Canada: Disclosure Of Derivative Positions Comes Under Renewed Scrutiny

Last Updated: July 25 2008
Article by Robert J. Brant, Garth M. Girvan, Ian Michael and Michael C. Nicholas

Most Read Contributor in Canada, September 2018

Recent pronouncements by a court in the United States, as well as regulatory activity in the United Kingdom, have highlighted the issue of whether rules requiring disclosure of beneficial interests in securities of public companies should extend to economic interests in securities held through derivative contracts such as cash-settled total-return equity swaps (TRSs) and similar financial instruments. The debate resulting from these developments may have implications for Canada's securities regulatory regime.

The CSX Decision in the United States

Considerable commentary has been published and debate waged since the June 11, 2008 decision of Judge Lewis Kaplan of the United States District Court for the Southern District of New York in CSX Corporation v. The Children's Investment Fund Management (UK) LLP et al. The defendants in this private securities law enforcement case — The Children's Investment Fund Management (UK) LLP (TCI) and 3G Fund LP (3G) and their respective affiliates — are hedge funds that ultimately led a proxy fight to elect five directors to CSX Corporation's (CSX) 12-member board.

Relying on anti-evasion provisions in beneficial ownership reporting rules under Rule 13d of the Securities Exchange Act of 1934, Judge Kaplan deemed TCI to be the beneficial owner of CSX shares that were the reference security for certain TRSs, and ruled that the defendants had failed to report their shareholdings in the manner required by US securities laws. Ultimately, Judge Kaplan found that he was precluded by binding precedent from enjoining the defendants from voting their shares in the contested CSX shareholders' meeting held on June 25, 2008. Judge Kaplan did, however, enjoin the defendants and their principals from further violations of the beneficial ownership reporting rules.

In the fall of 2006, TCI began investing in CSX, a major US railroad that it believed could achieve better performance and a higher stock price with some changes to its management and policies. From this period until the end of 2007, TCI, and at times, 3G, entered into TRSs that gave them economic exposure to CSX shares, but not legal ownership. TCI's exposure to CSX shares through TRSs became very significant. During that time, TCI accumulated exposure to approximately 11% of CSX's shares through eight different counterparties with a total notional value of in excess of US$2.0 billion. Over this period, neither of the defendants accumulated a legal ownership position of more than 5% of CSX's shares, thus falling under the threshold to report their ownership in CSX. In addition, none of the financial institution counterparties to the TRSs individually held more than 5% of CSX's shares — shares they had acquired to hedge their TRSs with one or both of the defendants.

The Court found that TCI had notified 3G of its holdings and interests in CSX in January 2007. In February 2007, 3G also began accumulating CSX shares, including entering into some TRSs for CSX shares. The Court also found that TCI had approached other hedge funds in the spring of 2007 and encouraged those funds to purchase CSX stock. About the same time, TCI filed a pre-merger notification report under the Hart-Scott-Rodino Act stating that TCI intended to acquire CSX shares for a value exceeding $500 million. In June 2007, 3G filed the same pre-merger notification. Ultimately, the Court found that TCI and 3G had been coordinating their acquisitions and dispositions of CSX stock throughout much of 2007. If TCI and 3G had been acting as a group, disclosure of their aggregate holdings would have been required at the 5% threshold. However, neither of the defendants made any regulatory disclosure of their holdings until December 19, 2007.

In the latter half of 2007, TCI began preparations for a proxy contest to replace some of the CSX directors. TCI's strategy was to install five nominees on CSX's 12-member board. On December 19, 2007, TCI and 3G entered into a formal agreement to coordinate their efforts to change policies at CSX. They formed a group along with three nominees who had agreed to stand for election as directors. The group filed a Schedule 13D disclosing its formation and their collective holdings. The group disclosed that it collectively owned 8.3% of CSX shares outstanding. The Schedule 13D filing also disclosed that TCI had TRSs giving it economic exposure to a further 11% of CSX shares outstanding. 3G similarly disclosed that it had TRSs for 0.8% of the CSX shares. Both TCI and 3G disclaimed beneficial ownership of the shares underlying the TRSs.

CSX proceeded to file its proxy statement on February 21, 2008, and the group filed its proxy statement on March 10, 2008. CSX quickly brought its action against TCI and 3G (a week later). On the issue of beneficial ownership reporting, CSX's suit made two principal allegations. First, CSX alleged that TCI had violated Section 13(d) of the Securities Exchange Act of 1934 by not disclosing its beneficial ownership of CSX shares. Second, CSX alleged that TCI and 3G had violated Section 13(d) by failing to disclose the formation of a group in a timely manner.

Judge Kaplan thought the unique facts of the CSX case led to persuasive arguments for concluding that the TRSs held by TCI represented an actual beneficial ownership interest in the underlying CSX shares under Rule 13d-3(a), but did not find it necessary to answer this question. Instead, Judge Kaplan relied on the anti-evasion provision in Rule 13d-3(b) to deem TCI to be the beneficial owner of the CSX shares subject to the TRSs it had entered into.

Interestingly, the decision of the Court contrasts with the observations of the SEC in a letter that was sent to the Judge at his request. The SEC letter noted that, as a general matter, a person who does nothing more than enter into an equity swap should not be found to have engaged in an evasion of the reporting requirements. The SEC went on to say that the anti-evasion provision of Rule 13d-3(b) requires an intent to evade and that this would require an intent to enter into an arrangement to create a false appearance.

While the anti-evasion analysis in the CSX decision was heavily fact-dependent, the important implication for derivative instruments more generally was the obvious inclination of the Judge to conclude, if necessary, that TRSs represent beneficial ownership of shares on their face. This implication, even though it was not the basis for the decision of the case, would represent a significant departure from the widespread view that owning economic interests in securities through cash-settled derivative contracts is not the equivalent of beneficial ownership of the reference securities. The mere possibility that such a conclusion was even proposed attracted amicus briefs from both the International Swaps and Derivatives Association (ISDA) and the Securities Industry and Financial Markets' Association, and even a short comment by ISDA on the Court's decision following its release.

Judge Kaplan clearly invited legislators to weigh in on the issue. Soon after the release of the CSX decision, Senator Charles Schumer of New York sent a letter to the SEC calling on the SEC to clarify the treatment of equity swaps.

The CSX shareholders' meeting ultimately proceeded on June 25, 2008, with TCI voting the shares that it had acquired during the period that Judge Kaplan found that it was not in compliance with applicable disclosure obligations. CSX initially said it would delay the announcement of the results of that vote until July 25, 2008, but announced the results on July 16, 2008. Four of the five nominees of TCI and 3G were elected to the CSX board, at least for now. Further developments are likely in this case as the CSX decision is currently under appeal. The Second Circuit Court of Appeals has agreed to hear an appeal by both parties on an expedited basis — likely in August.

Developments in the United Kingdom

Prior to the CSX litigation, the Financial Services Authority (FSA) in the United Kingdom had begun a public consultation on the disclosure rules for holding contracts for differences (CfDs), which are the UK equivalent of TRSs. CfDs, like TRSs, are contracts where the seller agrees to pay the buyer the difference between the current value of an asset and its value at contract time. CfDs are very similar to equity swaps, with the additional benefit of being traded on margin and being exempt from certain taxes in the UK.

Several alternatives had previously been proposed, but the FSA announced on July 2, 2008 that it has decided to implement a general disclosure regime for CfDs, including that they be aggregated with ordinary share positions when investors are calculating the required disclosure threshold at the existing level of 3%. Exemptions for market-makers and other appropriate intermediaries will be provided in order to reduce unnecessary disclosures and reduce the cost of implementing such disclosure.

Draft rules and a policy statement are proposed to be published by the FSA in September 2008, with final rules proposed to be published in February 2009 — and to be effective, at the latest, in September 2009. However, the FSA may try to advance that date.

Implications for Canada

The uncertainty arising from the CSX decision is not the first time Canadian regulators have had reason to consider the relationship between beneficial ownership reporting requirements and the use of equity swaps. The Ontario Securities Commission examined this issue as part of its August 8, 2006 decision in Sears Canada Inc.

In the Sears Canada case, a majority shareholder, Sears Holding, decided to make an offer to take Sears Canada private by way of an offer to acquire all of the shares it did not already own. This offer was actively opposed by a number of hedge funds on the basis that the price offered was too low. The contest between Sears Holding and the opposing hedge fund shareholders, led by Pershing Square Capital Management, resulted in litigation over a number of substantive issues on both sides. One of the issues litigated was the allegation that Pershing and the other opposing hedge funds had not properly complied with the reporting of their beneficial ownership interests in Sears Canada. Very similar to CSX, there were three aspects to this allegation: (i) whether the hedge funds were acting jointly or in concert together such that their holdings needed to be aggregated, (ii) whether one of the hedge funds used cash-settled equity swaps to avoid disclosure obligations, and (iii) whether the hedge fund that had used swaps continued to exercise a degree of control or direction over the shares of Sears Canada that were subject to those swaps.

The Commission determined there was insufficient evidence to conclude the hedge fund holding equity swaps that referenced Sears Canada shares had beneficial ownership or control or direction over the shares subject to those swaps. Accordingly, the hedge fund did not have any disclosure obligations under the early warning reporting requirements of the Securities Act. However, the Commission did specifically note that it was possible circumstances could arise where the Commission would invoke its public interest jurisdiction under the Securities Act to find a different result, stating:

"We wish to underscore that there might well be situations, in the context of a take-over bid, where the use of swaps to "park securities" in a deliberate effort to avoid reporting obligations under the [Securities] Act and for the purpose of affecting an outstanding offer could constitute abusive conduct sufficient to engage the Commission's public interest jurisdiction."

In other words, even though Canadian early warning reporting requirements do not contain the anti-evasion provisions that Judge Kaplan relied on in the CSX decision, the Ontario Securities Commission has indicated that if sufficient abusive conduct exists, it might well use its public interest power to impose sanctions.

The ongoing litigation with respect to CSX and the recent and relatively strict proposal by the FSA in the UK to require reporting of equity swaps will no doubt cause securities regulators in Canada to consider the early warning disclosure obligations with respect to equity swaps at least in certain circumstances. Currently in Canada, only insiders of public companies are generally considered to be subject to disclosure obligations with respect to certain transactions involving derivatives pursuant to Multilateral Instrument 55-103 Insider Reporting of Certain Derivative Transactions (Equity Monetization) (MI 55-103). MI 55-103 generally requires the filing of an insider report by an insider that enters into, amends or terminates an agreement, arrangement or understanding of any nature or kind that has the effect of altering, directly or indirectly, the insider's economic interest in a security of the reporting issuer, or its economic exposure to the reporting issuer. It may, however, be possible to also characterize the total return component of any TRS having a physical settlement option as a convertible security for purposes of Canada's early warning reporting requirements, thereby requiring the counterparty that is long the total return component to file an early warning report.

In addition to proxy battles, the consideration of disclosure requirements for equity swaps may have implications for the take-over bid regime as well. Prospective bidders might consider using equity swaps to quietly establish "toe holds" prior to the launch of a take-over bid. In such situations, large economic positions through TRSs could be converted from cash settlement to physical settlement, and create a large position that otherwise was not disclosable prior to settlement. A prospective bidder could also, by way of equity swaps, effectively park securities with a counterparty to a TRS in anticipation that those securities would be tendered to their bid. Further, in keeping with the above-described early warning reporting analysis, the counterparty to a physically settled equity swap that is long the total return component of the swap could be deemed to beneficially own the underlying interest of the swap if the counterparty has the right to acquire the reference securities within 60 days.

Two other developments have occurred in the United States as the use of derivatives has become more common by activist hedge funds in connection with proxy battles and take-over bids. First, over 40 New York Stock Exchange-listed US companies have, in recent months, amended their bylaws to require shareholders nominating directors for election to state their shareholdings, including any derivatives that provide the shareholder with economic exposure to the company's shares. Second, some US issuers have amended their shareholder rights plans ("poison pills") to expand the definition of beneficial ownership contained in such documents to include equity swap positions.

The implications of these developments in the United States and the United Kingdom — and the Ontario Securities Commission's statements in the Sears case — suggest that legislators and regulators in Canada may soon consider taking action to enhance disclosure rules to ensure the public is informed of the true economic interest of various actors in underlying shares of public companies. This will have implications for public companies, for investors and for intermediaries in derivative transactions.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on

Click to Login as an existing user or Register so you can print this article.

In association with
Related Topics
Related Articles
Related Video
Up-coming Events Search
Font Size:
Mondaq on Twitter
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
Email Address
Company Name
Confirm Password
Mondaq Topics -- Select your Interests
 Law Performance
 Law Practice
 Media & IT
 Real Estate
 Wealth Mgt
Asia Pacific
European Union
Latin America
Middle East
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of

To Use you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.


The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.


Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions