(The following story by Deborah Brewster appeared on the Financial Times website on July 2.)
LONDON — Lawyers yesterday warned that a court ruling involving CSX, the US railroad operator at war with two hedge funds, would have significant implications for US disclosure rules.
The ruling, they say, could mean investors, including activist hedge funds, must include derivatives when they calculate their total stake in a company.
The ruling, by Judge Lewis Kaplan in New York two weeks ago, comes amid rising concern from US companies and institutional investors that the use of derivatives in building company stakes has broken the link between economic ownership and voting rights.
In a case brought by CSX, the railway operator, Judge Kaplan ruled that he did not have the power to stop two hedge funds, The Children’s Investment Fund and 3G Capital, from voting their combined 8.7 per cent stake in CSX.
However, in a strongly worded statement, he said that the two had attempted to evade the spirit of the law by building their stake through swaps, a form of derivatives. He indicated that swaps, which are widely used by hedge funds, should be viewed as beneficial share ownership, treated in the same way as common shares and included in calculating the size of a stake.
The ruling is at odds with the Securities and Exchange Commission, which has said that swaps should not count as beneficial share ownership. The decision is also being appealed by the two funds, which together hold 11.8 per cent if swaps are included.
One lawyer who has studied the ruling said: “This has a significant rippling impact in a whole host of areas . . . the SEC will need to weigh in on this.”
Richard Swanson, a partner at law firm Arnold & Porter, said: “If the ruling is affirmed, most people would assume they should accept this as the correct interpretation of 13D rules [on disclosure], and disclose their swaps”.
The 13D rule requires a shareholder to disclose when their stake in a company has reached 5 per cent. The ruling might mean that they should count swaps in the total.
“A lot of hedge funds and others are out there now who are doing their calculations on how far above the 5 per cent they may be [with their swaps],” said Mr Swanson.
One lawyer said: “This will create significant uncertainty for hedge funds that have stakes of any size in a company. It will act as a significant inhibition to them, a form of poison pill.”
It would also have a “meaningfully chilling” impact on the swaps market, he said. Swaps are widely used by hedge funds and a reduction in their use would affect the big banks, which profit from them.
There are many trigger points which could be affected.
Section 16 of the 1934 Act says that if a shareholder has 10 per cent of a company, certain rules apply. They must disclose their trades every two days, and if they buy or sell within six months, the company can require them to disgorge any profits. “If swaps count, it could result in someone inadvertently triggering a company’s poison pill, which results in a series of actions taking place as soon as a shareholder reaches 15 per cent,” said the lawyer.
Also, many state laws say that if a shareholder acquires more than 15 per cent of a company without the approval of the board, then the shareholder cannot acquire more shares.
Many companies have change of control provisions at 30 per cent . . . the list goes on,” said the lawyer.
Most agreed that there would be pressure from market participants for the SEC would issue a clarifying ruling, stating which circumstances, if any, swaps should be included in the count.