When Economic Ownership Becomes Regulatory Control

Control can pass long before completion. How the DFSA treats options, debt instruments and side letters – and why a regulatory condition on the share transfer may not protect the deal.

1.  Introduction: Transactions Need Not Complete to Change Control

In private transactions, parties tend to treat control as something that passes at completion: the shares are transferred, the register is updated and a new owner appoints new directors. Regulators may take a different view. For them, the question is not so much whose name appears on the share register, but who has the present ability to influence the firm. In this article we consider the DFSA approach to control including in the context of borderline cases of options, debt instruments and side letters. What follows is based on our practical experience and concerns strictly firms operating in the DFSA-regulated environment of the DIFC; control thresholds, approval requirements and consequences described below are creatures of that regime and do not arise in the same way outside that regulated environment.

Consider this scenario. A DFSA-regulated financial services firm wishes to raise capital and is prepared to allow the incoming investor to take a significant equity stake. Rather than making a plain vanilla share purchase agreement, the parties assemble a structured package: an option to acquire shares at a later date; a debt instrument; the right to appoint observers to the board; a right to be consulted on, and to direct, the exercise of voting rights; an entitlement to dividends and liquidation proceeds; one or more side letters dealing with economic ownership. The actual transfer of legal ownership in the shares is expressly conditional on regulatory approval. On paper, then, the investor is not yet the registered shareholder, and the legal team may assume that the regulator’s approval will be required only when the option is in fact exercised.

Yet the regulator may conclude that the investor acquires control over the business before acquiring legal title to the shares. The economic and governance package – taken as a whole – may give the investor significant influence over the business long before formal completion. Under the DFSA regime a person becomes a “Controller” not only by holding 10% or more of the shares, but by holding “a current exercisable right” to acquire them, or by being able to exercise “significant influence” over management.[1] This article explains how that happens, why it matters, and how parties should structure and document regulated-sector investments to avoid an unwelcome regulatory surprise.

2.  Why “Control” Is Not Just Share Ownership

In regulated financial services, there are multiple tests for control. Under the DFSA’s General Module a person is a Controller of an Authorized Firm if, alone or with associates, they:

• hold 10% or more of the shares in the firm or its holding company; or
• are entitled to exercise, or control the exercise of, 10% or more of the voting rights in the firm or its holding company; or
• are able to exercise significant influence over the management of the firm as a result of holding shares or voting rights, or as a result of having a current exercisable right to acquire such shares or voting rights.[2]

Three features catch the eye. First, the thresholds are low: 10%, not by any stretch a majority. Second, voting rights and shareholdings are treated separately, so a person who controls the votes without owning the shares is caught. Third – and most importantly for structured deals – a current exercisable right to acquire shares or voting rights counts. A person may therefore be a Controller even though they hold no legal title to shares at all.

This is the first practical trap. A corporate lawyer instinctively asks: “Has the share transfer completed?” A regulator asks a different question: “Who can influence the firm today?” An option that is exercisable now, combined with voting influence or governance rights under a contractual agreement, may constitute acquisition of control right that requires prior regulatory approval. The DFSA requires a person to obtain prior written approval before becoming a Controller,[3] and requires the firm itself to notify the DFSA of any change or proposed change of its Controllers as soon as possible.[4] The same logic runs through other major regimes: under Part XII of the United Kingdom’s Financial Services and Markets Act 2000 a “controller” is a person holding 10% or more of the shares or voting power, or able to exercise significant influence over management, and acquiring control requires prior notice to the regulator.[5]

3.  Anatomy of an “Economic Ownership” Package

Sophisticated control structures are rarely documented in a single instrument. They operate through a bundle of rights spread across several documents, each apparently falling short of vesting control if considered in isolation. However, it is the combined effect that matters, and the DFSA assesses significant influence by reference to the arrangement as a whole.[6]

• Option Rights

The investor receives the right to elect to acquire shares at a later date. The key risk is that a current and exercisable option may be treated as far more than a right to acquire shares in the future. GEN 11.8.2 Guidance[7] explicitly and by default treats options as a current exercisable right to acquire shares or voting rights that triggers DFSA pre-approval. The default analysis may be displaced after consideration of the equity percentage of covered by the option and whether the option is exercisable immediately or subject to the satisfaction of certain named.

• Governance Rights

The investor receives contractual rights to nominate an observer to the board of directors and to be consulted on matters considered by the board. Even without casting any votes, an investor who delegates a nominee to attend board meetings and receives board papers can be viewed by DFSA as influencing management. Typical contractual rights include the right to receive notice of, and to attend, board meetings; the right to appoint observers to the board; the right to receive board papers; the right to be consulted before voting rights are exercised; and – most significant of all – the right to have a registered shareholder exercise its votes in accordance with the investor’s reasonable directions. That latter right will very likely be considered by DFSA as control of the votes.[8]

• Economic Rights

The investor receives the economic benefits of share ownership before it actually acquires that ownership. Examples include contractual rights to dividend proceeds, to liquidation proceeds ranking alongside shareholders, a profit share from a particular business line, or an entitlement to the upside and/or protection from the downside of the business through contractual indemnities or funded participation mechanics. The more an investor looks, economically, like a shareholder – sharing in dividends or ranking equally on a winding-up – the harder it becomes to maintain that they are no more than a future purchaser.

• Nominee and Holding Arrangements

Finally, another person may hold the legal title to shares, following the investor’s directions in exercising voting rights and collect economic benefits which are then passed on to the investor. A nominee-like arrangement can preserve formal ownership on the register unchanged while transferring real influence elsewhere – for example, where a holding company owned by an executive holds the shares but is obliged to pass on dividends and to vote as directed. The more a structure separates formal title from economic reality, the more important it becomes to consider whether regulatory control has already shifted.

4.  The Problem of Debt: When Financing Becomes an Acquisition

A debt instrument does not usually create regulatory control by itself. A lender does not become a controller merely because it has advanced money to a firm or its holding company. The relevance of the debt instrument lies in what it reveals about the wider transaction.

If the same investor who provides the debt also receives a current right to acquire shares, and the debt is reduced or treated as repaid when that right is exercised, the debt becomes consideration for the acquisition structure. The investor has not simply made a loan. The investor has, in economic terms, funded the purchase of equity.

This is where control analysis becomes important: regulatory control is not concerned only with the name on the share register. A debt instrument linked to acquisition of shares can be relevant precisely because it connects the financing, the acquisition of title and the economic transfer of ownership into a single transaction.

A short checklist helps:

• What is the commercial purpose of the debt instrument?
• Who funds it, and who receives the proceeds?
• Are the proceeds used to cash out existing shareholders?
• Does the security provide the lender with any control rights?
• Is repayment linked to a share transfer, e.g. the debt discharged when options are exercised?

5.  Why Regulatory Approval Conditions May Not Save the Day

Many transaction documents contain a clause to the effect that “the shares may not be transferred unless regulatory approval is obtained.” Such a condition is useful, but it may be not enough to fight off regulators. The reason is that the investor may have already acquired sufficient present rights to be treated as a Controller before any share transfer takes place.

It helps to distinguish three concepts that are often conflated: legal completion (the transfer of title to the shares); beneficial or economic ownership (who enjoys the economic value represented by the shares); and regulatory control (who can influence the firm’s business). A condition precedent may prevent legal completion. It does not, by itself, prevent acquisition of regulatory control. If an option is presently exercisable and is accompanied by the right to direct votes, to appoint observers and to receive the economic benefits attached to the shares, the holder may already satisfy the Controller test even though the formal transfer is locked behind a regulatory condition.

The lesson to the draftsman is to put in provisions not only for the transfer of shares, but for the rights the investor enjoys before the transfer. Pending regulatory approval, the parties should suspend the exercise of voting direction and consultation rights; board observer and information rights; dividend and liquidation economics; side letters treating the investor as an economic owner; and nominee arrangements. The cleanest structures separate, expressly, the rights that arise immediately from those that are conditional upon the regulator’s approval.

6.  Dangers of Side Letters

Side letters often give away the true deal. The core sale and purchase agreement, option agreement or subscription agreement may be drafted with appropriate regulatory caution; a side letter can change the substance significantly. Terms to watch for include “economic ownership” language; agreements to pass through dividends; indemnities that leave one party with the benefit of the upside or protection from the downside of economic performance of the business; obligations to follow another party’s instructions; arrangements designed to keep a person off a public register; and acknowledgements that another party is the “real” beneficial owner. Correspondence exchanged in negotiations can be equally revealing: an email to explain that a structure is intended to transfer “economic interest” while avoiding “direct payments of distributions” is, in effect, a confession to a nominee arrangement.[9]

If the main agreement says “no control before approval” but a side letter gives the investor the economic benefit and influence, it is the side letter that the regulator may take as conclusive evidence of acquisition of control t. Regulatory counsel must therefore review the entire suite of documents – option and debt terms, side letters, nominee and funded participation arrangements, deeds of indemnity, board observer letters and voting undertakings – not merely the headline SPA, which on its own may be entirely free of provisions by which control is conferred.

7.  Side Letters and Other Agreements Can be Reviewed by DFSA

Signing a side letter does not put it beyond the reach of the regulator: it is routine for DFSA to demand production and take copies of information and documents held in any form (including electronically on the firm’s systems) under Article 73 of the DIFC Regulatory Law No. 1 of 2004 (as amended) (“Regulatory Law”). DFSA’s regulatory investigative powers include the power to compel production of documents and information and the power to interview individuals under oath (Articles 78 and 80).

If it suspects material is being withheld, the DFSA can apply to the DIFC Court for a search warrant under Article 84. The warrant will authorise entry and search of premises and taking possession of the records; “documents” covers data stored in any form, that power reaches servers, phones and computers. The court warrant will authorise Dubai Police to assist the DFSA and to use force as may be necessary.

On top of that, firms and their staff owe a standing duty to be open and cooperative with the DFSA (GEN Principle 10). Concealment or destruction of evidence or giving false or misleading information are of themselves serious contraventions (e.g. Article 66), so trying to hide a side letter will generally make matters only worse. Legal professional privilege may not be used to facilitate commission of such contraventions.

8.  Practical Red Flags for Transaction Teams

The following indicators should prompt a control analysis before a transaction is signed. Each may be benign on its own; in combination they frequently are not.

• A large option. The investor holds an option over a substantial block – 10%, 25%, 30%, 50% or more – of the firm.
• The option is exercisable immediately. Even if the actual transfer is conditional on approval, an immediately exercisable option is a present right. If the exercise of the option itself is subject to prior regulatory approval, the position is different and the option is not a red flag.
• The investor can direct or influence voting, e.g. where the registered shareholder must take the investor’s views into account or act on its reasonable directions.
• The investor receives board information. Observer and information rights can be commercially reasonable, but in the context of running a business of a regulated firm they should be scrutinized as a potential sign of influence.
• The investor receives shareholder economic benefits before becoming a shareholder. Look for dividends, liquidation proceeds or a business profit share.
• The structure uses nominees or “economic owner” language. That will often be the most dangerous drafting, particularly where the aim is to keep a name off a register.
• Debt and equity are interwoven. For example, a loan or CLN that is repaid, cancelled or “deemed repaid” when options for equity are exercised.
• Different stories are told to different stakeholders. Banks hear one explanation, the regulator another, and the internal documents show a third.
• The investor wears several hats. The same person is investor, client, funder, introducer and business-line owner; multiple roles compound influence.
• Regulatory approval is considered only at completion. The control analysis is left to the end of the deal rather than carried out before signing.[10]

9. Potential Risks

A regulatory breach. Becoming a Controller – or crossing a higher control threshold – without the DFSA’s prior written approval is a contravention of GEN 11.8.4. Where control is acquired or increased without approval, or a condition of approval is breached, GEN 11.8.13 empowers the DFSA to intervene directly in the structure: it can direct a contravening Controller to divest within a specified period.

Separately, the contravention triggers the DFSA’s general sanctioning powers under the Regulatory Law 2004 (DIFC Law No. 1 of 2004). Where the DFSA considers that a person has contravened “any legislation administered by the DFSA”, Article 90(2) empowers it to impose a financial penalty “of such amount as it considers appropriate” (there is no statutory cap). Further powers cover public censure and directions for restitution, compensation or disgorgement of profits. Specified or lower-level breaches can instead attract a Fixed Penalty Notice of up to US$50,000 under Article 91.

Personal and corporate exposure. Contravention by a firm will often constitute contravention by its officers.[11] Under Articles 58 and 59 the DFSA may restrict, suspend or withdraw a person’s Authorized Individual or Key Individual status, and may prohibit or restrict any person from performing functions connected with financial services in or from the DIFC where it concludes they are not “fit and proper” – this is a disqualification that is publicized on the DFSA’s public register of prohibited/restricted individuals. A finding of lack of integrity (for example, breach of GEN Principle 1, or giving the DFSA false or misleading information contrary to Article 66 of the Regulatory Law) is grounds for personal disqualification, but also for action against the firm in exercise of the DFSA power to vary or withdraw a License where it is no longer satisfied as to fitness and propriety.

What might appear or be rationalized as a technical point of paperwork or timing can result in unlimited fines, forced divestment, restricted voting rights, public censure and personal disqualification.

10.  How to Structure the Process Properly

The following steps help transaction teams to structure and document investments in DFSA-regulated firms without losing sight of the need to comply with regulatory restrictions on acquisition of control.

• Identify every right that could amount or contribute to share ownership, voting control or significant influence, and map each one to the limbs of the Controller test.
• Review the full documents package. This means not only the SPA or option agreement, but any debt instruments, side letters, nominee arrangements, board observer letters, voting undertakings and any funded participation or indemnity arrangements.
• Separate pre-approval and post-approval rights. Make it explicit which rights arise immediately and which are suspended until regulatory approval is obtained.
• Avoid language indicative of acquisition of economic ownership before regulatory approval. If the investor must not yet control the firm, the documents should not describe them as economic owner.
• Align regulatory, banking and transaction narratives. Explanations given to banks, custodians, the regulator and counterparties must be consistent; inconsistent accounts are both a control red flag and, potentially, misconduct in their own right.[12]
• Build the regulator into the timetable. Treat notification and approval as part of the transaction plan, not as a post-signing administration, and be mindful of the obligation to notify changes as soon as possible.[13]
• Document the rationale. Where unusual rights are genuinely necessary, record why they are needed and why they do not amount to control. A closely considered and reasoned decision is far more persuasive than after-the-fact explanations.

***

Any references to laws and web-links are effective as of the date of this document. The information contained in this document is indicative only and does not purport to be an exhaustive analysis of the issues contained herein. Neither Akta FZC nor any of its employees are responsible for any actions (or lack thereof) taken as a result of relying on or in any way using information contained in this document and in no event shall be liable for any losses resulting from reliance on or use of this information.

[1] DFSA, Rulebook, General Module (GEN), Rule 11.8.2 (definition of “Controller”), available at: https://dfsaen.thomsonreuters.com/rulebook/gen-1182.

[2] GEN 11.8.2(3) and the accompanying Guidance: “significant influence” limb extends to a person who has “a current exercisable right to acquire” shares or voting rights, which the DFSA treats as capable of including an option (see note 1 above).

[3] GEN 11.8.4 (a person must not become a Controller of an Authorized Firm without obtaining the prior written approval of the DFSA), available at: https://dfsaen.thomsonreuters.com/rulebook/gen-1184.

[4] GEN 11.8.11(2) (an Authorized Firm must notify the DFSA in writing of any change, or proposed change, of its Controllers as soon as possible after becoming aware of it), available at: https://dfsaen.thomsonreuters.com/rulebook/gen-11811.

[5] For comparable United Kingdom regime see the Financial Services and Markets Act 2000, Part XII, in particular sections 178 (obligation to notify a proposed acquisition of control) and 422 (meaning of “controller” – 10% or more of the shares or voting power, or shares or voting power enabling the exercise of significant influence over management): https://www.legislation.gov.uk/ukpga/2000/8/section/422. See also the FCA’s guidance on the change in control regime: https://www.fca.org.uk/firms/change-control.

[6] The DFSA assesses significant influence holistically rather than by reference to any single right (GEN 11.8.2 and its Guidance; see note 1 above).

[7] Available at: https://dfsaen.thomsonreuters.com/rulebook/gen-1182-guidance.

[8] GEN 11.8.2(2) also captures a person “entitled to exercise, or control the exercise of” voting rights. A contractual right requiring a registered holder to vote in accordance with another person’s reasonable directions constitutes, in substance, control of those votes.

[9] On the need to identify the true beneficial owner behind a nominee holding, see the DFSA AML Module (definition of “Beneficial Owner” and the customer due diligence requirements in chapter 7) and FATF, Professional Money Laundering (July 2018), https://www.fatf-gafi.org/content/dam/fatf-gafi/reports/Professional-Money-Laundering.pdf.

[10] Each of these indicators maps onto one or more limbs of the Controller test in GEN 11.8.2 (see note 1 above) – shares, voting rights, or significant influence (including a current exercisable right to acquire shares or voting rights).

[11] Article 86(2) of the Regulatory Law.

[12] Inconsistent narratives are not only a control red flag but may themselves amount to misconduct: see DIFC Law No. 1 of 2004 (the Regulatory Law), Article 41B (misleading, deceptive or dishonest conduct in connection with a Financial Product or Financial Service) and Article 66 (false or misleading information provided to, or concealed from, the DFSA). See also GEN 5.3.20(b) (systems and controls against financial crime) and GEN 4.2.10 – Principle 10 (relations with regulators).

[13] GEN 11.8.11(2) (notification “as soon as possible”), available at: https://dfsaen.thomsonreuters.com/rulebook/gen-11811; and GEN 11.8.4 (prior written approval before a person becomes a Controller), https://dfsaen.thomsonreuters.com/rulebook/gen-1184.