May 2006

Investment Banking Update

An introduction to block trades

Block trades are secondary sales of large blocks of existing shares. They can provide a rapid and efcient solution for holders of substantial equity stakes wishing to monetise their positions through the equity capital markets. Typically these transactions are launched, executed and priced on a fast-track basis, sometimes within a 24-hour period.
Since January 2000, offering sizes have varied between 2.3 million and 5.9 billion. Block trades are generally best suited to liquid, well-researched stocks. In a block trade, investors are not given a prospectus: the shares are marketed to institutional investors through telephone calls. This update outlines the possible structures and timetables that can be adopted by sellers when executing block trades and examines some of the key issues that can arise during the specic stages of a block trade - before launch, documenting the block trade, disclosure and after announcement.

Timetable
There are two general approaches to a block trade timetable. In the rst, the seller appoints the manager in advance. This is most frequently used for AEOs but can be followed for both bought deals and back-stopped deals. The manager and the seller will rst agree on the purchase agreement, conduct due diligence, prepare announcements and take care of any formalities (see below). They will then launch the block trade when they believe the time is right. In the alternative approach, the manager is appointed in a competitive process immediately before the block trade is launched. In this case, the timetable is inevitably highly challenging. The seller, sometimes a state institution and sometimes a private seller, invites bids for a block of shares it wishes to sell. It does so by having one of its advisers (frequently a law rm) call a pre-determined list of investment banks (as potential managers) to alert them to the block trade. Sometimes the investment banks will be asked to sign a condentiality letter at this point. The condentiality letter (if used) will be sent after markets close and usually arrives around 5.00 pm. It will not disclose the underlying securities, but will require the interested parties to agree to be bound by an obligation of condentiality in return for the disclosure of details of the intended block trade transaction. Condentiality letters vary in scope, but sometimes contain additional provisions intended to prevent unsuccessful bidders from selling short the relevant shares or taking other action which might have an adverse effect on the proposed transaction. These restrictions can sometimes be onerous, and it is important to ensure that a representative of the equities trading arm of a participating investment bank is comfortable with them before the condentiality letter is signed by that bank. The sellers advisers will then circulate a package of documents, including an invitation to tender a bid, a draft timetable, a draft purchase agreement with schedules including an investor representation letter (if applicable), and, frequently, forms of supporting legal opinion (see Stage 2 below).

Structure and timing

A block trade can be structured in a number of ways: Bought deal. In a bought deal, the investment bank acting as manager of the block trade buys the shares from the seller before it starts its marketing efforts. The manager will generally resell the shares as soon as possible after they are acquired from the seller. To the extent that it is able to resell the shares at a higher price, the manager will keep the difference. Non-risk deal. This is often known as an accelerated equity offering (AEO). Here, the manager will build a book of demand for the seller before agreeing on a price (based on that demand). Frequently, the manager will receive a commission from the seller. Sometimes the manager will earn an agreed spread. Back-stopped deal. This falls somewhere between a bought deal and an AEO. In a back-stopped deal, the manager does not take the shares onto its own books before marketing (as with a bought deal), but it does guarantee the selling shareholder a minimum price.

Brussels Dubai Frankfurt London Madrid Milan Munich New Delhi New York Paris Singapore Tokyo

An example of a typical timetable is set out below: T-1 5.00 pm 5.30 pm Condentiality letter circulated Package of tender documents circulated to invited banks who have signed the condentiality letter Deadline for invited banks to submit bids Notication to successful manager(s) Conference call between seller and manager(s) Purchase agreement executed Launch of transaction Announcement of transaction Closing of books (potential to close earlier depending on how the deal is going) Settlement and delivery

with the issuer to assure itself that no material disclosures are imminent and that trading is in line with market expectations. The safest time to conduct a block trade is shortly after the publication of the issuers nancial results: all material information concerning the issuer can then reasonably be presumed to be in the public domain. If the issuer is a UK listed company and the seller is a body corporate in which a person discharging management responsibilities within the issuer is a director or senior executive with power to make management decisions, then the trade cannot take place during a close period as dened in the Model Code in Annex 1 to Chapter 1 of the UK Listing Authoritys Listing Rules (being 60 days before the preliminary announcement of its annual results, 60 days before the publication of its half-yearly report and 30 days before the announcement of its quarterly results (if applicable)) (paragraph 21, the Model Code and section 96B, Financial Services and Markets Act 2000 (FSMA)). Insider dealing is punishable by a ne or imprisonment (section 61, Criminal Justice Act 1993 (1993 Act)). Sounding out the market

7.00 pm 7.30 pm

8.00 pm T Before 8.00 am 4.30 pm

T+3

Timetable in stages and key issues

Stage 1 - Pre-launch
Before a block trade is announced, the parties will need to address the following issues: Due Diligence

The scope of the due diligence exercise for a block trade varies based on the circumstances of the transaction, the relationship between the manager and the issuer and the relationship between the seller and the issuer (for example, if the manager is the issuers corporate broker, it will already know the issuer well, so a shorter due diligence exercise might be needed). In any event, the scope of the due diligence exercise for a block trade is different from that of an initial public offering (IPO). The shares will already be listed and there will be signicant amounts of publicly available information, including annual reports, other nancial and corporate announcements and independent research reports. This is unlike an IPO, where marketing efforts are focused on a prospectus specially prepared for the offering. Timing

Successfully and protably bidding for block trades requires a good knowledge of the market dynamics of the relevant stock and the sector in which its issuer operates. It also requires a good sense of the likely appetite of investors. Getting this wrong can lead on the one hand to a failure to bid competitively for the block, and on the other to the incurring of a nancial loss. For this reason banks sometimes sound out the market by calling potential investors to assess their likely appetite before bidding for a block of shares at a particular price. The following legal and regulatory constraints should, however, be borne in mind before undertaking any market soundings: Insider dealing/market abuse. The fact that a particular prospective seller (or even an unnamed seller) is contemplating a substantial sale of specied securities is likely in itself to be inside information for the purposes of the criminal insider dealing legislation (1993 Act) and the market abuse legislation (Market Abuse Directive (2006/6/EC) (MAD) and FSMA). Market abuse is punishable by the Financial Services Authority (FSA) by an unlimited ne or public censure (section 123, FSMA). If, however, the identity of the issuer of particular securities is not disclosed (either expressly or by implication given the investment banks or the markets existing knowledge), any information relating to a potential sale will not be inside information within the meaning of the 1993 Act because it does not relate to

Managers will not usually wish to undertake a block trade in the shares of an issuer that will shortly report nancial results. Block trades will usually take place at least four weeks before the relevant announcement, although this may be reduced in exceptional circumstances. In any such case, the manager is likely to require a due diligence call

particular securities or to a particular issuer or issuers of securities and, though this is less clear, it is unlikely that such information would be inside information or relevant information under MAD (for similar reasons). If information disclosed by a potential seller to the investment bank is inside information/relevant information, the dissemination of that information to third parties before any announcement of a transaction will potentially constitute an insider dealing offence and/or market abuse, unless a defence or safe harbour applies. In relation to market abuse, it is possible that any dealing activity or dissemination of information would fall within the legitimate business or dutiful execution of client order safe harbours under the Code of Market Conduct in the FSAs Handbook of rules and guidance (MAR 1.3.7C and 1.3.12C). Either of these exemptions may apply unless the investment bank has received inside information that is not trading information (broadly, information that investments of a particular kind have been or are to be acquired or disposed of and certain related information, as dened in the Code of Market Conduct), and provided that the dealing or disclosure is carried out for the purpose of hedging the banks risk or to facilitate execution of the sellers order, and/or that any course of action is adequately disclosed to, or agreed with, the seller or that the banks behaviour is otherwise reasonable. Condentiality undertakings from third parties may also be required to enable information to be disclosed (MAR 1.4.5E). The position in this respect is less clear than it was previously, following the implementation of MAD, which explicitly prohibits the practice of front-running (trading on the basis of, and ahead of, a clients order). In relation to insider dealing, it is likely that the analysis of any such dissemination would be similar under the market information defence in Schedule 1 to the 1993 Act. FSA Regulation. The rst tier of the FSAs Handbook consists of the Principles for Businesses (Principles), which include that: a rm must conduct its business with integrity (Principle 1); a rm must conduct its business with due skill, care and diligence (Principle 2); a rm must pay due regard to the interests of its customers and treat them fairly (Principle 6); and a rm must manage conicts of interest fairly, both

between itself and its customers and between a customer and another client (Principle 8). The importance of the Principles, and the FSAs willingness to use them in enforcement cases, has become increasingly apparent during the last three years. The Principles are frequently the basis on which the FSA takes enforcement action, including in cases where market abuse or insider dealing legislation has not been infringed. A disclosure of trading information which damages a customers interests may not constitute market abuse but may breach Principles 6 and 8 (although, following the implementation of MAD with its express prohibition on front-running, it is more likely that a breach of the Principles will also constitute a breach of the insider dealing/market abuse legislation). Principles 6 and 8, and most of the FSA Conduct of Business (COB) Rules relating to designated investment business, concern business carried out with or for customers. For this purpose a customer includes a pre-existing and potential customer of the bank but does not include a market counterparty. Market counterparties include governments, government agencies, central banks and monetary authorities, supranational organisations, state investment bodies, other regulated rms and certain other market professionals. In many cases, the manager is unlikely to classify the seller in a block trade as a market counterparty which means that the principles and COB Rules will be relevant to the relationship. It follows that the Principles may be breached by reason of actions carried out by the managers employees before the bank has been mandated by a seller for a block trade, and irrespective of whether the seller is an existing customer of the bank. The Principles and COB Rules will clearly also apply after a mandate has been given (unless the seller is classied as a market counterparty). Even if a prospective seller is or would be a market counterparty, Principles 1 and 2 will still be relevant. It is open to a regulated rm to disclose to a seller (as a customer or a potential customer) that it may contact selected investors to gauge their appetite for a particular transaction, or kind of transaction, and to obtain the sellers consent to that course of action where appropriate. The FSA suggested in its Decision Notice in the Morgan Grenfell case that informing the customer of intended action was essential in circumstances where the customers interests might be disadvantaged by such action (April 2004). This disclosure might be made, in theory, at any time between the initial meeting with

the seller or its advisers and the time at which the rm is mandated to act on its behalf. It is open to a rm (without, it can be argued, breaching the Principles) to give non-public information to a limited number of investors who agree to keep the information condential and not to act on that information. In practice, such a course of action is likely to be possible only where the agreement relates to a brief period before the announcement of the trade. Misuse of condential information. Even before it signs a condentiality agreement, the manager is bound under common law not to misuse or disclose any condential information given to it in circumstances of condence. Any provision to the manager by a potential seller of information in relation to a proposed block trade (for example, its intention to enter into the trade, the nature of the trade it is contemplating or the identity of the securities to be traded) is likely to be held to be condential information. On the other hand, information obtained by the manager from its own research or from speculation will not. Each case will depend on its particular circumstances. For example, a seller who is known to have only one signicant holding is more likely to be able to establish that information given by it to the manager about its intention to undertake a block trade (even without identifying the security to be traded) is condential (as the identity of the security is implicit) than a seller with many holdings, who did not reveal which security it intended to sell. What constitutes misuse of condential information will depend on the reason the manager received the information in each case. However, any use or disclosure by the manager for its own benet, or that of a third party, of condential information without the sellers consent could constitute misuse of that information. Once a condentiality letter is signed the manager becomes bound by its terms. A breach of those terms is a breach of contract. Breach of agency duties. If the block trade is to be executed by the manager in an agency capacity, it will, following the mandate to act, owe the seller contractual and common law duties of agency; mainly, to act in the sellers best interests. Even before it receives a mandate for the block trade, the manager may owe agency duties to the potential seller independent of the block trade, for example, as a result of a corporate advisory or corporate broking role.

Stage 2 The purchase agreement, opinions and investor representation letters

The main documents required for a block trade include the following: Purchase agreement

The purchase agreement for a block trade will be short when compared to an underwriting agreement for an IPO, even if the block trade is worth billions of pounds. The purchase agreement will contain certain representations from the seller (including as to valid title, no encumbrances and compliance with securities laws). The purchase agreement will also contain pricing and settlement provisions and an indemnity from the seller to the manager. Many block trades are structured so that the manager buys the shares from the seller and resells the shares to investors as principal (rather than as agent of the seller). For shares of a company incorporated in the UK, the manager will need to qualify for the intermediaries exemption, which allows the manager to buy and resell the shares without itself incurring a stamp duty or stamp duty reserve tax liability (sections 80A and 88A, Finance Act 1986). Only the ultimate investors pay such duty or tax. In the case of an AEO in shares of a company incorporated in the UK, the manager will typically act as the sellers agent. In the case of AEOs in shares of continental European companies, the manager will typically act as principal: in such case, the manager and seller usually sign the purchase agreement only after the manager has found investors for the shares (that is, the book of demand is covered). Opinions

Sometimes law rms involved in a block trade will be asked to provide an opinion. This will generally cover the sellers corporate and other authority to sell the shares and its valid title to the shares. In addition, US securities lawyers will sometimes be asked to provide a no-registration opinion, conrming that the transaction does not need to be registered with the US Securities and Exchange Commission. See below US issues in block trades. A noregistration opinion is especially helpful to banks bidding in a competitive process if the proposed trade will be extended into the US. Investor representation letters

Sometimes investors are asked to sign investor representation letters in order to participate in the block trade. If the transaction is structured pursuant to section

4(11/2 ), there are specic representations the investor is asked to make; otherwise, these letters typically acknowledge that there is no offering document and acknowledge the US selling restrictions. See below US issues in block trades.

Stage 3 - Disclosure
A manager bidding for a block of shares will need to know exactly what information about its purchase and subsequent resale will require public disclosure and when. This varies considerably depending on the statutory requirements in the jurisdiction in which the issuer is incorporated and the regulatory requirements in the jurisdiction in which its shares are listed. This must always be checked carefully in advance. In the case of an issuer incorporated in England and Wales whose shares are listed on the London Stock Exchange, the following rules will apply: Announcement

ofoad its risk in full (it will have had some time on the evening of Day T-1 to market to qualied institutional buyers in the US, but would only have had between one and two hours to access European demand on the morning of Day T). This might pose a commercial problem by revealing the price the manager was committed to paying while the offering was still ongoing. There are exemptions under the Rules of the London Stock Exchange permitting the delayed publication of trade reports where a member rm elects to use block trading facilities. Under a block trade facility, for example, publication would occur at the earlier of when it has been 90 per cent offset and three business days after the relevant trade. The denition of a block trade for these purposes is made by reference to its size as a multiple of normal trading in the stock: for example, in the case of a SETSmm security, the trade must be at least 75 times the normal market size. Companies Act 1985

It would be usual for the seller to announce its disposal before markets open on Day T. In the case of a bought deal the announcement would refer to a disposal. In the case of an AEO or back-stopped deal, the announcement would refer instead to an intention to dispose. In each case, the announcement would go on to indicate the change in the sellers percentage holding in the issuer. It would not usually refer to the price at which the shares had been bought or back-stopped. An announcement before the commencement of marketing is sometimes thought to be necessary to avoid committing market abuse through the making of selective disclosure to potential buyers of the shares (MAR 1.4). The better view appears to be that the marketing of the shares is conducted by the manager in the proper course of its business of nding a buyer for its clients shares and that, for this reason, to do so should not be seen as market abuse. According to this view, the announcement is helpful in order to facilitate an orderly market in the relevant shares, rather than essential for the legality of the marketing effort. Trade reporting

Under section 198 of the Companies Act 1985 (1985 Act), the seller must disclose the sale to the issuer if it holds over 3 per cent of the nominal value of the issuers share capital and the block trade reduces its holding through a percentage threshold. The manager will also have a notiable interest in the case of a bought deal of this size (if the market maker exemption in section 209(8) of the 1985 Act is not available to it). In the case of a back-stopped deal, the managers interest arises from the underwriting commitment and is notiable under section 208(5) of the 1985 Act. The notication must be made within the two days next following the day on which the transaction occurs. The issuer must publish the notication under Rule 9.6.7 of the Listing Rules as soon as possible and in any event by the end of the business day following receipt of the information. This disclosure is not usually problematic, however, as (in all likelihood) by the time it is published to the market, the manager will have exited its position. In any event, the disclosure is not required to contain the price.

Under the Rules of the London Stock Exchange, the manager (assuming it is a member rm) must trade report the dealing within prescribed deadlines. Where a transaction is effected outside the trade reporting period (i.e. between 7.15 am and 5.15 pm), then the trade report must be submitted before 7.45 am on the next trading day. The trade report will contain details of the transaction, including size and price. This would involve disclosing the price (where the manager was purchasing as principal) at a time when the manager may not yet have been able to

Stage 4 - Post announcement: selling issues

One selling issue that often arises is the managers ability to disclose to potential purchasers the status of its book of demand during the offering. This is a question it will frequently be asked and the answer has potential legal implications. The simplest approach is to offer no comment. If that is not practicable, it is crucial to ensure that any statement made is not misleading, false or deceptive. If it is misleading and is made to induce the potential investor to participate in the

offering, then this could constitute a breach of section 397 of the FSMA which prohibits market manipulation, to which criminal liability could apply. Even if it is not intentionally misleading, the statement could constitute a negligent misstatement, a misrepresentation and a breach of contract. If the status of the book of demand is to be disclosed, this should not be done selectively. Typical statements regarding the status of the book of demand include the following:

At the bottom end of the price range, the book is approximately half covered, based on indicated demand as of this morning. The book is covered. The offering is oversubscribed/multiple times oversubscribed.

US issues in block trades

The registration requirements of the US Securities Act of 1933 (Securities Act) apply worldwide, so any securities offering must be registered with the US Securities and Exchange Commission or structured pursuant to an exemption from the registration requirements. Possible exemptions include the following:

(Rule 144A) or section 4(11/2). In the case of both exemptions, there cannot be general solicitation in the US, and the issuer cannot be an investment company, as dened in the US Investment Company Act of 1940, as amended (investment company). Specic representations will be needed in the purchase agreement for a Rule 144A offering. If the seller is unable to give representation (k) (fungibility) or (l) (ongoing information), the offering can be structured pursuant to section 4(11/2).

Regulation S
Regulation S of the Securities Act (Regulation S) is the exemption for securities sold outside the US. There are three categories of restriction based on the level of US trading volume in the securities. For shares of most European issuers, it will be sufcient if the shares are sold outside the US and there are no direct selling efforts in the US. It is usually possible to sell to a US institution so long as the buy order originates outside the US. Only on rare occasions will it be necessary to exclude sales to US persons outside the US. In any event, Regulation S permits sales to US-based advisers acting for non-US accounts whether or not the adviser is acting with discretion. In addition, a non-US adviser acting with discretion for a US account is not a US person.

Section 4(1)
If the seller is not an afliate of the issuer, it may be possible to structure the block trade under section 4(1) of the Securities Act, which will allow the trade to be extended to both QIBs and non-QIB investors in the US. The US securities lawyers involved should advise whether the seller is an afliate of the issuer. There is a presumption of afliation if the seller holds 10 per cent or more of the issuers voting securities or if it has representation on the issuers board of directors; however, other factors may be taken into account.

Investment company and PFIC

If the issuer is an investment company, it will be difcult to structure the block trade under Rule 144A or section 4(11/2). See Rule 144A and section 4(11/2). The US lawyers involved should advise whether the issuer is an investment company. If the issuer is a passive foreign investment company (PFIC), there may be adverse tax consequences for US investors that buy its shares. The US lawyers involved should advise whether the issuer is a PFIC.

Rule 144A and section 4(11/2)

If the block trade will be extended into the US, it is likely that the US securities lawyers involved will recommend that sales in the US be limited to qualied institutional buyers (QIBs). This will permit the block trade to be structured pursuant to Rule 144A under the Securities Act

This article was written by Nicholas Holmes of Ashurst and Peter Castellon of Citigroup and rst appeared in the May 2006 edition of PLC magazine.

Contacts
Jonathan Angell Philip Broke Nick Bryans Daniel Bushner (US) David Carter Anthony Clare Adrian Clark Andrew Edge Paul Gadd Charlie Geffen Richard Gubbins Bruce Hanton Nicholas Holmes David Kershaw Stephen Lloyd Robert Ogilvy Watson James Perry Michael Robins Susan Roy Nigel Stacey Eric Stuart (US) Jeffrey Sultoon Graeme Ward Nick Williamson Tel: +44 (0)20 7859 1364 Tel: +44 (0)20 7859 1736 Tel: +44 (0)20 7859 1504 Tel: +44 (0)20 7859 2880 Tel: +44 (0)20 7859 1012 Tel: +44 (0)20 7859 1927 Tel: +44 (0)20 7859 1767 Tel: +44 (0)20 7859 1941 Tel: +44 (0)20 7859 1210 Tel: +44 (0)20 7859 1718 Tel: +44 (0)20 7859 1252 Tel: +44 (0)20 7859 1738 Tel: +44 (0)20 7859 2058 Tel: +44 (0)20 7859 1205 Tel: +44 (0)20 7859 1313 Tel: +44 (0)20 7859 1960 Tel: +44 (0)20 7859 1214 Tel: +44 (0)20 7859 1473 Tel: +44 (0)20 7859 1203 Tel: +44 (0)20 7859 1028 Tel: +44 (0)20 7859 2876 Tel: +44 (0)20 7859 1717 Tel: +44 (0)20 7859 1785 Tel: +44 (0)20 7859 1894 Email: jonathan.angell@ashurst.com Email: philip.broke@ashurst.com Email: nick.bryans@ashurst.com Email: daniel.bushner@ashurst.com Email: david.carter@ashurst.com Email: anthony.clare@ashurst.com Email: adrian.clark@ashurst.com Email: andrew.edge@ashurst.com Email: paul.gadd@ashurst.com Email: charlie.geffen@ashurst.com Email: richard.gubbins@ashurst.com Email: bruce.hanton@ashurst.com Email: nicholas.holmes@ashurst.com Email: david.kershaw@ashurst.com Email: stephen.lloyd@ashurst.com Email: robert.ogilvywatson@ashurst.com Email: james.perry@ashurst.com Email: michael.robins@ashurst.com Email: susan.roy@ashurst.com Email: nigel.stacey@ashurst.com Email: eric.stuart@ashurst.com Email: jeffrey.sultoon@ashurst.com Email: graeme.ward@ashurst.com Email: nick.williamson@ashurst.com

Brussels Avenue Louise 489 1050 Brussels Belgium Tel +32 (0)2 626 1900 Fax +32 (0)2 626 1901 Dubai Level 42 Emirates Towers Sheikh Zayed Road PO Box 119974 Dubai United Arab Emirates Tel +971 (0)4 319 7530 Fax +971 (0)4 319 7546 Frankfurt Oberlindau 54-56 60323 Frankfurt am Main Germany Tel +49 (0)69 97 11 26 Fax +49 (0)69 97 20 52 20 London Broadwalk House 5 Appold Street London EC2A 2HA UK Tel +44 (0)20 7638 1111 Fax +44 (0)20 7638 1112 Madrid Alcal, 44 28014 Madrid Spain Tel +34 91 364 9800 Fax +34 91 364 9801/02 Milan Via Sant'Orsola, 3 20123 Milan Italy Tel +39 02 85 42 31 Fax +39 02 85 42 34 44

Munich Prinzregentenstrae 18 80538 Munich Germany Tel +49 (0)89 244 421 100 Fax +49 (0)89 244 421 101 New Delhi Liaison Office 6 Aurangzeb Road, D-1 New Delhi 110011 India Tel +91 11 2301 4054 Fax +91 11 2301 4089 New York 712 Fifth Avenue New York, NY 10019 USA Tel +1 212 245 4540 Fax +1 212 245 4335 Paris 22, rue de Marignan 75008 Paris France Tel +33 (0)1 53 53 53 53 Fax +33 (0)1 53 53 53 54 Singapore 6 Battery Road #15-08 Singapore 049909 Tel +65 6221 2214 Fax +65 6221 5484 Tokyo Shiroyama Trust Tower, 30th Floor 4-3-1 Toranomon Minato-Ku Tokyo 105-6030 Japan Tel +81 3 5405 6200 Fax +81 3 5405 6222

This update is not intended to be a comprehensive review of all developments in the law and practice, or to cover all aspects of those referred to. Readers should take legal advice before applying the information contained in this publication to specic issues or transactions. For more information please contact us at Broadwalk House 5 Appold Street London EC2A 2HA Tel +44 (0)20 7638 1111 Fax +44 (0)20 7638 1112 www.ashurst.com 2006 Ashurst Ref:DTP/550 May 06