Corporate Governance

Beneficial Ownership, Equity Swaps, and Proxy Contests: CSX v. The Children's Investment Fund (Part 3A)

By J. Robert Brown

We are writing a series of posts on CSX v. The Children's Investment Fund (TCI), a case that explores the obligation to disclose shares acquired by a counterparty in an equity swap.  While we will continue with the posts (they include comments on the position taken by the staff of the Division of Corporation Finance in the case), we note that the trial judge issue an opinion today (115 pages, not including various charts and graphs attached as an appendix). 

The court noted that the swaps did not require the purchase of shares as a hedge but that "the evidence is overwhelming that these counterparts in fact hedged the short positions . . . by purchasing shares of CSX common stock."  Moreover, "their position could not be hedged through the use of other derivatives."  As a result, it was "inevitable" that they would buy the shares of CSX.  "TCI knew that the banks would behave in this manner". 

As for influence over the voting of the shares, TCI consolidated its swap positions mostly in the hands of two commercial banks:  Deutsche Bank and Citigroup, removing the business (except for a negligible position) from six investment banking firms.  The court clearly did not believe that this shift occurred because of concern over financial solvency of the investment banking firms (calling the argument "not entirely persuasive").  Moreover, the opinion concluded that the decision to move the business to Deutsche Bank was done "substantially" out of the belief that TCI "could influence the voting of the shares it held to hedge TCI's swaps."  Moreover, some of the firms had policies that prohibited the voting of shares in contested situations.  By having that firm acquire shares, TCI could prevent them from being voted against its candidates. 

The court described the factual evidence that the swaps were used to evade the reporting requirements of Section 13(d) as "overwhelming."  With respect to the letter from the staff of the Division of Corporation Finance (something we will analyze in a later post), The court disagreed with the implication that an investor would engage in a plan or scheme to evade the beneficial ownership reporting requirements only when it had an intent to create a false appearance of non-ownership.  Instead, the rule applies "where one enters into a transaction with the intent to create the false appearance that there is no large accumulation of securities that might have a potential for shifting corporate control by evading the disclosure requirements of Section 13(d) or (g) though preventing the vesting of beneficial ownership in the actor."

We will have more to say about this position in a subsequent post.  Suffice it to say that the rule covers not only transactions done with an "intent to create a false appearance" but also those transactions that have that effect.  This suggests that an elevated state of mind is not required for a violation of Rule 13d-3(b). 

The court also found that group formation occurred before the filing of the Schedule 13D in December 2007, a factual question.  Interestingly, the court did not find a violation of the proxy antifraud provision, rule 14a-9.  A strong case (as we will discuss in another post) can be made that the proxy disclosure materially mislead shareholders by noting the total number of hedged shares and the use of eight financial institutions but omitting disclosure that most of the shares were really held by two firms, Citigroup and Deutsche Bank (more than 11% of the voting shares of CSX).  Investors presumably would find it material to know that only two institutions had most of the shares.  Such large positions create economic incentives to use the shares in a way that benefits the client (including voting them on behalf of TCI's candidates for the board) that may not be present for smaller positions.

And the relief?  The court declined to order corrective disclosure or void proxies.  It did, however, consider the sterilization of the shares acquired during the period when the hedge funds were out of compliance with Schedule 13D.  That remedy, however, was rejected because of the absence of irreparable harm.  "It necessarily follows that the alternation of the corporate electorate arguably affected by defendants' actions, which did no more than increase its likelihood of prevailing in the current contest, cannot be regarded as irrepearable injury that properly may be remedied by preventing the voting of the stock . . . "  The only relief was to grant an incution "restraining future violations of Section 13(d)" 

In other words, CSX technically won, establishing violations of Section 13(d) but lost in the sense that the defendant hedge funds were not penalized for the failure to make proper disclosure.

We will post later today about the implications of the case.  The opinion is on the DU Corporate Governance web site.

Full post as published by The Race to the Bottom on June 12, 2008 (boomark / email).