Thursday, August 4, 2011

Question Over Cash-Settled Derivatives Remains Unresolved, Requirement for Disclosing 13D Group Activity Narrowed

In a proxy fight that begun in late 2007, hedge funds TCI (The Children's Investment Fund Management) and 3G Capital Partners nominated five candidates to the board of railroad company CSX. Owning 9% of the stock and 11% more through long cash-settled derivatives, TCI and 3G Capital Partners were successful in getting four of their five nominees elected to the board. In the process, however, CSX sued the hedge funds for violating the Williams Act, arguing that they failed to report their cash-settled derivatives as beneficial ownership and that they were acting as a group before TCI filed its Schedule 13D statement, among other things. 

On June 11, 2008, Judge Kaplan of the lower court found that investors were deemed to constitute a group under broad circumstances: should investors merely meet to discuss, they would trigger a group filing requirement in the event that they own collectively more than 5% of a company's outstanding shares. 

A July 18, 2011 majority-opinion on CSX v. TCI by the U.S. Second Circuit Court of Appeals reversed this notion and accordingly narrowed the extent to which shareholders could be considered a group for Section 13(d) of the Williams Act, a 1968 amendment to the Exchange Act of 1934. The Second Circuit found that proof that shareholders were acquiring shares in concert was needed before they could be deemed a group. Subsequently, the Second Circuit remanded the case. Thus the Second Circuit's opinion represents a favorable shift for activist hedge funds--which will now have less reservations in communicating investments with other shareholders--as far as group filing requirements go.

As far as resolving the issue of whether or not cash-settled derivatives would count as beneficial ownership--this remains very much a work in progress. Both the lower court and now the Second Circuit side-stepped the issue. Judge Kaplan in the lower court took a broad view of cash-settled derivatives counting as beneficial ownership, finding that one should consider "all of the facts and circumstances to identify situations in which one has even the ability to influence voting, purchase, or sale decisions of its counterparties". Despite this broad view, Judge Kaplan ultimately never made a rule on his judgement and thus did not "sterilize" the shares derived from from the cash-settled derivatives (ie. they could be used for voting purposes). The Second Court also did not make a rule on the issue due to "disagreement within the panel".

In a separate concurrence, however, Judge Winter was clear about his opinion on cash-settled derivates. He found that "without an agreement between the long and short parties permitting the long party ultimately to acquire the hedge stock or to control the short party's voting of it, such swaps are not a means of indirectly facilitating a control transaction". According to corporate law firm Schulte Roth, which represented TCI in the proxy fight and ongoing litigation, "given Judge Winter's thoughtful analysis of the beneficial ownership question, it can be expected that, in the absence of guidance from Congress or the SEC, future courts confronted with this issue will take guidance from the Winter concurrence, and consider his analysis in the context of subsequent cases".

Posted by David Schatz