(The following column by Steven M. Davidoff appeared on the New York Times website on August 25.)
NEW YORK — This morning, the U.S. Court of Appeals for the Second Circuit heard CSX’s latest argument to avoid seating two directors nominated by The Children’s Investment Fund and 3G Partners, which I refer to as the TCI Group.
CSX is arguing that the TCI Group violated the federal securities laws, and that the group should be penalized by “sterilizing” TCI Group’s 6.4 percent interest in CSX. This would mean that the shares would not be counted as voting for purposes of CSX’s recent election.
The two TCI Group directors were elected to the board at this election. However, their win is based on receiving this 6.4 percent; if it doesn’t count, then the CSX board’s two nominees would be seated instead. Notably, CSX is not disputing the election of the TCI Group’s other two nominees, Gilbert H. Lamphere and Alexandre Behring. These two would have been elected with or without this 6.4 percent and have already been seated on the TCI board.
So, the current dispute is over whether the TCI Group will have 2 or 4 directors on the CSX board. It should make for fun meetings no matter what.
The argument this morning concerned the scope of the Section 13D rules as well as the proper penalty when it is violated. Section 13D generally requires that when an individual acquires beneficial ownership of greater than 5 percent of a class of publicly traded shares it must within 10 business days report that interest by filing a Schedule 13D with the SEC.
CSX is arguing that the TCI Group failed to file a Schedule 13D and report the ownership of cash-settled swaps that amounted to a holding in CSX of more than 5 percent. (To recap: Cash-settled swaps are derivatives that give the TCI Group economic exposure to CSX – without actually holding the shares. Instead the trade is settled in cash and during that time the counter-party has no voting right in the company without an arrangement, implicit or otherwise, with the bank writing the derivative. )
CSX’s argument appeared a bit stretched. The 13D rules require reporting of beneficial ownership of equity securities. Cash-settled derivatives are not that; they are merely contracts for settlement and are not interests in the actual securities. Nonetheless, the lower court opinion agreed with CSX and contained some heavy speculation that despite this, the actual mechanics of the bank-hedging and the hedge funds’ treatment of the derivatives satisfied this test.
In other words, the court found that while the swaps themselves were not equity securities, since the banks would hedge these swaps by themselves buying these equity securities, Section 13D could still apply.
Despite flirting with this finding, the court then sidestepped the issue, finding that the TCI Group violated 13D for another reason. Namely, the TCI Group’s use of cash-settled derivatives was a scheme to evade the reporting requirements of the 13D, a second prong. Here, there were some bad facts against the TCI Group including that they allegedly structured and spread their swaps in order to ensure that no bank had to report their own hedging position.
That’s all well and good. The narrower holding is certainly better-grounded and likely to be more palatable to the markets. In other words, hedge funds later accused of this conduct cans assert that this holding merely reflects the particularly egregious conduct of the TCI Group.
There is even an amicus brief in this case filed by a number of very prominent law professors arguing that the opinion should be upheld on this basis. If I had to guess, I would say the appellate court is likely to buy this argument, but not address the issue of whether 13D even picks up cash-settled derivatives. Perhaps someone who saw the arguments this morning has a more informed opinion. In any event, such a holding is likely still problematic because it still provides an opening for companies to challenge the use of cash-settled swaps in proxy contests and will chill their increasing use.
But all of this may be moot because I suspect that the CSX case is going to spur regulation of these derivatives sooner rather than later.
The hidden issue in the lower court opinion is its finding on the formation of a group. This has always been a troublesome issue under Schedule 13D: When do two actors form a group acting in concert triggering the 13D requirements? Section 13(d)(3) provides 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.” In such circumstances the “groups” holdings will be aggregated for purposes of the 13D filing requirements and they will be required to jointly file as a group any required 13D.
The lower court found that 3G and TCI had formed a group many months before they publicly stated they were one and filed a 13D. Since they formed a group earlier, their securities holdings were aggregated at that time for purposes of 13D, topping the 5 percent threshold. Another violation thus arose – the failure to jointly file a Schedule 13D reporting this group interest.
To make this finding, the lower court found that the close relationship of the parties, patterned buying, and references to the other in email messages created an inference of a group. This is a tough call. TCI and 3G met knowing the danger of acting as a group and appeared to structure their conduct accordingly, trying desperately not to form a group and even stipulating that they were not a group at the beginning of their few meetings. But as the judge pointed out substance trumps formality here, and the underlying conduct is looked to.
In addition, it is clear that the lower court judge here did not approve of the TCI group’s conduct. Under the very broad 13D rules it may indeed mean that the parties were a group. But the alleged group conduct here was rather light and mostly drawn from inferences and patterns (i.e., you had a prior close relationship). Going forward this presents a dilemma for any hedge fund: How do you communicate with other shareholders without running afoul of these rules? Particularly when any finding of a group appears so subjective and at the mercy of a judge’s broader views of your conduct.
Generally speaking, the purpose of these shareholder communications is to share information that each may act upon. This may then appear to the outside world as coordinating, and it very well may be. In the hands of a judge and the broad 13D standards, this effectively means that any contact creates liability under 13D if no joint 13D filing is made.
To some extent, given the remedy of 13D — that it is merely requiring corrective disclosure and doing more like sterilizing shares is quite hard for the court to do — hedge funds can take the risk. But the real issue before the Second Circuit Monday morning was the penalty for a 13D violation. Currently it is merely a tap on the wrist and required corrective disclosure unless the Securities and Exchange Commission steps in. But if the court modifies the possible penalties for 13D, this could create problems.
Moreover, even if the Second Circuit doesn’t act, the risk of being seen as violating the law may be too great and therefore chill communication. We are already getting conduct that looks like it is attempting to sidestep this issue: Hedge funds are now communicating publicly with letters and filings that are a call to arms instead of using private communications.
Harbinger Capital’s filings in Cleveland Cliffs that it may acquire up to one-third of the company’s shares is one of these signals. Harbinger could theoretically acquire this amount But given the complex array of Ohio anti-takeover statutes that inhibit such an acquisition, the act is more of a dog-whistle call to arbitrageurs to come and join in the contest.
The ultimate question though is how will this come back to affect companies. Stifling communication among investment firms is likely to lead to surprises. Moreover, if the goal is to make these companies more efficient, then what are we doing here? Are we really effectively implementing the tender offer rules of the Williams Act by broadly interpreting what is a group in a shareholder activist situation?
Perhaps the standard here should be lower than in a situation where a party seeks control. In any event, expect this to be an issue again next proxy season — to the extent hedge funds do decide to take the risk.
Likely when the S.E.C. does get around to acting on rules for cash-settled derivatives, it would do well to promulgate some safe harbors or clear examples of dos and don’ts for group communication and provide some guidance on this broader issue. Of course in doing so, the S.E.C. would do well to have a full examination of cash-settled swaps to determine if they really are the problem some cite. This would be putting the horse before the cart.