Corporate Governance

Beneficial Ownership, Equity Swaps, and Proxy Contests: CSX v. The Children's Investment Fund (Part 6)

By J. Robert Brown

We are discussing the letter submitted to the judge in CSX v. The Children's Investment Fund from the Division of Corporation Finance at the SEC. 

The second question went to the necessary "mental state" needed to establish a scheme to evade under Rule 13d-3(b).  Again, the staff recast the question.  "Your question concerning mental state then is how significant in the swap-party's mind is the motive of avoiding reporting must be for Rule 13d-3(b) to apply and the long swap-party to be deemed a beneficial owner of the shares held by the counter-party." 

The subsection provides that any person who "directly or indirectly" uses a "contract, arrangement, or devices with the purpose of or effect" as part of a "plan or scheme to evade the reporting requirements" of Section 13(d) or (g) "shall be deemed for purposes of such Sections to be the beneficial owner of such security."  17 CFR 240.13d-3(b). 

In other words, the transaction has to have the intent or effect of avoiding disclosure under Section 13(d) and extends the definition of beneficial ownership only to Sections 13(d) and (g).  In other words, a finding of beneficial ownership under this subsection does not implicate other sections such as Section 16. 

In describing the application of this subsection, the staff of the Division of Corporation Finance had this to say:

• In the Division's view, the long party's underlying motive for entering into the swap transaction generally is not a basis for determining whether there is "a plan or scheme to evade." . . . We believe that the mental state contemplated by the words "plan or scheme to evade" is generally the intent to enter into an arrangement that creates a false appearance.  Thus, 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 a false appearance of non-ownership of a security.  The significant consideration is not the person's motive but rather that the person knew or was reckless in not knowing that the transaction would create a false appearance.  In this regard, taking steps with the motive of avoiding reporting and disclosure generally is not a violation of Section 13(d) unless the steps create a false appearance.

The letter left the door ajar, but barely, to the possibility that an equity swap would fall within subsection (b). 

• We cannot rule out the possibility that, in some unusual circumstances, a plan or scheme to evade the beneficial ownership provisions of Rule 13d-3 might exist where the evidence does not indicate a false appearance or sham transaction.  No general principle can be designed for all potential future occurrences, and the rare case might present an egregious situation qualifying as a scheme to evade without also involving the creation of a false appearance of fact.  Notwithstanding this reservation, 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.

Again, there are concerns with the analysis.  Certainly the analysis is correct to note that there must be a false appearance.  The entire nature of subsection (b) is to pick up situations where beneficial ownership is disguised, misleading the market.  The notion that the party must have a requisite mental state that includes an "intent to create the false appearance of ownership," however, goes too far.

The language of the provision provides that any plan that has the effect of hiding ownership is enough.  Thus, it is enough that this be the effect, whatever the intent or motive.  This is logical given the requirements of Section 13(d).  Investors and the SEC should have the right to require accurate disclosure of beneficial ownership whether or not the shareholder intended to deceive.  This is consistent with the decisions that have held that violations of Section 13(d) do not require proof of scienter.

The trial court likewise rejected the need for an intent to create the false appearance of non-ownership.  Instead, as the court reasoned:

• The goal of Section 13(d) "is to alert the marketplace to every large, rapid aggregation or accumulation of securities . . . which might represent a potential shift in corporate control."  In consequence, the natural reading is that the Division refers to a false appearance that no such accumulation is taking palce.  Put another way, Rule 13d-3(b) applies where one 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) through preventing the vesting of beneficial ownership in the actor.

Nonetheless, even this view goes too far.  Shareholders want to know about accumulations that have the potential to shift control.  Adding in that they are only entitled to know if the investors "intends" to create a false appearance of this type information is to condition the disclosure of material information on intent rather than on the nature of the information itself.  It is an attempt to read into Section 13(d) a state of mind requirement where none exists.  The state of mind will likely be relevant at the remedy

Interestingly, the letter ended with a recognition of the "significant policy issues" raised by the case and that the Division was"considering whether or not to recommend to the Commission that it propose rules to address in a more direct way the use of equity swaps".  Nonetheless, this is not a reason for the courts to sit back and not apply the requirements of Section 13(d).  To the extent the court requires some disclosure of equity swaps, it will only put pressure on the agency to adopt rules providing increased guidance on the issue. 

Finally, the letter pointed out that once a Schedule 13D was filed the shareholder was required to disclose any "plans or proposals" to acquire additional shares, a pointed reminder that any plan to acquire the shares purchased by the counterparty as a hedge had to be disclosed.  But this does not address the concern over the need for the company and the market to know about the accumulation as it occurs and does not address the level of disclosure about the arrangements that must occur.  Thus, when the Funds revealed the equity swaps, they did not specify the position held by each of the eight relevant investment/commercial banks, something that may have been of great interest to investors. 

Full post as published by The Race to the Bottom on June 15, 2008 (boomark / email).