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.