It’s difficult enough to decide when it’s appropriate to dive into shareholder activism, but the Second Circuit Court’s recent decision has muddied the waters and made it that much harder for hedge funds.
Hedge funds that pursue strategies that turn on shareholder activism – on influencing corporate policy and, when necessary, the composition of a board of directors – may be shaking their heads after a decision by a panel of the Second Circuit Court of Appeals, CSX Corp. v. TCI (July 18, 2011). So, for that matter, may the incumbent boards of public corporations who suspect that they may be the targets of such activism. The decision – published two years and eleven months after it was argued – leaves some critical uncertainties, created by a district court decision three years ago … still hanging, still uncertain.
David Stowell, Finance Professor at Kellogg School of Management, Northwestern University, and a former JP Morgan Managing Director, is familiar with the litigation, one that he discussed as a case study in the use of derivatives by hedge funds in his 2010 book, “Introduction to Investment Banks, Hedge Funds, and Private Equity.”
Stowell, in a telephone conversation after the July 18 decision, said: “I think there is an unclear path that results from the 2d Circuit decision,” and both sides of the issue, corporate managers and potential activist investors on the other, “will proceed with caution” as a result.
Swaps and a Group
By 2006, two hedge funds accustomed to an activist shareholders’ strategy, The Children’s Investment Fund (TCI) and 3G Partners (3G) had become convinced that a classic rail company CSX Corp., had unrealized equity value that better management might unlock. Pursuant to that hypothesis, both funds purchased shares. They did something else, too: they entered into cash-settled total return swaps (TRS). They took the long position on these swaps, which meant they were paying their banks a LIBOR based stream of money in return for receiving a stream of money based on the changing value of the stock.
In a trial before the district court in the spring of 2008, CSX contended that the two hedge funds broke the law while pursuing the election of a slate of dissident nominees to the company’s board of directors.
CSX raised two issues under the so-called 13D rules, which implement section 13(d) of the Williams Act, a law enacted in 1968 to address what Congress saw as the growing problem of surreptitious corporate takeovers. The Williams Act requires various disclosures as a person or group of investors acquires increasing amounts of a company’s equity. The rules require for example that if two or more investors are acting together “for the purpose of acquiring, holding, or disposing or securities,” they must make timely disclosure that they have formed a group. CSX claimed, first, that TCI and 3G were acting as a group for such purposes months before they acknowledged as much.
The second issue CSX raised, (and this is the one that breaks new ground and has raised a good deal of interest) involves the TRS transactions. CSX contended that the rules requiring disclosure and imposing various thresholds on the basis of the amount of stock that a person or group holds should be interpreted as including beneficial ownership, not merely the ownership of the physical shares, and that the hedge funds had beneficial ownership of stocks legally owned by the investment banks that serve as their counterparties in the TRS transactions.
Trial Court Opinion
The U.S. District Court for the Southern District of New York, in June 2008, held that for 13(d) purposes TCI in particular must be deemed a beneficial owner of all the CSX shares held by banks as hedges against TCI’s swaps positions. It also held that TCI and 3G had acted as an unacknowledged group for at least ten months. Judge Kaplan wrote, “The securities markets operate in the real world, not in a law school contracts classroom. Any determination of beneficial ownership that failed to take account of the practical realities of the world would be open to the gravest abuse.”
Yet Judge Kaplan issued no sterilization order, that is, no order enjoining the “group” from voting the shares acquired while it was in violation of 13(d), because he held that binding precedent left him little or no room for such injunctive relief. He merely ruled that there had been violations and he enjoined the funds from doing it any more.
Both sides appealed. It was plainly a high-stakes appeal. In the words of the Coalition of Private Investment Companies, “a judicial ruling that injects any uncertainty as to the … shared understanding of ‘beneficial ownership’ by market participants and regulators would have sweeping consequences far beyond the confines of this case.”
The prominent law firm Wachtell, Lipton, Rosen & Katz, in a memorandum posted on their website only days after Kaplan’s decision, said: “Judge Kaplan’s decision is a strong challenge to the use of derivatives by activist shareholders bent on concealing their true economic position for their own ends.”
Where does that challenge stand now? It is not at all clear. The majority of the appeals panel had nothing to say about the significance of the swaps. “It is appropriate at this time to limit our consideration to the issue of group formation.” On that point, the majority said that the trial court had not built a record sufficient to support the finding that this was a group, and they remanded. Specifically, on remand the trial court should create a record that will show when the group’s members’ “outright ownership of CSX shares exceeded the 5 percent threshold,” for only if it knew that date could the appellate court decide whether it has to determine the status of the shares bought by banks as TRS hedges in order to dispose of this case.
Judge Ralph Winter, concurring, indicated that he viewed that district court’s decision on the alleged beneficial ownership of those TRS-related shares as “flawed,” and as “foreclosed” by statutes and by relevant Supreme Court precedents.
Winter observed how high the stakes are. “[A] short party’s purchasing of shares is the most practical and common method of hedging, and long parties will expect that it will be used … [thus] the district court’s ruling renders the long party to virtually all cash-settled total-return equity swaps a ‘beneficial owner’ of such swaps.” For that reason, Winter provided a detailed discussion of Congress’ and the SEC’s deliberations over swaps in recent years, and concluded that neither has offered any support for Kaplan’s view.
As to the formation of a “group,” Winters says that Kaplan’s finding is “clearly erroneous, and I concur in order to seek clarification on a remand.”