SEC Proposal Clarifies No Change
to "Beneficial Ownership" Rules for Swaps

March 18, 2011

SEC Proposes to Readopt Existing Rules to Address Dodd-Frank Provision

The SEC proposed yesterday to readopt the beneficial ownership rules currently in effect to preserve the status quo with respect to security-based swaps after Section 766 of the Dodd-Frank Act becomes effective on July 16, 2011.  The SEC proposed the readoption of the rules to dispel any notion that a failure by the SEC to enact rulemaking before July 16 would render the beneficial ownership rules inapplicable to investors that buy or sell such security-based swaps. Comments are due by April 15, 2011.

Section 766 of the Dodd-Frank Act amends the Exchange Act by adding a new Section 13(o) providing that purchases or sales of security-based swaps would be deemed to confer “beneficial ownership” of the underlying securities for purposes of Section 13 and 16 of the Exchange Act

only to the extent that the Commission, by rule, determines after consultation with the prudential regulators and the Secretary of the Treasury, that the purchase or sale of the security-based swap . . .provides incidents of ownership comparable to direct ownership of the equity security, and that it is necessary to achieve the purposes of this section that the purchase or sale of the security-based swaps, or class of security-based swap, be deemed the acquisition of beneficial ownership of the equity security.” (emphasis added).

In the SEC’s proposing release, the SEC expressed concern that this language implies that if the SEC does not enact new rules, its existing rules and practices regarding the treatment of derivatives with regard to beneficial ownership would no longer apply thereby giving investors the ability to use security-based swaps to accumulate control positions without disclosure. Yesterday’s proposal is intended to clarify that an investor must continue to make its determination of whether a security-based swap confers “beneficial ownership” based on the existing standards set forth in Rules 13d-3 and 16a-1 of the Exchange Act on a case-by-case basis.

Existing Application of Beneficial Ownership Rules to Security-Based Swaps

When a person or group becomes a 5% owner in the equity securities of a public company, it is required to make a disclosure filing under Section 13(d) of the Exchange Act. Owners of more than 10% of a public company’s equity securities (and certain other insiders) are also required to make certain disclosures under Section 16 of the Exchange Act and are subject to disgorgement of “short-swing profits” realized from trades in those securities as well as restrictions on short sales.

Ownership for these purposes is based on “beneficial ownership” of shares.  For Section 13 purposes, “beneficial ownership” is defined as sole or shared voting or investment power held “directly or indirectly, through any contract, arrangement, understanding, relationship or otherwise” and includes rights to acquire beneficial ownership within sixty days (e.g., through the exercise of any option or warrant). Beneficial ownership will also be deemed to exist if a person or group enters into a scheme or arrangement to evade these reporting requirements under the anti-avoidance rule in Rule 13d-3.  For purposes of determining whether a holder has crossed the 10-percent threshold for Section 16 purposes, the beneficial ownership standards are the same as set forth in Section 13(d). For all other purposes under Section 16, beneficial ownership means having or sharing a direct or indirect pecuniary interest in those securities.

Certain security-based swaps have received significant attention in recent years due to their widely-publicized use by shareholder activists to obtain large economic positions in public companies without obtaining voting rights in the underlying shares. Although Rule 13a-3 does not specifically address whether security-based swaps constitute “beneficial ownership” of the underlying securities for Section 13 purposes, it has been generally well accepted that security-based swaps that are by their terms and in fact settled in cash, do not constitute “beneficial ownership” of the underlying equity. In a decision based heavily on the particular facts, the federal district court in the CSX case held that the cash-settled equity swaps at issue were deemed to constitute beneficial ownership of the underlying securities under the anti-avoidance section of Rule 13d-3 described above.

The SEC’s proposal seeks to preserve the current state of affairs with respect to this issue and, as stated in the proposing release, “is neither intended nor expected to change any existing administrative or judicial application or interpretation of the rules.” However, while the status quo is being preserved for the time being, the release confirmed that the staff is “engaged in a separate project to develop proposals to modernize reporting” under Sections 13(d) and (g).

See a copy of the SEC's proposing release.

See a copy of the prior Davis Polk newsflash discussing the CSX decision.


If you have any questions regarding this newsflash, please contact any of the lawyers listed below or your regular Davis Polk contact.

Daniel N. Budofsky 212 450 4907
Alan F. Denenberg650 752
Peter R. Douglas212 450
Mark M. Mendez212 450 4829
Phillip R. Mills212 450
Barbara Nims212 450
Mutya Fonte Harsch212 450


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