Do total return swaps provide beneficial ownership of an underlying corporation? Some U.S. judges have said no, while others haven’t been able to decide. The question arose in a case brought to the U.S. District Court Southern District of New York in 2007 by CSX Corporation, who took private action against The Children’s Investment Fund for attempting a hostile takeover of the company after amassing over 10% exposure to the company through cash-settled TRS, on top of an 8% equity stake it had purchased in conjunction with another fund. TCI, an activist investor, filed a 13D with the Securities and Exchange Commission as the law requires when an investor amasses more than 5% equity stake in the company. The filing did not include TCI's TRS holdings and it only revealed those positions a few months before the proxy vote.
The case has bounced around the U.S. District and Appeals Courts and at this point little is clear. TCI was found to be in violation of Section 13D disclosure requirements, not because of its equity swap exposure, but because it failed to timely disclose it had formed a group with another hedge fund in buying equity in CSX. The District Court granted a permanent injunction against TCI for that violation, but refused to sterilize the fund's votes in the proxy contest. The permanent injunction means that if TCI violated 13D again, for whatever reason, it could be held in contempt of court. However, its votes at the CSX shareholder meeting counted, essentially meaning TCI hadn’t egregiously broken the 13D rules.
The 2nd Circuit U.S. Court of Appeals upheld the decision not to sterilize, or discount, the votes, but remanded the question of permanent injunction back to the District Court. This time, the District Court has to decide whether or not TCI was in violation of Section 13D without taking into consideration its equity swap exposure at all. In the same breath, two of the Judges on the Appeals Court avoided the overall TRS question, while one, Judge Ralph Winter, opined that cash-settled equity swap agreements in and of themselves do not constitute beneficial ownership because they don’t confer the right to vote on a companies’ Board. In order for there to be ultimate clarity, the Court would have had to issue a majority opinion, or the U.S. Congress or SEC would have to take action.
The market is wondering if anyone sees the elephant in the room. If action isn’t taken soon, say lawyers, corporations could begin to connect the dots and realize that their poison pills need to be updated. Poison pills are clauses or triggers in stock acquisition agreements meant to make equity less attractive to acquirers and thus discourage hostile takeovers.
“You may see lawyers advising their corporate clients to include equity swap arrangements, like total return swaps, as part of the beneficial ownership test that triggers a poison pill,” said Stephen Alexander, partner at Bingham McCutchen in Los Angeles, Calif., and co-author of a note on the case. Such a move would discourage investors from amassing large TRS exposures and using them in their role as an activist investor. But it would also have a major impact on banks and hedge funds who use such derivatives to gain exposures to equity without the intention of being an activist investor. For now, the issue is still up in the air for derivatives players.
