The SEC’s Division of Corporation Finance’s letter to Judge Kaplan of June 4, 2008 played a significant role in Judge Kaplan’s decision, as I have addressed in my blogs of June 24 and July 26, and it will undoubtedly play a significant role in the deliberations of the Second Circuit on the parties’ appeal of Judge Kaplan’s decision, scheduled to be heard by the Second Circuit on August 25, 2008. The Division’s response was at the invitation of Judge Kaplan, and addressed two questions put to the SEC by him, the first being whether TCI, as the long party in its cash-settled equity swaps, held “beneficial” ownership of CSX’s common stock held by the counterparty banks. Second, Judge Kaplan asked the Commission “what mental state is required to establish the existence of a plan or scheme within the meaning of Rule 13d-3(b).”
A. Judge Kaplan’s First Question
Because of time constraints, only Corp Fin could respond to the Judge’s inquiries. As explained in his cover letter, transmitting the Division’s response (signed by Brian Breheny, Deputy Director), Brian Cartwright, General Counsel of the Commission, expressed his regrets that he was unable to provide the views of the Commission itself to Judge Kaplan.
As I observed in my blog of July 17, commenting on the opening briefs of CSX and TCI on appeal, Corp Fin’s amicus letter strikes me as more supportive of TCI’s position than of CSX’s position, and it may very well have nudged Judge Kaplan to base his finding that TCI’s and 3G’s use of swaps conferred beneficial ownership of the counterparties’ CSX shares under Rule 13d-3(b) rather than under Rule 13d-3(a). By its letter Corp Fin expressly disagrees with CSX’s legal interpretation of Rule 13d-3 that the “economic incentives” of counterparties can establish beneficial ownership in the long parties in the shares held by the counterparties, regardless of any “arrangement, understanding or relationship” with the counterparties by the long parties.
“As a general matter, economic or business incentives, in contrast to some contract, arrangement, understanding, or relationship concerning voting power or investment power between the parties to an equity swap, are not sufficient to create beneficial ownership under Rule 13d-3(b).”
Amicus Letter at 2 (footnote omitted).
Corp Fin states that a “standard” cash-settled equity swap does not, in and of itself, confer on the long party “any voting power or investment power over the shares a counterparty purchases to hedge its position.” That conclusion is not changed, observes Corp Fin, “by the presence of economic or business incentives that the counterparty may have to vote the shares as the other party wishes or to dispose of the shares to the other party.”
B. Judge Kaplan’s Second Question
To understand Corp Fin’s response to Judge Kaplan’s second question, about the mental state required to establish the existence of a Rule 13d-3(b) “plan or scheme,” it is helpful to have the text of the Rule in front of us:
“Any person who, directly or indirectly, creates or uses a trust, proxy, power of attorney, pooling arrangement or any other contract, arrangement or device with the purpose or effect of divesting such person of beneficial ownership of a security or preventing the vesting of such beneficial ownership as part of a plan or scheme to evade the reporting requirements of section 13(d) or (g) of the Act shall be deemed for purposes of such sections to be the beneficial owner of such security.”
Analyzing the Judge’s second question, Corp Fin concluded, based upon the trial transcript, that the Judge wanted to know “how significant in the swap-party’s mind the motive of avoiding reporting must be for Rule 13d-3(b) to apply and the long swap-party to be deemed a beneficial owner of the shares held by the counter-party.” Amicus Letter at 3.
By an answer helpful to TCI and 3G, Corp Fin concluded that “the long party’s underlying motive for entering into the swap transaction generally is not a basis for determining whether there is ‘a plan or scheme to evade.’” A “purpose or effect” concluded Corp Fin should be separated from “plan or scheme” and not define the mental state necessary to find a “plan or scheme.”
The requisite “mental state” that should underlie Rule 13d-3(b)’s “plan or scheme to evade” should be an “intent to enter into an arrangement that creates a false appearance.”
“Thus, a person who entered into a swap would be a beneficial owner under Rule 13d-3(b) if it were determined that the person did so with the intent to create the false appearance of non-ownership of a security. This significant consideration is not the person’s motive but rather that the person knew or was reckless in not knowing that the transaction would create a false appearance.”
C. The Parties’ Reaction to the Amicus Letter
The amicus letter was submitted after the parties had submitted their post-trial briefs, so CSX’s brief on appeal was its first opportunity to publicly disclose its reaction to the letter (TCI and 3G couldn’t wait and commented on the letter by a submission to the trial court on June 6, 2008). Needless to say, one party embraced it and the other did not.
TCI and 3G heavily rely upon the amicus letter in urging the Second Circuit to reverse Judge Kaplan, even spending considerable time attempting to establish that Corp Fin’s position should be accorded as much or virtually as much deference as a court would accord a position of the SEC itself.
CSX, on the other hand, manifests some of the same disdain for Corp Fin’s position as it does for the credibility of TCI’s Hohn and Amin:
“After the post-trial briefing was complete, the Staff [Corp Fin] submitted its comments. In those comments [the Staff’s letter of June 4, 2008], the Staff invented a completely new standard for Rule 13d-3(b), which neither party had advanced at trial and which is just wrong.”
CSX Responding Brief at 37.
CSX rips the Staff for misreading its own rule by impermissibly rearranging its text, reading “effect” out of the rule, and eviscerating the “purpose or effect” aspect of the Rule. The Staff’s “false appearance” test is not only invented, it is so new that it “may violate the notice and comment rulemaking requirements of the Administrative Procedure Act, ….”! Responding Brief n. 19.
D. How the Former SEC Commissioners, Officials, and Corporate and Accounting Professors Respond to the Amicus Letter
It’s no surprise: Given that eight of the “gang of 25” (see my blog of July 26) are former SEC commissioners and officials (and include former Chairman Arthur Levitt, Jr.), this amicus group’s brief finds only positive things to say about Corp Fin’s letter. Notwithstanding that the group strongly urges the Second Circuit to affirm Judge Kaplan’s decision and endorses his reasoning and analysis, the group concludes that Corp Fin “in fact supports the District Court’s decision here.” Brief at 19. The group reads the amicus letter as not requiring the establishment of a motive to evade the reporting requirements of Section 13(d), focusing on the words “purpose or effect” of Rule 13d-3(b). Scienter is not, argues the group, “an element of a Section 13(d)(1) violation.” Brief at 19-20.
Corp Fin’s “false appearance” test, as interpreted by the amicus group, “is not a false appearance of non-ownership [of the referenced security], but a ‘false appearance that there is no large accumulation of securities that might have the potential for shifting corporate control.’” Brief at 21.
E. Who’s Right
With all due respect to the amicus group, I think they misinterpret and distort the position of Corp Fin, which I think is right in its analysis of the required “mental state” necessary to establish a violation of Rule 13d-3(b). While a plan or scheme may have the purpose or effect of evading the reporting requirements of Section 13(d) or (g) of the Exchange Act, and thus not require an intent to violate the reporting requirements of Section 13(d), there must still be a plan or scheme, and that requirement connotes wrongdoing intent or recklessness in not appreciating wrongdoing by the actor. Take two examples. One: spouse, with a desire to hide assets from former spouse, acquires more than 5% of the equity securities of an Exchange Act company, in the name of a trusted colleague. Spouse pays for the shares. Spouse has an understanding with colleague to convey beneficial ownership of the shares to spouse on demand. Spouse is not a sophisticated investor, and knows nothing about the Exchange Act. Has spouse violated Rule 13d-3(b)? I would guess that Corp Fin would say yes, as I do.
Example Two. Generous donor, with the intent of donating more than 5% of the equity securities of an Exchange Act company to donee, purchases the shares for donee, but makes a failed gift. Donor is a sophisticated investor, but in good faith believes he has gifted the shares to donee. Has donor violated Rule 13d-3(b)? (He undoubtedly has violated Section 13d-3(a).) I would think Corp Fin would say no, as I do.
The reason why CSX attacks Corp Fin’s amicus letter, and the amicus group strives to interpret it to support its position, is that Corp Fin’s position on economic incentives is problematic for Judge Kaplan’s aversion to the use of cash-settled equity swaps to avoid Section 13(d) reporting. If it is perfectly legitimate to enter into cash-settled equity swaps with the purpose and effect of avoiding Section 13(d) reporting, then much of the foundation of Judge Kaplan’s decision is eroded. This explains to my mind CSX’s tedious detailing and repetition of the defendants’ conduct found unsavory by Judge Kaplan, and the actions taken in parallel by TCI and 3G and their counterparties: the point of it all is to establish an “arrangement,” “understanding,” or “device” whereby TCI and 3G’s counterparties acted on their behalf in purchasing and selling the shares of CSX or in voting such shares at the June 25, 2008 shareholders’ meeting.
Wednesday, July 30, 2008
Saturday, July 26, 2008
CSX v. TCI; Commentary on the Amicus Brief by Former SEC Commissioners, Officials, and Corporate and Accounting Professors
By my post of June 24, 2008, I commented on the battle of the parties’ experts over the application of the SEC’s Rule 13d-3 to swaps, for TCI and 3G Professor Bernard Black of Texas, and for CSX Professors Joseph Grundfest of Stanford, Henry T.C. Hu of Texas, and Marti G. Subrahmanyam of NYU.
CSX’s professors have dramatically expanded their group to a “gang of 25” (there are 25 amici listed in the brief) and have submitted their brief to the Second Circuit in support of Judge Kaplan’s decision finding TCI and 3G violated Section 13(d) of the Exchange Act in their use of cash-settled equity swaps in their campaign to reinvigorate (in their view) the management of CSX. The amicus group is a distinguished lot, and includes several former chairmen, commissioners, and officials of the SEC and a host of distinguished corporate law and accounting professors. (Professor Subrahmanyam is not part of the group, having served as CSX’s primary expert below.) The group wholeheartedly endorses Judge Kaplan’s decision and reasoning, concluding that if the defendants’ conduct as found by Judge Kaplan does not constitute a violation of Section 13(d), then the anti-evasion part of Rule 13d-3 (paragraph (b)) “would be rendered a nullity.” Brief at 4.
A. The Amicus Group’s Six-Factor Test
The amicus group organizes its support of Judge Kaplan’s decision by articulating a six-factor test that, on the facts found by Judge Kaplan, is sufficient in their view to constitute a party a “beneficial owner” of securities under Section 13(d). These six factors apply when a person has:
1. Acquired a position in the derivative markets that, if held in the form of the registrant’s voting equity, would trigger a disclosure requirement. (The group emphasizes that this factor constitutes a necessary but insufficient condition for coming within the scope of Rule 13d‑3(b).).
2. Engaged in significant efforts to influence corporate management or corporate control.
3. Engaged in efforts with the purpose or effect of influencing the voting position of counterparties who, by virtue of the foreseeable equity hedges held as a result of the equity swap positions at issue, own the registrant’s voting shares.
4. Caused a pre-positioning of the registrant’s voting shares in a manner that materially facilitates the rapid and low-cost acquisition of a reportable position upon the termination or other unwind of the derivative transactions at issue.
5. Caused the derivative positions at issue to be structured in a manner calculated to prevent counterparties from becoming subject to disclosure obligations under the Federal securities laws.
6. Withheld from the market information regarding the person’s activities (e.g., the person’s equity or derivative positions) that is material.
As appropriate for scholars, the Group hedges over whether all of the factors must be satisfied in order for conduct to constitute a plan or scheme to evade the reporting requirements of Section 13(d), or whether in appropriate circumstances a defendant’s behavior with respect to only some of the conditions may be sufficient to satisfy the anti-evasion prong of Ruled-3 (paragraph (b) of the Rule). The Group concludes that all six factors were satisfied by TCI and 3G in this case.
B. Critique of the Six-Factor Test
It is hard to see how any cash-settled equity swap referencing more than 5% of the outstanding equity securities of an Exchange Act company would not satisfy tests 1, 4, 5, and 6, at least where the long party spreads its swaps among two or more counterparties. Judge Kaplan did not find that TCI or 3G “caused” their counterparties to hedge their positions by buying CSX shares, only that the counterparties consistently did so and their doing so (at least on the purchase side) was monitored by TCI. And given that Section 13(d) requires any person acquiring beneficial ownership of more than 5% of an Exchange Act company’s equity securities even for investment purposes to disclose its position, how can it be said that the identity of a long party entering into swaps referencing more than 5% of an Exchange Act company’s equity securities is ever not material?
The amicus group, in its factor nos. 2 and 3, focuses on TCI’s and 3G’s efforts to influence CSX’s management and to influence the voting position of their counterparties. Section 13(d) is not limited, however, to disclosure of 5% shareholders who wish to effect a change in control of the company: passive investors must also disclose their positions in Exchange Act companies, as long as their positions are greater than 5%, even if they have no intent or desire to change or influence the control of the company. Exchange Act §§ 13(d)(5), 13(g). The anti-evasion prong of Rule 13d-3 applies to plans or schemes to evade the reporting requirements of Section 13(d) not only by activist investors but also by passive investors, since passive investors must disclose their positions on Schedule 13G, just as activist investors must disclose their positions on Schedule 13D.
So is the amicus group saying that a desire to influence management and the voting of equity securities is a necessary predicate for finding a plan or scheme to evade the reporting requirements of Section 13(d) or 13(g) of the Exchange Act under Rule 13d-3(b)? If Rule 13d-3(b) covers plans or schemes to evade the reporting requirements of Section 13(d) and (g) not only by activist investors but also by passive investors, as it most certainly does, then why must the desire to influence management or the voting of equity securities be a necessary element to finding conduct violative of Rule 13d-3(b)?
In concluding that the record supports its materiality test (no. 6), the amicus group cites as material nondisclosure that TCI withheld the fact that it held a significant stake in CSX and was seeking influence and control through swaps. Brief at 18. Then the group cites, from the district court’s record, TCI’s admission that one of its motivations in avoiding disclosure “was to avoid paying a higher price for the shares of CSX, which would have been the product of front-running that it expected would occur if its interest in CSX were disclosed to the market generally.” Id.
Assume a European Warren Buffett acquires more than 5% of an Exchange Act company’s equity securities, but does so by means of entering into cash-settled equity swaps referencing the company’s equity securities, and spreads his swap positions among two or more brokers to avoid the brokers’ reporting of their positions under Section 13(d). Our investor is motivated in large part by tax considerations, namely, to avoid the reporting of income to the IRS on dividend or equivalent distributions, and the withholding of taxes on such distributions, but he also wants to avoid disclosure of his identity, given that he is regarded as the European Warren Buffett and disclosure of his identity would give a boost to the company’s share price, which he does not want to do because he may buy additional shares.
Assume further that our investor knows, given the size of his position in the company, that it is more likely than not that his counterparties will hedge their exposure on his swaps by purchasing shares in the company. Our investor further knows, as a sophisticated investor, that he could unwind his swaps and, more likely than not, take physical delivery of the company’s shares from his counterparties rather than a cash-settlement equal to any appreciation in the shares.
By my reckoning, our European Warren Buffets meets two-thirds of the amicus group’s six-factor test (factor nos. 1, 4-5). Has he engaged in a plan or scheme to evade the reporting requirements of Section 13(g) of the Exchange Act? Can one ever engage in a plan or scheme to avoid reporting a passive position in an Exchange Act company on Schedule 13G?
And when would the amicus group have had TCI report its position in CSX under Section 13(d)? The group points out that by the end of 2006, TCI had accumulated swaps referencing approximately 8.8% of CSX’s outstanding shares. Brief at 16. Should TCI have reported its position then or only later when it engaged in “significant” efforts to influence CSX’s management or, later still (between October and November 2007) when TCI consolidated its swap positions with Deutsche Bank and Citigroup?
C. The Amicus Group’s Expansive Reading of Rule 13d-3(b)
Given Judge Kaplan’s view of the way in which cash-settled equity swaps work, apparently endorsed by the amicus group, it strikes this observer that both of them would have been more comfortable with a finding that a cash-settled equity swap is an indirect contract, arrangement, or relationship by which the long party, at a minimum, shares investment power over the referenced shares, and that therefore the long party beneficially owns those shares under Rule 13d-3(a). But apparently concerned about upsetting the apple cart for the derivatives industry, both Judge Kaplan and the amicus group seek to narrow the import of the decision by slotting it under the “anti-evasion” part of Rule 13d-3–paragraph (b). But by doing so, both Judge Kaplan and the amicus group make the anti-evasion prong of Rule 13d-3 boundless. The amicus group concludes that Rule 13d-3(b) provides an alternative method of finding beneficial ownership to voting or investment power under Rule 13d-3(d)(a) (Brief at 20), arguing that “a person can violate Rule 13d-3(b) even if he is not a beneficial owner under Rule 13d-3(a).” Id. at 21. If this is true, beyond the literal sense (e.g., a holder grants an irrevocable power of attorney over shares to party B with a side letter by which B agrees to revoke the power upon the holder’s request), and if Rule 13d-3(b) is designed to attack the “false appearance” that there is no large accumulation of securities that might have a potential for shifting corporate control when swaps referencing more than 5% of an issuer’s securities are used, then it is hard to see how a plain vanilla equity swap involving more than 5% of the referenced securities spread among two or more counterparties, where the counterparties hedge their positions by purchasing the referenced shares, does not always fall under Rule 13d-3(b).
The ISDA and the Securities Industry and Financial Markets Association, through the Cleary firm, has also filed an amicus brief, and I think this well-done brief gets it right in its interpretation of Rule 13d-3(b):
“On its face, the Rule [Rule 13d-3(b)] indicates that but for the enumerated arrangements, a person would fall within the definition of ‘beneficial owner.’ Not any ‘device’ will do; it must be one that has the purpose or effect of ‘divesting’ or ‘preventing the vesting of beneficial ownership.’ . . . Thus, at a minimum, the implication of Rule 13d-3(b) requires an analysis of whether, absent a ‘device’ a person would be a ‘beneficial owner.’ . . .”
ISDA Brief at 5.
D. Other Audience: The SEC
The Daily Deal of July 22, 2008 reports that the amicus group may not only influence the Second Circuit’s deliberations, but also those of the SEC:
“Behind the scenes, SEC officials are considering whether they want to require earlier disclosure of swap contracts. The commission may soon propose requiring activist fund managers to treat synthetic shares used in swaps as equivalent to real shares for the purpose of the agency’s 13D disclosure.”
It will be interesting, if the Commission takes up this project, how it interprets or proposes to modify Rule 13d-3(b): will the focus be on activist shareholders only, leaving passive investors aside? We will see.
CSX’s professors have dramatically expanded their group to a “gang of 25” (there are 25 amici listed in the brief) and have submitted their brief to the Second Circuit in support of Judge Kaplan’s decision finding TCI and 3G violated Section 13(d) of the Exchange Act in their use of cash-settled equity swaps in their campaign to reinvigorate (in their view) the management of CSX. The amicus group is a distinguished lot, and includes several former chairmen, commissioners, and officials of the SEC and a host of distinguished corporate law and accounting professors. (Professor Subrahmanyam is not part of the group, having served as CSX’s primary expert below.) The group wholeheartedly endorses Judge Kaplan’s decision and reasoning, concluding that if the defendants’ conduct as found by Judge Kaplan does not constitute a violation of Section 13(d), then the anti-evasion part of Rule 13d-3 (paragraph (b)) “would be rendered a nullity.” Brief at 4.
A. The Amicus Group’s Six-Factor Test
The amicus group organizes its support of Judge Kaplan’s decision by articulating a six-factor test that, on the facts found by Judge Kaplan, is sufficient in their view to constitute a party a “beneficial owner” of securities under Section 13(d). These six factors apply when a person has:
1. Acquired a position in the derivative markets that, if held in the form of the registrant’s voting equity, would trigger a disclosure requirement. (The group emphasizes that this factor constitutes a necessary but insufficient condition for coming within the scope of Rule 13d‑3(b).).
2. Engaged in significant efforts to influence corporate management or corporate control.
3. Engaged in efforts with the purpose or effect of influencing the voting position of counterparties who, by virtue of the foreseeable equity hedges held as a result of the equity swap positions at issue, own the registrant’s voting shares.
4. Caused a pre-positioning of the registrant’s voting shares in a manner that materially facilitates the rapid and low-cost acquisition of a reportable position upon the termination or other unwind of the derivative transactions at issue.
5. Caused the derivative positions at issue to be structured in a manner calculated to prevent counterparties from becoming subject to disclosure obligations under the Federal securities laws.
6. Withheld from the market information regarding the person’s activities (e.g., the person’s equity or derivative positions) that is material.
As appropriate for scholars, the Group hedges over whether all of the factors must be satisfied in order for conduct to constitute a plan or scheme to evade the reporting requirements of Section 13(d), or whether in appropriate circumstances a defendant’s behavior with respect to only some of the conditions may be sufficient to satisfy the anti-evasion prong of Ruled-3 (paragraph (b) of the Rule). The Group concludes that all six factors were satisfied by TCI and 3G in this case.
B. Critique of the Six-Factor Test
It is hard to see how any cash-settled equity swap referencing more than 5% of the outstanding equity securities of an Exchange Act company would not satisfy tests 1, 4, 5, and 6, at least where the long party spreads its swaps among two or more counterparties. Judge Kaplan did not find that TCI or 3G “caused” their counterparties to hedge their positions by buying CSX shares, only that the counterparties consistently did so and their doing so (at least on the purchase side) was monitored by TCI. And given that Section 13(d) requires any person acquiring beneficial ownership of more than 5% of an Exchange Act company’s equity securities even for investment purposes to disclose its position, how can it be said that the identity of a long party entering into swaps referencing more than 5% of an Exchange Act company’s equity securities is ever not material?
The amicus group, in its factor nos. 2 and 3, focuses on TCI’s and 3G’s efforts to influence CSX’s management and to influence the voting position of their counterparties. Section 13(d) is not limited, however, to disclosure of 5% shareholders who wish to effect a change in control of the company: passive investors must also disclose their positions in Exchange Act companies, as long as their positions are greater than 5%, even if they have no intent or desire to change or influence the control of the company. Exchange Act §§ 13(d)(5), 13(g). The anti-evasion prong of Rule 13d-3 applies to plans or schemes to evade the reporting requirements of Section 13(d) not only by activist investors but also by passive investors, since passive investors must disclose their positions on Schedule 13G, just as activist investors must disclose their positions on Schedule 13D.
So is the amicus group saying that a desire to influence management and the voting of equity securities is a necessary predicate for finding a plan or scheme to evade the reporting requirements of Section 13(d) or 13(g) of the Exchange Act under Rule 13d-3(b)? If Rule 13d-3(b) covers plans or schemes to evade the reporting requirements of Section 13(d) and (g) not only by activist investors but also by passive investors, as it most certainly does, then why must the desire to influence management or the voting of equity securities be a necessary element to finding conduct violative of Rule 13d-3(b)?
In concluding that the record supports its materiality test (no. 6), the amicus group cites as material nondisclosure that TCI withheld the fact that it held a significant stake in CSX and was seeking influence and control through swaps. Brief at 18. Then the group cites, from the district court’s record, TCI’s admission that one of its motivations in avoiding disclosure “was to avoid paying a higher price for the shares of CSX, which would have been the product of front-running that it expected would occur if its interest in CSX were disclosed to the market generally.” Id.
Assume a European Warren Buffett acquires more than 5% of an Exchange Act company’s equity securities, but does so by means of entering into cash-settled equity swaps referencing the company’s equity securities, and spreads his swap positions among two or more brokers to avoid the brokers’ reporting of their positions under Section 13(d). Our investor is motivated in large part by tax considerations, namely, to avoid the reporting of income to the IRS on dividend or equivalent distributions, and the withholding of taxes on such distributions, but he also wants to avoid disclosure of his identity, given that he is regarded as the European Warren Buffett and disclosure of his identity would give a boost to the company’s share price, which he does not want to do because he may buy additional shares.
Assume further that our investor knows, given the size of his position in the company, that it is more likely than not that his counterparties will hedge their exposure on his swaps by purchasing shares in the company. Our investor further knows, as a sophisticated investor, that he could unwind his swaps and, more likely than not, take physical delivery of the company’s shares from his counterparties rather than a cash-settlement equal to any appreciation in the shares.
By my reckoning, our European Warren Buffets meets two-thirds of the amicus group’s six-factor test (factor nos. 1, 4-5). Has he engaged in a plan or scheme to evade the reporting requirements of Section 13(g) of the Exchange Act? Can one ever engage in a plan or scheme to avoid reporting a passive position in an Exchange Act company on Schedule 13G?
And when would the amicus group have had TCI report its position in CSX under Section 13(d)? The group points out that by the end of 2006, TCI had accumulated swaps referencing approximately 8.8% of CSX’s outstanding shares. Brief at 16. Should TCI have reported its position then or only later when it engaged in “significant” efforts to influence CSX’s management or, later still (between October and November 2007) when TCI consolidated its swap positions with Deutsche Bank and Citigroup?
C. The Amicus Group’s Expansive Reading of Rule 13d-3(b)
Given Judge Kaplan’s view of the way in which cash-settled equity swaps work, apparently endorsed by the amicus group, it strikes this observer that both of them would have been more comfortable with a finding that a cash-settled equity swap is an indirect contract, arrangement, or relationship by which the long party, at a minimum, shares investment power over the referenced shares, and that therefore the long party beneficially owns those shares under Rule 13d-3(a). But apparently concerned about upsetting the apple cart for the derivatives industry, both Judge Kaplan and the amicus group seek to narrow the import of the decision by slotting it under the “anti-evasion” part of Rule 13d-3–paragraph (b). But by doing so, both Judge Kaplan and the amicus group make the anti-evasion prong of Rule 13d-3 boundless. The amicus group concludes that Rule 13d-3(b) provides an alternative method of finding beneficial ownership to voting or investment power under Rule 13d-3(d)(a) (Brief at 20), arguing that “a person can violate Rule 13d-3(b) even if he is not a beneficial owner under Rule 13d-3(a).” Id. at 21. If this is true, beyond the literal sense (e.g., a holder grants an irrevocable power of attorney over shares to party B with a side letter by which B agrees to revoke the power upon the holder’s request), and if Rule 13d-3(b) is designed to attack the “false appearance” that there is no large accumulation of securities that might have a potential for shifting corporate control when swaps referencing more than 5% of an issuer’s securities are used, then it is hard to see how a plain vanilla equity swap involving more than 5% of the referenced securities spread among two or more counterparties, where the counterparties hedge their positions by purchasing the referenced shares, does not always fall under Rule 13d-3(b).
The ISDA and the Securities Industry and Financial Markets Association, through the Cleary firm, has also filed an amicus brief, and I think this well-done brief gets it right in its interpretation of Rule 13d-3(b):
“On its face, the Rule [Rule 13d-3(b)] indicates that but for the enumerated arrangements, a person would fall within the definition of ‘beneficial owner.’ Not any ‘device’ will do; it must be one that has the purpose or effect of ‘divesting’ or ‘preventing the vesting of beneficial ownership.’ . . . Thus, at a minimum, the implication of Rule 13d-3(b) requires an analysis of whether, absent a ‘device’ a person would be a ‘beneficial owner.’ . . .”
ISDA Brief at 5.
D. Other Audience: The SEC
The Daily Deal of July 22, 2008 reports that the amicus group may not only influence the Second Circuit’s deliberations, but also those of the SEC:
“Behind the scenes, SEC officials are considering whether they want to require earlier disclosure of swap contracts. The commission may soon propose requiring activist fund managers to treat synthetic shares used in swaps as equivalent to real shares for the purpose of the agency’s 13D disclosure.”
It will be interesting, if the Commission takes up this project, how it interprets or proposes to modify Rule 13d-3(b): will the focus be on activist shareholders only, leaving passive investors aside? We will see.
Thursday, July 17, 2008
CSX v. TCI; Opening Briefs on Appeal
CSX and TCI/3G filed their opening briefs with the U.S. Second Circuit Court of Appeals (No. 08-3016-cv) on July 7, 2008. Both sides are appealing Judge Kaplan's decision of June 11, 2008 (2008 WL 2372693), CSX that portion of the decision declining to issue an injunction prohibiting TCI and 3G from voting 6.4% of CSX's outstanding shares at the June 25, 2008 shareholders' meeting, and TCI/3G the Judge's judgment on liability and the scope of the injunction the Judge did enter enjoining the defendants from future violations of Section 13(d) of the Exchange Act and the rules promulgated by the SEC thereunder.
The briefs are well done, CSX's by Cravath and TCI/3G's by Kirkland & Ellis and Schulte Roth. CSX's is the more colorful, running with Judge Kaplan's many findings of TCI's principal's--Christopher Hohn and Snehal Amin--lack of credibility. In CSX's brief, they come off as foul conspirators, misleading the market, the court, and even Congress. The defendants, assert CSX, engaged in a "clandestine" "scheme" to take control of CSX in violation of securities laws; repeatedly undertook to "conceal" knowledge of their swaps referencing CSX common from the market; "selectively" disclosed information to CSX so as to exert pressure on CSX; testified repeatedly before the Court below and Congress "falsely" (some five pages are devoted to detailing this "false" testimony); "stuffed the ballot box" in the June 25 shareholders' election for directors; and "manipulated" the playing field. Just the type of stuff one expects from plaintiff's lawyers.
The apparent purpose behind this heated advocacy is to convince the Second Circuit to do equity and burn these guys, by issuing the injunction Judge Kaplan stated he was willing to issue but felt constrained by the Second Circuit's decision in Treadway Companies v. Care Corporation, 638 F.2d 357 (1980) not to issue, namely, enjoin TCI/3G from voting the shares they acquired during the period between when Judge Kaplan found they formed a Section 13(d) group (February 12, 2007) and when they filed a 13D (December 19, 2007). In this effort, CSX emphasizes the broad powers of federal courts to redress violations of the securities laws, the wilfulness of the defendants' Section 13(d) violations, and their tilting the playing field so as to preclude a fair election for the CSX directors on June 25. CSX even relies, as one ground for its injunctive request, upon the defendants' false testimony in the trial court. This is rough stuff. And to think that Hohn and Amin (and Behring--3G's managing director) probably think of themselves as the good guys in this fight.
One can understand the effort--the insurgents announced right after the meeting that they believed four of their five nominees were elected to the CSX board. At the conclusion of the meeting, CSX took the highly unusual step of postponing announcement of the results until July 25, but on July 16 announced preliminarily that four of the insurgents' nominess, including Hohn and Behring, were elected. The results are of course subject to the outcome of CSX's appeal. So the outcome of the election will be determined by the Second Circuit (did something like this ever happen before?).
To this oberver the Second Circuit would have to move away from Treadway (and its parent, Rondeau v. Mosinee Paper Corp., 422 U.S. 49 (1975)) to grant the relief sought by CSX. The trick in Section 13 litigation is to maintain a level playing field, to coin a phrase, between management and insurgents. Treadway teaches that the interests sought to be protected by Section 13(d) are fully protected "when the shareholders receive the information required to be filed." That happened here--TCI/3G filed their 13D in December 2007 and distributed a proxy statement to CSX's shareholders in advance of the June 25th shareholders' meeting. Judge Kaplan rejected all of CSX's claims that the 13D and proxy statement contained material misstatements and omissions. So unless the Second Circuit panel gets inflamed by the defendants' allegedly "egregious" conduct, I would think CSX has an uphill battle in convincing the Second Circuit to issue an injunction dis-enfranchising TCI/3G and "kicking" the insurgents' nominees off the CSX board.
The problem I have with much of the supposed harm to the CSX shareholders alleged by CSX is this: the shareholders who may have been harmed by TCI's and 3G's tardy 13D filing sold their shares. They're no longer shareholders. Their redress against TCI and 3G would be to assert that had TCI and 3G disclosed their CSX positions earlier they might have received a higher price for their shares. But presumably they would have been sellers nevertheless: if a shareholder sells at $10 she undoubtedly is a seller at $12. And if this is true, how does enjoining TCI and 3G from voting the shares they acquired from such shareholders redress the harm from tardy disclosure to such shareholders?
While CSX's opening brief is the more colorful and hard-hitting of the two opening briefs, I find the defendants' persuasive. It has the more difficult task--convincing the Second Circuit to reverse Judge Kaplan's findings of liability. I posted blogs on Judge Kaplan's decision on June 23 and 24, and as I said in my June 24 post: " . . . once the beneficial ownership bell is rung on equity SWAPs it will not be unrung." Picking up on this theme, the defendants refer to Judge Kaplan's decision as having "triggered an earthquake in federal securities law and practice" by calling into question the widespread use of cash-settled equity swaps.
Judge Kaplan invited the SEC to address two issues before him, and the SEC's Division of Corporation Finance did so by its letter of June 4, 2008. In this letter, the Division states its disagreement with CSX's postion that economic incentives for counterparties can alone establish "beneficial ownership" of the referenced shares in the long party. It states its position that a standard cash-settled equity swap, standing alone, is not sufficient to create beneficial ownership of the referenced shares in the long party. It appears that Judge Kaplan was influenced by this postion and the pleas of several amici to punt on deciding whether the TCI/3G CSX SWAPs conferred beneficial ownership on TCI/3G under Rule 13d-3(a) (the basic statement of beneficial ownership for Section 13(d) purposes) and to focus on Rule 13d-3(b) instead, the "anti-evasion" prong of the beneficial ownership rule (to use the term for paragraph (b) of Professor Grundfest et al.--see my post of June 24). By relying on the anti-evasion prong of Rule 13d-3, the Judge undoubtedly intended to narrow his ruling to deflect the cries of the chicken-littles.
But from a doctrinal standpoint, the Judge would have been better off doing what he wanted to do, namely, hold that cash-settled equity swaps, at least of the size of those before him, necessarily confer beneficial ownership of the referenced securities on the long party, and openly disagreeing with the SEC's view as stated in its June 4, 2008 letter to the court. That position would have squared with the reality of a cash-settled equity swaps as seen by the Judge and would have comported with his guide to the interpretation of securities law:
The briefs are well done, CSX's by Cravath and TCI/3G's by Kirkland & Ellis and Schulte Roth. CSX's is the more colorful, running with Judge Kaplan's many findings of TCI's principal's--Christopher Hohn and Snehal Amin--lack of credibility. In CSX's brief, they come off as foul conspirators, misleading the market, the court, and even Congress. The defendants, assert CSX, engaged in a "clandestine" "scheme" to take control of CSX in violation of securities laws; repeatedly undertook to "conceal" knowledge of their swaps referencing CSX common from the market; "selectively" disclosed information to CSX so as to exert pressure on CSX; testified repeatedly before the Court below and Congress "falsely" (some five pages are devoted to detailing this "false" testimony); "stuffed the ballot box" in the June 25 shareholders' election for directors; and "manipulated" the playing field. Just the type of stuff one expects from plaintiff's lawyers.
The apparent purpose behind this heated advocacy is to convince the Second Circuit to do equity and burn these guys, by issuing the injunction Judge Kaplan stated he was willing to issue but felt constrained by the Second Circuit's decision in Treadway Companies v. Care Corporation, 638 F.2d 357 (1980) not to issue, namely, enjoin TCI/3G from voting the shares they acquired during the period between when Judge Kaplan found they formed a Section 13(d) group (February 12, 2007) and when they filed a 13D (December 19, 2007). In this effort, CSX emphasizes the broad powers of federal courts to redress violations of the securities laws, the wilfulness of the defendants' Section 13(d) violations, and their tilting the playing field so as to preclude a fair election for the CSX directors on June 25. CSX even relies, as one ground for its injunctive request, upon the defendants' false testimony in the trial court. This is rough stuff. And to think that Hohn and Amin (and Behring--3G's managing director) probably think of themselves as the good guys in this fight.
One can understand the effort--the insurgents announced right after the meeting that they believed four of their five nominees were elected to the CSX board. At the conclusion of the meeting, CSX took the highly unusual step of postponing announcement of the results until July 25, but on July 16 announced preliminarily that four of the insurgents' nominess, including Hohn and Behring, were elected. The results are of course subject to the outcome of CSX's appeal. So the outcome of the election will be determined by the Second Circuit (did something like this ever happen before?).
To this oberver the Second Circuit would have to move away from Treadway (and its parent, Rondeau v. Mosinee Paper Corp., 422 U.S. 49 (1975)) to grant the relief sought by CSX. The trick in Section 13 litigation is to maintain a level playing field, to coin a phrase, between management and insurgents. Treadway teaches that the interests sought to be protected by Section 13(d) are fully protected "when the shareholders receive the information required to be filed." That happened here--TCI/3G filed their 13D in December 2007 and distributed a proxy statement to CSX's shareholders in advance of the June 25th shareholders' meeting. Judge Kaplan rejected all of CSX's claims that the 13D and proxy statement contained material misstatements and omissions. So unless the Second Circuit panel gets inflamed by the defendants' allegedly "egregious" conduct, I would think CSX has an uphill battle in convincing the Second Circuit to issue an injunction dis-enfranchising TCI/3G and "kicking" the insurgents' nominees off the CSX board.
The problem I have with much of the supposed harm to the CSX shareholders alleged by CSX is this: the shareholders who may have been harmed by TCI's and 3G's tardy 13D filing sold their shares. They're no longer shareholders. Their redress against TCI and 3G would be to assert that had TCI and 3G disclosed their CSX positions earlier they might have received a higher price for their shares. But presumably they would have been sellers nevertheless: if a shareholder sells at $10 she undoubtedly is a seller at $12. And if this is true, how does enjoining TCI and 3G from voting the shares they acquired from such shareholders redress the harm from tardy disclosure to such shareholders?
While CSX's opening brief is the more colorful and hard-hitting of the two opening briefs, I find the defendants' persuasive. It has the more difficult task--convincing the Second Circuit to reverse Judge Kaplan's findings of liability. I posted blogs on Judge Kaplan's decision on June 23 and 24, and as I said in my June 24 post: " . . . once the beneficial ownership bell is rung on equity SWAPs it will not be unrung." Picking up on this theme, the defendants refer to Judge Kaplan's decision as having "triggered an earthquake in federal securities law and practice" by calling into question the widespread use of cash-settled equity swaps.
Judge Kaplan invited the SEC to address two issues before him, and the SEC's Division of Corporation Finance did so by its letter of June 4, 2008. In this letter, the Division states its disagreement with CSX's postion that economic incentives for counterparties can alone establish "beneficial ownership" of the referenced shares in the long party. It states its position that a standard cash-settled equity swap, standing alone, is not sufficient to create beneficial ownership of the referenced shares in the long party. It appears that Judge Kaplan was influenced by this postion and the pleas of several amici to punt on deciding whether the TCI/3G CSX SWAPs conferred beneficial ownership on TCI/3G under Rule 13d-3(a) (the basic statement of beneficial ownership for Section 13(d) purposes) and to focus on Rule 13d-3(b) instead, the "anti-evasion" prong of the beneficial ownership rule (to use the term for paragraph (b) of Professor Grundfest et al.--see my post of June 24). By relying on the anti-evasion prong of Rule 13d-3, the Judge undoubtedly intended to narrow his ruling to deflect the cries of the chicken-littles.
But from a doctrinal standpoint, the Judge would have been better off doing what he wanted to do, namely, hold that cash-settled equity swaps, at least of the size of those before him, necessarily confer beneficial ownership of the referenced securities on the long party, and openly disagreeing with the SEC's view as stated in its June 4, 2008 letter to the court. That position would have squared with the reality of a cash-settled equity swaps as seen by the Judge and would have comported with his guide to the interpretation of securities law:
"The securities markets operate in the real world, not in a law school contracts classroom. Any determination of beneficial ownership that filed to take account of the practical realities of that world would be open to the gravest abuse." (Opinion at 62.)
In its opening brief before the Second Circuit, TCI/3G attack Judge Kaplan's finding that they violated the anti-evasion prong of Rule 13d-3, arguing that (i) the Judge ignored the views of the SEC's Division of Corporation Finance of Rule 13d-3, and (ii) the Judge interpretated the Rule such that he extended its scope beyond Section 13(d) of the Exchange Act, the Rule's parent.
Section 13d-3(a), the basic definition of beneficial ownership, is broadly drafted, including within the scope of beneficial ownership of a security, direct or indirect ownerhip of the security, whether "through any contract, arrangement, understanding, relationship, or otherwise . . ." This definition, though, is tied to "voting power" or "investment power," that is the power to dispose or direct the disposition of a security.
The anti-evasion prong of Rule 13d-3, paragraph (b), includes within beneficial ownership any agreement or "device" "with the purpose or effect" of divesting a person of beneficial ownership or preventing the vesting of such ownership "as part of a plan or scheme to evade the reporting requirements of Section 13(d) or 13(g) of the [Exchange] Act . . ."
While the Division's June 4 letter to Judge Kaplan has some ambiguity, the Division is clear that a standard cash-settled equity swap does not confer voting or investment power upon the long party and thus does not confer beneficial ownership of the referenced securities upon the long party. The Division also states that "taking steps with the motive of avoiding reporting and disclosure generally is not a violation of Section 13(d) unless the steps create a false appearance."
TCI/3G rely heavily upon the Division's interpretation, and the deference that should be shown to an administrative agency when interpretating its own rules, in arguing that Judge Kaplan found beneficial ownerhship of the CSX referenced shares in TCI when, under Rule 13d-3, there should be none. So the SEC letter is likely to play a large role in the Second Circuit's decision. My reading of it is that it is more supportive of TCI's/3G's position than it is of CSX's position.
Notwithstanding the breadth of Rule 13d-3(a), Judge Kaplan concluded that the concept of beneficial ownership must be extended by Rule 13d-3(b); otherwise, what would be the point of paragraph (b)? TCI/3G concede the rule of statutory construction that words should be read so as not to render them superfluous, but argue, creatively in my opinion, that the anti-evasion prong of Rule 13d-3 should be construed as a "belt and suspenders" approach to the definition of beneficial ownerhship: paragraph (b) simply states the obvious--that sham transactions meant to disguise beneficial ownership will not be recognized as doing so. The argument has some appeal, but whether it flies before the Second Circuit is anyone's guess.
Friday, July 11, 2008
InBev & Anheuser-Busch; Litigation Skirmishing
July 11, 2008
Today the press reports that, after weeks of very public proposals and public posturing, InBev S.A. (Euronext: INB) has raised its offer from $65 to $70 per share for all of Anheuser-Busch Companies, Inc. (NYSE: BUD); that the parties are now negotiating a "friendly" deal; and that it could be announced as early as this weekend. Apparently the stockholders of AB haven't warmed to the board's and management's hostility to the initial $65 a share offer and would like to see this deal happen.
InBev's hand was undoubtedly strenghened by its proposal to conduct a consent solicitation of AB's shareholders requesting them to oust the current board and replace it with InBev's 13 nominees. This was made possible by AB's elimination of its classified board in April 2006 and Delaware's (AB is a Delaware corporation) GCL Sections 141(k), permitting the removal of a director or entire board, if the board is not classified, by the holders of a majority of the shares entitled to vote in the election of directors, and 228(a), permitting stockholder action by written consent unless otherwise provided in the certificate of incorporation (not bylaws).
When AB de-classified its board in 2006 it, in effect, grandfathered the existing directors so that, for example, the term of the 2006-elected directors
would run until the 2009 annual meeting. This raises the question of whether these (now numbering 5) directors can be removed without cause since the removal provision (Section 141(k)) does not permit removal without cause if the board is classified.
To clarify this question, InBev filed a declaratory judgment action in the Delaware Chancery Court on June 26, 2008 (no. 3857--VCP) (where a slew of shareholder suits have also been filed) seeking a declaration that the entire board of AB may be removed without cause. I have read InBev's brief in support of its motion for summary judgment on this question (InBev's in a hurry) and, not having the benefit of an opposition yet, conclude this is a close question. InBev (Sully and Young Conaway, local counsel) make a credible case for its position, but AB would undoubtedly argue that the stockholders, in declassifying the board and grandfathering the sitting directors, meant to continue classification to that extent, the stockholders' wishes should control, and therefore Section 141(k) is not available to InBev to remove the five 2006 directors this year. If a deal is struck, then this question will not be answered. And, even if InBev doesn't get its declaration, it can still seek removal and replacement of seven of the 13 current directors.
InBev's use of the removal-by-consent tactic to encourage negotiations may prompt Delaware issuers that do not prohibit action by shareholder consent and do not have classified boards to examine amending their certificates to do so or to classifying their boards (which also requires stockholder consent under GCL Section 141(d)).
AB also got into the litigation act with its action, filed July 7, 2008, the same day InBev filed its preliminary consent solicitation on Schedule 14A with the Commission, in federal district court in the Eastern District of Missouri (St. Louis). You didn't expect BUD to file in Delaware did you?
AB alleges proxy fraud under Rule 14a-9 and Section 14(a) of the Exchange Act. Its allegations focus on InBev's failure to disclose, in its many press releases, press leaks, published comments, and, incidentally, in its preliminary consent solication (filed that day with the SEC) the conditions to the $40 billion financing committment InBev touts as in hand to finance the deal with AB, and how it can make St. Louis the North American headquarters for the combined company, as InBev has been assuring everyone in Missouri that it will do, given that InBev operates in Cuba and an Amercan company can't do business in Cuba. Pretty clever.
The allegations strike me as a stretch, a real stretch. Yes the terms of any financing and the conditions to any financing for a deal would normally be disclosed in a M&A transaction under Regulation M-A, item 1007, but InBev's consent solicitation is seeking the approval of the AB stockholders not for an AB/InBev combination but for the removal of AB's current board and its replacement with InBev's nominees. These nominees are all independent of InBev, appear solid, and are committed to acting in the best interests of AB and its stockholders. So what's the relevance at this point of the conditions to InBev's financing or how InBev will separate its Cuban operations from the AB operations?
Merits aside, the Missouri action does operate as a place-holder for further disclosure claims against InBev, in what AB must believe is a friendlier forum, should a deal not be cut and further skirmishes take place between AB and InBev. And, when you think of it, what's several million dollars in attorney fees to gain a tactical advantage when you're talking about a $50 billion deal?
Today the press reports that, after weeks of very public proposals and public posturing, InBev S.A. (Euronext: INB) has raised its offer from $65 to $70 per share for all of Anheuser-Busch Companies, Inc. (NYSE: BUD); that the parties are now negotiating a "friendly" deal; and that it could be announced as early as this weekend. Apparently the stockholders of AB haven't warmed to the board's and management's hostility to the initial $65 a share offer and would like to see this deal happen.
InBev's hand was undoubtedly strenghened by its proposal to conduct a consent solicitation of AB's shareholders requesting them to oust the current board and replace it with InBev's 13 nominees. This was made possible by AB's elimination of its classified board in April 2006 and Delaware's (AB is a Delaware corporation) GCL Sections 141(k), permitting the removal of a director or entire board, if the board is not classified, by the holders of a majority of the shares entitled to vote in the election of directors, and 228(a), permitting stockholder action by written consent unless otherwise provided in the certificate of incorporation (not bylaws).
When AB de-classified its board in 2006 it, in effect, grandfathered the existing directors so that, for example, the term of the 2006-elected directors
would run until the 2009 annual meeting. This raises the question of whether these (now numbering 5) directors can be removed without cause since the removal provision (Section 141(k)) does not permit removal without cause if the board is classified.
To clarify this question, InBev filed a declaratory judgment action in the Delaware Chancery Court on June 26, 2008 (no. 3857--VCP) (where a slew of shareholder suits have also been filed) seeking a declaration that the entire board of AB may be removed without cause. I have read InBev's brief in support of its motion for summary judgment on this question (InBev's in a hurry) and, not having the benefit of an opposition yet, conclude this is a close question. InBev (Sully and Young Conaway, local counsel) make a credible case for its position, but AB would undoubtedly argue that the stockholders, in declassifying the board and grandfathering the sitting directors, meant to continue classification to that extent, the stockholders' wishes should control, and therefore Section 141(k) is not available to InBev to remove the five 2006 directors this year. If a deal is struck, then this question will not be answered. And, even if InBev doesn't get its declaration, it can still seek removal and replacement of seven of the 13 current directors.
InBev's use of the removal-by-consent tactic to encourage negotiations may prompt Delaware issuers that do not prohibit action by shareholder consent and do not have classified boards to examine amending their certificates to do so or to classifying their boards (which also requires stockholder consent under GCL Section 141(d)).
AB also got into the litigation act with its action, filed July 7, 2008, the same day InBev filed its preliminary consent solicitation on Schedule 14A with the Commission, in federal district court in the Eastern District of Missouri (St. Louis). You didn't expect BUD to file in Delaware did you?
AB alleges proxy fraud under Rule 14a-9 and Section 14(a) of the Exchange Act. Its allegations focus on InBev's failure to disclose, in its many press releases, press leaks, published comments, and, incidentally, in its preliminary consent solication (filed that day with the SEC) the conditions to the $40 billion financing committment InBev touts as in hand to finance the deal with AB, and how it can make St. Louis the North American headquarters for the combined company, as InBev has been assuring everyone in Missouri that it will do, given that InBev operates in Cuba and an Amercan company can't do business in Cuba. Pretty clever.
The allegations strike me as a stretch, a real stretch. Yes the terms of any financing and the conditions to any financing for a deal would normally be disclosed in a M&A transaction under Regulation M-A, item 1007, but InBev's consent solicitation is seeking the approval of the AB stockholders not for an AB/InBev combination but for the removal of AB's current board and its replacement with InBev's nominees. These nominees are all independent of InBev, appear solid, and are committed to acting in the best interests of AB and its stockholders. So what's the relevance at this point of the conditions to InBev's financing or how InBev will separate its Cuban operations from the AB operations?
Merits aside, the Missouri action does operate as a place-holder for further disclosure claims against InBev, in what AB must believe is a friendlier forum, should a deal not be cut and further skirmishes take place between AB and InBev. And, when you think of it, what's several million dollars in attorney fees to gain a tactical advantage when you're talking about a $50 billion deal?
Tuesday, July 8, 2008
SEC v. Talbot; Disclosure of Merger Negotiations
A NYSE company (Fidelity National Financial, Inc. ("FNF")) owns approximately 10% of a Nasdaq company (LendingTree--the "Issuer"). The CEO of the Issuer informs an officer of FNF that the Issuer is in merger negotiations, the acquiror will pay a premium to market, a majority of the Issuer's board is in favor of the transaction, and the acquiror will want FNF's support of the transaction. Three or four days later, the board of FNF holds a regular meeting and the CEO conveys the information about the pending deal. He advises the board that FNF will make about $50 million on its investment in the Issuer. All but one member of the board present considers the information about the pending deal confidential. The one who didn't, Talbot, an experienced businessman and attorney, buys 10,000 shares of the Issuer in two transactions before the Issuer's announcement of the deal on May 5, 2003. He later testifies that he thought the information about the deal was simply a "rumor." He made some $68,000 on his purchases of the Issuer's stock. After the SEC commenced its investigation of his and other Issuer employees' purchases of the Issuer's stock in September 2003, Talbot resigns from the FNF board.
What is surprising about this case is that it got as far as it did. In the SEC's civil enforcement action against Talbot, the lower court ruled for Talbot and against the Commission on cross-motions for summary judgment, finding that, since FNF owed no fidiciary duty of confidentiality to the Issuer, the requisite "chain of fiduciary relationships" did not exist for application of the "misappropriation theory" of Rule 10b-5 liability blessed by the Supreme Court in United States v. O'Hagen, 521 U.S. 642 (1997). The Ninth Circuit batted that finding down, concluding that all that is required is a fiduciary duty of loyalty and confidentiality to the source of the confidential information--here, FNF, the company on whose board Talbot sat. Held: Talbot engaged in "textbook" misappropriation of confidential information, on which he traded, from FNF. This finding doesn't strike this observer as a stretch: Talbot really blew it in purchasing Issuer shares after learning of its pending merger at the FNF board meeting.
What is somewhat surprising is that both the lower court and the Ninth Circuit concluded there was a genuine issue of material fact on the materiality of the information Talbot received about the pending deal, thus precluding summary judgment in favor of the Commission. To the SEC (as stated in its briefs before the Ninth Circuit) it was "obvious" that the information received by the FNF board was material, but the lower court and the Ninth Circuit cited Talbot's "rumor" testimony and that of another director with a similarly foggy recollection of the report on the pending deal in refusing to decide the issue on summary judgment. It strikes this observer that, if the CEO of a public company advises a 10% shareholder that a deal is in the works, a majority of his board is in favor of it, and the acquiror wants the support of the 10% shareholder, you're in materiality-land.
Let's assume the disclosure was material so that Talbot's trading on it violates Rule 10b-5. How about LendingTree? If the information disclosed by the Issuer's CEO to FNF was material, does that mean LendingTree should have simultaneously disclosed the pending deal in a press release or in a 8-K report? Can information be material for one purpose (precluding trading on the information by insiders) but not be material for another (requiring disclosure by the target of the pending deal)?
We know from the Supreme Court's decision in Basic, Basic Inc. v. Levinson, 485 U.S. 224, 241 n. 18 (1988), that what is material is not context-specific, so the answer to the last question is that if information is material for one purpose it is material for all purposes relevant to Rule 10b-5. So should LendingTree have disclosed the pending deal when its CEO spilled the beans to FNF? Under Regulation FD, disclosure of material nonpublic information to market professionals selectively is taboo, and, if it occurs, must be publicly disclosed (simultaneously in the case of intentional disclosure and "promptly" in the case of non-intentional disclosure (with "intentional" defined in Rule 101)). The Regulation also applies to selected disclosures to any shareholders of the issuer "under circumstances in which it is reasonably foreseeable that the [shareholder] will purchase or sell the issuer's securities on the basis of the information." Rule 100(b)(1)(iv). (There is an exception from FD's disclosure requirements for persons to whom disclosure is made "who expressly agree[] to maintain the disclosed information in confidence . . .", Rule 100(b)(2)(ii), but that would not help LendingTree in this case because the CEO made the disclosure to FNF before LendingTree presented a confidentiality agreement to FNF).
Leaving aside whether LendingTree tripped over Regulation FD in its first disclosure to FNF, the answer to whether it should have made disclosure before it did is, by custom, no. As the Court in Basic noted in its famous note 17, "[s]ilence, absent a duty to disclose, is not misleading under Rule 10b-5." While we are in a "continuous" disclosure world, it it still the case that just because information is material does not mean an issuer has to immediately announce it. This is certainly the practice with respect to the disclosure of deals, which typically are announced when the definitive agreement is signed, and not before. See 1 A. Fleischer and A. Sussman, Takeover Defense Section 2.03[C]; NYSE Company Manual Section 202.01. Exceptions come into play when the issuer knows or should know that unusual market activity is attributable to leaks from the issuer or its agents. But otherwise, silence or a "no comment" response when asked represent best practice when it comes to disclosing merger negotiations before entry into a definitive agreement.
It should also be best practice for a general counsel, when attending a board meeting such as FNF's, where deal disclosure is made, to loudly and clearly admonish the directors and officers present that trading on such information is verboten. Such advice can save those present a lot of grief. Just ask Talbot.
What is surprising about this case is that it got as far as it did. In the SEC's civil enforcement action against Talbot, the lower court ruled for Talbot and against the Commission on cross-motions for summary judgment, finding that, since FNF owed no fidiciary duty of confidentiality to the Issuer, the requisite "chain of fiduciary relationships" did not exist for application of the "misappropriation theory" of Rule 10b-5 liability blessed by the Supreme Court in United States v. O'Hagen, 521 U.S. 642 (1997). The Ninth Circuit batted that finding down, concluding that all that is required is a fiduciary duty of loyalty and confidentiality to the source of the confidential information--here, FNF, the company on whose board Talbot sat. Held: Talbot engaged in "textbook" misappropriation of confidential information, on which he traded, from FNF. This finding doesn't strike this observer as a stretch: Talbot really blew it in purchasing Issuer shares after learning of its pending merger at the FNF board meeting.
What is somewhat surprising is that both the lower court and the Ninth Circuit concluded there was a genuine issue of material fact on the materiality of the information Talbot received about the pending deal, thus precluding summary judgment in favor of the Commission. To the SEC (as stated in its briefs before the Ninth Circuit) it was "obvious" that the information received by the FNF board was material, but the lower court and the Ninth Circuit cited Talbot's "rumor" testimony and that of another director with a similarly foggy recollection of the report on the pending deal in refusing to decide the issue on summary judgment. It strikes this observer that, if the CEO of a public company advises a 10% shareholder that a deal is in the works, a majority of his board is in favor of it, and the acquiror wants the support of the 10% shareholder, you're in materiality-land.
Let's assume the disclosure was material so that Talbot's trading on it violates Rule 10b-5. How about LendingTree? If the information disclosed by the Issuer's CEO to FNF was material, does that mean LendingTree should have simultaneously disclosed the pending deal in a press release or in a 8-K report? Can information be material for one purpose (precluding trading on the information by insiders) but not be material for another (requiring disclosure by the target of the pending deal)?
We know from the Supreme Court's decision in Basic, Basic Inc. v. Levinson, 485 U.S. 224, 241 n. 18 (1988), that what is material is not context-specific, so the answer to the last question is that if information is material for one purpose it is material for all purposes relevant to Rule 10b-5. So should LendingTree have disclosed the pending deal when its CEO spilled the beans to FNF? Under Regulation FD, disclosure of material nonpublic information to market professionals selectively is taboo, and, if it occurs, must be publicly disclosed (simultaneously in the case of intentional disclosure and "promptly" in the case of non-intentional disclosure (with "intentional" defined in Rule 101)). The Regulation also applies to selected disclosures to any shareholders of the issuer "under circumstances in which it is reasonably foreseeable that the [shareholder] will purchase or sell the issuer's securities on the basis of the information." Rule 100(b)(1)(iv). (There is an exception from FD's disclosure requirements for persons to whom disclosure is made "who expressly agree[] to maintain the disclosed information in confidence . . .", Rule 100(b)(2)(ii), but that would not help LendingTree in this case because the CEO made the disclosure to FNF before LendingTree presented a confidentiality agreement to FNF).
Leaving aside whether LendingTree tripped over Regulation FD in its first disclosure to FNF, the answer to whether it should have made disclosure before it did is, by custom, no. As the Court in Basic noted in its famous note 17, "[s]ilence, absent a duty to disclose, is not misleading under Rule 10b-5." While we are in a "continuous" disclosure world, it it still the case that just because information is material does not mean an issuer has to immediately announce it. This is certainly the practice with respect to the disclosure of deals, which typically are announced when the definitive agreement is signed, and not before. See 1 A. Fleischer and A. Sussman, Takeover Defense Section 2.03[C]; NYSE Company Manual Section 202.01. Exceptions come into play when the issuer knows or should know that unusual market activity is attributable to leaks from the issuer or its agents. But otherwise, silence or a "no comment" response when asked represent best practice when it comes to disclosing merger negotiations before entry into a definitive agreement.
It should also be best practice for a general counsel, when attending a board meeting such as FNF's, where deal disclosure is made, to loudly and clearly admonish the directors and officers present that trading on such information is verboten. Such advice can save those present a lot of grief. Just ask Talbot.
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