CSX Decision and Beneficial Ownership in Connection with Equity Swaps

Yesterday, the Federal District Court for the Southern District of New York issued an important decision regarding the use of equity swaps to assemble an economic position in publicly traded shares. (CSX Corporation v. The Children’s Investment Fund Management (UK) LLP (“TCI”), et al.). The Court held that the activist hedge fund defendants had violated Section 13(d) of the Securities Exchange Act of 1934 by failing to disclose in a timely fashion their “beneficial ownership” of CSX shares created through long positions in cash-settled equity total return swaps that referenced CSX shares. The Court based its holding on the anti-evasion provisions in the definition of “beneficial ownership” (Rule 13d-3(b)), concluding that TCI had entered into the equity swaps with the purpose or effect of preventing the vesting of beneficial ownership as part of a “plan or scheme” to evade the reporting requirements of Section 13(d).

Broadly viewed, this interpretation of the anti-evasion provision could make it difficult for an activist investor or potential bidder to use equity swaps or other cash-settled derivatives to acquire, without disclosure, an economic interest greater than 5% in a corporation, even though the swap gives the investor no voting rights or right to take or direct delivery of any shares. Nevertheless, even a broad interpretation would not seem to interfere with purely passive investors establishing economic exposures greater than 5% through equity swaps without being required to make Schedule 13G filings.

The Court also indicated that it was strongly inclined toward the view, under the basic definition of “beneficial ownership” (Rule 13d-3(a)), that TCI, as the holder of long positions under cash-settled equity total return swaps, beneficially owned the stock referenced by the swaps. This view was based primarily on the fact that, consistent with customary practice, TCI’s swap counterparties hedged their positions by purchasing shares and were likely to dispose of those shares upon termination of the swaps. The Court, however, concluded it did not need to decide this issue because of its determination that TCI had beneficial ownership of those shares under the anti-evasion provision. The Court’s view could have a chilling effect on segments of the market for total return swaps, particularly in light of the potential consequences of beneficial ownership under the short swing profits provision of Section 16(b).

The Court further held that the two hedge fund defendants had violated Section 13(d) by failing to disclose on a timely basis the creation of a “group” between them under Section 13(d)(3) based on, among other factors, discussions between the two funds, purchase activity (and pauses) apparently coincident to meetings between the two funds, and efforts by both funds to identify potential nominees for election as directors in a proxy contest.

The Court concluded that the defendants’ current Schedule 13D disclosure was not false or misleading in any material respect, but permanently enjoined the defendants from future violations of Section 13(d). The Court indicated that it was inclined to offer a broader remedy but determined that, under controlling Supreme Court and Second Circuit precedent, it did not have the legal authority to grant further relief, such as enjoining the defendants from voting their CSX shares or conducting the proxy contest. The Court stated that any further penalties “must come by way of appropriate action” by the SEC (which would involve civil action) or the Department of Justice (which would involve criminal action).

It is likely that at least one of the parties will appeal the decision to the Second Circuit. In the interim, market participants are left with an opinion that could make investors significantly more cautious in acquiring purely economic positions through equity total return swaps and simultaneously allay management concerns regarding significant undisclosed equity swap positions relating to their companies.

The decision is attached. For additional information about this case and its potential implications, please contact any of our partners listed on this website (www.clearygottlieb.com) under Capital Markets, Derivatives, Mergers, Acquisitions & Joint Ventures or Securities Enforcement.

CLEARY GOTTLIEB STEEN & HAMILTON LLP