Swaps and other derivative instruments have evolved to facilitate a variety of investment strategies with respect to a single security. The bundle of rights associated with a single share can be "unbundled" in different ways through the use of these derivative instruments. For example, investors can acquire economic exposure to a security without owning the security or even having the right to acquire it, or can hedge their exposure to a security without having to sell.
Derivative trading has for a long time figured prominently in contests for corporate control. Investors in these transactions value the ability to move quickly in and out of a large position without much market awareness of their activity.
Many of the rights acquired under derivative instruments do not fit clearly within existing categories for disclosure under the securities laws in the United States or Canada. Recent decisions in both the U.S. and Canada, however, signal that instruments previously thought to be outside of the disclosure regime may be disclosable in contests for control, or possibly if used to avoid reporting requirements in other contexts
In its 2006 decision in Sears,1 the Ontario Securities Commission noted that if swaps were used to "park securities" in the context of a take-over bid, in a deliberate effort to avoid reporting obligations and for the purpose of affecting an outstanding offer, this could constitute abusive conduct sufficient to engage the Commission's public interest jurisdiction.
More recently a U.S. federal court in New York was asked to address these issues in the context of a proxy battle for rail company CSX Corporation. This commentary discusses the facts before that court and the basis for the court's findings that a disclosure obligation existed.
Facts and Findings
The CSX2 decision released in June 2008 involved a complaint by CSX Corporation against two large hedge funds (The Children's Investment Fund (TCI) and 3G Capital Partners) that initially acquired interests in CSX stock by entering into cash settled "total return" swaps. The case focuses on the use of the swaps to obtain significant market power, without disclosure, over a year before the funds launched a proxy fight for five out of the 12 positions on the CSX board.
The swaps in question gave the hedge funds the economic exposure to the CSX stock, but no ownership of the stock or any right to acquire it. The court found, however, that the bank or other financial counterparty to a large total return swap almost always hedges its position through a matching purchase of shares. In addition, the court noted that, at least in large swap transactions, it was easy for the "long" party (such as the funds) to close out the swap position by acquiring the underlying shares. Thus, the contracts enabled the funds to accumulate a substantial economic position (eventually over 14 percent of the outstanding stock in the case of TCI) through the swaps but to avoid market awareness of their position until they were ready to publicly announce their intentions with respect to the stock.
Using the anti-avoidance principles of Rule 13d-3(b) under the Securities Exchange Act of 1934 (the "Exchange Act"), the CSX court found that the funds had acquired beneficial ownership of the CSX shares through the use of the total return swaps. Accordingly, the funds should have reported their interests in the CSX stock over a year before the proxy fight was commenced. As all the material facts were eventually disclosed, however, the court did not prevent the funds from continuing the proxy battle or voting their shares.
Prior to the CSX decision, the prevailing view was that a total return swap that called for cash settlement did not confer reportable "beneficial ownership" under Section 13(d) of the Exchange Act because it did not give the "long" party the right to vote or dispose of any actual shares. This was in effect the view expressed by the staff of the U.S. Securities and Exchange Commission in a letter addressed to the court. As the funds argued, there was no obligation, just a financial incentive, for their counterparties to purchase shares to hedge the total return swap.
Ultimately, the CSX court declined to rule as to whether, in the abstract, a cash-settled total return swap creates beneficial ownership for purposes of Section 13(d). Instead, the court relied on the anti-avoidance provisions of Rule 13d-3(b) to conclude that, in this particular case, the funds had acquired beneficial ownership for the purpose of the rule because they had used the total return swap to evade the reporting requirements of Section 13(d).
Critical to the court's decision was the fact that the funds appeared to be planning a proxy fight and acting as significant shareholders of CSX long before they acquired more than their swap positions. Moreover, the funds appeared to have structured the swaps deliberately to avoid reporting requirements. For example, the court noted that the hedge funds had originally spread their positions among counterparties to ensure that no counterparty acquired more than five percent of the stock (the reporting threshold for Section 13(d)), and then later consolidated their positions in the hands of a few counterparties who were thought to be likely to vote in favor of the funds' proposals. It was therefore the motives of the two hedge funds which were at issue – rather than the instruments themselves.
What Does the CSX Decision Mean
The CSX decision raises potential issues for holders of derivative instruments. Although the court confined its comments largely to the specific facts before it, its findings (unless overturned on appeal) will require derivative investors to look closely at their intentions with respect to the issuer of the underlying securities and to be sensitive to the potential need to file under Section 13(d) in situations where a filing was not thought to be necessary.
Regulatory change could also be on the horizon. As noted by the CSX court, disclosure of certain derivative positions is required in the United Kingdom. It is also possible that the U.S. Securities and Exchange Commission will review this issue, possibly in conjunction with proxy access proposals in 2009. The Ontario Securities Commission is actively studying the issue.
Issuers are also now considering what action they should take to deal with parties who hold interests in their securities through derivative instruments. For example, in the United States, a few companies have already amended their poison pills to include derivatives when calculating levels of beneficial ownership that would trigger the pill.
1. Sears Canada Inc., Re, 22 B.L.R. (4th) 267 (Ontario Securities Commission, August 8, 2006).
2. CSX Corporation v. The Children's Investment Fund et al. (U.S. District Court for the Southern District of New York, June 11, 2008).
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.