U.S. District Court Addresses Section 13(d) Beneficial Ownership and Reporting Standards

June 12, 2008

On June 11, 2008, in a closely watched case, Judge Lewis A. Kaplan of the U.S. District Court for the Southern District of New York issued a decision in CSX Corporation v. The Children’s Investment Fund Management (UK) L.L.P. et al (1:08-cv-02764-LAK (filed Mar. 17, 2008)) that will have continuing implications for beneficial ownership reporting under Section 13(d) of the Securities Exchange Act of 1934. Section 13(d) requires a public filing by a person who acquires beneficial ownership of more than 5% of a company’s equity securities, and the same standard is used for determining whether a person is a greater than 10% stockholder subject to Section 16(b) of the Exchange Act. 

In March 2008, CSX Corporation (“CSX”), a large railroad company, filed a complaint against The Children’s Investment Fund (“TCI”) and 3G Capital Partners (“3G”), two large hedge funds that are engaged in a proxy fight with CSX, for failing to file a Schedule 13D reporting their beneficial ownership of CSX stock. Among the issues vetted in the decision are whether TCI and 3G beneficially own shares that underlie cash-settled “total return equity swap” agreements and whether the two funds had formed a Section 13(d) “group” before the time that they reported they did. 

In its decision, the Court ruled that based on the specific facts before it:

• TCI should be treated as beneficially owning the shares underlying its cash-settled equity swaps under the anti-avoidance provisions of Rule 13d-3(b) of the Exchange Act, and in turn, that TCI violated Section 13(d) by not filing a Schedule 13D within 10 days of acquiring beneficial ownership of greater than 5% of CSX shares; and

• TCI and 3G formed a group no later than February 13, 2007, and in turn, that TCI and 3G violated Section 13(d) of the Exchange Act by failing to file the required disclosure within 10 days of forming a group.

While the Court did not annul the voting power of any shares for which the two hedge funds have proxies at an upcoming CSX shareholders meeting, it did enjoin the two hedge funds from further disclosure violations and left a decision regarding penalties to the SEC and DOJ. 

TCI’s Alleged Beneficial Ownership

One of the main issues raised by the CSX case is whether, in calculating their beneficial ownership, investors are required to count shares in which they have an economic interest through swap or hedging transactions. In the CSX case, TCI held cash-settled “total return equity swaps” under which it obtained the economic risk of stock ownership, but no contractual rights in the underlying shares. While not contractually required under the swaps, the counterparty typically acquires some percentage or the full number of shares that are notionally covered by the swap. The CSX ruling states that decisions by a person to enter into this type of swap arrangement or to terminate the swap can result in the counterparty buying or selling the shares that are notionally covered by the swap. The Court also stated that the counterparty may be likely to vote shares as its client would want in order to maintain a positive business relationship and to bolster the likelihood of obtaining business from the client in the future. The SEC has not authoritatively addressed whether these types of arrangements result in beneficial ownership for Section 13(d) purposes, although the SEC staff provided its views to the Court on the appropriate manner of interpreting the applicable rules. 

The Court’s Analysis of whether TCI Beneficially Owned the Shares Underlying its Equity Swaps

The CSX Court analyzed whether TCI’s swaps resulted in beneficial ownership of CSX shares under two SEC rules. Rule 13d-3(a) states: 

For the purposes of sections 13(d) and 13(g) of the Act a beneficial owner of a security includes any person who, directly or indirectly, through any contract, arrangement, understanding, relationship, or otherwise has or shares: (1) Voting power which includes the power to vote, or to direct the voting of, such security; and/or, (2) Investment power which includes the power to dispose, or to direct the disposition of, such security.

In addition, Rule 13d-3(b) states: 

Any person who, directly or indirectly, creates or uses a trust, proxy, power of attorney, pooling arrangement or any other contract, arrangement, or device with the purpose of [sic] effect of divesting such person of beneficial ownership of a security or preventing the vesting of such beneficial ownership as part of a plan or scheme to evade the reporting requirements of section 13(d) or (g) of the Act shall be deemed for purposes of such sections to be the beneficial owner of such security.

Citing expansive aspects of the language in Rule 13d-3(a), in releases issued by the SEC when it adopted these rules and in past court decisions, the CSX Court seemed inclined to find that TCI shared voting or investment power over shares that its swap counterparties had purchased, on the theory that under the facts TCI had the ability to influence the counterparties’ actions. Nevertheless, the Court did not rule on this issue, as it determined that TCI’s beneficial ownership arose under Rule 13d-3(b). 

Importantly, the Court did not rule that all equity swap arrangements result in vesting beneficial ownership in the swap party, and did not address whether counterparties to swap transactions are deemed to be part of a Section 13(d) group. 

As noted above, Rule 13d-3(b) essentially provides that an investor who: (a) uses a contract, arrangement, or device, (b) with the purpose or effect of divesting such person of beneficial ownership of a security or preventing the vesting of such beneficial ownership, and (c) as part of a plan or scheme to evade the reporting requirements of Section 13(d), is deemed to beneficially own the shares in question. In analyzing whether the three triggers of Rule 13d-3(b) were met, the Court first noted that TCI’s equity swaps were clearly contracts, so the first component of Rule 13d-3(b) was satisfied. 

Next, the Court found that under the specific facts and circumstances of this case, the evidence was persuasive that TCI created and used the equity swaps for the purpose of preventing the vesting of beneficial ownership of CSX shares in TCI and was part of a plan or scheme to evade the reporting requirements of Section 13(d), thus meeting the two remaining components of Rule 13d-3(b). In particular, the Court noted that the chief financial officer of TCI told the board that one of the reasons for using swaps is “the ability to purchase without disclosure to the market or the company” and that TCI emails discussed the need to make certain that its counterparties stayed below 5% physical share ownership, in order to avoid triggering a disclosure obligation. 

The Court further stated that its conclusion was supported by its reading of a June 4, 2008 letter from the Deputy Director of the SEC’s Division of Corporate Finance (due to the Court’s timing, the SEC did not have sufficient time to formally submit an amicus brief in response to the Court’s invitation that it do so). While the SEC staff letter stated that “as a general matter, a person that does nothing more than enter into an equity swap should not be found to have engaged in an evasion of the reporting requirements,” the Court found that TCI did more than just enter into an equity swap since, at the very least, it entered into the equity swaps for the purpose of avoiding the disclosure requirements of Section 13(d). The Court interpreted a statement in the SEC staff’s letter that “a person who entered into a swap would be a beneficial owner under Rule 13d-3(b) if it were determined that the person did so with the intent to create the false appearance of non-ownership of a security” as merely illustrating a specific intent that would satisfy the standard under the rule, but not as limiting the situations where the rule would apply. In light of this, the Court found that Rule 13d-3(b) applies where an investor enters into a transaction with the intent to create the false appearance that there is no large accumulation of securities that might have a potential for shifting corporate control by evading the disclosure requirements of Section 13(d) or (g) by preventing the vesting of beneficial ownership in the investor. Thus, the Court found that, under Rule 13d-3(b), TCI was deemed to be the beneficial owner of shares held by its counterparties to hedge the equity swaps.

The Court’s Analysis of When TCI and 3G Formed a “Group”

Relying on Section 13(d)(3) and an analysis that was highly specific to the facts in this case, the Court ruled that TCI and 3G formed a group prior to December 12, 2007 (the date TCI and 3G claimed its group was formed), and that TCI and 3G thus violated Section 13(d) of the Exchange Act by failing to file the required disclosure within 10 days of forming a group. 

Section 13(d)(3) states that “[w]hen two or more persons act as a partnership, limited partnership, syndicate, or other group for the purpose of acquiring, holding, or disposing of securities of an issuer, such syndicate or group shall be deemed a ‘person’ for the purposes of this subsection.” Section 13(d) caselaw provides that a key question in determining the formation of a group is whether there is a formal or informal understanding regarding the furtherance of a common objective. The Court noted that, in this case, the evidence for making this determination is highly circumstantial. 

The Court found that based on the timing of purchases and sales of CSX stock by TCI and 3G, meetings between TCI and 3G, and the lack of credibility of TCI and 3G representatives, TCI and 3G formed a group no later than February 13, 2007 which was roughly ten months in advance of the Schedule 13D filing in which they reported themselves a group. 

The Court dismissed arguments by TCI and 3G that they did not form a group simply because they started conversations with a statement that they were not forming a group and they avoided a written agreement. The Exchange Act, the Court noted, is concerned with substance, not formalities.

The Court’s Judgment

Based on its findings that TCI and 3G violated Section 13(d), the Court enjoined TCI and 3G from further Section 13(d) violations. However, the Court ruled that it could not preclude TCI and 3G from voting their CSX shares. Rather, it decided that any penalties for TCI’s violations and 3G’s violations must come directly from the SEC or DOJ.

Conclusion

The CSX decision addresses a complex question of whether a person can structure a transaction in a manner that is designed to avoid beneficial ownership under Section 13(d). However, as noted above, the Court did not interpret Section 13(d) to mean that equity swap arrangements necessarily result in beneficial ownership. It is clear that the Court’s conclusion was heavily influenced by the facts of the case, including the court’s belief that TCI had, during the entire process, intended to acquire control of CSX. While focusing on the particular facts before it, the Court’s decision is important in demonstrating where beneficial ownership may be deemed to exist, but not for clarifying the standards for determining when beneficial ownership will exist. That guidance may come from an appeal of the CSX case to the Second Circuit, from future cases addressing the issue or from further SEC action. In the meantime, companies and investors will need to carefully evaluate specific arrangements and circumstances, mindful that a court may find beneficial ownership to exist even when contractual rights do not clearly establish it, especially in hostile control contests.