Beneficial Ownership, Equity Swaps, and Proxy Contests: CSX v. The Children's Investment Fund (Part 3)

We are addressing the ongoing litigation between CSX, the railroad company, and a number of hedge funds, including The Children's Investment Fund and 3G Capital Partners. The case revolves around the obligation of the Funds to disclose certain equity swaps involving shares of CSX.  The Funds have launched a proxy contest, with the annual meeting scheduled for June 25.  The district court issued its opinion in the case on June 11.  The opinion is posted on the DU Corporate Governance web site.  

The Funds disclosed ownership of approximately 8.7% of the voting shares of CSX. In addition, however, the Funds disclaimed ownership of another 11% or so of the shares owned by various swap parties that were acquired as a result of cash settled equity swaps with the Funds.

CSX aggressively responded to the efforts of the Funds, including testimony in Congress and a shift in the date for the shareholder meeting (from May 7 to June 25).   Interestingly, because the meeting was scheduled for a rail yard outside of New Orleans, a decision that some have suggested was designed to be deliberately inconvenient.  See NYT DealBook ("That may be true, but it also provides a less-than-ideal backdrop for the two activist hedge funds to have their Gordon Gekko moment, shouting over rail whistles while sweating buckets in their Armani suits.has caused some to suggest it was a tactic to reduce attendance.")  It is hard to imagine how CSX benefits from any such strategy (the dissidents are likely to attend where ever the meeting is held).  Moreover, at the hearing in May, a CSX official noted that the meeting will be in an air conditioned tent, an environment hardly likely to cause serious sweating in the Armani suits.

Most critically, the company filed suit on March 17, alleging violations of Sections 13D and 14(a). Specifically, the complaint asserted that the Funds beneficially owned the shares referenced in the swap arrangements and that the disclaimer of beneficial ownership was false.  Beneficial ownership arose:

• because of the arrangements or understandings between defendants and the counterparties. Based on those understandings or relationships, the counterparties will vote the shares in accordance with defendants' wishes, or they will deliver physical shares of CSX stock to defendants upon settlement of the swaps.

Among other things, the complaint alleged that TCI officials represented as early as January 2007 that they owned "a significant stake in CSX, between 10 and 14 percent" with a "large portion" held through swaps "that it could 'convert at any time' to physical ownership."  Moreover, the complaint contained allegations of share movements suggestive of some type of arrangement between the Funds and the investment banking firms. As the complaint noted:

• 44. In anticipation of a May 7, 2008 annual meeting date and a related record date of February 27, 2008, representatives of CSX began notifying brokers and the NYSE of the record and meeting dates beginning on January 30, 2008. That information became generally available to bankers, brokers and other financial institutions.
• 45. Financial institutions that hold shares of publicly traded companies for their own account or for the account of their customers frequently lend such shares to traders who engage in short-selling of such shares. Under the terms of the lending arrangements, ownership of the shares is transferred to the short-seller, but the financial institution has the right to require the short-seller to return ownership of the shares to the financial institution at any time.
• 46. Where a financial institution holds shares for its own account to hedge its commitments under a swap arrangement, the financial institution has no incentive to require that the short-sellers return shares ahead of a record date for a shareholder meeting unless there is a contractual requirement or some explicit or implicit understanding with the swap holder with respect to the voting of the shares.
• 47. Between February 15, 2008 and February 27, 2008, the two-week period prior to original the record date, almost 37 million shares of CSX common stock were transferred to financial institutions that have been identified by defendants as counterparties to their swaps that reference shares of CSX common stock (net of any shares transferred from such institutions), establishing custody of those shares in such institutions as of the record date.
•  48. The number of shares involved in those transfers substantially exceeds the number of shares transferred in connection with dividend and voting record dates in 2007, including those dates after which TCI and 3G acquired substantial positions in CSX stock.
• 49. After the record date passed, between February 28, 2008 and March 10, 2008, over 20 million shares were transferred from the same financial institutions back to third parties.

To the extent the movement was related to the swaps, the information suggested an explicit or implicit understanding between the Funds and the swap dealers.  The Funds would hotly contest whether in fact this movement had anything to do with the swaps, noting in particular that the movement occurred during the period prior to the payment of a dividend. 

Testimony from the swap desks at Deutsche Bank would indicate that there had been recall of shares ordered.  Nonetheless, the court found the movement persuasive.

• TCI would have the Court reject this scenario as speculative.  It argues that the record date for voting coincided closely with the record date determining the right to receive dividends and that it would have been quite natural for Deutsche Bank to have acted to ensure its receipt of those  funds.  Moreover it argues that Deutsche Bank witnesses denied that any recall occurred.
• TCI's argument falls considerably short.  For one thing, CSX adjourned its annual meeting and changed the record date after the record date for payment of a dividend had passed.  There is no evidence that the record date for the dividend has changed.  Nevertheless, a similar influx and outflow of shares took place around the adjourned record date.  In consequence, the desire to receive the dividend is not a likely explanation for what transpired.  Moreover, the bank witnesses upon whom TCI relies in fact lacked any personal knowledge of the material facts. (footnotes omitted). 

CSX would win the argument but lose the war.  In its complaint, the company sought, among other things, an injunction prohibiting the Funds from acquiring the shares referenced in the swap arrangements and directing them to sell their shares of CSX and terminate the swap arrangements.  The court did none of these things and merely enjoined the Funds from future violations. 

Numerous documents filed in the case, including the complaint, various motions and legal memorandum, and an assortment of amicus briefs (including one from the Division of Corporation Finance at the SEC) and legal opinions, can be found at the DU Corporate Governance web site.