Legal News

Judge Kaplan Reprimands Hedge Funds in Takeover Battle with CSX

By Dan Slater

Two hedge funds who were sued by railroad CSX received a strongly-worded rebuke from NY District Judge Lewis Kaplan yesterday for the way they used swaps to plot a takeover of the company, and failed to disclose their coordinated actions.

In a 130-page opinion, Kaplan (pictured) found that that the two hedge funds — 3G Capital Partners and The Children’s Investment Fund — had consciously avoided securities laws in their proxy battle with CSX. He found that the two funds had jointly plotted a bid for control of CSX, but consciously failed to disclose their intentions. Here are stories from the WSJ and NYT. Click here for the opinion.

The flap concerned the way in which equity swaps are used by activist investors to build up positions in companies. As the NYT describes the product, one party — typically a brokerage — promises to pay the other — here, a hedge fund — all the economic rewards of owning a stock, and the fund promises to compensate the firm if the stock loses value. According to the NYT, swaps give the holder no voting rights and, in the view of the funds, mean they don’t need to comply with disclosure rules because, under securities laws, only “beneficial ownership” — meaning both voting rights and economic benefits — must be disclosed.

For Judge Kaplan, that was the rub. He said the funds sought to justify their actions “on the basis of formalistic arguments,” even when they had “defeated the purpose of the law.” He found that TCI and 3G used the swaps in a way that consciously allowed them to build a position while delaying such disclosure to the broader stock market. The swaps hung “like the sword of Damocles over the neck of CSX,” he wrote. Viewing those swaps as anything but regular shares owned outright, “failed to take account of the practical realities of the world,” and would “be open to the gravest abuse.” The funds reportedly own 8.7% of the company’s shares, and have positions in equity swaps that amount to another 12.3% of the shares.

However, Kaplan said that it was too late to reverse the funds’ actions, and that he was legally prevented from “sterilizing” or neutralizing their votes when shareholders choose a board of directors on June 25. Instead, the funds were permanently enjoined from making future violations.

Representing CSX were Cravath’s Rory O. Millson, Francis P. Barron and David R. Marriott. The Children’s Investment Fund was represented by Schulte Roth’s Howard O. Godnick, Michael E. Swartz and Yocheved Cohen. On 3G’s side were Kirkland & Ellis’s Peter Duffy Doyle and Andrew M. Genser.

Full post as published by Law Blog - WSJ.com on June 12, 2008 (boomark / email).