Corporate Governance

From the Pages of The Pomerantz Monitor: Hedge Funds Secretly Engage in ?Total Return Equity Swaps? to Gain Seats on CSX Board

By Carolyn Moskowitz

The August issue of The Pomerantz Monitor reports on the questionable tactics successfully used by hedge funds to gain seats on the CSX board. For years, two offshore hedge fund groups, The Children's Investment Funds and the 3G Funds, have wanted to buy CSX, one of the largest railroad systems in the U.S. But CSX was not interested. So the two fund groups recently launched a proxy contest seeking, among other things, to place five directors on the 12-person CSX board, to pave the way for an acquisition.

But first, they secretly entered into a series of "total return equity swaps" with some investment banks. The swaps agreements provided that the banks would pay the hedge funds an amount equal to the total returns the funds would have earned had they bought several million CSX shares, while the hedge funds would, in return, provide the banks with imputed interest on a hypothetical loan that would have been used to buy those shares. These arrangements did not require that anyone purchase a single share of CSX stock, much less give the hedge funds actual ownership of any CSX shares.

§13(d) of the Securities Exchange Act applies whenever an investor acquires "beneficial ownership" of more than 5% of a company's stock, and requires such investors to file a disclosure statement revealing their position and any plans they may have with respect to the company. The purpose of this statute is to prevent shareholders from ambushing management by secretly amassing a large stock position from which to mount a takeover challenge. CSX sued, claiming that the swaps agreements had given the hedge funds "beneficial ownership" of millions of shares of CSX stock, pushing their interest over 5%, and that the funds failed to file a Schedule 13(d).

The court held a full-scale trial on CSX's charges, and on June 11 decided that the hedge funds knew the banks would buy CSX shares to hedge their positions under the swaps agreements; and that they also knew that banks would vote those shares as the hedge funds desired. In fact, the court concluded that the hedge funds had entered into these swaps transactions for the very purpose of secretly acquiring de facto control over millions of CSX shares while evading the reporting requirements of §13(d).

However, the court would not enjoin the voting of any of the shares in question, because the funds' proxy statements, seeking shareholder votes for their slate of directors, had already disclosed all their interests in the swaps agreements. This disclosure, the court held, effectively mooted the problem caused by the failure to file a §13(d) statement. So the hedge funds were allowed to vote all their shares, including any swaps shares, at the annual meeting.

Two weeks later, on June 25, CSX held its annual meeting, and at the conclusion the hedge funds declared that they had won four board seats. CSX initially refused to declare the winners, announcing that the election results were "too close to call," but on July 16 it conceded that four insurgent directors had, in fact, been elected. Results will not be final, however, until CSX?s appeal of the district court?s ruling has been decided. Oral arguments on that appeal are scheduled for August 25.

This case has been closely watched because the use of swaps to amass undisclosed positions in corporations is a common tactic in the industry. And now there is news that about 40 NYSE-listed companies have enacted bylaws this year that expressly require that investors nominating directors or proposing resolutions at annual meetings disclose all transactions involving the borrowing or lending of shares or hedge transactions, to protect against stock-price declines. The counter-attack has begun.

Full post as published by PomTalk on August 12, 2008 (boomark / email).