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

The trial judge issued an opinion in CSX v. The Children's Investment Fund today.  The lengthy opinion can be found on the DU Corporate Governance web site.

The case concluded that the defendant hedge funds had engaged in a plan or scheme to avoid the disclosure obligations under Section 13(d).  In so doing, the court concluded that the funds were beneficial owners of shares acquired by counterparties in equity swaps to hedge their risk.  It is apparently the first case to conclude that at least sometimes parties to equity swaps will have a duty to disclose beneficial ownership of shares acquired by the those on the other side of the transaction.  It is not a case that extends reporting obligations to all equity swaps. 

In arriving at its holding, the court concluded that Rule 13d-3(b) extended beneficial ownership to any contracts or transactions that were intended to hide large accumulations "that might have a potential for shifting corporate control".  In some respects, the holding was narrow.  The court relied extensively on evidence indicating that the hedge funds deliberately used the swaps to avoid the disclosure requirements in Section 13(d) and that they used their economic might that came from the swaps to try to exert influence over management.  In other words, the facts indicated that the swaps were not executed only for economic reasons, but were designed to influence management.

On the other hand, the facts are arguably irrelevant.  Anytime an investor enters into an equity swap transaction for a controlling block of stock, it would have the capacity to influence control.  Moreover, by using swaps, the investor would avoid the disclosure requirements of Section 13(d).  Thus, the holding of the case arguably applies to any swap position that results in the accumulation of enough shares to have the potential to influence control.  Of course, the more the facts demonstrate actual efforts to exert control, as was the case here, the easier it will be for a court to conclude that the size of the swap position was sufficient to meet this requirement.

The case for now cuts off a massive hole in the takeover disclosure regime.  It was arguably possible for an acquirer to enter into a large enough equity swap position to be able to secretly acquire control of a company without making any disclosure to the market, the very type of transaction that the Williams Act was designed to prevent.  While the precise point at which a swap position will be sufficient to influence control is unclear (it could apply to any swap position that avoids the filing of a Schedule 13(d)), it certainly applies to secret accumulations designed to acquire control.