A June 11, 2008, decision by the US District Court for the Southern District of New York creates uncertainty regarding whether the long party to a cash-settled total return equity swap will be deemed to beneficially own the publicly-traded reference security for purposes of Section 13(d) of the Securities Exchange Act of 1934. CSX Corp. v. The Children's Investment Fund Management (UK) LLP, 08 Civ 2764 (LAK) (S.D.N.Y. June 11, 2008). Ruling in the context of a proxy litigation between CSX Corporation, one of the U.S.'s largest railroads, and two families of activist hedge funds, The Children's Investment Fund Management (UK) LLP ("TCI") and 3G Fund L.P. ("3G"), Judge Lewis A. Kaplan found that TCI used total return swaps specifically to avoid being labeled as the beneficial owner of the CSX shares acquired by its counterparties to hedge their short positions, and did so as part of a plan or scheme to evade the reporting requirements of Section 13(d). While offering extensive dicta about whether and when ownership of cash-settled total return swaps should be deemed beneficial ownership of the reference security – statements that will undoubtedly become fodder for many litigations to come – the court ultimately rested its decision more narrowly on a series of factual findings concerning these investors' efforts to evade Section 13(d)'s reporting requirements. Under SEC Rule 13d-3(b), such evasive maneuvers are functionally disregarded, and the person is deemed to beneficially own the very securities that he sought to avoid beneficially owning. Thus, Judge Kaplan found that because TCI had consciously structured its investments to try to end-run its otherwise applicable reporting obligations, it was deemed to have beneficial ownership of the shares subject to its swap contracts, and accordingly, had violated Section 13(d) by failing to file a Schedule 13D in the required time.
The ruling is important for financial institutions and investors who deal in derivatives such as equity swaps and who must determine if and when reporting under Section 13(d) is required. Holders of cash-settled total return swaps have historically relied on the absence of the legal right to vote or dispose of the reference security as a basis not to file a 13D with respect to the shares referenced in those swap contracts. While the court did not completely jettison those market expectations, the CSX decision suggests that a court may disregard the form of the investment and ignore the swap holder's legal rights and focus instead on its economic or practical ability to influence the voting or disposition of the shares by the counterparty. The decision may also impact determinations regarding beneficial ownership under other federal and state laws, as well as under shareholder rights plans (so-called "poison pills"), bond indentures and other contractual provisions which reference beneficial ownership as defined in Section 13(d) or that are interpreted using similar principles or language.
Court's Analysis. Before eventually determining that the court need not resolve whether the holder of a cash-settled total return swap beneficially owns the reference stock under Rule 13d-3(a), Judge Kaplan discussed (in what amounts to lengthy dicta) several factors that would be relevant to such a determination. First, the court observed that in practice swap counterparties usually do, and the counterparties in this case actually did, hedge their side of the swap by purchasing the reference shares, and sell the reference shares immediately after the swap is terminated. Second, the court noted that cash-settled swaps can be, and often are, settled in kind, merely upon the agreement of the parties. Such circumstances, the court suggested, might justify a conclusion that the holder of the swap contract beneficially owns the underlying shares because as a practical (though not a legal) matter, it has investment decision-making power over the reference shares held of record by the counterparty. Third, the court focused on a perceived incentive of a swap counterparty to vote the shares as requested by the long party because, in the court's view, an investor that has a significant ability to influence how voting power will be exercised has beneficial ownership under Rule 13d-3(a). These views – which were unnecessary for the court's eventual holding – will likely spawn further debate about when swap holders are, in reality, beneficial owners of the reference security.
But the court ultimately ruled that it was not necessary to resolve these questions or to reach a conclusion as to the status of the swaps under Rule 13d-3(a) because TCI would instead be deemed to beneficially own the reference shares pursuant to Rule 13d-3(b), which provides that one who creates a contractual arrangement that prevents the vesting of beneficial ownership as part of a plan or scheme to avoid disclosure that would have been required if the shares had been purchased directly is deemed to be the beneficial owner of those reference shares.
Judge Kaplan construed Rule 13d-3(b) expansively, rejecting a proposed reading of a submission from the Staff of the SEC Division of Corporate Finance that "a plan or scheme to evade" the reporting requirements under Rule 13d-3(b) exists only when a party enters into a transaction with the intent to create "a false appearance of non-ownership of a security." Judge Kaplan instead held that "Rule 13d-3(b) 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 reporting requirements] through preventing the vesting of beneficial ownership in the actor."
The Court focused on the broad purpose of Section 13 "to alert the marketplace to every large, rapid aggregation or accumulation of securities, regardless of technique employed, which might represent a potential shift in corporate control." Judge Kaplan viewed the investment in equity swaps as inherently being a way to methodically amass a substantial economic interest in an issuer without making the disclosures that would be required of a direct investor who surpassed the 5% reporting threshold. According to Judge Kaplan, such a strategy permits an investor "to ambush an issuer with a holding far greater than 5 percent." Here, the factual record demonstrated an activist strategy by TCI to try to influence CSX corporate strategy, which likely influenced the court's implicit reasoning that such behavior by an investor with an ever-increasing economic stake in the issuer is what Section 13(d) disclosure is designed to help flag for the marketplace. Judge Kaplan was also critical of the ability of the equity swap investor to create a large economic holding in an issuer without the run up in the stock price that would typically accompany an investor's disclosure of a large and increasing stake. (Notably, the court did not appear to consider the effect that counterparty hedging would have on market prices.)
Fact-Driven Inquiry. The Court noted, but ultimately rejected, views offered by amici that the settled expectation of the marketplace was that equity swaps do not confer beneficial ownership of the reference shares and stated that "the Court is inclined to the view that the Cassandra-like predictions of dire consequences of holding that TCI has beneficial ownership under Rule 13d-3(a) have been exaggerated." The Court went on to say, however, that it was limiting its ruling to the particular facts here that demonstrated an effort to evade the Section 13(d) reporting requirements, which included:
- TCI specifically admitting using swap contracts to amass
a position while avoiding having to disclose those purchases
to the issuer or the markets;
- TCI repeatedly referred to "owning" the shares
that were the subject of the swaps;
- TCI purposely placed a large portion of the swap
contracts with a counterparty that it had reason to believe
would vote the reference shares as desired by TCI;
- TCI was aware that its counterparties would hedge the
positions by acquiring a matching number of CSX shares and
would dispose of those shares as soon as the swap contracts
were terminated, and TCI thus knew that it had the economic
ability to cause the counterparties to buy and sell the CSX
shares; and
- TCI "spread[] its swap contracts among eight
counterparties to avoid any one hitting the 5 percent
disclosure threshold and thus triggering its own reporting
obligation."
Group. Judge Kaplan also held that on the facts and circumstances of the case, TCI and 3G became a group for purposes of Section 13(d)(3) of the Exchange Act nearly ten months earlier than they disclosed a group had been formed. In this regard, the court noted that the two funds had a close relationship, that they affirmatively discussed TCI's investment in CSX on several occasions, and that 3G's trading either mirrored TCI's or occurred in the immediate wake of a discussion with TCI. The clear lesson is that funds that "compare notes" about their respective positions or tactics, even with caveats that seek to preserve the point that they do not think they are a group, nonetheless may be found to be a group based on those discussion and ensuing parallel behavior.
Remedy. CSX sought to enjoin TCI and 3G from voting the shares they accumulated while in violation of their respective disclosure obligations. The Court rejected this request on the ground that it was bound by Second Circuit precedent not to disenfranchise such shares in the absence of any irreparable harm, which the Court was unable to find. However, Judge Kaplan invited the Second Circuit to overturn his ruling on this issue, stating that if he had the ability he would have enjoined the voting of the shares.
Judge Kaplan did, however, issue a permanent injunction against TCI and 3G enjoining them from any future violations of Section 13(d). The Court found that there was a substantial likelihood of future violations in the event that the funds did not prevail in the proxy battle. The Court found it key that further Section 13(d) violations could allow defendants to increase their position to a point of working control and that remaining shareholders would find themselves with shares in a corporation with a controlling shareholder and thus deprived of the opportunity to gain a control premium.
Implications of the Decision. While the ruling is clear that all determinations as to beneficial ownership, whether under Rule 13d-3(a) or Rule 13d-3(b), are highly contextual and fact specific, it also highlights how that judgment may be based not only on whether a holder has the legal right to effect voting or investment decisions, but also on whether a person "has any relationship that, as a practical matter, confers on a person 'significant ability to affect' how voting power or investment power will be exercised." That means that a party's subjective intent will be scrutinized, as will its relationships and understandings with the counterparties. Certainly it would be advisable to have no oral agreements or understandings with the counterparty regarding the potential disposition or voting of the shares if the swap transaction is to fall outside the ambit of Section 13(d). Furthermore, market participants should expect that filings (or the failure to file) may now be subject to much more factual second-guessing since, the court suggests, the transaction structure and attendant legal rights may not be controlling.
In addition to the direct implications for Schedule 13D filings, the CSX decision could have more farreaching impact to the extent that courts look to interpretations of Section 13(d) for guidance regarding the meaning of "beneficial ownership" in other areas, such as under banking statutes or gaming laws. For instance, it is possible that a court could look to Section 13(d) jurisprudence in the context of state antitakeover statutes that rely on the notion of beneficial ownership, such as Section 203 of the Delaware General Corporation Law. (Indeed, Section 203 uses a broader definition of beneficial ownership than does Section 13(d), creating a risk that as CSX-type analysis might sweep in even more market participants as beneficial owners.) Similarly, many shareholder rights plans, as well as change of control provisions in many indentures, employment agreements and other contracts, reference the definition of beneficial ownership under Section 13(d). Unlike here, where the Court ultimately provided the issuer with scant remedy, triggering Section 203 of the Delaware General Corporation Law, a shareholder rights plan or a change of control provision under an indenture could have a major impact on both the issuer and the investor.
Judge Kaplan's ruling did not address Section 16 under the Exchange Act, which subjects persons who beneficially own more than 10% of a class of a company's equity securities to profit recapture on purchases and sales that occur within 6 months of each other. Nonetheless, the determination of whether a holder beneficially owns 10% for purposes of Section 16 is based on whether the holder beneficially owns shares for purposes of Section 13(d). If a court were to engage in an analysis of the investor's subjective motives to hold or otherwise find that the holder of a swap providing economic exposure to more than 10% of a company's equity securities not only sought to evade its Section 13(d) reporting obligations but is also therefore, by reason of Rule 13d-3(b), a "beneficial owner" for purposes of Section 16, the holder potentially would be subject to significant monetary liability.
In sum, while the Court stated that its holding was limited to the facts of this case, its discourse about when a swap transaction may confer beneficial ownership of the reference shares, and its finding that the purchase of cash-settled swaps was part of a plan or scheme to evade the reporting requirements of Schedule 13(d) and, therefore, that TCI would be deemed the beneficial owner of the shares held by its counterparties, injects a degree of uncertainty into an area in which many rely on settled expectations of the marketplace that cash-settled equity swaps in and of themselves do not confer beneficial ownership of the reference shares. In addition to the complexity added to 13D reporting decisions, this opinion could have a broader impact in other contexts when a determination of beneficial ownership is required.
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