Beneficial Ownership, Equity Swaps, and Proxy Contests: CSX v. The Children's Investment Fund (Part 7)

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 an opinion in the case on June 9.  The opinion is posted on the DU Corporate Governance web site.  

The case has attracted considerable attention, including a number of amicus briefs, a relatively unusual step at the district court level.  A brief was filed by the International Swaps and Derivatives Association and the Securities Industry and Financial Markets Association and another by the Coalition of the Private Investment Companies (CPIC).

The ISDA/SIFMA Brief argued strenuously that the "long" party in a cash settled equity swap was not the beneficial owner of the shares acquired by the counterparty, pointing to the terms of a standard agreement.

• Such a party does not itself own any of the underlying equity securities; equity swaps convey only a synthetic economic interest in the performance of a designated equity security.  The standard ISDA Master Agreement and related forms of schedule, definitions, and transaction confirmation that govern the legal rights and obligations of parties to equity swaps do not convey to the long party either title to the underlying shares or any contractual right to acquire or to direct its counterparty's acquisition or disposition of shares, or the voting of shares, if any, acquired by the counterparty.  The standard ISDA documentation expressly provides that the long party has no interest or expectation with respect to any of the hedge transactions in which the counterparty engages. 

The relevant definitions are on the ISDA web page.     

Nor did the common practice in the industry change the result.  The Brief noted that while "counterparties generally may hedge equity swaps with referenced shares, it is far from invariably so."  Moreover, even where shares were acquired, swap dealers could sell the underlying shares "before the equity swap is terminated, and without the counterparty's knowledge."  Moreover, some dealers apparently as a matter of policy did not sell shares to its counterparty.  As for voting rights, the Brief noted that a study by PwC confirmed "that most market participants generally do not exercise their voting rights at all for shares purchased as a hedge and that they generally rebuff attempts by others to influence their votes." 

The Brief provided some useful information and contained a number of reasons why a cash settled equity swap was not inherently a transaction that resulted in beneficial ownership.  The authority for some of the propositions, however, was weak.  At one point the Brief stated that "[m]any, if not most, swap dealers, in fact have policies limiting their traders' ability" to sell shares to their counterparty.  As authority, the brief cited the letter written by Bernie Black that merely said that "[o]ther dealers, as a matter of policy, will refuse to sell matched shares directly to the swap counterparty."  In other words, it was an overstatement to state that "[m]any, if not most" swap dealers did not allow for the sale of shares to counterparties and, in any event, the authority was not from industry but was an observation of a law professor. 

Moreover, while noting that not all equity swaps necessarily resulted in the purchase of referenced shares, the Brief said nothing about the usual practice with respect to swaps the size of the ones at issue in this case.  In his letter, Bernie Black opined that "[u]nder current market conditions, for sizeable equity swaps, the cheapest means of hedging is usually to acquire matched shares."  In other words, large equity swaps invariably relied upon actual purchases of shares to hedge, whereas smaller positions might not. 

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.

Comments

[Ami de Chapeaurouge]

Dear Professor Brown,

This is a very helpful entry for the practitioner indeed, for it is in the trenches where these demarcations will be determined.

I get away from reading Professor Black's brief in support of TCI and studying Cleary Gottlieb's submission on behalf of ISDA and SIFMA that somehow they have not digested the decision by the Federal Court of Australia much (I didn't see it cited) in Glencore International AG (ACN 114 271 055) v Takeover Panel [2006] FCA 274 that as unequivocally states as certain passages in the New Zealand appellate decision (that is cited and quoted by Cleary) Perry Corporation - vs - Ithaca (Custodians) Ltd. [NZCA] that in the overwhelming amount of cases "in order to hedge its risk under such an arrangement, a bank might buy the relevant equity securities." Consider also the following entry: "The Panel found that there was no practicable hedge available to the Banks, for their exposure under the swaps, other than buying shares in the Company."

By talking to investment bankers in Frankfurt, London and New York involved either for or against Porsche, Schaeffler and MLP - the three recent German change-of-control cases employing total return equity swaps replacing tender offer, street sweep and all conventional takeover wisdom to engineer a takeover change-of-control transaction without control premium and, one might argue, to the detriment of shareholders and shareholder culture, invariably the natural hedge of purchasing referenced shares seems to have been employed. If one approaches these fact patterns and scenarios not through the lenses of aggressive and hard-knuckled takeover tactics and strategy, but merely argues from a total return portfolio perspective, one might reach Cleary's conclusions that are overstated when they reason that while "counterparties generally may hedge equity swaps with referenced shares, it is far from invariably so."

This evolution in the derivatives, stock-lending and takeover field has moved from hedge funds to mainstream strategic acquirors and currently subverts, if not transforms, the traditional wisdom of takeover attack work as pioneered by Skadden Arps and Fried Frank following the adoption of the 1968 Williams Act and corresponding amendment to the 1934 Securities and Exchange Act. Thought through, it appears, as though nothing will be as it was before. Only fools do classify this as a "hedge fund" issue where some activist instigators threaten to take over the world. It is not the CSX battles where the Maginot line currently runs, but the battles for Volkswagen AG, Continental AG and other strategic targets in this re-drawn battle-line for takeovers without a control-premium. You have rendered a considerable service to this debate and its finer points by contrasting Cleary's statement with the arguments by Professor Black in his brief tempering and identifying it as some sort of an overstatement. Especially our clients in the investment banking world should be grateful to your distinctions. This is not a distinction without a difference, it is a leading distinction thanks to your analysis.