Track Changes
A recent court ruling involving CSX Corp. may forever change the activist blueprint
June 26, 2008
Activist shareholders were put on guard in June, after a ruling in U.S. District Court threatened to forever alter how hedge funds pursue investments and accumulate positions in target companies.
In the decision, stemming from the proxy fight involving CSX Corp., U.S. District Court judge Lewis Kaplan found that The Children’s Investment Fund Management (TCI) and 3G Fund had violated the Securities and Exchange Commission’s disclosure rules, requiring shareholders – once they exceed 5% ownership – to make their positions public via 13D filings.
The decision served notice that the courts are looking at the use of derivatives, which historically have allowed investors to build stakes in public companies without having to disclose their actual positions. The case also issued a ruling on hedge fund collaboration, saying that the Exchange Act “is concerned with substance” as opposed to “incantations and formalities” – basically, the ruling said if it looks like two groups are working in concert, even if there are public avowals to the contrary, the courts could take action.
“Some people deliberately go close to the line dividing legal from illegal if they see a sufficient opportunity for profit in doing so,” Kaplan wrote in the first line of his 115-page opinion. “A few cross that line and, if caught, seek to justify their actions on the basis of formalistic arguments even when it is apparent that they have defeated the purpose of the law.”
Specifically, Kaplan cited TCI’s use of total return equity swaps, a derivative that he wrote “gave the defendants substantially all of the indicia of stock ownership save the formal legal right to vote the shares.”
He went on to describe that the parties left holding the voting rights of these swaps are often the same investment banks vying to attract a hedge fund’s business, and the institutions are likely aware that future mandates “may depend upon voting in the ‘right’ way.’”
Kaplan specifically noted that by February of last year, TCI had built up a 14% position in CSX that managed to skirt the SEC’s disclosure rules since it was made up entirely of equity swaps. And he speculated later on in the ruling, that “TCI was in a position to influence the counterparties… with respect to the exercise of their voting rights.”
Moreover, he wrote that TCI began contacting other hedge funds and in early 2007 began a dialogue with 3G regarding its investment in CSX. It wasn’t until December of that year, long after 3G began building its own stake in the company, that the pair formally declared themselves as a group.
“Both defendants were more than cognizant of the obligation to file promptly upon forming a group,” Kaplan wrote, adding that the investors either “knew full well or recklessly disregarded” the likelihood that they had done so in their accumulation of CSX shares.
While CSX was successful in proving its case, the decision did little for the company, as it was hoping the court would bar the stockholders from voting their shares in the then-upcoming proxy contest. (As of press time, on June 26, TCI was claiming victory in nominating four representatives to the CSX board, although the company maintained it could take up to a month before the final vote was tallied.) The court, instead, only issued a permanent injunction against future violations.
The ruling, however, broke new ground as it relates to the activist blueprint.
“It effectively threw a hand grenade on the trading desks of activist investors,” William Lawlor, a partner at law firm Dechert LLP tells Mergers & Acquisitions, describing that it’s been common practice for activists to use derivatives as a way to avoid reporting thresholds.
The case, however, could force regulators to address the issue and set a specific course of action as it relates to disclosing derivative positions. The staff at the SEC issued a letter to Kaplan that effectively backed TCI, but the case has only intensified the pressure on securities regulators to provide more clarity regarding derivative positions. Charles Schumer, for instance, wrote a letter to SEC chairman Christopher Cox shortly after the decision, indicating that he his considering legislation to correct what he called a “gap in the law,” according to a Dow Jones report.
Regarding hedge fund collaboration, Lawlor notes that Kaplan’s decision hit upon a “gray area.”
Indeed, it’s not uncommon for hedge funds to advertise their positions and strategy, opening the door for peers to pile in for a particular investment. When Carl Icahn targeted Yahoo, for instance, it wasn’t long after that T. Boone Pickens, Third Point and Paulson & Co. followed suit with parallel investments.
But Lawlor notes that in the case of TCI and 3G, the court “looked closely at the communications and historical relationship between the two investors,” which, on top of parallel trading patterns, provided enough circumstantial evidence in the judge's view to warrant the decision.
What all of this ultimately means to the M&A market remains to be seen. Both TCI and 3G have appealed the ruling, and regulators have yet to issue an authoritative decree as to how investors should treat derivatives. In the meantime, Lawlor notes that several funds are taking a conservative position as it relates to cash-settled swaps, either by disclosing derivative positions as if they were common stock or by staying under the 5% reporting trigger. Lawlor also warns that it’s in the best interest of activist investors “to be careful” in how they communicate with like-minded shareholders. As CSX case demonstrates, it can only take an email to form a group.
CSX photo on homepage is courtesy of Chris Denbow, via flickr.com
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