Disclosure of Derivative Positions Comes Under Renewed Scrutiny
Recent pronouncements by a court in the United States, as well as regulatory activity in the United Kingdom, have highlighted the issue of whether rules requiring disclosure of beneficial interests in securities of public companies should extend to economic interests in securities held through derivative contracts such as cash-settled total-return equity swaps (TRSs) and similar financial instruments. The debate resulting from these developments may have implications for Canada’s securities regulatory regime.
The CSX Decision in the United States
Considerable commentary has been published and debate waged since the June 11, 2008 decision of Judge Lewis Kaplan of the United States District Court for the Southern District of New York in CSX Corporation v. The Children’s Investment Fund Management (UK) LLP et al. The defendants in this private securities law enforcement case — The Children’s Investment Fund Management (UK) LLP (TCI) and 3G Fund LP (3G) and their respective affiliates — are hedge funds that ultimately led a proxy fight to elect five directors to CSX Corporation’s (CSX) 12-member board.
Relying on anti-evasion provisions in beneficial ownership reporting rules under Rule 13d of the Securities Exchange Act of 1934, Judge Kaplan deemed TCI to be the beneficial owner of CSX shares that were the reference security for certain TRSs, and ruled that the defendants had failed to report their shareholdings in the manner required by US securities laws. Ultimately, Judge Kaplan found that he was precluded by binding precedent from enjoining the defendants from voting their shares in the contested CSX shareholders’ meeting held on June 25, 2008. Judge Kaplan did, however, enjoin the defendants and their principals from further violations of the beneficial ownership reporting rules.
In the fall of 2006, TCI began investing in CSX, a major US railroad that it believed could achieve better performance and a higher stock price with some changes to its management and policies. From this period until the end of 2007, TCI, and at times, 3G, entered into TRSs that gave them economic exposure to CSX shares, but not legal ownership. TCI’s exposure to CSX shares through TRSs became very significant. During that time, TCI accumulated exposure to approximately 11% of CSX’s shares through eight different counterparties with a total notional value of in excess of US$2.0 billion. Over this period, neither of the defendants accumulated a legal ownership position of more than 5% of CSX’s shares, thus falling under the threshold to report their ownership in CSX. In addition, none of the financial institution counterparties to the TRSs individually held more than 5% of CSX’s shares — shares they had acquired to hedge their TRSs with one or both of the defendants.
The Court found that TCI had notified 3G of its holdings and interests in CSX in January 2007. In February 2007, 3G also began accumulating CSX shares, including entering into some TRSs for CSX shares. The Court also found that TCI had approached other hedge funds in the spring of 2007 and encouraged those funds to purchase CSX stock. About the same time, TCI filed a pre-merger notification report under the Hart-Scott-Rodino Act stating that TCI intended to acquire CSX shares for a value exceeding $500 million. In June 2007, 3G filed the same pre-merger notification. Ultimately, the Court found that TCI and 3G had been coordinating their acquisitions and dispositions of CSX stock throughout much of 2007. If TCI and 3G had been acting as a group, disclosure of their aggregate holdings would have been required at the 5% threshold. However, neither of the defendants made any regulatory disclosure of their holdings until December 19, 2007.
In the latter half of 2007, TCI began preparations for a proxy contest to replace some of the CSX directors. TCI’s strategy was to install five nominees on CSX’s 12-member board. On December 19, 2007, TCI and 3G entered into a formal agreement to coordinate their efforts to change policies at CSX. They formed a group along with three nominees who had agreed to stand for election as directors. The group filed a Schedule 13D disclosing its formation and their collective holdings. The group disclosed that it collectively owned 8.3% of CSX shares outstanding. The Schedule 13D filing also disclosed that TCI had TRSs giving it economic exposure to a further 11% of CSX shares outstanding. 3G similarly disclosed that it had TRSs for 0.8% of the CSX shares. Both TCI and 3G disclaimed beneficial ownership of the shares underlying the TRSs.
CSX proceeded to file its proxy statement on February 21, 2008, and the group filed its proxy statement on March 10, 2008. CSX quickly brought its action against TCI and 3G (a week later). On the issue of beneficial ownership reporting, CSX’s suit made two principal allegations. First, CSX alleged that TCI had violated Section 13(d) of the Securities Exchange Act of 1934 by not disclosing its beneficial ownership of CSX shares. Second, CSX alleged that TCI and 3G had violated Section 13(d) by failing to disclose the formation of a group in a timely manner.
Judge Kaplan thought the unique facts of the CSX case led to persuasive arguments for concluding that the TRSs held by TCI represented an actual beneficial ownership interest in the underlying CSX shares under Rule 13d-3(a), but did not find it necessary to answer this question. Instead, Judge Kaplan relied on the anti-evasion provision in Rule 13d-3(b) to deem TCI to be the beneficial owner of the CSX shares subject to the TRSs it had entered into.
Interestingly, the decision of the Court contrasts with the observations of the SEC in a letter that was sent to the Judge at his request. The SEC letter noted that, as a general matter, a person who does nothing more than enter into an equity swap should not be found to have engaged in an evasion of the reporting requirements. The SEC went on to say that the anti-evasion provision of Rule 13d-3(b) requires an intent to evade and that this would require an intent to enter into an arrangement to create a false appearance.
While the anti-evasion analysis in the CSX decision was heavily fact-dependent, the important implication for derivative instruments more generally was the obvious inclination of the Judge to conclude, if necessary, that TRSs represent beneficial ownership of shares on their face. This implication, even though it was not the basis for the decision of the case, would represent a significant departure from the widespread view that owning economic interests in securities through cash-settled derivative contracts is not the equivalent of beneficial ownership of the reference securities. The mere possibility that such a conclusion was even proposed attracted amicus briefs from both the International Swaps and Derivatives Association (ISDA) and the Securities Industry and Financial Markets’ Association, and even a short comment by ISDA on the Court’s decision following its release.
Judge Kaplan clearly invited legislators to weigh in on the issue. Soon after the release of the CSX decision, Senator Charles Schumer of New York sent a letter to the SEC calling on the SEC to clarify the treatment of equity swaps.
The CSX shareholders’ meeting ultimately proceeded on June 25, 2008, with TCI voting the shares that it had acquired during the period that Judge Kaplan found that it was not in compliance with applicable disclosure obligations. CSX initially said it would delay the announcement of the results of that vote until July 25, 2008, but announced the results on July 16, 2008. Four of the five nominees of TCI and 3G were elected to the CSX board, at least for now. Further developments are likely in this case as the CSX decision is currently under appeal. The Second Circuit Court of Appeals has agreed to hear an appeal by both parties on an expedited basis — likely in August.
Developments in the United Kingdom
Prior to the CSX litigation, the Financial Services Authority (FSA) in the United Kingdom had begun a public consultation on the disclosure rules for holding contracts for differences (CfDs), which are the UK equivalent of TRSs. CfDs, like TRSs, are contracts where the seller agrees to pay the buyer the difference between the current value of an asset and its value at contract time. CfDs are very similar to equity swaps, with the additional benefit of being traded on margin and being exempt from certain taxes in the UK.
Several alternatives had previously been proposed, but the FSA announced on July 2, 2008 that it has decided to implement a general disclosure regime for CfDs, including that they be aggregated with ordinary share positions when investors are calculating the required disclosure threshold at the existing level of 3%. Exemptions for market-makers and other appropriate intermediaries will be provided in order to reduce unnecessary disclosures and reduce the cost of implementing such disclosure.
Draft rules and a policy statement are proposed to be published by the FSA in September 2008, with final rules proposed to be published in February 2009 — and to be effective, at the latest, in September 2009. However, the FSA may try to advance that date.
Implications for Canada
The uncertainty arising from the CSX decision is not the first time Canadian regulators have had reason to consider the relationship between beneficial ownership reporting requirements and the use of equity swaps. The Ontario Securities Commission examined this issue as part of its August 8, 2006 decision in Sears Canada Inc.
In the Sears Canada case, a majority shareholder, Sears Holding, decided to make an offer to take Sears Canada private by way of an offer to acquire all of the shares it did not already own. This offer was actively opposed by a number of hedge funds on the basis that the price offered was too low. The contest between Sears Holding and the opposing hedge fund shareholders, led by Pershing Square Capital Management, resulted in litigation over a number of substantive issues on both sides. One of the issues litigated was the allegation that Pershing and the other opposing hedge funds had not properly complied with the reporting of their beneficial ownership interests in Sears Canada. Very similar to CSX, there were three aspects to this allegation: (i) whether the hedge funds were acting jointly or in concert together such that their holdings needed to be aggregated, (ii) whether one of the hedge funds used cash-settled equity swaps to avoid disclosure obligations, and (iii) whether the hedge fund that had used swaps continued to exercise a degree of control or direction over the shares of Sears Canada that were subject to those swaps.
The Commission determined there was insufficient evidence to conclude the hedge fund holding equity swaps that referenced Sears Canada shares had beneficial ownership or control or direction over the shares subject to those swaps. Accordingly, the hedge fund did not have any disclosure obligations under the early warning reporting requirements of the Securities Act. However, the Commission did specifically note that it was possible circumstances could arise where the Commission would invoke its public interest jurisdiction under the Securities Act to find a different result, stating:
"We wish to underscore that there might well be situations, in the context of a take-over bid, where the use of swaps to "park securities" in a deliberate effort to avoid reporting obligations under the [Securities] Act and for the purpose of affecting an outstanding offer could constitute abusive conduct sufficient to engage the Commission’s public interest jurisdiction."
In other words, even though Canadian early warning reporting requirements do not contain the anti-evasion provisions that Judge Kaplan relied on in the CSX decision, the Ontario Securities Commission has indicated that if sufficient abusive conduct exists, it might well use its public interest power to impose sanctions.
The ongoing litigation with respect to CSX and the recent and relatively strict proposal by the FSA in the UK to require reporting of equity swaps will no doubt cause securities regulators in Canada to consider the early warning disclosure obligations with respect to equity swaps at least in certain circumstances. Currently in Canada, only insiders of public companies are generally considered to be subject to disclosure obligations with respect to certain transactions involving derivatives pursuant to Multilateral Instrument 55-103 Insider Reporting of Certain Derivative Transactions (Equity Monetization) (MI 55-103). MI 55-103 generally requires the filing of an insider report by an insider that enters into, amends or terminates an agreement, arrangement or understanding of any nature or kind that has the effect of altering, directly or indirectly, the insider’s economic interest in a security of the reporting issuer, or its economic exposure to the reporting issuer. It may, however, be possible to also characterize the total return component of any TRS having a physical settlement option as a convertible security for purposes of Canada’s early warning reporting requirements, thereby requiring the counterparty that is long the total return component to file an early warning report.
In addition to proxy battles, the consideration of disclosure requirements for equity swaps may have implications for the take-over bid regime as well. Prospective bidders might consider using equity swaps to quietly establish "toe holds" prior to the launch of a take-over bid. In such situations, large economic positions through TRSs could be converted from cash settlement to physical settlement, and create a large position that otherwise was not disclosable prior to settlement. A prospective bidder could also, by way of equity swaps, effectively park securities with a counterparty to a TRS in anticipation that those securities would be tendered to their bid. Further, in keeping with the above-described early warning reporting analysis, the counterparty to a physically settled equity swap that is long the total return component of the swap could be deemed to beneficially own the underlying interest of the swap if the counterparty has the right to acquire the reference securities within 60 days.
Two other developments have occurred in the United States as the use of derivatives has become more common by activist hedge funds in connection with proxy battles and take-over bids. First, over 40 New York Stock Exchange-listed US companies have, in recent months, amended their bylaws to require shareholders nominating directors for election to state their shareholdings, including any derivatives that provide the shareholder with economic exposure to the company’s shares. Second, some US issuers have amended their shareholder rights plans ("poison pills") to expand the definition of beneficial ownership contained in such documents to include equity swap positions.
The implications of these developments in the United States and the United Kingdom — and the Ontario Securities Commission’s statements in the Sears case — suggest that legislators and regulators in Canada may soon consider taking action to enhance disclosure rules to ensure the public is informed of the true economic interest of various actors in underlying shares of public companies. This will have implications for public companies, for investors and for intermediaries in derivative transactions.