Court Requires Activist Hedge Funds to Disclose Swaps in CSX
June 13, 2008
A federal district court in New York recently ruled that an activist hedge fund that had acquired “long” positions in cash-settled equity swaps of CSX Corporation in advance of an upcoming proxy contest had entered into the swaps “for the purpose of preventing the vesting of beneficial ownership in CSX shares. . . and as part of a plan or scheme to evade the reporting requirements.” Under the anti-avoidance provision of Rule 13d-3(b), the court found that, the hedge fund was deemed to be a beneficial owner of the shares held by its counterparties by reason of its avoidance purpose. While the court sidestepped deciding whether a holder of cash-settled equity swaps is otherwise a “beneficial owner” under Section 13(d) of the 1934 Act, the court’s analysis suggested that it believed such arrangements did constitute beneficial ownership. Most notably however, the remedy ordered by the court was limited to an injunction against future Section 13(d) violations—it did not prevent defendants from voting their CSX shares in the upcoming proxy contest.
Under Section 13(d), any person or group that acquires more than 5% of the equity securities in a public company is required to make a disclosure filing with the SEC (under Schedule 13D or 13G), based on whether the person has acquired “beneficial ownership” of the shares. Disclosure is also triggered when an investor passes that 5% threshold as part of a “group.” Although the rules do not specifically address whether derivative instruments, like the cash-settled total return equity swaps involved in this case, constitute beneficial ownership of the underlying securities for Section 13 purposes, it was generally well-accepted, and indeed the position of the SEC's Division of Corporation Finance, that such cash-settled swaps do not constitute beneficial ownership. However, this view had not been tested by a U.S. court until this case.
The case arose last March when CSX brought suit against two activist hedge funds, The Children’s Investment Fund (TCI) and 3G Fund (3G), alleging, among other things, that the hedge funds failed to file a timely Schedule 13D after forming a group with reference to CSX shares, and that the Schedule 13D and proxy statement they eventually filed was false and misleading. Prior to the filing of the Schedule 13D, the hedge funds had not filed any disclosure documents with the SEC even though according to the court, TCI represented to CSX that it held economic positions in the company amounting to over 10% of the company’s stock and TCI and 3G had begun discussing CSX in the early part of 2007.
In finding TCI to be a beneficial owner of the shares held by its counterparties under Rule 13d-3(b) because of the above-noted avoidance purpose, the court pointed to evidence that TCI created and used the cash-settled swaps as part of a plan or scheme to evade the reporting requirements. The court noted that TCI made sure its counterparties held less than 5% physical ownership in CSX at any given time and deliberately spread its swap exposure among 8 different banks in order to avoid any counterparty crossing a reporting threshold.
The court also found that TCI and 3G formed a group with respect to CSX shares in light of their lengthy relationship, frequent communications and pattern of transactions following meetings among them.
Importantly, the court did not rule on whether the cash-settled swaps would have made TCI a beneficial owner under Rule 13d-3(a) in the absence of an avoidance purpose, although it rejected the “Cassandra-like predictions of dire consequences” that many (including the SEC’s Division of Corporation Finance) warned would occur if TCI were held to have beneficial ownership under Rule 13d-3(a). Indeed, “ [t]he overwhelming majority of swap transactions would proceed as before without any additional Regulation 13D or G reporting requirements,” reassured the court. However, it did note a number of “substantial reasons” to support a holding that cash-settled swaps confer beneficial ownership even without an avoidance purpose, including:
- The broad definition of “beneficial ownership,” which looks not just to the mere possession of the right to vote but also to the “ability to influence” voting.
- The fact that TCI had the ability potentially to influence purchases and dispositions of CSX shares by entering into and unwinding its cash-settled total return swaps due to the economic realities inherent in such instruments (the “short” counterparties to TCI’s cash-settled swaps bought CSX shares to hedge their short exposure and sold CSX shares to reduce their “long” exposure when TCI chose to unwind the swap transactions).
- TCI’s influence over certain of its counterparties’ exercise of their voting rights through its ability to choose its counterparties based on its knowledge of the counterparties’ voting policies.
We believe this ruling will significantly diminish the use of cash-settled swaps where the primary perceived benefit is the avoidance of reporting beneficial ownership under Regulation 13D. Despite the court’s failure to equate cash-settled swaps with beneficial ownership for Rule 13d-3(a) purposes, the court’s application of Rule 13d-3(b) in this case is likely to cause investors involved in activist situations to regard such swaps as conferring beneficial ownership. In addition, even if activists do not concede beneficial ownership where targets (or courts) might find an avoidance purpose, swap counterparties may take a more conservative approach, and should review their swap documentation with the CSX decision in mind.
Perhaps ironically, the decision’s positive impact on CSX is extremely limited due to the court’s refusal to grant any significant injunctive relief against TCI or 3G or their ability to vote. It is possible that on appeal, the appellate court could grant a more severe penalty by stripping or otherwise limiting the hedge funds' ability to vote their CSX shares. Alternatively, the higher court could strictly limit the district court’s finding of beneficial ownership to the specific facts of this case, which would be a favorable development for swap counterparties concerned about their own Section 13 and 16 positions. In any event, the increased interest in the treatment of derivative securities under the current disclosure regime resulting from these developments will cast a spotlight on the SEC to devise rule-making that will address these issues head-on.
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