Beneficial Ownership, Equity Swaps, and Proxy Contests: CSX v. The Children's Investment Fund (Part 1)

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 critical legal issue centers on the obligation of parties to disclose shares purchased by swap dealers as a hedge in equity swap arrangements.  What exactly are these equity swaps?  The transactions are "synthetic," that is, they reference but do not actually involve shares of a company, in this case CSX.  According to TCI, one of the hedge funds invovled in this case:  

• Each Total Return Swap agreement is a private contract between TCI and a counterparty bank pursuant to which TCI has taken a “synthetic position” with reference to CSX common stock. Under those contracts, TCI receives cash payments in an amount equal to any dividend payments and increases in the price of CSX common stock, and makes cash payments in an amount equal to any decreases in the price of CSX common stock, over the time period during which the swap agreement is in effect. In exchange, the swap counterparty receives a specified fixed or floating cash flow that is unrelated to the ultimate performance of CSX common stock. Thus, TCI has economic exposure to the referenced shares. TCI’s Total Return Swaps do not confer voting rights to TCI. Additionally, there are no conversion rights by which TCI could acquire any referenced security held as a hedge under the Total Return Swap agreements. TCI’s Total Return Swaps could only be settled for cash.

Nonetheless, these types of swaps commonly involve the actual purchase of shares.  The counterparties (in this case the investment and commercial banks) purchase the shares to hedge their exposure.  Although economically rational to do so, it is not required.  Moreover, in some instances, hedging can occur through the use of other instruments, without the need to actually purchase shares.  As TCI describes:

• Although TCI’s counterparties to the Total Return Swap agreements may purchase shares in CSX to hedge their risk, they are not required to do so. The agreements explicitly allow for the swap counterparties to enter into a number of different instruments, or not to hedge at all, in their sole discretion. The Total Return Swaps agreements do not require the swap counterparties to purchase common stock as a hedge. Under the terms of TCI’s swap agreements, the acquisition of any CSX common stock (or, for that matter, any other asset) with which a counterparty bank chooses to hedge is in the sole discretion of the counterparty bank.

Why do funds invest in equity swaps? TCI explained its motivation. The swaps provided "financing benefits, including lower funding costs and lower margin requirements" and certain tax benefits. But, as TCI bluntly acknowledged, they allow for the circumvention of ownership disclosure requirements.

• Total Return Swaps are not subject to the same reporting requirements associated with beneficially owned securities. Disclosure of an investment prior to the establishment of an investment position exposes a hedge fund to “front-running.” Specifically, if an investor becomes aware that a fund is building or selling a position, it can trade on that information and cause price differentials for the fund that is also buying or selling that position, thus making it more expensive to trade.

Perhaps true, although it is tantamount to saying that nondisclosure keeps the market in the dark about the accumulations.  Moreover, there was testimony at the May hearing that TCI alerted some funds to the purchases, arguably inviting them to front run.  More importantly, avoidance of the disclosure requirements allows shareholders to accumulate a large swap position in a company that can sometimes be converted into shares without alerting the market or the company of the ongoing transactions. 

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.