On June 11, 2008, Judge Lewis Kaplan of the U.S. District Court for the Southern District of New York issued an opinion in the CSX proxy fight litigation that, if upheld on appeal, will significantly affect the analysis of when an economic interest in publicly traded shares acquired through a cash-settled total return swap (TRS) will be considered to confer beneficial ownership for purposes of the filing obligations imposed by Section 13(d) of the Securities Exchange Act of 1934 on owners of more than 5 percent of a company’s voting equity securities. (CSX Corporation v. The Children’s Investment Fund Management (UK) LLP, et al., SDNY 08 Civ. 2764 (LAK)) The opinion’s reasoning is of even greater significance because (although not discussed in the opinion) the same definition of beneficial ownership is used to determine whether the short-swing profit recovery provisions of Section 16(b) of the Exchange Act apply to owners of more than 10 percent of a company’s equity securities.
In rendering his opinion, Judge Kaplan’s reasoning extended well beyond a narrower, if not explicitly contrary, interpretation of the beneficial ownership rules advocated by the staff of the U.S. Securities and Exchange Commission (SEC) in a friend of the court filing and supported by the International Swap Dealers Association and the Coalition of Private Investment Companies in friend of the court briefs.
The case arose when CSX sued The Children’s Investment Fund (TCI) and the 3G Fund, both activist hedge funds, and their managers, alleging failures to file statements on Schedule 13D when required and inaccurate disclosures with regard to the number of shares owned when they did, as well as misstatements in their proxy statement. The funds countersued CSX for proxy misstatements.
In what may have been a Pyrrhic victory for CSX, Judge Kaplan found for CSX on the 13D claims but against both CSX and the funds on their assertions of proxy violations. In addition to his TRS findings, Judge Kaplan decided that TCI and 3G had engaged in a garden-variety failure to disclose that they had formed a group with respect to their holdings in CSX shares in February 2007, well prior to their acknowledgment of having done so in December. Even though he agreed that that there had been Section 13(d) violations, however, he found that under binding Second Circuit precedents he could not order voting sterilization of any portion of the funds’ shares or any other remedy that would be immediately helpful to CSX. Instead, he ruled that he was constrained to confine the remedies he could impose to an injunction against the funds and their managers not to engage in further violations of the U.S. securities laws.
In a typical cash-settled TRS the “long party” (in this case TCI and 3G) swaps the right to receive the dividends and the upside price movement on the underlying securities for the obligation to pay the counterparty (or “short party,” typically an investment or commercial bank) the downside price movement on the securities plus an agreed interest rate (typically a spread over LIBOR) on the value of the securities. Judge Kaplan found that the swap counterparty in a cash-settled TRS for all practical purposes always hedges the swap by purchasing the underlying securities and will sell the securities when the swap is terminated; he cited evidence that no other kind of hedge is generally feasible and that, while possible, investment and commercial bank swap counterparties almost never effect an unhedged swap based on publicly traded securities.
Judge Kaplan first determined that he did not need to reach the issue of whether TCI and 3G, as TRS long parties, should automatically be deemed to have been the “beneficial owners” of the CSX hedging shares held by the counterparties according to the definition of beneficial ownership found in Rule 13d-3(a). That provision defines beneficial ownership to include a party’s power to control either the voting or disposition of the securities in question. The opinion concedes that the long party in a cash-settled TRS does not have the legal power to control either of those attributes, but Judge Kaplan cited various SEC pronouncements for the proposition that the word “control” in context should be read with an “influence” component. It is in this respect that the opinion departs most significantly from the views expressed by the SEC staff.
After noting that the TRS counterparty almost always hedges by acquiring the underlying securities, Judge Kaplan’s opinion emphasizes that the terms of a cash-settled TRS can be modified at any time to provide for in-kind settlement and that in-kind settlement can in any event be effected upon swap termination. In addition, he noted that even if the long party does not acquire the hedging securities upon termination, the long party knows that the securities are effectively locked up until the swap’s termination and provide a source of securities to purchase on the open market upon termination (the occurrence of which, of course, is generally at the instance of the long party).
Judge Kaplan found that counterparties’ policies differ on whether, and the extent to which, the TRS long party may influence the manner in which the hedging securities are voted. Some counterparties have no policy on voting securities held for hedging purposes; other do not vote as a matter of policy; others’ policies provide that they will vote according to their own preferences; others are explicitly willing to be influenced by the TRS long party. Deutsche Bank, one of TCI’s counterparties, fell into the last category, and Judge Kaplan’s opinion implies, without finding as such, that such a willingness constituted a factor in TCI’s selection of Deutsche Bank as one of the counterparties in which TCI concentrated its TRS transactions as its transactions in relation to CSX’s stock waxed and waned. In that connection he also noted that counterparties have a business incentive to be known in the TRS marketplace to be willing to vote hedging shares in a manner pleasing to long parties and that, given the structure of TRSs, hedged counterparties have no economic interest in the shares to sharpen their voting judgment.
In the end, however, although he clearly implied that he would have found that a TRS long party always has beneficial ownership as defined in Rule 13d-3(a) had that been the only issue before him, Judge Kaplan did not rest his decision on that basis. Nor did he conclude, as urged by CSX, that TCI and 3G had formed groups with their TRS counterparties for the purpose of acquiring, holding, voting or disposing of CSX shares as defined in Rule 13d-5(b)(1) (although he indicated that the group finding was a close one that might have come out differently).
Instead, Judge Kaplan found that, in the specific context of TCI’s and 3G’s use of TRSs in relation to CSX shares, they should be deemed to have been, and to be, beneficial owners of the hedging shares as a result of the application of Rule 13d-3(b). That portion of Rule 13d-3 provides that a party is deemed to own securities if it directly or indirectly “creates or uses … any … contract, arrangement, or device with the purpose or 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 13(g) of the [Exchange] Act.” Extensively reviewing the history of TCI’s use of CSX TRSs, the judge found that, among other things, TCI had made sure not to engage in TRSs with any counterparty that would cause that counterparty to own more than 4.9 percent of the shares, specifically for the purpose of keeping any counterparty from having to file and delaying the commencement of a Schedule 13D filing obligation on TCI’s part. Further, he found that Christopher Hohn, who runs TCI, had stated outright to a CSX executive that TCI’s swaps could be converted into direct ownership at any time. In addition, the opinion is replete with findings of fact that question the veracity of Christopher Hohn and Alexandre Behring (who runs 3G). Indeed, in connection with his consideration of the probability of future violations as part of his decision as to whether to issue an injunction, Judge Kaplan found that “both [Hohn and Behring] testified falsely in a number of respects, notably including incredible claims of failed recollection, to avoid responsibility for their actions.”
The following are some further issues and implications:
- Both sides have stated that they will appeal. Although the Second Circuit is likely to respect Judge Kaplan’s findings of fact, it may be expected that the defendants will challenge his failure to distinguish between a plan or scheme to “evade” the disclosure of beneficial ownership (which Rule 13d-3(b) requires) and a plan or scheme to “avoid” such disclosure. CSX, on the other hand, may be expected to argue that beneficial ownership should be found directly based on “control” of the hedging shares, with control defined as having a significant “influence” component.
- The most interesting technical legal question may be whether other courts—and perhaps even the SEC staff—will carry forward Judge Kaplan’s expressly not made, but strongly implied, ruling that a TRS always gives rise to beneficial ownership under Rule 13d-3(a), but that is not the most important takeaway when a long party’s combined direct and TRS holdings of interests in a voting equity security would exceed 5 percent. Unless Judge Kaplan’s “evasion” ruling is overturned, it will always be possible in similar circumstances for the securities’ issuer (or the SEC) to argue that the TRSs are being used as a plan or scheme to evade the Section 13(d) reporting obligations. While such a contention might be turned back in particular factual circumstances, the roadmap provided by Judge Kaplan’s opinion will be eagerly followed by others (including, of course, issuers seeking the advantage in corporate control fights).
- As previously noted, for TRS long parties whose holdings could be deemed to exceed 10 percent of an issuer’s outstanding shares—perhaps including TCI and 3G in this very case—Judge Kaplan’s ruling could give rise to short-swing profit recovery concerns under Section 16(b) of the Exchange Act with respect to purchases and sales that occur while a 10 percent holding position is deemed to exist. This is because the Regulation 13D-G definition of beneficial ownership is also used to determine the obligation of make filings under the SEC’s rules under Section 16(a), which in turn set the stage for potential liability under Section 16(b). In this connection Judge Kaplan’s failure to find that a group had been formed between TCI and 3G, on the one hand, and their TRS counterparties, on the other hand, could be particularly significant from the perspective of the counterparties because, if the counterparties were members of a group, they might be deemed owners of all the shares owned by the group and therefore be found liable under Section 16(b) to the extent of their own economic interest in transactions in the shares. However, a lack of group membership on the part of the TRS counterparties would confer no advantage on TRS long parties such as TCI and 3G if they are deemed to beneficially own their counterparties’ shares under Rule 13d-3(a) or Rule 13d-3(b). In addition, the effect of a counterparty’s knowing participation (if found to be the case) in a plan or scheme to evade within the meaning of Rule 13d-3(b) is not clear from a Section 16 perspective (among other things, such a participation would probably be a significant factor in a group determination).
- As a result of the incorporation of the Regulation 13D-G definition of beneficial ownership into other contexts, additional consequences may follow from a holding that TRS long parties hold beneficial ownership. Among those consequences could be the triggering of state takeover statutory provisions, poison pills and other corporate charter, bylaw and contractual provisions. Indeed, some poison pills have already been adopted that include derivative economic holdings in the calculation of kinds of “ownership” that trigger the pill.
- Pending appeal, investment and commercial bank counterparties may wish to avoid possible issues by obtaining representations from their TRS long parties that the holdings of the long party, with TRS interests included, do not exceed 5 percent of the issuer’s shares.