Client Alert

Recent Court Decision May Affect Disclosure of Equity Swaps; However, Activist Hedge Funds May Vote Shares in CSX Proxy Fight

June 25, 2008

The Court of Appeals for the Second Circuit recently rejected a request by CSX Corporation to block one of its activist shareholders from voting its shares in connection with a contested election of directors, as a penalty for the shareholder's violation of Section 13(d) of the Securities and Exchange Act of 1934.

That ruling was made in response to an appeal by CSX from the recent decision by Judge Lewis A. Kaplan of the U.S. District Court for the Southern District of New York in CSX Corporation v. The Children's Investment Fund Management (UK) L.L.P. et al.¹ Judge Kaplan held that the defendants violated Section 13(d) of the Exchange Act by failing to disclose that they acted as a "group" and had acquired beneficial ownership of more than 5% of the common stock of CSX Corporation through the use of so-called "total return equity swaps" tied to that stock. Judge Kaplan rejected CSX's motion to enjoin the defendants from voting their shares. Judge Kaplan emphasized that he was constrained by precedent and stated that were he free to enjoin the defendants' voting power, he would. Instead, he issued a permanent injunction against future Section 13(d) violations and left any subsequent decisions regarding penalties to the SEC and the Department of Justice. The Second Circuit let Judge Kaplan's ruling stand for now, although it could decide to block voting of the shares after it hears the full appeal in August.

The Children's Investment Fund ("TCI") and 3G Capital Partners ("3G") — so-called "activist" hedge funds — are engaged in a proxy battle seeking to replace members of the CSX board and amend the company's by-laws to permit certain shareholders to call special meetings. TCI and 3G acquired 8.7% of CSX shares and long positions in total return equity swaps tied to those shares giving it an additional economic exposure equal to 12.3% of CSX shares.

Section 13(d) of the Exchange Act requires any investor who beneficially owns more than 5% of a company's stock to make a public filing disclosing that ownership within 10 days of acquisition and requires a filing within 10 days of the formation of a group.

Total return equity swaps such as those involved in this case generally give the "long" counterparty substantially the same economic benefits that it would have if it owned the underlying stock directly, including dividends and distributions and any increases in the value of the underlying stock. However, unlike direct share ownership, the long counterparty does not have the right to vote the shares directly, because it is not the record owner, and it must look to the "short" counterparty for payment of the economic returns, rather than looking to the issuer for dividends and distributions and to open market sales for changes in the value of the stock. Market participants have generally taken the position that the long counterparty is not the beneficial owner of the underlying security, and thus has no beneficial ownership disclosure obligations under the Exchange Act.

Specifically, the District Court ruled that:

• TCI beneficially owned the shares held by its counterparties in cash-settled equity swaps in which TCI was the long counterparty²; and
• TCI and 3G formed a group no later than February 13, 2007, not December 12, 2007 as claimed by TCI and 3G.

Judge Kaplan avoided holding that all total return swaps result in beneficial ownership for the swap long counterparty. Rather, he limited his ruling to the specific facts of the case, finding that the defendants acquired the swaps "with the purpose and effect of preventing the vesting of beneficial ownership in TCI as part of a plan or scheme to evade the reporting requirements of Section 13(d)" and, as a result, beneficially owned the stock subject to the swaps by virtue of SEC Rule 13d-3(b).

Beneficial Ownership

Two SEC rules define beneficial ownership for the purposes of Section 13(d) — Rules 13d-3(a) and 13d-3(b). Judge Kaplan avoided the question of whether any holder of a cash-settled equity swap beneficially owns the underlying stock held by its counterparty under the broad definition of Rule 13d-3(a). Instead, Judge Kaplan focused on the facts and circumstances of this case and relied upon Rule 13d-3(b) which states:

Any person, who directly or indirectly, creates or uses a trust, proxy, power of attorney, pooling arrangement or any other contract, arrangement, or device with the purpose of [sic] effect of divesting such person of beneficial ownership of a security or preventing the vesting of such beneficial ownership as part of a plan or scheme to evade the reporting requirements of section 13(d) or (g) of the Act shall be deemed for purposes of such sections to be the beneficial owner of such security.

The evidence persuaded the District Court that TCI used equity swaps "rather than buying stock for the purpose, perhaps among others, of avoiding the disclosure requirements of Section 13(d) by preventing the vesting of beneficial ownership in TCI." The District Court also concluded this was done as part of a plan or scheme to evade reporting requirements among other things because TCI admitted that one its motivations was "to avoid paying a higher price for the shares of CSX, which would have been the product of front-running that it expected would occur if its interest in CSX were disclosed to the market." Since the swap agreements between TCI and its counterparties were contracts, the District Court ruled that the three requirements of Rule 13d-3(b) were met and that TCI was deemed to be the beneficial owner of the referenced shares.

The District Court's ruling was despite the SEC staff's view, set forth in a letter from Brian V. Breheny, Deputy Director of the Division of Corporation Finance of the SEC to the Court dated June 4, 2008, that "a standard cash-settled equity swap agreement, in and of itself, does not confer on a party…any voting power or investment power over the shares a counterparty purchases to hedge its position." This conclusion "is not changed by the presence of economic or business incentives that the counterparty may have to vote the shares as the other party wishes or to dispose of the shares to the other party."

Group Formation

Judge Kaplan further concluded that TCI and 3G violated Section 13(d)(3) of the Exchange Act by forming a group no later than February 13, 2007. The defendants claimed in SEC filings that they formed a group on December 12, 2007. The District Court supported its finding with strong circumstancial evidence, including similar purchases and sales of CSX stock by TCI and 3G, as well as meetings and communication between the co-defendants and what Judge Kaplan described as the "frequent lack of credibility" of certain witnesses for the defendants.

Implications

The effects of Judge Kaplan's expansive reading of Section 13(d) beneficial ownership, if upheld on appeal, will reach beyond administrative SEC filings. The implications of the decision may extend beyond the direct reporting requirements of Section 13(d) because courts often look to interpretations of Section 13(d)'s definition of beneficial ownership in other areas.

For example, Judge Kaplan's definition of beneficial ownership may expose swap long counterparties to insider trading liability for short-swing profits under Section 16(b) of the Exchange Act. For the purposes of that section, SEC Rule 16a-1 defines "beneficial owner" as "any person who is deemed a beneficial owner pursuant to Section 13(d)." The arduous task of monitoring shares held by swap counterparties to determine their level of beneficial ownership would impose a significant burden on swap holders and, in this situation, would carry a significant risk of monetary liability.

Similarly, Judge Kaplan's ruling opens up the possibility that swap holders will be subject to the reporting requirements of Section 16(a) which require the beneficial owner of more than 10% of a company's stock to disclose those holdings within two business days. Judge Kaplan's decision, combined with this short disclosure period, may impose upon swap long counterparties the difficult task of monitoring the number of shares of the referenced stock held by swap counterparties, paying attention to if and when they cross the 10% threshold.

Many contracts refer to Section 13(d)'s definition of beneficial ownership, including change of control provisions in bond indentures, credit agreements and other contracts and so-called "triggers" for benefit payments, option vesting and other provisions in executive employment and severance agreements.

In addition, companies that have "poison pill" rights plans triggered by an acqurior crossing certain levels of beneficial ownership may want to review their plans in light of the CSX decision and the increased use of equity derivatives. The Wall Street Journal recently reported that "[a]t least two companies -- Louisiana-Pacific Corp. and Micrel Inc. -- have changed their shareholder-rights plans in recent months to include derivatives when calculating levels of 'beneficial ownership' that would trigger their poison pill."³

In a letter to SEC Chairman Christopher Cox, Senator Charles Schumer called on the SEC to clarify the treatment of equity swaps, expressing his concern that the uncertainty resulting from the ruling will be detrimental to the financial markets.⁴ He questioned whether proper disclosure will happen if there are not serious penalties for false reporting and suggested that legislation may be needed to provide such penalties.

See the District Court decision here: http://www1.nysd.uscourts.gov/cases/show.php?db=special&id=79.

See the letter from the SEC to Judge Kaplan here.

^1. CSX v. The Children's Investment Fund Management (UK) L.L.P., 08 Civ 2764 (LAK), slip op. at 1, 2 (S.D.N.Y. June 11, 2008).
^2. As Judge Kaplan observed, the "short" counterparties in these types of swaps normally hedge their positions by purchasing shares of the underlying stock referenced by the swap.
^3. Mara Lemos-Stein, Poison Pills Target Derivatives, The Wall Street Journal, June 18, 2008, at B5C.
^4. Judith Burns, Schumer Pressures SEC on Equity Swap Rules, The Wall Street Journal, June 18, 2008, at C-7.

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