Portfolio Media, Inc. 648 Broadway, Suite 200 New York, NY 10012 www.law360.com Phone: +1 212 537 6331 Fax: +1 212 537 6371 customerservice@portfoliomedia.com The CSX Case In Historical Perspective Law360, New York (August 27, 2008) -- CSX Corporation vs. The Children s Investment Fund Management (UK) LLP, et al.[1] is the latest milestone in the evolving tug-of-war between activist investors and public companies. It also highlights significant regulatory risks in Section 13(d) reporting, of which public companies, investors, and their counsel should be aware. In order to fully understand the case and what it could ultimately represent, it is important to understand the history behind it and the trends and forces that made the case inevitable. The Historical Context Of The CSX Case The story of the CSX case began 40 years ago. In 1968, Congress adopted the Williams Act, which addressed a gap in securities regulation: the use of cash to purchase control of companies. Before the Williams Act, an investor s accumulation of a company s equity securities had no transparency. The legislation followed reports of coercive tender offers that deprived stockholders of the time and information needed to make a reasoned decision to sell or hold. The Williams Act required disclosure if an investor acquired directly or indirectly beneficial ownership of more than 10 percent of the equity securities of a class that is registered under Section 12 of the Securities Exchange Act. Consequently, beginning from the 10 percent threshold, significant accumulations of equity ownership would become transparent to the market. In 1970, Congress amended the statute by lowering the trigger from 10 percent to the 5 percent trigger that is current law. The Williams Act left the SEC wide discretion in defining beneficial ownership. Congress did so, no doubt, because of the myriad of complex forms that ownership can
take. Indeed, the SEC embarked on a lengthy factual study of beneficial ownership before adopting final rules in 1977. The SEC must have been impressed by the complexity of what it found. The temporary rules on beneficial ownership, in place for nearly a decade, were very literal and narrow, generally tracking legal forms of ownership. By contrast, Rule 13d-3, adopted in 1977 (and largely unchanged to date), was openended and looked beyond legal forms of ownership to actual voting and investment power. Rule 13d-3(a) permits the SEC to reach any set of facts that bestow voting or investment control over a company s equity securities (or the ability to obtain such control within 60 days). The rule currently covers any person who, directly or indirectly, through any contract, arrangement, understanding, relationship, or otherwise has or shares: Voting power which includes the power to vote, or to direct the voting of, such security; and/or, Investment power which includes the power to dispose, or to direct the disposition of, such security. In addition, paragraph (b) of Rule 13d-3 would capture any person who sought to circumvent the definition in paragraph (a). It currently provides that: Any person who, directly or indirectly, creates or uses a trust, proxy, power of attorney, pooling arrangement or any other 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 (g) of the Act shall be deemed for purposes of such sections to be the beneficial owner of such security. The scheme to evade provision in paragraph (b) would eventually become pivotal to the CSX court ruling. The second part of the story leading up to the CSX case is the growth in complex financial derivatives. If the Williams Act did not fully take these types of instruments into account, it is because they simply did not exist at the time in any significant degree. Of course, derivative instruments have been around since at least 580 BC, when the Greek philosopher Thalus, betting on a strong harvest, entered into an option contract to secure rights to local olive presses.[2]
And much of the 20th century saw growth in futures trading relating to physical commodities.[3] But the day of complex financial derivatives did not begin in earnest until the 1980s and 1990s. This is not the first time that more recent growth of complex derivative instruments has tested the applicability of older laws and rules. The SEC has, for instance, been struggling for years to clarify the application of Rule 144 (the safe harbor for the resale of restricted and controlled stock) in light of the growth of derivative instruments, including equity swaps.[4] The final chapter leading up to CSX is the growing conflict between public companies and activist funds. These funds typically seek changes in corporate governance and management direction. In July 2008, for instance, Carl Icahn obtained three seats on Yahoo s board in a deal that ended a proxy fight.[5] Other companies that have recently received the attention of activist funds include Kraft, Heinz and Home Depot. The CSX Decision In the CSX case, The Children s Investment Fund Management (UK) LLP, a fund management company, an affiliated fund management company and a fund they advised (collectively TCI ) were unhappy with the management of CSX. TCI acquired long positions in equity swaps with a handful of counterparties. These long positions, in effect, provided TCI with an economic interest equivalent to direct investment in the underlying shares (i.e., the counterparties would have to pay in cash to TCI any increase in value of shares of CSX covered by the swaps). The counterparty banks held the short positions, requiring TCI to pay in cash to the counterparty any decrease in value of shares of CSX. The Court found that at one point TCI s long positions under the swaps were equivalent economically to ownership of approximately 14 percent of the company s outstanding shares. The swap agreements as drafted specified cash settlement and by their terms did not provide TCI a contractual right to acquire or vote the underlying equity securities. The Court found that TCI, based on swap positions, attempted to engage CSX management in discussions of a possible leveraged buyout, or in the alternative, obtain sufficient control of the company to alter its management and enhance the company s value. According to the Court, the swap counterparties holding the short positions predictably hedge their exposure by purchasing actual shares of common stock. The Court found that, in this case, the counterparties hedged nearly 100 percent of their exposure.
How could the counterparties hedged positions have helped TCI? According to the Court, TCI hoped to influence how the counterparties voted the shares of common stock that the latter held to hedge their risk. The Court also noted that the swap agreements could be amended at any time to settle in stock instead of cash. Thus, in its view, so long as the counterparties cooperated, TCI could become the owner of a substantial block of CSX stock overnight; in fact, the Court found that TCI had threatened to do so. The Court concluded that TCI s conduct offended the purposes of the Williams Act, i.e., early warning to the markets for accretions of significant voting and investment power. The Court stopped short, however, of concluding that TCI was a beneficial owner of CSX equity securities under rule 13d-3(a) Instead, the Court relied on rule 13d-3(b), concluding that TCI had schemed to evade the Williams Act reporting requirements. Why did the Court rely on the rarely used scheme to evade provision? Rule 13d-3(a) is so broad that it could in theory also cover any conduct that violates paragraph (b). Paragraph (a), quoted above, covers any person who, directly or indirectly, through any contract, arrangement, understanding, relationship, or otherwise has or shares voting or investment power. This stands in contrast to similar scheme to evade provisions in other rules that do appear to cover conduct that would not otherwise be captured by the rule. For example, Rule 144 under the Securities Act of 1933 provides a safe harbor from registration for resales of securities acquired in unregistered securities transactions (e.g., by company insiders) where certain conditions are satisfied (i.e., holding period, specified public disclosures, volume and manner of sale limitations). The scheme to evade provision, contained within rule 144 s preamble, seemingly covers the situation in which a person complies with the technical requirements of the rule, but not its underlying policies.[6] If the scope of rule 13d-3(b) is eclipsed by the broader paragraph (a), what is its purpose? The paragraph was likely added as an enforcement tool. It permits a court or regulator to reach conduct that it sees as a threat to the purposes of the rule without having to marshal the sometimes extensive evidence required to demonstrate actual beneficial ownership. Paragraph (a) clearly requires that the court conclude the investor in fact succeeded in acquiring the voting or investment power necessary to demonstrate beneficial ownership.
By contrast, the purpose or effect language in paragraph (b) appears to require no more than a showing that the investor attempted to circumvent the section 13(d) disclosure requirements. By relying on paragraph (b), the Court did not have to conclude that TCI actually succeeded in obtaining investment or voting power over CSX common stock (or the ability to obtain such control within 60 days). The Court may well have doubted that it had sufficient evidence to reach such a conclusion. Furthermore, the Court may have preferred the narrower holding as one less likely to create precedent that might both concern derivatives market participants and hamstring efforts by the SEC to further interpret or amend its rules. In fact, the Court appears to urge the SEC to use its rulemaking power to expand the scope of beneficial ownership under 13D. While the Court s dicta concerning the possibility that swap arrangements confer beneficial ownership on the holder of a long swap position has concerned some market participants, the actual holding is no watershed. The Court s holding is narrowly limited to its conclusion, based on the specific facts of a single case that TCI had the purpose of circumventing the Williams Act disclosure requirements. The Court did not conclude that TCI was a beneficial owner as a result of entering into the swaps. The Court s decision could become more significant if the SEC responds to the decision with rule interpretations or amendments. Even if the SEC sought to expand Rule 13d-3, it is unclear how much latitude it would have. Section 13(d) of the Exchange Act speaks of beneficial ownership of equity securities. Would the SEC have the statutory authority to revise its rules to reach equity swap agreements that are cash settled? In an amicus letter to the Court, the SEC s Division of Corporation Finance confirmed its belief that it has the authority to use rulemaking in this area of law, stating Rule 13d-3, properly construed, is narrower in coverage than the statute. Perhaps Congress will specifically address the issue.[7] The case is currently on appeal and any additional rulemaking or legislative action will likely await the decision. Practice Considerations In the interim, there are some implications that both investment funds and public companies should start to think about. Public companies should review any plan or document that refers to beneficial ownership, including change of control provisions, shareholder rights plans, and advance notice bylaws.
In light of the Court s decision, consideration should be given to whether such provisions might be construed more narrowly or broadly than the company intends. Some companies have reportedly broadened the definition of beneficial ownership in their shareholder rights plans to ensure that they would be triggered by the accumulation of economic power through the holding of derivative positions. Investment funds should be aware that using a cash settled total return swap instead of purchasing equity securities outright is not a foolproof mechanism for avoiding beneficial ownership if other facts are present. Such other facts might include express or tacit understandings as to a counterparty s hedging arrangements, voting of shares held on swap, or willingness to amend the terms of a swap to physically settle a transaction. Hedge funds should review their policies and procedures for monitoring positions and filing reports on Schedules 13D and 13G to ensure that they take into account the possibility for deemed beneficial ownership under Rule 13d-3(b). They should also review compliance procedures for identifying behavior that would indicate a plan or scheme to evade. Funds that hold direct equity positions and positions through swaps in the same issuers should be particularly vigilant in monitoring when a passive investment intent changes to a more active investment intent. While standard documentation for a cash settled total return swap does not normally include the types of provisions that would be likely to cause the long party to the swap to have beneficial ownership, funds should be careful not to inadvertently negotiate rights that would cause a different conclusion. Further, as indicated in the Court s dicta, jurisdictions outside the United States may take a different view on the need to report positions held through swaps, and funds active outside the U.S. must make sure to educate themselves as to filing requirements in the jurisdictions in which they trade. The CSX court raised questions that were inevitable given the growth of the financial derivative markets since the adoption of the Williams Act in 1968. Despite public attention devoted to the decision, its ruling was narrow. However, along with the outcome of the ongoing appeal, any response by regulators or lawmakers could be significant and bears monitoring. --By Frank G. Zarb Jr. and Adam R. Bolter, Katten Muchin Rosenman LLP Frank Zarb is a partner in the securities practice at Katten and a former member of the SEC staff. Adam Bolter is an associate in the firm s financial services practice. Both are based in Katten s Washington, D.C., office. Special thanks to Marilyn Selby Okoshi, a
partner in the firm s financial services practice, for her contributions to this article, and to Christopher Livingston, a summer associate, for assisting with the article s research. [1] S.D.N.Y. No. 08 Civ. 2764 (June 11, 2008). [2] Don M. Chance, Essays In Derivatives (John Wiley and Sons, 1998). [3] Remarks of Emil E. Henry Jr., Assistant Secretary of the Treasury, Before the Fixed Income Forum, Hedge Funds and Derivative Markets: History, Issues, and Current Initiatives (March 9, 2006). [4] See Revision of Holding Period Requirements in Rule 144, Section 16(a) Reporting of Equity Swaps and Other Derivative Securities, SEC Release No. 33-7187 (Jun. 27, 1995). [5] Scott Morrison, Yahoo Appoints Icahn to Board, Wall St. J., Aug. 6, 2008. [6] See e.g., SEC no-action letter, Harmony Trading Corp., pub. avail., Nov. 22, 1999 (SEC denied no-action relief because conduct that technically complied with the rule was inconsistent with its purposes). [7] See, Letter from Senator Charles Schumer (NY) to Christopher Cox, Chairman of the SEC, dated June 17, 2008.
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