CSX Corporation v. TCI and 3G Fund
CSX Corporation v. TCI and 3G Fund, June 11, 2008 | 08 CV 02764, U.S. District Court (S.D. N.Y.).
U.S. Court deems hedge fund beneficial owners of shares due to arrangements designed to avoid disclosure obligations. The Court, however, finds itself constrained from ordering remedy sought by target company.
In a somewhat empty victory for the plaintiff railroad company, the U.S. District Court for the Southern District of New York found that the defendant hedge funds employed surreptitious means to avoid disclosure requirements while accumulating shares of CSX. Despite its findings, the District Court found itself restrained by precedent from preventing TCI and 3G Fund from exercising the votes associated with the shares they acquired during the time they were offside disclosure obligations. The plaintiff, therefore, had to settle for an injunction inhibiting the defendants from any future violations of disclosure obligations.
Facts
The plaintiff, CSX, operated one of the largest railroads in the U.S. Believing that opportunities existed to increase the value of CSX, TCI decided to begin accumulating shares in the company with the view of pressing management into making the changes TCI considered necessary. Rather than investing in CSX directly, however, TCI entered into Total Return Swap (TRS) agreements with various financial institutions. In a TRS agreement, the financial institution agrees to pay the investor cash flows based on an underlying asset in exchange for the accruing interest based on the agreed principal amount. In such an arrangement, the financial institution need not necessarily purchase the underlying asset, however, in practice this usually occurs.
TCI began entering into such swap agreements with various financial institutions beginning in October 2006. As it accumulated an indirect position in CSX, TCI also began to investigate a leveraged buyout of the company. CSX, however, was not cooperative in this regard. By February 2007, TCI “owned” almost 14 percent of CSX and began contacting other hedge funds it believed were favourably disposed to its approach to CSX, with the intention of promoting the purchase of CSX shares. One of the hedge funds with which it communicated was 3G Fund, which had already begun amassing shares in CSX. TCI and 3G had a long-standing relationship, and over the course of 2007, the two funds exchanged views and information regarding CSX, both initiated searches for director-nominees to the board of CSX and both prepared for proxy fights. The defendants, however, did not file disclosure regarding their coordinated efforts until December 2007.
In accumulating its positions in CSX, meanwhile, until October 2007, TCI distributed its TRS agreements among eight institutions. The reason for this arrangement was found by the Court to be “so as to prevent any one of them from acquiring greater than 5 percent of CSX’s shares and thus having to disclose its swap agreements with TCI.” Due to an impending proxy battle, however, TCI decided to consolidate its swaps among the two institutions it believed would vote in its favour at an upcoming shareholder meeting. Despite attempts to negotiate a resolution, a proxy battle could not be avoided and CSX brought an action claiming that TCI violated the Exchange Act by failing to disclose its beneficial ownership of CSX stock and that TCI and 3G further violated the Act by failing to make timely disclosure upon the formation of their group.
Exchange Act and SEC Rules
Section 13(d)(1) of the Exchange Act requires that any person acquiring beneficial ownership of 5% of a class of shares disclose, inter alia, information regarding the purpose of the purchases and any proposals to make major changes in the corporate structure of the company, as well as information regarding the shares owned by associates. The section was enacted “to address the increasing frequency with which hostile takeovers were being used to effect changes in corporate control.” Section 13(d)(3) of the Act, meanwhile, provides that two or more persons acting as a formal or informal partnership will be deemed a “person” for the purposes of the five percent ownership trigger.
To that end, SEC Rule 13d-3(a) provides that for the purposes of section 13(d) of the Act, “beneficial owner” includes those that directly or indirectly have or share “[v]oting power which includes the power to vote, or to direct the voting” of the shares and/or “[i]nvestment power which includes the power to dispose, or to direct the disposition” of the security. Further, under Rule 13d-3(b), those that create or use a pooling or any other arrangement in order to prevent the vesting of beneficial ownership of the shares or to evade the reporting requirements of the Act shall be deemed to be the beneficial owner of the security.
SEC Rule 13d-3(a) Analysis
While the TRS arrangements gave TCI no direct voting or disposal rights, the District Court considered whether, as cited in SEC v. Drexel Burnham Lambert Inc., 837 F. Supp. 587, 607 (S.D.N.Y. 1993), TCI had “a significant ability to affect how voting power or investment power” would be exercised. TCI argued that the institutions with which it made arrangements had no obligation to purchase the underlying asset and that they could have hedged their short positions in CSX with other investments. The District Court, however, found this argument to be unpersuasive, finding that for all practical purposes, the financial institutions hedged their positions in the shares subject to the TRS agreements by actually purchasing the underlying shares. “This is precisely what TCI contemplated and, indeed, intended.” The District Court cited the fact that TCI entered into TRS agreements with numerous institutions to avoid any one of them crossing the five percent disclosure trigger, which would not have been an issue had the financial institutions not purchased the underlying securities. Further, the banks behaved in the same way at the back end of the transactions, selling the underlying shares at the termination of a TRS agreement. Thus, the District Court found that, despite not directly holding the shares itself, TCI significantly influenced the banks’ purchases and disposals of CSX shares.
With respect to voting power, the District Court found that while there was no evidence that TCI and the financial institutions with which it entered into swaps had any agreement with respect to how the financial institutions would vote, TCI moved most of its swaps to Deutsche Bank beginning in October 2007 due to an alignment of interests between it and the bank. The similar interests of these two parties were due to the fact that Deutsche Bank also held investments in CSX. Further, the policies of some of the banks with which TCI had agreements allowed TCI to prevent shares from being voted. The Court, however, conceded that the situation with respect to voting power was “murkier” than that of investment power, and ultimately stopped short of a finding of beneficial ownership under Rule 13d-3(1). While the Court may have been leaning towards a finding of beneficial ownership under this Rule, it found that it was “ultimately unnecessary to reach such a conclusion to decide this case” due to its ruling on the violation under Rule 13d-3(b), considered below.
SEC Rule 13d-3(b) Analysis
As discussed above, Rule 13d-3(b) provides that pooling arrangements for the purpose or effect of avoiding reporting requirements deem beneficial ownership on the creator of the arrangement. On this point, the District Court found that TCI’s arrangements created the false appearance that no accumulation was taking place. Thus, the Court found that “TCI created and used the TRSs with the purpose and effect of preventing the vesting of beneficial ownership” in the company as part of a scheme to avoid its disclosure requirements. As such, TCI was deemed to be a beneficial owner of the shares held by the financial institutions with which it entered into swap agreements.
Section 13(d) and Group Formation
With respect to the formation of the group, which required disclosure under section 13(d) of the Act, The District Court further found that TCI and 3G Group formed a “group” for the purposes of the legislation, no later than February 13, 2007, the date of a particular email and subsequent discussion between the defendants regarding activity in CSX stock. The circumstances of the case persuaded the Court that the defendants’ activities from at least as early as this date were “products of concerted action notwithstanding the defendants’ denials.”
Disposition
While the Court found that the defendants violated section 13(d) of the Exchange Act in failing to file timely disclosure with respect to beneficial ownership and group formation, the Court did not find that the eventual disclosure filed by the defendants was false or misleading as to a material fact.
Further, despite the findings on the disclosure violations, the District Court found itself bound by precedent in assessing relief. While CSX pleaded for injunctive relief prohibiting the defendants from voting any of the shares they owned, the District Court found the argument to sweep too broadly, and limited its consideration only to those shares acquired during the time the defendants were offside their reporting requirements. Even within this more limited focus, the District Court found itself bound by the decision of Treadway Cos., 638 F.2d (D.D.C., 1978), on the principle of irreparable harm. In that case, the acquisition of a 31 percent block of shares, wherein some of the purchases were completed during a period of noncompliance, was found to be “insufficient to threaten irreparable injury on the remaining shareholders” because control had not passed.
The District Court was obviously displeased with the limitations placed on it by this precedent, finding that “[i]t is questionable whether a bright line rule that appears to foreclose the existence of ‘a degree of effective control’ in the absence of a stock holding larger than 31 percent is consistent with commercial realities” and that “courts have recognized that minority shareholding or board representation may confer a degree of control, at least in some circumstances.” As the proportion of shares held in this case by the defendants fell below even the level found in Treadway, the Court found itself bound, and CSX “cited no case…in which irreparable harm was found because a defendant had obtained a degree of effective control.” The Court was clear, however, that had it not been so limited, it would have exercised its discretion to grant an injunction against TCI from voting the shares it acquired during disclosure non-compliance. The District Court, however, did find the probability of future violation to be substantial and as such enjoined the defendants from future violations. ╔
On September 15, 2008, the U.S. Court of Appeals for the Second Circuit upheld the District Court decision declining to enjoin the defendants from voting their shares of CSX. The Second Circuit also stated that an opinion would follow.
