U.S. Legal Issues For Non-U.S. Equity Derivative Market Participants: A Primer - Part 1

Many trades are executed in the U.S. markets on behalf of non-U.S. clients who wish to hedge or monetize positions in the American Depositary Receipts or common stock of non-U.S. issuers that trade substantially in the U.S.

Many trades are executed in the U.S. markets on behalf of non-U.S. clients who wish to hedge or monetize positions in the American Depositary Receipts or common stock of non-U.S. issuers that trade substantially in the U.S. The following is a primer on some of the U.S. legal issues that usually need to be considered before executing these trades, especially when the client is an “insider”.

Check The Facts

Cross-border trades often involve senior officers, directors, or large shareholders of the issuer, who are generally considered to be insiders or affiliates under U.S. securities laws, and whose trades in the U.S. markets accordingly are heavily regulated by the Securities and Exchange Commission. Understanding the client’s relationship to the issuer is important in deciding which trades the client can do in the U.S., and when.

Established non-U.S. issuers whose shares trade on a U.S. exchange typically file detailed annual reports with the SEC on Form 20-F. Non-U.S. companies that have recently had their IPO in the U.S. will have filed the offering prospectus and other documents on Form F-1. These filings can be found on the SEC’s Web site.

In the 20-F, there is extensive information about management and large shareholders in Items 4, 6 and 7, including the number and percentage of shares owned by each individual and a summary of any special contracts or arrangements that the company has with such persons. In an F-1, this information appears under Management, Principal and Selling Shareholders, Related Party Transactions, and Shares Eligible for Future Sale.

Contractual Issues

The Form 20-F or F-1 may show the client has entered into contracts that affect the client’s ability to trade or hedge. Joint control agreements often exist and often prohibit any transfer of the client’s shares without the prior written consent of the other parties to the agreement. Many agreements prevent the client from placing any lien on the shares, which of course may raise credit issues. If the company has recently had its IPO, there are almost always lockup agreements between the insiders and the underwriters, in which the insiders agree not to sell or transfer their shares for six months or more.

General Insider Trading Rule (Rule 10b-5); “Plan” Exception (Rule 10b5-1)

In the U.S. market, regardless of whether the issuer is a U.S. company, anyone who has material non-public information about the issuer and who can be said to owe it a duty of non-disclosure--insiders, employees, their spouses and relatives, and also advisors, such as attorneys and accountants--is prohibited by Rule 10b-5 under the Securities Exchange Act from trading on the basis of such information.

The SEC enforces this prohibition much more vigorously than most securities regulators outside the U.S. Accordingly, publicly traded U.S. companies prohibit trades in their stock by their insiders--and often by all employees--at least four times each year, during the periods beginning when an insider might reasonably begin to have a good idea of how the company’s fiscal quarter will turn out, and ending one or two days after the announcement of earnings for that quarter. For the same reason, U.S. companies also prohibit trades by their insiders whenever the company is engaged in serious discussions about a material acquisition, merger, sale of assets, purchase of assets, spin-off, etc. Periods during which insiders or other employees are prohibited from trading are often called blackout periods.

Rule 10b5-1 was intended in part to make it easier for insiders to trade during blackout periods if they have previously set up written plans that contain a formula for the amount and price of the securities to be traded and the dates of the trades. Such plans must be set up at a time when the insider does not have material non-public information.

A simple example would be the ceo of a calendar-year company entering into a written plan with a broker-dealer two days after the ceo’s company announces 4th quarter earnings. The written plan would provide for the broker-dealer to sell 5,000 shares for the ceo on every trading day for the next six months, at the closing price. Even though the company would generally prohibit trades by its insiders between mid-March and the announcement of first quarter earnings in mid-April, and again near the end of the second quarter, the ceo’s sales under the Rule 10b5-1 plan could continue.

Rule 10b5-1 can be used for a hedging transaction such as a costless collar or a variable prepaid forward, if the trade confirmation is properly prepared and (if applicable) the requirements of Rule 144 are met (see the discussion in next week’s Learning Curve). This can be helpful on trades with large notionals relative to the trading volume.

The rule also permits insiders to enter into plans that give a dealer full discretion to execute the trades. Such a plan must not permit the insider to exercise subsequent influence over how, when or whether to effect purchases or sales, and must prohibit any other person from exercising influence over the plan while in possession of material non-public information.

Ownership Reports: Schedules 13D, 13G

Like several countries in the E.U. and Asia, the U.S. requires reports of ownership positions in publicly traded companies. These reports are required to be filed with the SEC--and are thus publicly available--by any beneficial owner of more than 5% of the shares of a class of voting securities of a company, if that class is traded or quoted in the U.S. There is no exemption for non-U.S. owners and no netting of short positions and long positions is permitted. Indirect ownership through options, warrants, preferred stock or convertible bonds counts, as long as the instrument is exercisable or convertible in the next 60 days, even if it is out of the money, and regardless of whether it is listed or over-the-counter.

Beneficial ownership means that the person has or shares the right to (i) vote the stock, or (ii) dispose of the stock. If a person has the right to acquire beneficial ownership in the next 60 days, that person is considered to be a beneficial owner now. Various rights, if available in the next 60 days, including the right to exercise an option or warrant, or to convert a convertible bond or preferred stock, will be considered beneficial ownership of the underlying shares today.

The SEC also requires reporting of ownership by groups, which are broadly defined as two or more people or entities which have agreed with each other in writing or orally regarding the acquisition, disposition or holding of securities. If a 2% owner and a 4% owner enter into a voting agreement that includes all their shares, they are likely to be considered a 6% group, and need to file a report.

There are two forms used for the ownership report: Schedule 13D and Schedule 13G. The 13D report requires much more detail and needs to be amended to reflect changes much more quickly than the 13G report. Once a person starts filing on 13D, and as long as that person continues to beneficially own more than 5% of the class, any trade of 1% or more of the class must be described promptly in an amendment, and the trade confirmation must be filed as an exhibit to the amendment.

Pre-IPO holders are entitled to file on 13G, unless they build up their position after the IPO by more than 2% of the outstanding, in any 12-month period. Passive holders who acquire their shares post-IPO may be able to file on 13G if they own less than 20% of the class and they do not have the purpose or intent of changing or influencing the control of the company. Certain other holders are also permitted to file on 13G.

Mechanical Insider Trading Rule (Section 16, Securities Exchange Act)

This rule is harsh, complex, and potentially very costly, but it seldom applies to non-U.S. issuers. It generally only applies if more than 50% of the issuer’s voting securities are held of record in the U.S., and any one of the following also applies:

* a majority of the executive officers or directors are U.S. citizens or residents,

* the business of the issuer is principally administered in the U.S., or

* more than 50% of the assets are in the U.S.

This week’s Learning Curve was written by Steve Gray, a director in the legal department at Credit Suisse in New York and James Rothwell, partner at Davis Polk & Wardwell in New York.