CSX v. TCI: Corp Fin's June 4, 2008 Amicus Letter on Appeal

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.