In global practice, there exists a special type of security transaction where legal title to property transfers to the creditor (so-called title-based security). In a classic pledge, the creditor acquires only a pledge right over the encumbered property. Title-based security allows the creditor to avoid complexities in case of the debtor's default: the creditor does not need to go through the foreclosure procedure, as the property is already in their ownership. Russian legislation lacks systemic regulation of such security transactions (unlike the mentioned pledge). Nevertheless, the scheme of title-based security underlies certain contractual constructs, including the repo agreement.
Complex Structure
A repo agreement consists of two interconnected sale and purchase transactions of securities: a spot transaction – the sale of securities, and a forward transaction – the subsequent buyback of the securities. The transactions are conducted for the purpose of lending money or securities to market participants. The creditor receives income in the form of the price difference between the first and second parts of the transaction.
Two Owners
The legal nature of the repo agreement was a subject of dispute for a long time. A classic example of its non-recognition as an independent contractual construct is the Ruling of the Presidium of the Supreme Arbitrazh Court dated 06.10.1998 No. 6202/97. The highest instance recognized the repo agreement as a sham transaction.
Disputes were ended by amendments to the Federal Law No. 39-FZ "On the Securities Market" dated 22.04.1996 (hereinafter – the Securities Market Law), which came into force on January 1, 2010. The amendments enshrined the concept of a repo agreement (Art. 51.3 of the Securities Market Law).
But debates continue to this day. The problem lies in the discrepancy between the legal and "economic" owner of the securities upon concluding a repo agreement. For example, in tax legislation, securities belonging to a person received under a repo agreement are not taken into account when determining the person's share in an organization (clause 4, Art. 105.2 of the Tax Code). And the Central Bank of Russia instructed non-state pension funds (NPFs) to account for securities expected to be received under the second part of a repo agreement or subject to transfer under the second part of a repo agreement as part of the NPF's investment portfolio (Regulation of the Central Bank of Russia dated 01.03.2017 No. 580-P).
In some provisions of the Securities Market Law, the legislator also provides for caveats in the relationships between parties upon the transfer of securities (clauses 13, 14, 17, Art. 51.3 of the Securities Market Law). All examples demonstrate that:
Balance of Rights
The legislator did not provide special rules for the parties to a repo agreement regarding the distribution of corporate rights. Therefore, the buyer under the first part of the repo agreement independently and at its discretion exercises the voting right at the general meeting of shareholders. But if the seller in the spot transaction sells a large block of shares, they are interested in retaining the voting right. To achieve this, the parties may include a condition in the agreement that the seller votes by proxy issued by the buyer, or the buyer undertakes to vote in accordance with the seller's instructions.
With the bona fide execution of such a condition, the seller under the first part of the repo retains corporate control. But the buyer in the spot transaction may not issue or may revoke the proxy or fail to fulfill the obligation to vote as instructed by the seller. In such a case, the seller can only seek recovery of damages or a penalty, because they cannot compel the non-performing counterparty to issue a proxy for voting at the meeting.
Violation of Minority Shareholders' Rights
If a person, acquiring a block of shares, crosses the ownership threshold of 30/50/75%, they must make a mandatory offer to the remaining shareholders to acquire their shares. This obligation arises if the person becomes the owner of the securities, meaning it acquires legal title to them.
The seller under the first part of the repo does not fall under the requirement of the law on the mandatory offer because formally they transferred title to another person. This can lead to a violation of minority shareholders' rights, as the seller retains "economic" ownership of these securities and possesses corporate control over the company.
Repo – A Loophole for Shareholders
To avoid making a mandatory offer, a shareholder can artificially reduce their ownership threshold. They can do this by transferring securities into a repo.
Company "A" acquires 25% of the shares of public company "B". 20% of these shares are transferred into a repo. Then, Company "A" acquires another 20% of Company "B"'s shares and immediately also transfers them into a repo. Then the company again acquires 10% of Company "B"'s shares. As a result, while formally owning 15% of Company "B"'s shares, Company "A" actually controls 55% of Company "B"'s shares (provided that such a repo agreement contains a condition allowing Company "A" to somehow dispose of the votes at the general meeting of shareholders).
The seller of the securities or the "economic" owner can maintain this position for a long time. If a person crosses the statutory threshold for ownership of shares in a public company, the obligation to make a mandatory offer may not be performed if said person and/or its affiliates alienated said securities, resulting in the number of shares no longer exceeding the threshold value (for example, Ruling of the Supreme Arbitrazh Court dated 12.02.2013 No. VAS-820/13 in case No. A12-16867/2011). After concluding the forward transaction, the buyer merely needs to transfer the securities into a repo again within the specified period, and the obligation to make a mandatory offer disappears once more.
How to Change the Existing Approach
The problem is that the criterion formulated in the law – the acquisition of ownership rights to securities – narrows the circle of persons obliged to make a mandatory offer. Changing the criteria (expanding them) would prevent the described abuses. Interestingly, EU Directive 2004/25/EC of 21 April 2004 on takeover bids (hereinafter – the Directive), which formed the basis of the domestic approach to regulating transactions with large shareholdings, contains a different approach to determining the circle of persons obliged to make a mandatory offer. According to Art. 5 of the Directive, the obligation to make an offer arises also for a person who does not own shares of the company but has a certain level of corporate control on the grounds that the company's shares belong to a person acting in concert with them.
A Different Approach
The provisions of the Directive use the concept of "persons acting in concert," who cooperate with the person obliged to make a mandatory offer or with the company whose shares are the subject of the mandatory offer for the purpose of obtaining corporate control or frustrating the successful outcome of the making of a mandatory offer (Art. 2 of the Directive).
In 2012, the Supreme Arbitrazh Court attempted to improve the approach to determining the circle of persons obliged to make an offer. The Private Law Department of the Supreme Arbitrazh Court prepared and published a draft information letter "On Certain Issues of Practice in the Application of Chapter XI.1 of the Federal Law 'On Joint-Stock Companies' by Arbitrazh Courts" (hereinafter – the draft letter). Its provisions proposed expanding the list of circumstances upon the occurrence of which the obligation to make a mandatory offer arises (clause 14 of the draft letter):
Interestingly, one of the circumstances proposed to trigger the mandatory offer mechanism is the transfer of securities to a trustee. Drawing a direct analogy between a trust management agreement and a repo agreement is incorrect for many reasons; however, in both cases, there exists an "economic" owner who may retain corporate control.
The draft letter attempts to move away from legal title as the sole criterion for corporate control. Such clarification would not completely solve the problem outlined above but demonstrates the need to change the approach existing in the legislation.
The State Duma adopted in the first reading the draft Federal Law No. 1036047-6 dated 05.04.2016. According to the Draft, a mandatory offer must be made by a person who has obtained the right to dispose, independently or jointly with persons controlled by it and persons controlling it, of more than 30% of the votes attributable to the shares of a public company. The proposed formulation – the right to dispose of votes – allows considering any methods of indirect control (for example, arising from a change in the controlling person of a shareholder of a public company; conclusion of a shareholders' agreement or a repo agreement, as analyzed above) as sufficient grounds for the obligation to make a mandatory offer. We can assess such a change exclusively positively.
Complex Structure
A repo agreement consists of two interconnected sale and purchase transactions of securities: a spot transaction – the sale of securities, and a forward transaction – the subsequent buyback of the securities. The transactions are conducted for the purpose of lending money or securities to market participants. The creditor receives income in the form of the price difference between the first and second parts of the transaction.
Two Owners
The legal nature of the repo agreement was a subject of dispute for a long time. A classic example of its non-recognition as an independent contractual construct is the Ruling of the Presidium of the Supreme Arbitrazh Court dated 06.10.1998 No. 6202/97. The highest instance recognized the repo agreement as a sham transaction.
Disputes were ended by amendments to the Federal Law No. 39-FZ "On the Securities Market" dated 22.04.1996 (hereinafter – the Securities Market Law), which came into force on January 1, 2010. The amendments enshrined the concept of a repo agreement (Art. 51.3 of the Securities Market Law).
But debates continue to this day. The problem lies in the discrepancy between the legal and "economic" owner of the securities upon concluding a repo agreement. For example, in tax legislation, securities belonging to a person received under a repo agreement are not taken into account when determining the person's share in an organization (clause 4, Art. 105.2 of the Tax Code). And the Central Bank of Russia instructed non-state pension funds (NPFs) to account for securities expected to be received under the second part of a repo agreement or subject to transfer under the second part of a repo agreement as part of the NPF's investment portfolio (Regulation of the Central Bank of Russia dated 01.03.2017 No. 580-P).
In some provisions of the Securities Market Law, the legislator also provides for caveats in the relationships between parties upon the transfer of securities (clauses 13, 14, 17, Art. 51.3 of the Securities Market Law). All examples demonstrate that:
- *De facto*, the "economic" owner of the securities remains the original seller;
- The legislator takes this circumstance into account and, when economic possession of securities is of paramount importance, provides for corresponding caveats in the norms.
Balance of Rights
The legislator did not provide special rules for the parties to a repo agreement regarding the distribution of corporate rights. Therefore, the buyer under the first part of the repo agreement independently and at its discretion exercises the voting right at the general meeting of shareholders. But if the seller in the spot transaction sells a large block of shares, they are interested in retaining the voting right. To achieve this, the parties may include a condition in the agreement that the seller votes by proxy issued by the buyer, or the buyer undertakes to vote in accordance with the seller's instructions.
With the bona fide execution of such a condition, the seller under the first part of the repo retains corporate control. But the buyer in the spot transaction may not issue or may revoke the proxy or fail to fulfill the obligation to vote as instructed by the seller. In such a case, the seller can only seek recovery of damages or a penalty, because they cannot compel the non-performing counterparty to issue a proxy for voting at the meeting.
Violation of Minority Shareholders' Rights
If a person, acquiring a block of shares, crosses the ownership threshold of 30/50/75%, they must make a mandatory offer to the remaining shareholders to acquire their shares. This obligation arises if the person becomes the owner of the securities, meaning it acquires legal title to them.
The seller under the first part of the repo does not fall under the requirement of the law on the mandatory offer because formally they transferred title to another person. This can lead to a violation of minority shareholders' rights, as the seller retains "economic" ownership of these securities and possesses corporate control over the company.
Repo – A Loophole for Shareholders
To avoid making a mandatory offer, a shareholder can artificially reduce their ownership threshold. They can do this by transferring securities into a repo.
Company "A" acquires 25% of the shares of public company "B". 20% of these shares are transferred into a repo. Then, Company "A" acquires another 20% of Company "B"'s shares and immediately also transfers them into a repo. Then the company again acquires 10% of Company "B"'s shares. As a result, while formally owning 15% of Company "B"'s shares, Company "A" actually controls 55% of Company "B"'s shares (provided that such a repo agreement contains a condition allowing Company "A" to somehow dispose of the votes at the general meeting of shareholders).
The seller of the securities or the "economic" owner can maintain this position for a long time. If a person crosses the statutory threshold for ownership of shares in a public company, the obligation to make a mandatory offer may not be performed if said person and/or its affiliates alienated said securities, resulting in the number of shares no longer exceeding the threshold value (for example, Ruling of the Supreme Arbitrazh Court dated 12.02.2013 No. VAS-820/13 in case No. A12-16867/2011). After concluding the forward transaction, the buyer merely needs to transfer the securities into a repo again within the specified period, and the obligation to make a mandatory offer disappears once more.
How to Change the Existing Approach
The problem is that the criterion formulated in the law – the acquisition of ownership rights to securities – narrows the circle of persons obliged to make a mandatory offer. Changing the criteria (expanding them) would prevent the described abuses. Interestingly, EU Directive 2004/25/EC of 21 April 2004 on takeover bids (hereinafter – the Directive), which formed the basis of the domestic approach to regulating transactions with large shareholdings, contains a different approach to determining the circle of persons obliged to make a mandatory offer. According to Art. 5 of the Directive, the obligation to make an offer arises also for a person who does not own shares of the company but has a certain level of corporate control on the grounds that the company's shares belong to a person acting in concert with them.
A Different Approach
The provisions of the Directive use the concept of "persons acting in concert," who cooperate with the person obliged to make a mandatory offer or with the company whose shares are the subject of the mandatory offer for the purpose of obtaining corporate control or frustrating the successful outcome of the making of a mandatory offer (Art. 2 of the Directive).
In 2012, the Supreme Arbitrazh Court attempted to improve the approach to determining the circle of persons obliged to make an offer. The Private Law Department of the Supreme Arbitrazh Court prepared and published a draft information letter "On Certain Issues of Practice in the Application of Chapter XI.1 of the Federal Law 'On Joint-Stock Companies' by Arbitrazh Courts" (hereinafter – the draft letter). Its provisions proposed expanding the list of circumstances upon the occurrence of which the obligation to make a mandatory offer arises (clause 14 of the draft letter):
- acquisition of direct or indirect control over a company that owns shares of the society;
- appointment of a person to the management bodies of the society;
- transfer of securities to a trustee.
Interestingly, one of the circumstances proposed to trigger the mandatory offer mechanism is the transfer of securities to a trustee. Drawing a direct analogy between a trust management agreement and a repo agreement is incorrect for many reasons; however, in both cases, there exists an "economic" owner who may retain corporate control.
The draft letter attempts to move away from legal title as the sole criterion for corporate control. Such clarification would not completely solve the problem outlined above but demonstrates the need to change the approach existing in the legislation.
The State Duma adopted in the first reading the draft Federal Law No. 1036047-6 dated 05.04.2016. According to the Draft, a mandatory offer must be made by a person who has obtained the right to dispose, independently or jointly with persons controlled by it and persons controlling it, of more than 30% of the votes attributable to the shares of a public company. The proposed formulation – the right to dispose of votes – allows considering any methods of indirect control (for example, arising from a change in the controlling person of a shareholder of a public company; conclusion of a shareholders' agreement or a repo agreement, as analyzed above) as sufficient grounds for the obligation to make a mandatory offer. We can assess such a change exclusively positively.