CSX v. TCI; Black v. Hu: Et Tu Henry?

One of the many intriguing aspects of the battle between CSX and TCI and 3G is the line-up of experts. For TCI and 3G we have Professor Bernard Black of Texas and for CSX we have Professors Joseph Grundfest of Stanford, Henry T.C. Hu of Texas, and Marti G. Subrahmanyam of NYU. Their opposing letters are in the record, Professor's Black's of May 29, 2008 and his adversaries of June 2, 2008.

These are heavy hitters, eminently qualified to provide expert and weighty advice on securities law and corporate governance. What makes the contest intriguing is that Professors Black and Hu, besides being colleagues at University of Texas School of Law, are co-authors of the leading studies of the separation, through derivatives and other mechanisms, of economic ownership of shares from voting rights to those shares. See, e.g., their article in the May 2006 issue of the Business Lawyer, "Empty Voting and Hidden (Morphable) Ownership: Taxonomy, Implications, and Reforms."

But in the CSX group's letter to Brian Cartwright (General Counsel) of the SEC of June 2 (responding at CSX's request to two inquiries of Judge Kaplan to the SEC, after Professor Black, at TCI's and 3G's request, volunteered the answers to the SEC), the gloves come off.

The CSX professors forcefully argue that, on the facts that they understand were established at trial, TCI clearly violated the "anti-evasion prong" (as they term it) of the SEC's Section 13 Rule defining a beneficial owner, Rule 13d-3(b). This is the ground on which Judge Kaplan found TCI and 3G to have violated Section 13(d) of the Exchange Act. In critiquing Professor Black's more restrictive interpretation of Rule 13d-3, the CSX professors conclude he has "misread" the Rule; asserts positions "contrary to our understanding of the law, market practice, and the facts developed in the pending litigation"; incorrectly characterizes single stock futures as SWAP equivalents; and makes assertions that are "entirely speculative." Sounds like he would get a failing grade in their classroom.

On the facts found by Judge Kaplan it is hard to disagree with the conclusion that the defendants engaged in a scheme to avoid reporting their economic stake in CSX before they did in December 2007. But once the beneficial ownership bell is rung on equity SWAPs it will not be unrung. While the CSX professors emphasize the limited nature of their conclusion on TCI's beneficial ownership of CSX's common, their attempt to do so runs up against the alternative grounds for finding Rule 13d-3 beneficial ownership: one has beneficial ownership of shares if he, directly or indirectly, through any contract, arrangement, understanding, relationship, or otherwise, has or shares:

(i) voting power, or

(ii) investment power which includes the power to dispose, or to direct the disposition of the subject shares.

Much of the professors' foundation for their conclusion that TCI clearly violated the "anti-evasion prong" of Rule 13d-3 (paragraph (b)) is TCI's efforts to influence the management of CSX and the voting of the CSX shares held by their counterparties. But attempts to influence management, or the voting of shares, is not the only predicate for finding beneficial ownership of shares--it can also be established solely by finding "investment power," and, given the "market customs" attendant to large cash-settled equity SWAPs, it's hard to avoid the conclusion that TCI was, on those customs. the beneficial owner of the CSX shares held by its counterparties even if it had not engaged in the efforts cited by the professors to influence CSX's management or to influence the voting of the counterparties' shares. As the professors note: "A person is the beneficial owner of a security even if it only indirectly shares the power to direct the voting or disposition of the security." (Page 6)

So beneficial ownership of more that 5% of equity securities can lead to a Section 13 filing even if one is a passive investor--i.e., on Schedule 13G.

So it's not at all clear to this observer that the position of Professors Grundfest et al. can be as restricted as they strive to make it.

JFF