Implications Of The Second Circuit Decision In 'CSX Corporation v. The Children's Investment Fund Management (UK) LLP'

INTRODUCTION

CSX Corporation's (CSX) 2008 annual meeting resulted in significant litigation concerning the beneficial ownership provisions of Section 13(d) of the Securities Exchange Act of 1934 (Exchange Act). Two hedge funds, The Children's Investment Fund Management (TCI) and 3G Capital Partners (3G), conducted a proxy contest relating to the meeting.

TCI and 3G entered into cash-settled total return equity swaps (TRSs) relating to CSX common shares. TRSs are contracts in which parties agree to exchange sums equivalent to the income streams produced by specified assets. This type of swap does not transfer title to the underlying assets or require that either party actually own them.

The litigation arising out of the 2008 CSX proxy contest centered around the beneficial ownership implications of TRSs. Although the U.S. Court of Appeals for the Second Circuit recently dealt with these issues, it did not resolve the beneficial ownership questions raised by TRSs. However, the Second Circuit decision provides guidance on when a "group" is formed for purpose of Section 13(d), as well as the use of an injunction as a remedy for violations of Section 13(d).

EXECUTIVE SUMMARY

The CSX case dramatically demonstrates the difficulty of using 13(d) violations as a defensive tactic. This litigation started in 2008, failed to impact the voting by TCI and 3G at the 2008 CSX annual meeting and just now, three years later, is being "decided" on appeal.

TRS Implications. The Second Circuit was unable to reach agreement concerning whether or when the long party in a cash-settled TRS will be deemed to beneficially own shares referenced by the TRS held by the counterparty. Legitimate hedging transactions may not be impacted by this litigation, or by the SEC rules described below. Risk continues to exist in situations like those presented in the CSX case, where swaps are used in connection with attempts to influence management.

Implications for Group Formation. The Second Circuit, however, did provide some guidance on when shareholders have formed a group for purposes of Section 13(d). The Second Circuit held that a group is not formed as a result of concerted action by shareholders unless the purpose of the concerted action is to acquire, hold, vote or dispose of equity securities of the issuer.

When a "group" has been formed for the purpose of 13(d), all members of the group are deemed to beneficially own all the shares owned by the other members of the group. If the shares beneficially owned by all members of the group exceed 5 percent of the outstanding class, a filing with the SEC is required. Failure to file can result in securities law violations. In addition, creation of a "group" can have consequences under Section 16 of the Exchange Act, including Section 16(b).

This Second Circuit decision provides more leeway to shareholders to discuss with other shareholders the business of a company in which they hold shares. However, shareholders still need to be aware of the circumstances that could result in a finding of "group" status.

Implications for Shareholder Rights Plans. Because the beneficial ownership of TRSs is in a state of flux, issuers may want to review their shareholder rights plans and equity security-based compensation plans. Under these plans, beneficial ownership is usually based on the Section 13 definition. It is currently unclear whether this definition includes these types of TRSs, so an issuer may want to deal with these types of securities expressly in its plans, rather than relying solely on the Section 13(d) beneficial ownership definition.

EXPLANATION OF TRSs

Total-return swaps are contracts in which parties agree to exchange sums equivalent to the income streams produced by specified assets. Total-return equity swaps involve an exchange of the income stream from:

a specified number of shares in a designated company's stock; and a specified interest rate on a specified principal amount. The party that receives the stock-based return is called the "long" party and the party that receives the interest-based return is called the "short" party.

In a TRS, the long party periodically pays the short party a sum calculated by applying an agreed-upon interest rate to an agreed-upon notional amount of principal, as if the long party had borrowed that amount of money from the short party. The short party periodically pays the long party a sum equivalent to the return to a shareholder in the specified company – the increased value of the shares, if any, plus income from the shares – as if the long party owned actual shares in that company.

As a result, the financial return to the long party in a total-return equity swap is similar...