Corporate Governance

Beneficial Ownership, Equity Swaps, and Proxy Contests: CSX v. The Children's Investment Fund (Part 7)

By J. Robert Brown

We are addressing the ongoing litigation between CSX, the railroad company, and a number of hedge funds, including The Children's Investment Fund and 3G Capital Partners. The case revolves around the obligation of the Funds to disclose certain equity swaps involving shares of CSX.  The Funds have launched a proxy contest, with the annual meeting scheduled for June 25.  The district court issued an opinion in the case on June 9.  The opinion is posted on the DU Corporate Governance web site.  

The case has attracted considerable attention, including a number of amicus briefs, a relatively unusual step at the district court level.  A brief was filed by the International Swaps and Derivatives Association and the Securities Industry and Financial Markets Association and another by the Coalition of the Private Investment Companies (CPIC).

The ISDA/SIFMA Brief argued strenuously that the "long" party in a cash settled equity swap was not the beneficial owner of the shares acquired by the counterparty, pointing to the terms of a standard agreement.

• Such a party does not itself own any of the underlying equity securities; equity swaps convey only a synthetic economic interest in the performance of a designated equity security.  The standard ISDA Master Agreement and related forms of schedule, definitions, and transaction confirmation that govern the legal rights and obligations of parties to equity swaps do not convey to the long party either title to the underlying shares or any contractual right to acquire or to direct its counterparty's acquisition or disposition of shares, or the voting of shares, if any, acquired by the counterparty.  The standard ISDA documentation expressly provides that the long party has no interest or expectation with respect to any of the hedge transactions in which the counterparty engages. 

The relevant definitions are on the ISDA web page.     

Nor did the common practice in the industry change the result.  The Brief noted that while "counterparties generally may hedge equity swaps with referenced shares, it is far from invariably so."  Moreover, even where shares were acquired, swap dealers could sell the underlying shares "before the equity swap is terminated, and without the counterparty's knowledge."  Moreover, some dealers apparently as a matter of policy did not sell shares to its counterparty.  As for voting rights, the Brief noted that a study by PwC confirmed "that most market participants generally do not exercise their voting rights at all for shares purchased as a hedge and that they generally rebuff attempts by others to influence their votes." 

The Brief provided some useful information and contained a number of reasons why a cash settled equity swap was not inherently a transaction that resulted in beneficial ownership.  The authority for some of the propositions, however, was weak.  At one point the Brief stated that "[m]any, if not most, swap dealers, in fact have policies limiting their traders' ability" to sell shares to their counterparty.  As authority, the brief cited the letter written by Bernie Black that merely said that "[o]ther dealers, as a matter of policy, will refuse to sell matched shares directly to the swap counterparty."  In other words, it was an overstatement to state that "[m]any, if not most" swap dealers did not allow for the sale of shares to counterparties and, in any event, the authority was not from industry but was an observation of a law professor. 

Moreover, while noting that not all equity swaps necessarily resulted in the purchase of referenced shares, the Brief said nothing about the usual practice with respect to swaps the size of the ones at issue in this case.  In his letter, Bernie Black opined that "[u]nder current market conditions, for sizeable equity swaps, the cheapest means of hedging is usually to acquire matched shares."  In other words, large equity swaps invariably relied upon actual purchases of shares to hedge, whereas smaller positions might not. 

Numerous documents filed in the case, including the complaint, various motions and legal memorandum, and an assortment of amicus briefs (including one from the Division of Corporation Finance at the SEC) and legal opinions, can be found at the DU Corporate Governance web site.

Full post as published by The Race to the Bottom on June 16, 2008 (boomark / email).