NEWS ANALYSIS: Porsche-VW highlights inadequacies of German system

By Philip Lamb and Nadim Khan, Lewis Silkin Hedge funds may have lost as much as €30 billion after their moves to short sell VW stock backfired. In a surprise announcement Porsche revealed it had covertly acquired a further 31.5% stake in VW through the purchase of cash-settled call options on top of the 42.6% it already owned. Since the German state of Lower Saxony owned 20% of VW, that meant only about 6% of VW shares were left on the market.

The realisation there were not enough shares available to cover their positions sent short sellers into panic to cover their bets. VW's shares soared by as much as 200% as funds scrambled to buy shares to close their short positions and fulfil their delivery obligations.

The two days of frantic trading has led to what is thought to be one of the heaviest losses on a single company's shares ever taken by hedge funds.

Porsche, which has claimed to have acted within German law by covertly increasing its VW holding, said it would give up 5% of the company in order to allow hedge fund obligations to be settled and to “avoid further market distortions”

Porsche said it was not behind any of what it called market distortions. "Porsche SE denies all responsibility for these market distortions and for the resulting risks to which the short sellers have exposed themselves," it said in a statement. It said it had complied with the law and had not been active in the market during the share price movements, denying any allegations of price manipulation.

To people conversant with the UK markets, the idea of a shareholder being able to increase secretly holdings in a publicly quoted company from 42% to 74% is difficult to grasp. The concept of ‘creeping control’ has long been regulated by the UK Takeover Panel. Transparency has been a hot topic in the UK public markets for a number of years, including the adoption of the European Union’s Transparency Directive and the Disclosure Rules and Transparency Rules (DTRs).

The DTRs require disclosure of voting rights attached to shares. Notification must be made once a shareholding of 3% or more is acquired and for every 1% increase above the 3% threshold (or disposals falling below those thresholds) regardless of whether a takeover is contemplated.

The reason the VW situation could not happen in the UK is because of the City Code on Takeovers and Mergers. These rules include an obligation, where a company is in a takeover situation, for any holder who has an interest of 1% or more of the company's securities to disclose any dealing, including the acquisition of derivatives, in the target company's securities.

When a person holds between 30% and 50% of the voting rights of a quoted company, irrespective of whether it is in a takeover situation, a purchase of an interest in one share (will trigger a rule 9 mandatory bid.

The definition of ‘interests in securities’ under the code would have covered the option arrangements entered into by Porsche and it would have had to announce immediately a bid on acquisition of the first option.

With good timing, the UK Financial Services Authority (FSA) released its draft rules for a more comprehensive, disclosure regime just as the Porsche story broke. This will bring the FSA regime into line with the Takeover Code and will require the disclosure of all economic interests above the 3% threshold held through contracts for differences or other equity derivatives, regardless of the holder’s control over voting rights.

Direct and indirect holdings will need to be aggregated going forwards. Final rules will be published in February 2009 with implementation due by September 2009. UK rules do not actively encourage or discourage stake building. They only require disclosure of it.

With the adoption of the EU’s Market Abuse Directive, the FSA has retained ‘super-equivalent’ provisions including acts which amount to misleading behaviour or market distortion. Failure to disclose significant short positions is now evidence of market abuse.

It must be questionable whether Porsche’s behaviour would have amounted to market abuse under the FSA’s Code of Market Conduct in the UK. Porsche itself talked about market distortions while denying it had any part in them.

The Porsche saga has demonstrated that the UK markets continue to lead the way in regulating disclosure and encouraging transparency. The problem faced for regulators has been in keeping up with the increasingly complex financial instruments developed by the markets.

It cannot be healthy for the efficient functioning of the markets that control of large quoted public companies can change hands under the counter. Transparency leads to fairer dealing for all in the market, with investors having access to the same information, something which the German regulatory authorities are no doubt looking at urgently given the scale of the losses.