Beneficial Ownership, Equity Swaps, and Proxy Contests: CSX v. The Children's Investment Fund (International Views) (Part 11)

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 looked at whether a party to an equity swap must treat the shares purchased by a counterparty in a hedging transaction as beneficially owned. As the filings of the parties noted, there is no case in the US that squarely addressed the issue.

The problem of swaps and the need to disclose the underlying shares acquired as a hedge did, however, arise in other jurisdictions. In Ithaca (Custodians) Ltd. v. Perry Corp. , [2004] 1 NZLR 731, 2003 NZLR LEXIS 76 (C.A.), a case arising in New Zealand. In the case, the lower court concluded that merely becoming a party to an equity swap did not give rise to disclosure obligations.  Nonetheless, the court concluded that the parties to the swap had an “arrangement or understanding that gave Perry Corporation power to reacquire" the hedged shares.  

On appeal, the court agreed with the portion of the opinion concluding that equity swaps did not trigger ownership disclosure requirements but reversed the portion of the lower court decision finding an "arrangement or understanding."  The appellate court first held that "if not inevitable, it was almost certain" that shares of Rubicon would be purchased by the counterparties as a hedge.  In addition, the court concluded that "it was almost certain that the shares would be sold to Perry Corporation upon the termination of the swaps if Perry Corporation wished to buy."  That was not, however, enough to trigger an understanding or arrangement sufficient to trigger ownership reporting requirements.  "As there must be a meeting of minds and communication, mutual expectations based on commercial reality (but without such consensus or communication) are not sufficient to give rise to an arrangement or understanding."  The court explained:

• [I]f we hold that knowledge of market reality suffices to create an arrangement or understanding under § 5(1)(f) and that consensus and communication are not required, this would create uncertainty as to the scope of disclosure generally, as it would raise questions about how certain market reality must be before there is an obligation to disclose. In particular it would, in effect, mean that the majority of equity swaps in New Zealand would create disclosure requirements, whether cash-settled or not. There are obvious policy issues involved in extending disclosure requirements to interests under equity swaps as the regime conceptually is directed at voting rights rather than economic interests. Most equity swaps create only economic interests.

Id. at *57.

While the law in New Zealand and the United States on ownership disclosure seem similar, there is at least one pronounced difference in the takeover disclosure regime that requires consideration.  New Zealand caps voting rights of a shareholder at 20%.  See Rule 6(1) of the New Zealand Takeover Code.  With some exception (see Rule 7), the percentage can only be increased if the shareholder makes a a full or partial offer to all shareholders.  In other words, in New Zealand, a shareholder could not use swaps as a method of secretly acquiring a majority of a company's shares.  In the United States, that is not true.  Assuming a shareholder could take enough swap positions to necessitate the purchase of a majority of a company's outstanding shares by the counterparties, it would be quite possible for the shareholder to terminate the swaps, purchase the shares, and obtain control of a company, without any publicity or offers to the other shareholders. 

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.