New Zealand Court Of Appeal recognises "market reality" in overturning lower court decision in equity swaps case

David Craig, Partner | November 2003

In a unanimous decision handed down on 4 November, the full bench of the New Zealand Court of Appeal overturned the decision of the High Court in Ithaca (Custodians) Limited v Perry Corporation. The Court of Appeal's decision will be welcomed by participants in the equity swaps markets, who would have been unsettled with the ease at which the High Court inferred an "arrangement or understanding" giving rise to a disclosable "relevant interest" for the purposes of the Securities Markets Act 1988 (the Act).

The Court of Appeal's judgment is littered with phrases that will be well received by the business world, such as "commercial reality", "practical business sense" and, in particular, "market reality". In fact, the latter phrase is the key to the Court's decision.

This newsletter outlines the broad basis for the decision principally as it affects the equity swaps market. However, the decision and its reasoning are complex and, together with another recent Court of Appeal decision on other aspects of the substantial security holder disclosure regime in New Zealand and the decision's broader ramifications require careful analysis.

The facts and the High Court decision - a recap

We outlined the facts of this case, and the relevant legislation, in our March 2003 newsletter. In summary, GPG alleged that Perry had an "arrangement or understanding" with its two equity swap counterparties, Deutsche and UBS, under which Perry had the power to acquire the underlying shares in Rubicon (an NZX-listed company) held by the counterparties as a hedge. That "arrangement or understanding" gave rise to a "relevant interest" that was required to be (but was not) disclosed pursuant to the Act.

The High Court agreed with GPG. It held that:

• in relation to cash-settled equity swaps generally, the floating rate payer has no "relevant interest" in the underlying shares;
  
  
• however, in relation to the particular facts of this case, Perry retained a "relevant interest" in the Rubicon shares sold to, and held by, Deutsche and UBS as a hedge.

As Perry had not complied with its disclosure obligations under the Act in relation to that "relevant interest", the High Court ordered, among other things:

• the forfeiture of 12,000,000 shares; and
  
  
• the sale of the remaining 24,000,000 shares subject to the equity swaps.

The issues on appeal

The issues for the appeal were:

• whether the High Court was correct in holding that an "arrangement or understanding" existed between Perry and the swap counterparties giving rise to a "relevant interest" in the Rubicon shares;
  
  
• if not, whether Perry nonetheless had a relevant interest by virtue of section 5(2) of the Act (which states that, where a person has a "relevant interest" in shares but is "accustomed to act" in accordance with the directions of another person, that other person also has a "relevant interest"); and
  
  
• if there was a relevant interest, whether the High Court's orders were disproportionate to the breach or otherwise inappropriate.

The Court of Appeal's decision

Issue one - was there an "arrangement or understanding"?

The Court of Appeal was asked to consider two sub-issues:

• whether the mere entry into these particular equity swaps constituted an "arrangement or understanding" giving rise to a "relevant interest" because of the inevitability of the Rubicon hedge shares being available for repurchase; and
  
  
• if not, whether the High Court was correct in holding that there was an actual "arrangement or understanding" giving rise to a "relevant interest".

Was there an "arrangement or understanding" because the Rubicon hedge shares were inevitably available for repurchase?

The Court of Appeal concluded that, because of the illiquidity of Rubicon shares, it was almost certain (if not inevitable) that those shares would be held by both counterparties as a hedge for the duration of the swap. This was despite the fact that the counterparties were free at all times to use the hedge shares for their own purposes (such as in a securities lending transaction). Furthermore, the Court of Appeal's view was that those hedge shares would inevitably have been available for purchase by Perry on termination of the swaps if it wished to do so.

However, these "market realities" alone did not mean that the equity swap transactions constituted an "arrangement or understanding" to which the Act applies. This is because, in order for there to be an "arrangement or understanding", there must be communication and consensus between the parties. Mere mutual expectations based on commercial reality, but without consensus or communication, are not sufficient to give rise to an "arrangement or understanding".

In reaching this conclusion, the Court of Appeal was influenced by the policy issues involved in extending the disclosure requirements to the extent sought by GPG. In the Court's view, such an extension would "mean that the majority of equity swaps in New Zealand would create disclosure requirements, whether cash-settled or not" (at para 76). The Court also acknowledged that such an extension would take New Zealand out of line with a number of other important jurisdictions (such as Australia, the United States and the UK).

Was there an actual "arrangement or understanding"?

The Court of Appeal considered in turn each of the factors that the High Court had relied on in reaching its conclusion that an actual "arrangement or understanding" existed. The Court of Appeal's overall conclusion was that the factors that could raise a reasonable suspicion of an arrangement were clearly outweighed by those pointing to there being no arrangement, but merely the operation of market reality.

In commenting on some of the specific factors relied on by the High Court, the Court of Appeal echoed some of the views expressed in our March newsletter. For example, the Court of Appeal held that:

• Entering into an equity swap for the purpose of avoiding the Act's disclosure obligations is a legitimate purpose and one that does not necessarily signal the existence of a side arrangement or understanding.
  
  
• Rubicon's description and treatment of Perry as a major shareholder could be explained as merely a "convenient shorthand" in a context where all involved were clearly aware of the true situation. Furthermore, the Court stated that it would have been surprised if Rubicon had treated Perry other than in the manner it did:
  
  Indeed, the reality of the commercial world is that companies must take into account the interests of a number of stakeholders. Depending on the circumstances the voting shareholders may not even be the most important group. (At para 97)
  
  
• The High Court's focus on the wording used in a conversation between Perry's head trader and a Deutsche salesperson (which included expressions such as "take the shares back" and "unwind the swap") was less than helpful. The Court of Appeal stated that:
  
  People in ordinary business situations cannot be expected to speak with the precision that one would do if seeking to elucidate legal relationships. (At para 125).
  

As well as disagreeing with the factors that the High Court had held supported the existence of an "arrangement or understanding", the Court of Appeal also disagreed with factors that the lower court regarded as being neutral.

Specifically, the Court of Appeal was of the view that evidence given by certain Deutsche and UBS employees as to the division of functions within the respective banks was "of central importance" (at para 172). The Court of Appeal accepted the existence of a division between sales functions (which involve client contact) and hedging functions (which do not). Given this strict division, sales staff are not in a position to enter into the types of arrangements that were alleged to exist in this case as they cannot control the use of hedge shares during the term of a swap.

The second issue - does section 5(2) apply?

If Deutsche Bank and UBS were "accustomed to act" in accordance with Perry's directions, instructions or wishes in relation to dealings with the underlying Rubicon shares, this would have given rise to a relevant interest for Perry pursuant to section 5(2) of the Act. While the Court acknowledged that the swap counterparties had, on occasion, accommodated Perry as to the timing and means of swap unwinds and the sale of hedge shares, this was largely as a result of the counterparties operating in their commercial interests. The fact that those interests may coincide with the interests of their client did not necessarily mean that section 5(2) would apply.

The third issue - were the High Court's ordersdisproportionate or inappropriate?

Given that the Court of Appeal concluded that there were no reasonable grounds for suspecting that Perry had a relevant interest in the Rubicon hedge shares, it was not necessary for the Court to consider the appropriateness of the forfeiture and divestiture orders made by the High Court.

Implications for equity swap counterparties

• The Court of Appeal confirmed that the mere entry into a cash-settled equity swap does not, of itself, give rise to a "relevant interest". Something more is required, such as a side agreement in relation to hedge shares. Counterparties should confirm by way of a "single agreement" clause that no such side agreements exist and should ensure that this is the case in fact.
  
  
• The Court of Appeal accepted that, when the underlying shares are sold to the floating amount payer at the outset and repurchased at termination, it is more likely that an arrangement exists than if that were not the case. However, there would still need to be a reason for that arrangement, which will, on the basis of the Court of Appeal's reasoning, be difficult to establish where (as in the Perry case) "market reality" in practice performs the same function as such an arrangement. It follows, therefore, the most "at risk" transactions would have an initial sale and a subsequent repurchase and would involve liquid, high capitalisation shares. Put another way, it is important to realise that the decision does not mean that an equity swap cannot give rise to a "relevant interest" that would require disclosure under the Act. The Court of Appeal says (at para 76) that "the regime conceptually is directed at voting rights rather than economic interests. Most equity swaps create only economic interests".
  
  
• The Court of Appeal was influenced by the fact that both Deutsche and UBS maintained a strict division between their sales and hedging functions and that this was reinforced by the banks' legal departments. Clearly, it is helpful for swap counterparties to be able to point to such internal policies and (more importantly) to be able to show that they are adhered to.
  
  
• While this decision should be seen as endorsing a "business as usual" policy for most swap counterparties, the matter may not be at an end. GPG has not yet publicly announced whether it will appeal the Court of Appeal's decision to the Privy Council, New Zealand's highest court. The decision has already provoked considerable comment from both legal commentators and business people.
  

(Disclosure of interest: Bell Gully represented Rubicon in the Perry case. The views expressed in this note are solely those of the author. They do not necessarily represent the views of Bell Gully or any of its clients.)