Hedge funds in hiding

Shareholder proposals and proxy actions have become par for the course at most large public US companies. The majority of corporations have become accustomed to and relatively adept at dealing with shareholder actions, but managing such situations becomes far more complicated when organized, professional investor groups openly flout federal disclosure rules. A company might reasonably expect action that violates SEC rules to be disallowed but this is not always the case as seen in the ruling in the CSX Corp v The Children’s Investment Fund (TCI) case, which allowed two hedge funds, Britain’s TCI and Brazil’s 3G Capital Partners, which held derivative ownership in the large US railroad company, to vote their shares despite evidence that they evaded SEC disclosure laws. It’s an outcome that has wide-ranging implications for any corporation that wishes to ward off surprises among its shareholder base.

Breaking down the pre-litigation precursors, according to a summary by law firm Blank Rome, in December 2007 TCI and 3G notified CSX of their intention to initiate a proxy contest. They intended to solicit proxies for use at CSX’s 2008 annual shareholder meeting to elect their nominees to five of the 12 seats on the company’s board of directors. They also sought to amend CSX’s bylaws to permit holders of 15 percent of CSX shares to call a special meeting of shareholders at any time and for any purpose permissible under the laws of Virginia, the state in which CSX is incorporated.

In March 2008 CSX returned fire, filing a suit alleging TCI and 3G violated SEC disclosure regulations by failing to reveal the number of shares they owned in the company. How did they manage such an elusive feat? By hiding. The funds, the company alleged, used their hidden ownership position and alliances to launch their campaign to get their own nominees onto the CSX board. 

Getting away with breaking the rules

CSX’s standpoint was shared by others. In his ruling, Judge Lewis Kaplan of the United States District Court for the Southern District of New York stated, ‘Some people deliberately go close to the line dividing legal from illegal if they see a sufficient opportunity for profit in doing so. A few cross that line and, if caught, seek to justify their actions on the basis of formulistic arguments even when it is apparent that they have defeated the purpose of the law. This is such a case.’

The judge found that the hedge funds did violate disclosure rules by not revealing their ownership stakes, but he did not bar them from voting their shares, which collectively represented 8.7 percent of the company’s stock, on top of their equity swap derivative ownership, which represented another 12.3 percent.

‘This is important because it shows, at least in one court’s view, that you can have beneficial ownership of securities, even if you only own cash-settled total return swaps or derivatives,’ asserts Keith Higgins, an attorney with Ropes & Gray in Boston.

A difference of opinion

That ruling runs counter to previous SEC opinions on the matter, says Keith Gottfried, a partner at Blank Rome. ‘If you do not have the right-to-vote shares and all you have is an economic interest in the shares, the SEC has been pretty clear,’ he explains. ‘Judge Kaplan wrote a letter to the SEC and asked that the SEC give an opinion. They gave a ‘staff interpretation’, which means it’s not actually an official opinion of the SEC, but it’s got a fair amount of persuasive authority.’

In that document the staff said that economic interest is not an official ownership. ‘I don’t think the judge necessarily agreed with that,’ says Gottfried, ‘I think the issue that a lot of people were hoping he would decide is whether or not cash equity swaps constitute beneficial ownership under Rule 13D.’

Ruling but no solution

By refusing to sanitize the shares, which would render them devoid of voting rights, Kaplan allowed the activist funds to vote. His ruling ‘wasn’t necessarily what people would have liked,’ says Gottfried, which for him would have been a clear ruling on whether equity swaps represent beneficial ownership. ‘He says that they have beneficial ownership; he says they violated 13D; he scolds them. It’s clear that he’s very, very unhappy with the behavior, with the testimony and all that kind of thing. And then he says, Notwithstanding all that, I wish I could do something to exert some punishment. He’d like to be able to grant some injunctive relief, but the problem that the judge faced is that 13D does not, by its terms, provide any remedies.’ In short, TCI and 3G broke the rules and deserved to be punished but there is no clear language on what that punishment should be.

Higgins agrees with that assessment. ‘[13D] doesn’t have any teeth in that [Judge Kaplan] didn’t say, You can’t vote the shares. He says, You should have filed your 13D earlier. It didn’t really have the outcome CSX was looking for in this instance,’ Higgins concludes.

Gottfried explains that 25 years of case law have made it unanimous among circuit courts that no monetary damages are due for 13D violations. Yet on issues of non-monetary relief, the circuits have been split, he says. ‘I think what Kaplan was basically saying was that, They could grant injunctive relief and they did grant some injunctive relief. It is very, very limited and if I could issue a decision, an order, to sterilize your shares, which means prevent them from voting, I would do so, but court precedent does not allow me to do so. And then that got appealed up the 2nd Circuit.’ The 2nd Circuit did ultimately end up affirming Kaplan’s opinion on injunctive relief.

An unfair distribution of power

Some fear that, although the ruling admonishes the actions of the hedge funds, the lack of remedy and the idea that swaps and other derivative shares can be voted may embolden funds who have personal or political agendas and ownership hidden in derivatives.

‘If you don’t have the appropriate 13D disclosure, then you can’t see groups forming on the horizon that may mean to either hurt or help your company. You don’t know what their intentions are and you can’t see their intentions coming,’ says Joseph Pastore, III, a partner with the law firm Drier in Stamford, Connecticut.

Not being able to identify potential predators can out a company that is in a vulnerable position, but there are some simple steps companies can take to better protect themselves. Pastore says that companies can include language in the corporate bylaws that limits the ability of shares to be traded in various derivative structures. This may help to increase the amount of information a company has about its investor base, but it is no guarantee. ‘I don’t know that you could necessarily control it,’ he concedes.

Higgins says that a number of companies are, in fact, successfully amending their bylaws to provide additional protections. First, he recommends amending the director and officer questionnaire to determine if there is derivative ownership among board members. That can be done simply by asking a few questions about ownership, although he admits that this is not typically the issue at hand.

The other two routes companies can take to protect themselves lie in advance-notice bylaws. Companies that have advance notice bylaws for presenting at a meeting are now requiring proponents to file a shareholder proponent notice in advance. The companies then use this as leverage to extract information from the proponent, including the beneficial shares and any derivative securities held, as well as any alignment with other entities. This type of disclosure may also be required to receive shareholder communications, allowing companies to use their own rules and guidelines to gather information about potential conflicting agendas. 

‘All it says is, If you’re going to make a shareholder proposal, the shareholders should know precisely what your economic interest in our company is. You may have 8 percent of the vote, but you may have sold off some economic interest,’ says Higgins.  

A third option that some companies are trying to master is directly addressing beneficial ownership through their shareholder rights plans. As Higgins says, some companies have gone so far as to amend their definition in response to the CSX case in order to try and address the specific ownership rights of such derivative securities. But as the treatment of derivative securities is immensely confusing, Higgins cautions, ‘I think it’s a lot more complicated than that. I don’t advise addressing them in shareholder rights plans. It could have unintended consequences.’

Rules may be about to change

With the disparity between Judge Kaplan’s ruling and the SEC’s opinions on beneficial ownership and derivative securities – not to mention the role of these securities in the broadening financial crisis that is gripping global markets – Gottfried predicts that when President Elect Barack Obama’s administration takes office, issues surrounding derivatives will be front and center for review, especially Section 13 and the specific laws surrounding disclosure of ownership.

‘If you look at [the SEC] opinion, they’ve suggested that notwithstanding what they believe they’re entitled to rule on – because under administrative law principles, you’re very limited in what you can do in terms of giving interpretive advice without necessarily violating rule-making principles – they said that they may need to go back and look at further rule-making to cover hedge fund disclosures, and that was before the market meltdown,’ Gottfried explains.

Pastore agrees that the SEC will be paying attention to derivatives and the issues surrounding them in 2009 and beyond. ‘They absolutely have to. We’re living in a frontier land for this particular type of security. Imagine if you woke up in 1810 and they were just coming out with equity in companies or something like that. That’s kind of where we are,’ he says. Less than a decade old, these securities are evolving and there has been disagreement over whether they can be regulated, Pastore continues: ‘I think a lot of it is nonsense. It acts like a security, it fights like a security, certainly it affects the economy like a security and it needs to be regulated like a security.’

In the meantime, each of the experts agree that corporate secretaries need to confer with their counsel and review their bylaws to determine how they can use in-house controls to best ascertain the motives of derivative shareholders who may have beneficial ownership privileges. By using information flow and meeting agenda access, among other tools, to encourage further disclosure, companies can better spot potential issues, especially if they are of a more nefarious nature.