which needs to be invested. Putting that in theUS is a good thing overall,” said Paul Lee, part-ner at Debevoise & Plimpton.

Many say the increased deal speed that ispossible at sovereign funds will help the USsteer clear of recession. It could reduce liquidi-ty problems at America’s large banks, and helpto keep loans flowing.

Deals are often processed faster within sover-eign funds as they are subject to less regulationand have a streamlined internal decision-mak-ing process, unlike pension funds and otherlarge investors.

That lack of regulation could be a cause forconcern, but lawyers point out that the fundsrarely take more than a 5% stake in the com-pany, suggesting they do not intend to takeover any part of it. The acquisition of less than5% of voting securities establishes the pre-sumption that the acquirer is not takingcontrol.

Investors would only gain a voice in themanagement of the company if they held morethan 5%. That would involve greater regula-tion and so transparency. An acquirer of 5% ormore of voting securities of a public companymust report the acquisition to the SEC; 4.9%acts as a reporting and regulatory clearancethreshold.

“The natural inclinations of sovereign fundsare consistent with the natural inclinations ofinvestors in the US financial sector. Those nor-mally mean acquiring no more than 4.9%, orin some cases 9.9% of the financial institu-tion,” said Lee.

These sovereign funds also don’t rely onleverage, which has been a source of concernaround hedge fund investments. Sovereignfunds have a more stable capital base, whichpermits long-term investments. They can alsotolerate greater risk.

Some in the US are scared that these fundswill dominate financial institutions. But eventhough Wall Street has already accumulated$59 billion of investment, Lee said that “in thefinancial sector, it’s less likely that one wouldsee sovereign foreign investors acquiring a con-trolling stake”.

One suggested solution for concerns overtransparency is for sovereign funds to agree to

“This is aboutprotectingimportant industrial sectors”

German Chancellor Angela Merkel

“We will protect innocentFrench managers fromthe extremelyaggressivefunds”

French President Nicolas Sarkozy

“ChinaInvestmentCorporationis entirely commercial”

China’s Premier Wen Jiabao

“We need tohave a lot morecontrol over whatthey do and howthey do it”

US presidential candidate Hillary Clinton

“The Britishcommitment toopen marketsmeans we willwelcome sover-eign funds”

UK government official

The political(over)reaction


a code of conduct, rather like that imposed byprivate equity funds on themselves. Canadahas already declared something similar, withfunds being required to have independentCanadian boards and commit to selling toCanadian consumers (see box at the end of thisstory).

Some also point out that, despite the high-profile investments in Citigroup and MerrillLynch, these funds are nothing new to the US.

Foreign states have been recycling the dollarback into the US for years. The difference nowis that the declining dollar encourages foreigninvestors to turn away from treasuries and intostock.

Australia: Controversial, but hereto staySovereign wealth funds are creating the samereaction in the southern hemisphere. They

may be causing equal measures of panic andglee among central governments and flailinginvestment banks, but it would appear that thelegality of their dealings cannot be questioned.

China’s State Administration of ForeignExchange (Safe) purchased stakes in three ofAustralia’s largest banks in late December,attracting some opposition. Complaints cen-tred on Safe’s denial of the investments, and itsrequest that the Financial Times not publishdetails of the stake. Some observers also ques-tioned why Safe is making the kind of riskyinvestment that China Investment Corp, thecountry’s sovereign wealth fund, is supposed tobe responsible for.

However, the investments are comparativelysmall, with each stake worth A$200 million($176 million), and fly well below the thresh-old of equity investments needing regulation inAustralia.

Australia and New Zealand Bank andCommonwealth Bank of Australia said HongKong-registered Safe Investment Companyhad bought stakes of less than 1% in each ofthe lenders.

“We’re speaking about very minor levelshere,” said David Olsson, capital markets part-ner at Mallesons Stephen Jaques’ Melbourneoffice.

“There is a political element to these com-plaints. But providing everyone follows thesame rules, there can’t be too many objections.From an Australian perspective, once we reach10% to 20% and there is a significant equityinterest, there is obviously an increase in regu-lation,” he added.

As already mentioned, Australia has sinceoutlined its regulatory response to sovereignwealth. Australia also has a foreign investmentreview board which would evaluate any invest-ments on national merits should they reachsuch a level.

Inevitable changeDespite the fact that they are nothing new, sov-ereign wealth funds will continue to strike fearinto politicians. This is because the centralissue is a lack of transparency, and so a lack ofcontrol.

Sovereign wealth funds will have to changethe way they operate. In Europe, private equi-ty has had to succumb to a code of conduct.And hedge funds have begun to follow a simi-lar route. If they want to maintain theirinvestment plans overseas, sovereign wealthfunds will have to find similar ways to mollifyopposition. Adhering to the rules set down byregulators would go a long way to pacifying thesensational focus on sovereign wealth so far in2008.

By Lynann Butkiewicz, Nicholas Pettifer andTom Young

Last month’s IMF announcement stating that it

is developing best practice guidelines for

sovereign wealth funds has received a muted

response.

“The current economic climate is a perfect

storm for political discussion to happen in

public. The IMF is a voice in the discussion, but

a relatively small voice,” said John Douglas,

regulatory partner at Paul Hastings Janofsky &

Walker.

“I’m not belittling it, but the IMF proposals

will have a modest impact. [The US] political

process is full of people who think they are

kings and queens in their own right.”

On March 21, the IMF executive board

approved further analysis on how sovereign

wealth fits into the global economy. More

importantly, it agreed that IMF staff should work

with sovereign wealth funds to develop best

practice. The board also established an inter-

national working group of sovereign wealth

funds to aid discussions and begin drafting

proposals next month.

The main issues the IMF will look to

develop best practice on are public gover-

nance, transparency and accountability. It will

also coordinate its work with that of the OECD.

But it is hard to see why the IMF is investing

time in this area. As detailed in the main body of

this article, the European Council recently met

to approve the European Commission’s plans

for a voluntary code of conduct.

Douglas felt that the US Congress would

make its own mind up, even if an IMF voluntary

code was established:

“For instance, you’d think the relatively

small sovereign wealth investment in

Blackstone wouldn’t create much fuss. And it

almost certainly would have complied with

any proposed code of conduct. But if

Blackstone were then to invest in the defence

industry, the issues would rush to the fore,” he

said.

Even with the IMF guidelines, it is hard to

see the US government relying on them if

sovereign wealth remains political. The

Committee on Foreign Investment in the United

States (Cfius) would probably be tightened

and the US Treasury would likely come up with

its own code of conduct.

Why is IMF meddling with sovereign wealth?

UAE

Norway

Singapore(GIC1/)

Saudi Arabia

Kuwait

China

Singapore(Temasek Holdings 1/(

Libya

Algeria

Qatar

US (Alaska)

875,000341,200

330,000

300,000

250,000

200,000

159,210

50,000

42,600

40,000

38,000

0 225000 450000 675000 900000Estimated assets ($ millions)

Co

un

try

Largest sovereign wealth funds

Source: Morgan Stanley September 2007




Canada has officially taken note ofthe increasing tide of invest-ments through state-ownedenterprises (SOEs). On

December 7 2007, the Canadian govern-ment announced that special guidelineswould apply to the review of Canadianinvestments by SOEs under the InvestmentCanada Act (ICA), Canada’s foreign invest-ment review legislation. In brief, theguidelines define SOEs as enterprises ownedor controlled directly or indirectly by a for-eign government (which would includesovereign wealth funds). They only apply toSOE investments that are already reviewableunder the ICA, and do not prohibit suchinvestments. According to the guidelines,the government will examine adherence toCanadian standards of corporate gover-nance, and will assess whether the SOE willoperate the target business according tocommercial dictates. The guidelines alsooffer examples of the types of binding com-mitments that SOEs may be required toprovide. Importantly, they do not single outinvestments in particular economic sectors,or by particular countries.

Winning approvalThe ICA requires that the Minister ofIndustry approve acquisitions that exceedcertain monetary thresholds before closingor in some cases, afterwards, according towhether the deal will yield a “net benefit toCanada”. The guidelines go beyond thegeneral factors the Minister will consider inapproving a reviewable investment, andfocus on issues particular to SOEs. Theyidentify the “governance and commercialorientation of SOEs” as central in assessingwhether SOE investments should beapproved. The government will examineadherence to Canadian standards of corpo-rate governance – transparency anddisclosure, the presence of independentdirectors, audit committees and the equi-table treatment of shareholders, andcompliance with Canadian laws and stan-dards. It will also consider how and to whatextent the investor is owned or controlledby a state.

The government will also evaluate theSOE’s commercial orientation regarding thetarget business, including: “where to export;

where to process; the participation ofCanadians in its operations in Canada andelsewhere; the support of ongoing innova-tion, research and development; and theappropriate level of capital expenditures tomaintain the Canadian business in a global-ly competitive position.” The guidelines alsooutline the types of binding commitments

or undertakings that may be required toensure that SOE investments benefitCanada. The SOE may have to commit toappointing Canadians as independent direc-tors, employing Canadians in seniormanagement, incorporating the target busi-ness in Canada, and listing the shares of theacquiring company or the target Canadianbusiness on a Canadian stock exchange.

Uncovering the motivesThe guidelines give insight into the govern-ment’s concerns about SOEs. But theirlevel of generality is so high that they raisemore questions than they answer. Forexample, they do not indicate what degreeof ownership or control is required for anentity to be an SOE. If an SOE is definedin accordance with the ICA nationality ofcontrol provision, control may be suffi-cient. Interestingly, investors controlled byindividuals closely linked with a foreigngovernment (including relatives) or by for-eign government pension funds might falloutside the definition.

A big concern is that SOEs will pursuepolitical agendas at odds with Canada’snational interests. The guidelines do notpropose to assess the motives behind invest-ments, but they list factors that mightreflect a deviation from commercial princi-ples. For example, the government willconsider the destination of exports, reflect-ing potential concerns that the SOE couldbuy up resources to fuel its home economy,

rather than supply Canadian customers. The guidelines address governance con-

cerns by measuring the SOE againstCanadian standards. A requirement forindependent directors might have the aimof ensuring that the Canadian business isgoverned by an entity with some directorsnot from the SOE’s home state. However,the home state could view this requirementas unacceptable meddling.

A tepid welcomeAmbiguity also exists concerning what thegovernment means by adherence toCanadian laws and standards. If the SOEdoes not already conduct business inCanada, will it be held to Canadian envi-

ronmental or labour standards in its homecountry?

The possible requirement that the targetbusiness be listed on a Canadian exchangeis of particular interest. This could be seenas indicating that the government mightrequire a minority Canadian shareholdingin certain instances. Such a step would beone way for the government to ensure thatSOE disclosure meets Canadian securitieslaws, while at the same time givingCanadians the opportunity to become partowners of the target Canadian business.

SOEs should note that the guidelines’impact is limited to investments alreadyreviewable under the ICA. Investments thatdo not constitute acquisitions of control(such as small shareholdings), or are belowthe review thresholds, are not reviewable.

Given the guidelines’ lack of precision, itis unclear whether the government willbecome more restrictive towards state-owned investment than before. To resolvethis uncertainty and avoid discouragingSOE investment, it should set up a timelyand transparent process for responding toinvestors’ questions, and should communi-cate results in a way that protects investorconfidentiality. Such a process wouldincrease predictability and consistency ininvestor treatment. Without it, the guide-lines may make Canada less welcoming toSOE investors.

By partner Jeff Singer and counsel SandraWalker at Stikeman Elliott LLP

Canada’s positionAlthough Canada has set out its views on foreign state buyers, its guidelines offer insufficient guidance

“It is unclear whether the government will become more restrictive towards state-owned investment than before”


GERMANY

Since Porsche became the largestshareholder of Volkswagen, pressattention has focused on the twoGerman carmakers. Two court cases

have been particularly prominent. The firstreferred to the so-called Volkswagen Act: onOctober 23 2007 the European Court ofJustice decided that the Federal Republic ofGermany violated European law by main-taining certain provisions of the VolkswagenAct, a decision that will undoubtedly haveconsequences for Porsche as Volkswagen’slargest shareholder. The second court case –decided just one day later, on October 24, bythe Labour Court of Stuttgart – dealt withemployee co-determination issues withinPorsche. It appears to have had no initialeffect on Volkswagen, but a knock-on effectmay occur when Porsche acquires theremaining shares and increases its participa-tion in Volkswagen to more than 50%. In itsmost basic terms, the Labour Court ofStuttgart confirmed that Porsche does nothave to take care of any issues Volkswagenhad in the process of establishing a EuropeanStock Corporation. The background to theEuropean Court of Justice decision, and itsimplications for Volkswagen, are worthinvestigating.

The VW ActAfter the war, Volkswagen was first con-trolled by the British High Commissionbefore the company was eventually returnedto German hands. It soon became commer-cially successful. The Volkswagen Act,becoming federal law in 1960, gave specialrights to the Federal Republic of Germany,the State of Lower Saxony, and the trade

unions. The voting rights of any shareholderwere restricted to 20% as a maximum,regardless of how many shares the sharehold-er had – a shareholder with 51% of the shareswould only have voting rights of a sharehold-er owning 20%. The Bundesländer ofLower-Saxony and the Federal Republic ofGermany were each entitled to send twomembers to the supervisory board, as long asthey were shareholders. The establishmentand transfer of production sites required amajority of two-thirds of the members of thesupervisory board. The majority requirementfor resolutions at the general shareholders’meeting was set at 80%, instead of the stan-dard requirement of 75%. The VolkswagenAct followed a series of discussions betweenthe Federal Republic of Germany, the Stateof Lower Saxony, and other jurisdictionsabout the company’s ownership. The tradeunions had also participated in these discus-sions, as some of their funds were used by thenational socialist regime to build up the com-ponents of what later became Volkswagen. Itwas a compromise to balance ownershipinterests when Volkswagen GmbH was con-verted from a limited liability companyunder German law to the stock corporationVolkswagen AG, today’s listed legal entity.

The decision to overturn these provisionswill mean that the shareholders’ rights will bestrengthened. They will be able to influencethe company’s business in the future – a his-toric change in the company’s policy.

To evaluate the business consequences ofthe Volkswagen Act for Volkswagen, thebasic legal structures of a stock corporationunder German law need to be kept in mind.According to German law, a stock corpora-

tion has a management board and a supervi-sory board. The management board runs thecompany and represents it externally; thesupervisory board supervises and advises themanagement board. The supervisory boardalso has the authority to appoint and recallthe members of the management board. Itwill negotiate the details of their employ-ment, including remuneration.

The application of the Volkswagen Actresulted in the following. On the level of thesupervisory board, the representatives ofmajority shareholders will only have a minor-ity position with no decision-makinginfluence. The supervisory board ofVolkswagen AG has 20 members. Theemployees elect 10 members, according toGerman employee co-determination rules,and shareholders elect the other 10. The twomembers of the supervisory board appointedby the State of Lower Saxony are deductedfrom the 10 elected by the shareholders.These two members, along with the employ-ee representatives, account for a clearmajority of 12 of the 20 members.Conversely, the remaining shareholders ofVolkswagen AG could only elect six to eightmembers to the supervisory board, depend-ing on whether the Federal Republic ofGermany used its special right to appointtwo members. Regarding shareholders, ashareholder with 20% of the shares has aright of veto in any general shareholders’meeting against all the other shareholders.Since the State of Lower Saxony owns morethan 20% of Volkswagen, it has been in aposition to use its veto rights against funda-mental corporate changes. It could alsoprevent attempts to reduce its influence orchange the company in a way that wouldhave adverse effects on the economy ofLower Saxony.

All in all, buying shares in Volkswagen AGwas highly unattractive for investors in thepast. Because of the restrictions of theVolkswagen Act, shareholder rights had novalue. Critics argued that the (non-) develop-ment of the share price of Volkswagen was aresult of the Volkswagen Act.

Golden sharesBut the main issue in the public debate aboutthe special rights in the Volkswagen Act wasnot the influence given to the managementof the company through the supervisoryboard, or the State of Lower Saxony’s vetorights in shareholders’ meetings, but therestriction of voting rights to 20% of thevotes, no matter how many shares a share-holder owned. Such special rights are calledgolden shares because they are usually associ-ated with the ownership of a special sharethat grants these rights. With Volkswagen,

A complicatedvictoryThe rules that protected VW stock are now illegal. But that doesn’t necessarily help shareholders, it just makes everything more complicated

“The decision of the European Court ofJustice may have no immediate legal consequences”


GERMANY

though, it was originally a governmental lawthat granted the rights.

On March 4 2005, the EuropeanCommission initiated legal action against theFederal Republic of Germany as the bodyresponsible for the Volkswagen Act. TheCommission argued that the provisions ofthe Act infringed on the free movement ofcapital, and the freedom of establishmentguaranteed under the EC. The EuropeanCourt of Justice took the side of theCommission. Its decision was not unexpect-ed, as Court of Justice decisions on goldenshare provisions in other member states ofthe EU also declared them be void.

Given that expectation, it was only a matterof time before investors would begin to showmore interest in Volkswagen AG. After all, it isEurope’s biggest carmaker, yet it has a ratherlow share price. Porsche stepped in first, andtoday is the largest shareholder in VolkswagenAG, owning roughly 31% of the shares. Thevalue of shares both in Porsche and inVolkswagen AG has increased swiftly sincethen. The markets now expect that Porschewill rapidly increase its share in Volkswagen tomore than 50%.

A complicated pictureBut from a financial and legal perspective,such an increase of Porsche’s participationquota may not make sense, at least at themoment. The shares in Volkswagen AG arestill quite expensive. Although Porsche hasalready bought options for additional shares,it did not exercise those options. Rather, itdecided to sell them at a profit of roughly€3.6 billion ($5.3 billion), according to arecent Porsche press release.

In addition, legal issues could bring therecent increase of Volkswagen share pricesinto question. Such thoughts may haveinfluenced Porsche’s decision not toincrease its interest in Volkswagen AG, atleast for the time being. Although onewould expect that the special rights grantedby the Act are no longer valid, it may bepossible to argue that legally they still hold.The decision of the European Court ofJustice may have no immediate legal conse-quences. The Court of Justice decidedagainst the Federal Republic of Germanybecause it did not change an act of federallaw after the historic reasons for the lawhad disappeared. The Federal Republic ofGermany as defendant must now change orremove the Volkswagen Act. But the deci-sion is directed neither against VolkswagenAG nor against its shareholders. TheVolkswagen Articles of Association, whichrepeat the respective provisions of theVolkswagen Act, could come into play,since they make it possible to argue that the

special rights have a separate legal basis. Asa result, the rights could apply even if theVolkswagen Act itself is no longer valid.

Porsche’s problemOn these grounds, one could argue that thespecial rights granted by the Articles ofAssociation still apply in principle.Presumably, the Court of Justice decision willnot automatically result in the immediate orpartial ineffectiveness of the provisions of theArticles of Association, because the provi-sions violate neither the law nor morality.The violation of European law is not neces-sarily associated with the legal content of thespecial rights, and such rights are by nomeans special in business life. What is unusu-al is that the Federal Republic of Germanyitself has granted them to itself and to theState of Lower Saxony.

The Articles of Association are not theresult of any law, but of a majority resolutionof the shareholders of Volkswagen AG underthe German Stock Corporation Act(Aktiengesetz). The Federal Republic ofGermany is only able to change or terminatethe Volkswagen Act by law. It will not be ableto change the Articles of Association, as thisis a matter for the shareholders, in accordwith the Articles of Association and GermanCorporate Law. So it will not be easy to arguethat a decision against the Federal Republicof Germany, as the body responsible for theVolkswagen Act, results in the partial ineffec-tiveness of a corporate agreement resolved bythe shareholders of a public listed companyat some point of time.

It should therefore be expected thatPorsche, the new majority shareholder, willtry to amend the Articles of Association ofVolkswagen AG at the next opportunity.Presumably, there will not be an extraordi-nary shareholders’ meeting solely for thispurpose because such meetings are lengthyand costly procedures for listed companies.An attempt to amend the Articles ofAssociation may therefore take place at thenext annual shareholders’ meeting ofVolkswagen AG in 2008.

Another aspect of this problem relates totrade unions: the decision of the EuropeanCourt of Justice did not cover the specialrights granted to them – the right of veto inthe supervisory board regarding the estab-lishment and transfer of production sites.The works council of Volkswagen AG andthe representatives of the trade unions havealready argued that the Volkswagen Actshould only be amended insofar as it wascriticised by the European Court of Justice;this would protect their particular rights.On January 16 2008 the German Secretaryfor Justice, Brigitte Zypries (a member of

the Social Democratic Party) presented thefirst draft of the new Volkswagen Act. TheSecretary explained that the Act would notbe removed completely, but upheld, insofaras it did not contradict European Law. Thespecial rights of the employee representa-tives on the Supervisory Board wouldprevail, according to this draft. More sur-prisingly, the majority requirements formaterial decisions of the general sharehold-ers’ meeting would remain at 80%, becauseit is argued that the European Court ofJustice only rejected the combination of therestriction of voting rights and this majori-ty requirement.

This recent development demonstrates thatGerman politics is far from giving up its influ-ence in Volkswagen without resistance. It mayeven be possible that the EuropeanCommission will challenge the newVolkswagen Act, should the draft be imple-mented. On the other hand, the new draftcould be seen in the light of the upcomingelections in Hesse and, in particular, in LowerSaxony, on January 27 2007.

Given these strong political overtones,Porsche will consider its next steps carefully.As noted above, the State of Lower Saxonyowns shares representing about 21% of thevotes. It will be interesting to see how theState of Lower Saxony will vote in futureshareholders’ meetings, should Porsche initi-ate amendments to the Articles ofAssociation. Notwithstanding any issueswith a new Volkswagen Act, there is no guar-antee that the State of Lower Saxony wouldvoluntarily vote in favour of the proposedamendments, by which some or all of its spe-cial rights, including the veto rights, wouldbe removed. The State of Lower Saxonycould buy protection by deciding to increaseits share to 25% of all shares. But it couldalso rely on the traditionally low presence ofshareholders at the general shareholders’meetings, as there is a distinction betweentotal votes and votes at those meetings. 21%of all voting rights could grant an actual vot-ing power of more than 25% of the votes inthe general shareholders’ meeting. As onlythat is important, the existing voting rightsof the State of Lower Saxony could already besufficient to constitute a veto right that is inaccordance with the German StockCorporation Act.

All this demonstrates that the public per-ception of the consequences of the EuropeanCourt of Justice decision may have been pre-mature. Apart from stock priceconsiderations, Porsche will closely watch thenext steps that the Federal Republic ofGermany and the State of Lower Saxony take.

By Robert Heym, associate at Reed SmithLLP


UNITED KINGDOM

The FSA’s recent consultationpaper on the disclosure regimegoverning contracts for differ-ences highlights market

concerns that “hedge funds may outflank tra-ditional institutional investors by usingeconomic interests to influence companies”(CP 07/20 Disclosure of Contracts forDifferences). The view that funds holdinglarge contract for difference (CFD) positionsmay influence management is widely held,particularly among traditional institutionalinvestors. Yet there is no strong legal basis forit, and there is little evidence that CFDs areused for that purpose. So how should issuersdeal with CFD holders?

InfluenceIn the UK, company directors have a dutyto “promote the success of the company forthe benefit of its members as a whole”. Acompany is not obliged to look beyond itsregister of shareholders in identifying itsmembers. As long as a company owes aduty to its members, that concept is limit-ed to the legal owners of shares, recordedon the company’s register. While directorsneed to have regard to the interests of stake-holder groups such as employees, there isno need for a company to look after theinterests of the world at large. More specif-ically, a company does not have to take careof the interests of holders of CFDs.

Writers of long CFDs will often hedgetheir positions by taking an equivalentposition in underlying securities. When aholder of a long CFD position can directhow the shares used to hedge the CFD arevoted, or require physical settlement of theCFD, one could argue that its interest isakin to an equity interest and that manage-ment should recognise this and act on it.In these circumstances, directors maythink that the interests of the shares’ regis-tered holder (that is, the CFD writer) areeffectively the same as the interests of theCFD holder. Indeed, a board may be reluc-tant to ignore the demands of a CFDholder that controls a large proportion ofthe company’s voting rights.

CFDs can be part of activist or takeoverstrategies, or attempts to avoid disclosurerequirements, but they have other func-tions too. The stamp duty savings arebeneficial. Crucially, CFDs are issued onthe basis of up-front margin payments thatare much less than the overall value of theposition, allowing flexibility on fundingand leverage. As the FSA’s consultationpaper points out, many CFD agreementsdo not enable the CFD holder to directvoting rights. They are cash settled. Theholder has a purely economic and no pro-prietary interest in the shares underlying

the CFD. The FSA’s position in assess-ing changes of control in authorisedfirms is consistent with this analysis.Although the acquisition of a 10%

equity holding in an authorised firmrequires FSA approval, the FSA may not

count a person’s interest in certain CFDswhen assessing whether that threshold hasbeen breached. This is a valuable tool forbidders building stakes in an FSA-autho-rised target before a takeover offer is made.Pearl Assurance used the option recentlywhen building its stake in Resolution. Still,the Takeover Code requirements and theregimes governing price sensitive informa-tion should be carefully considered.

When CFDs have no proprietary rightsto the underlying shares, it is difficult tosee why a board should feel obliged to acton the CFD holder’s views – it is not amember and has no right to vote or tobecome a member. CFD holders often seekto influence management or the outcomeof a takeover offer. If the CFD holder pur-sues an activist strategy, the directors mayconsider the issues the holder raises to berelevant, and may act on them, regardlessof the company’s legal obligations to thatCFD holder; but that is different from thequestion of to whom the directors owetheir legal duties.

Contrary viewson disclosureShould holders of contracts for difference have to disclosetheir positions, even if they have no access to votingrights? The debate is raging at UK and EU level

Disclosure obligationsIn formulating a response to a CFD hold-er’s approach, a company should considerthe extent to which the holder controlsvoting rights or is able to demand a physi-cal settlement. If a fund manager wants toinfluence the board, it should incorporatecontrol of voting rights in the CFD.

In the Hedge Fund Working Group’sfinal report in January 2008, it acknowl-edged that many of its consultees wantfurther discussion in this area. It stated“companies have a right to know whoowns them or who has an ability to easilyobtain significant voting power.” If direc-tors need to know the extent of the CFDholder’s voting rights to see what theirduties are to that holder, a mechanismshould be in place to give them that infor-mation.

But because the legal relevance of theCFD holder’s interest in a companydepends largely on its access to votingrights, the company’s knowledge should belimited to information about those withthe ability to acquire shares or votingrights as a result of their interest in theCFD. Other holders simply don’t own thecompany in the way that a shareholderdoes.

Although not expressed in those terms,the FSA’s suggested approach, Option 2 inthe consultation paper, endorses much ofthis rationale. Under Option 2, disclosureof a CFD position is not required when theCFD is structured so that the agreementwith the writer prevents the holder fromexercising or seeking to exercise votingrights; the terms of the agreement excludefurther arrangements or understandingsregarding the sale of the underlying shares;and the holder explicitly states that it doesnot intend to use its CFDs to seek access tovoting rights.

But Option 2 goes further. It allowsissuers to request disclosure of pure eco-nomic interests. This would arise whenreasonable cause exists for the issuer toseek disclosure, and when the holdingexceeds 5% of the economic interests in

the issuer (and at 5% levels afterwards inaccord with the Transparency Directive, orwhen an interest fell below those thresh-olds). This aspect of the proposal is likelyto generate tension. Fund managers will bekeen to keep their proprietary trading posi-tions confidential when no effort is madeto influence management or exercise vot-ing control. On the other hand, issuersmay wish to know the identity of the eco-nomic owners of their business. Thetension is even more acute in the case ofthe FSA’s Option 3: a general disclosureobligation regarding CFDs would be creat-ed, even when the position taken is apurely economic one. By contrast, the USimposes a disclosure obligation on CFDholders seeking to exercise voting controlor influence management, and requiresonly limited annual disclosure of pure eco-nomic CFDs.

No real agreementAlthough the UK City Code on Takeoversand Mergers requires more general disclo-sure of economic interests in an offerperiod, that regime differs from the gener-al need for disclosure because, as the Panelhas stated, the distinction between thosewith control over the underlying sharesand those who only have an economicinterest in their price “is not easily drawnin the context of a takeover”. The Panel’srationale for requiring disclosure of CFDswithout reference to the CFD holder’s eco-nomic interest was that:

“To draw a distinction between holdersof “controlling CFDs” and holders of“purely economic CFDs”, particularly in amarket where CFDs are written “over thecounter”, would be over-simplistic in thecontext of a takeover where the price of atakeover stock is determined by the out-come or the likely outcome of the bid andwhere an interest in the price of a takeoverstock is therefore an interest in the out-come of the bid.”

The Takeover Code requirements andthe proposed changes to the Disclosureand Transparency Rules can be reconciled,but at a fundamental level they do notagree. The Panel appears to have been will-ing to look beyond the form of CFDdocumentation when determining its viewof CFD holders’ controlling interests inrelation to underlying shares.

EU roleBoth the FSA and key players such as theHedge Fund Working Group haveacknowledged the need for a public debateabout CFDs. CESR has also assessed theneed for further consultation and potentialharmonisation of regulators’ stances ondisclosure of derivative positions as part ofits review of the implementation of theTransparency Directive. More work on thesubject now seems likely at EU level.

It will be interesting to see whether theFSA takes a broader view of CFDs in thesame way that the Takeover Panel hasdone, in this era of principles-based regula-tion. Fund managers will probably pressfor disclosure obligations to be limited tothose seeking voting control or wishing toinfluence management. For now, the FSAseems to support a regime based on legalrelations consistent with fundamentalcompany law principles and the legalduties that the directors of issuers owe.

By partner Mark Geday and associateStephen Newby at Herbert Smith. The firmadvised the Hedge Fund Working Group onits best practice standards issued in January2008


UNITED KINGDOM

“The Takeover Code and the FSA’s proposed changes can be reconciled, but at a fundamental level they do not agree”

CFD HolderUnderlying Company

CFD Writer

£Fee/margin

Risk/reward ofexposure

to movements inunderlying share price

Shares

(Hedge exposureunder CFD)

The framework for a contract for difference


PRIVATE EQUITY AWARDS

Innovation has become something of adirty word in 2008. Much of the financialtrickery used by banks and their lawyersto construct capital markets offerings has

been blamed for the world’s economic woes. Butthe real blame lies with the way those deals weresold, explained and rated. There’s nothing wrongwith complication per se.

At IFLR we are proud to celebrate innova-tion. It is not necessarily good, and someproducts may mask risk with overcomplicatedlayers of packaged securities or derivatives. Butit is not necessarily bad either, and the lawyersthat worked on those deals deserve recognitionfor their hard work and, most of all, their inge-nuity.

At IFLR we are also rather proud of ourawards. As the only legal award that is trans-parent and specific with its criteria, the ownerof an IFLR trophy can feel he has been reward-ed for work well done and objectively judged.Not for some opaque combination of impor-tance, size or simply “having a great year”.

Throughout the 11 years they have beenrunning, IFLR has strived to reward genuinelegal innovation in European finance. That,

and nothing else. We analyse legal innovation,and nothing else.

Every year one or two firms don’t read ourcriteria correctly, and send us reams of infor-mation about how many lawyers they havehired. Some tell us they worked on all of thetop five deals last year. One or two protest thattheir deal had a lot of media coverage. Wedon’t care. IFLR only rewards legal innovation,and to an extent the market impact of thatinnovation.

This has created consistency. It means thatthe awards are transparent. The most innova-tive deals win, and the firms that worked onthose innovative deals win. Many awards cere-monies fall short of this transparency. No onereally knows why firms win awards. Clientsvote for their favourite firms, using whatevercriteria they prefer.

Here, we are proud of the analysis our jour-nalists put in every year. People trust ourawards, just like they trust our magazine. Theresearch process itself began in November andlasted right up until a few weeks ago. Thankyou very much to all those who took the timeto help, through providing information and

taking calls from our various journalists. I wish you all continued success in 2008.

Simon Crompton, IFLR editor

We are proud to celebrate innovation

Other nominated firms:Clifford ChanceFreshfields Bruckhaus DeringerShearman & Sterling

Paul Weiss Rifkind Wharton & Garrison rodethe wave of Asia’s private equity success storyin 2007.

The firm’s highlight was arguably its rolein Oaktree Capital’s $1 billion buyout ofFu Sheng in Taiwan. This was the first pri-vate equity buyout of a listed company inTaiwan, and acted as a benchmark for otherprivate equity hopefuls. The main obstaclescame from the regulators. With Taiwan’s StockExchange ailing, the FSC worried about pri-vate equity investors buying majority stakesand de-listing companies

Paul Weiss also acted as internationalcounsel for KKR’s investment in TianruiCement in China. This was a prime exam-ple of the recent move to onshore structuresin China.

Asia team of the yearPaul Weiss Rifkind Wharton & Garrison

Jeanette Chan and Jack Lange from Paul Weiss Rifkind Wharton & Garrison



Other nominated firms:Allen & OveryClifford ChanceLovells

Freshfields had a major role in two of theIFLR short-listed private equity deals. Itadvised CVC Capital partners on the sale ofits stake in ista International for $3.2 billion.The Freshfields private equity team also repre-sented Permira in its acquisition of ValentinoFashion and its subsidiary Hugo Boss.Thisdeal effectively created two public-to-privatetransactions in two jurisdictions (Italy andGermany) under the same deal umbrella

Elsewhere the firm advised Centaurus andPaulsson as major shareholders of Stork inrelation to Candover’s bid, Cinven on the dis-posal of Klöckner Pentaplast to an affiliate ofThe Blackstone Group for €1.3 billion andInvestor AB and Morgan Stanley PrincipalInvestments on their €2.85 billion acquisitionof Mölnlycke Health Care Group from Apax.

Europe team of the yearFreshfields Bruckhaus Deringer

Nick Shrimpton (centre) presents the award to Ludwig Leyendecker and Olivervon Rosenberg from Freshfields (left and right, respectively)

Simpson Thacher & Bartlett won roleson half of the deals shortlisted this year.The practice excelled in its representationof private equity firms in some of the

most significant transactions of the year.It acted for KKR in the First Data andTXU acquisitions. It also advisedBlackstone in its acquisition of Hilton.

Other nominated firms:Blakes Cassels & GraydonIn its representation of Hilton Hotelswhen Blackstone acquired the company,the firm took part in a trend of privateequity behaving like strategic investors.

Davis Polk & WardwellThe firm’s role representing the target inthe Citadel cash investment in E*TradeFinancial places the firm under consider-ation for team of the year.

Osler Hoskin & HarcourtThe firm’s role for KKR in its $29 billionacquisition of First Data helped to reopena sluggish market.

Schulte Roth & ZabelIt represented Cerberus in the highlytalked about acquisition of Chrysler,making one of America’s icons the prod-uct of a private equity buyout.

Sullivan & CromwellRepresented the targets on Hilton Hotelsand TXU - at $45 billion, the largest everUS leveraged buyout.

Americas team of the yearSimpson Thacher & Bartlett

Adele Bonnie of Simpson Thacher receives her award from Simon Crompton



CVC – Zhuhai ZhongfuThis deal marks the largest private equity

investment to date in tradeable A-shares of a

China-listed company. It is also the first control-

oriented Pipe (private investment in public equity)

deal in China involving a direct investment in

tradeable A-shares.

CClliiffffoorrdd CChhaannccee advised CVC Asia Pacific on

its acquisition of a 29% interest in tradeable A-

shares in Zhuhai Zhongfu Enterprise. JJuunn HHee also

advised CVC along with MMaapplleess && CCaallddeerr.

The deal took advantage of laws passed in

2006 that encouraged investors in the A-share

market. But these laws were drafted to appeal to

trade buyers not private equity investors, with the

necessity of a $500 million net capitalisation in

order to qualify – understandably difficult for a

company with no draw down.

Central Ministry of Commerce approval was

needed and despite being notoriously difficult to

achieve, was gained within six months. CVC and

Clifford Chance structured the entire deal before

approaching the Ministry. AAllpphhaa LLaaww FFiirrmmrepre-

sented Zhuhai Zhongfu.

Longreach – EnTieThis deal was the first majority buyout in the rapidly

consolidating Taiwanese banking industry. The

existing consumer credit problems in the sector,

which were compounded by the sub-prime fallout

and resulting credit crisis, were overcome.

The transaction was effected through a

unique and complex structure that involved the

issue of common shares and newly-issued Series

1 Convertible Perpetual Preferred Shares, which

are convertible into common shares at a one-to-

one ratio. It is also still rare for a (primarily)

Japanese fund to pursue a foreign business. It

inspired copycat deals, with other Japanese funds

showing signs of emulating Longreach’s outward-

looking business model.

SShheeaarrmmaann && SStteerrlliinnggacted as international

counsel for Longreach while DDeebbeevvooiissee &&

PPlliimmppttoonnrepresented Orix, the co-investor.

HHoouutthhooffff BBuurruummaaalso represented Longreach

alongside TTssaarr && TTssaaii LLaaww FFiirrmmand MMaapplleess &&

CCaallddeerr. LLeexxcceell LLaaww OOffffiicceessalso advised Orix.

Project CapricornThis was a $135 million structured equity-linked

private financing for an Indonesian coal mine

owned by PT Ilthabi Bara Utama (IBU).

The equity units entitle the holders to part of a

royalty stream that will be paid out of IBU’s Ebitda

and can be exchanged for equity in the unlisted

company once the notes expire or automatically

converted in the event of an initial public offering.

The deal is tightly structured and investors

have been granted full senior secured priority. In

addition, IBU can only draw down the funds on a

staggered basis, with each drawdown subject to

completion of pre-determined milestones.

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