The U.S. District Court for the Southern District of New York (the “Court”) found for the plaintiff, a New York Stock Exchange traded corporation (the “Company”), against two hedge funds that had accumulated a significant economic position in the Company through the use of total return equity swaps (“TRSs”) based on the Company’s common stock, in a suit alleging violations of the position reporting requirements of Section 13(d) of the Securities Exchange Act of 1934, as amended (the “1934 Act”). The suit was filed in the midst of a proxy fight between the Company and the defendant hedge funds in which the latter were seeking, among other things, to elect their nominees to five of the twelve seats on the Company’s Board of Directors. Section 13(d) requires any person that acquires directly or indirectly the beneficial ownership of equity securities registered under the 1934 Act in excess of 5% of that class to make specified filings with the issuer and the SEC. Beneficial ownership under Section 13(d) is, in general terms, determined by whether a person has (1) voting power over the securities in question, which includes the power to vote, or to direct the voting of, those securities, and/or (2) investment power, which includes the power to dispose, or to direct the disposition of, those securities.
The Company’s Section 13(d) Allegations. The Company made two allegations related to Section 13(d) reporting: (1) that one of the defendants violated Section 13(d) by failing to disclose beneficial ownership of shares of the Company’s common stock represented by the TRSs, which when combined with Company shares the defendant had purchased directly would have brought its interest above the 5% threshold, and (2) that both defendants had failed to disclose the formation of a group under Section 13(d) in a timely manner. Section 13(d)(3) provides that when two or more persons act as a partnership, syndicate or other group for the purpose of acquiring, holding or disposing of securities of an issuer, that syndicate or group shall be deemed a person for purposes of Section 13(d) disclosure requirements. The Company contended that the defendants had been acting in concert to accumulate the Company’s common stock well before they ultimately filed a Schedule 13D that listed both direct holdings in the Company’s common stock and the Company stock underlying their TRS holdings, and thus their filing was not timely. The Company sought, among other things, an order (a) requiring corrective disclosure by the defendants, (b) voiding proxies defendants had obtained and (c) precluding defendants from voting their shares of the Company.
The TRS Holdings and Beneficial Ownership. In a TRS, the “short” party agrees to pay the “long” party cash flows based on the performance of an underlying reference asset in exchange for payment by the long party of interest at a negotiated rate on the agreed notional amount of the underlying reference asset, in this case an amount of Company common stock. A TRS does not grant the long party the right to vote the shares underlying the swap. The Court acknowledged there was no evidence that the defendant in question had explicit agreements with any of the counterparties regarding how the shares underlying the TRSs would be voted, but cited ways that the voting of those shares could be influenced to the defendant’s benefit. In addition, a TRS typically does not give the long party any right to direct the disposition of shares of the reference asset. The Court nevertheless found the bank counterparties to the TRSs would have been compelled as a practical matter to purchase shares of the Company’s common stock in order to hedge their exposures under the TRSs. The Court further observed that although they contemplate cash settlement, TRSs may be settled in kind. Ultimately, however, the Court declined to rule on the issue of whether the defendant in question had actual beneficial ownership within the meaning of Section 13(d) of the Company stock underlying its TRS holdings.
Instead, citing, among other things, (A) statements by the defendant’s CFO (although not specifically with reference to the Company) that one of the reasons for using swaps was to avoid disclosure to the market or the target company, (B) e-mails by defendant personnel emphasizing the importance of keeping TRS exposure to any one counterparty below the level where the counterparty’s purchase of Company stock to hedge the TRS position would cross the 5% Section 13(d) reporting threshold and (c) the fact that the defendant kept its direct investment in Company stock below the 5% threshold, the Court found that the defendant was deemed to have beneficial ownership by virtue of Rule 13d‑3(b) pursuant to the 1934 Act. Rule 13d‑3(b) provides in substance that a party that creates an arrangement to prevent the vesting of beneficial ownership as part of a plan or scheme to avoid the disclosure required had there been an outright purchase of the stock is deemed to be a beneficial owner of those shares.
Group Formation under Section 13(d)(3). In analyzing the question of whether the defendants had timely disclosed that they were acting in concert, i.e., as a group, with respect to their acquisition of Company stock, the Court made extensive findings regarding the longstanding prior relationship between the two defendants, the admitted exchanges of views and information between the two regarding the Company, the patterns of share purchases by one of the defendants immediately following meetings between its personnel and the managing partner and partner of the other defendant leading that defendant’s efforts with respect to the Company and the two defendants’ parallel proxy fight preparations. On this basis, the Court found that the defendants had formed a group approximately ten months prior to the filing of their Schedule 13D.Relief Granted. Addressing the remedies that it deemed relevant to the Section 13(d) violations it had found, the Court permanently enjoined the defendant hedge funds from further Section 13(d) violations, but bowing to precedent in the Second Circuit, did not grant the Company’s request that the hedge funds be precluded from voting the stock of the Company that they acquired between the time of group formation as found by the Court and the time the defendants made their Schedule 13D filing. The court indicated that any penalties for the defendants’ violations of Section 13(d) would have to be the result of SEC or DOJ action. (CSX Corp. v. Children’s Investment Fund Management (UK), 08 Cir. 2764 (LAK) (S.D.N.Y. June 11, 2008).)