CSX v. TCI; Cash-Settled Equity SWAPs As Conferring Beneficial Ownerhip of the Referenced Stock

Judge Kaplan's June 11, 2008 decision in CSX v. The Children's Investment Fund Management (UK) LLP ("TCI") et al., 2008 WL 2372693 (now on appeal by both sides to the Second Circuit) must be creating heartburn up and down Wall Street, for his holding that a long position in cash-settled equity SWAPs conferred, on the facts of the case before him, "beneficial ownership" of the referenced shares (common of CSX Corporation (NYSE: CSX)) on TCI and its 13D partner, 3G Fund L.P. and affiliates ("3G"). While the victory for CSX is somewhat Pyrrhic in that the Judge concluded that neither TCI's/3G's Schedule 13D nor their Section 14(a) proxy statement were materially misleading, and he refused to restrain TCI and 3F from voting the 6.4% of CSX's shares they acquired after formation of their Section 13(d) "group," CSX has made good use of the court's findings of Section 13 violations in its proxy contest with TCI and 3G in connection with the scheduled June 25th annual shareholders' meeting. And, of course, the decision has to be of concern to the defendants for the damage it wreaks to their reputations.

But what is of concern here is the impact of the Judge's finding that TCI and 3G, as the long parties to cash-settled equity SWAPs with CSX common as the referenced stock, beneficially owned the CSX shares acquired by the counterparties to hedge their short positions in CSX. Judge Kaplan's opinion is extensive (115 pages, with a table of contents no less) and follows extensive expedited discovery and a two day bench trial. His analysis of the SEC's Rule 13d-3 (defining "beneficial owner" for purposes of Sections 13(d) and (g) of the Exchange Act) is meticulous. Ultimately, apparently in deference to the defendants' vigorous argument, the positions of amici (including the ISDA), and the position of the SEC's Division of Corporation Finance, the Judge did not find, under Rule 13d-3(a) (the general definition of "beneficial owner"), that ownership of the long side of the SWAPs conferred beneficial ownership on TCI and 3G of the CSX shares held by the counterparties. (He may have passed on Rule 13d-3(a) to avoid a broader ruling.) What he did conclude is that TCI and 3G must be deemed to be the beneficial owners of the counterparties' CSX shares under the "plan or scheme to evade the reporting requirements of Section 13(d)" catch-all of Rule 13d-3(b).

But it's hard to see how this alternative, fact-based finding gives long parties to equity SWAPs much comfort. Given the Judge's conclusion that the counterparties had no practical alternative to purchasing physical shares to hedge their short positions or any reason to hold their positions once the SWAPs terminated (according to Professor Black's letter to the SEC, filed with the Court, it is "market custom" for swap counterparties to hedge short positions by purchasing matched shares and to sell most or all of the matched shares on termination of the SWAP), it became a simple matter for the Judge to conclude that TCI and 3G possessed a "significant ability to affect" the purchase and sale by the counterparties of the referenced shares, here CSX common. Wouldn't this be true for all long parties whose counterparties cover their short position by purchasing matched shares?

While the Judge's decision is intensely fact-driven, it's hard to see how SWAP parties and their counsel cannot come away from the decision with these concerns:

1. As a matter of course do not long parties to cash-settled equity SWAPs now have to include in their ownership of the referenced issuer's stock the shares held as hedges by the short counterparties?

2. If the shares held by the counterparties are benefically owned by the long party for Section 13(d) purposes, are they not also beneficially owned by the long party for Section 16 purposes (both reporting and short-swing profit recovery if the long party's aggregate postion in the issuer's equity securities exeeds 10% of its outstanding shares)?

3. Will long parties now trip poison pills if their short parties' ownership of the referenced shares are deemed beneficially owned by the long party?

4. Will such provisions as Delaware's control share statute (GCL section 203) be tripped by such beneficial ownership?

5. If the long party trips Section 13(d) by its ownership of the short parties' hedged position, how can the counterparty not be part of the long party's Section 13D group?

It's a safe bet that the briefing before the Second Circuit on the parties' appeal of Judge Kaplan's decision will raise these and other possible consequences of the decision (amici briefs are due July 18, 2008).