In case you missed it, possible trend-setting legal parries are commanding attention from New York jurists, institutional investors and proxy specialists. According to corporate governance expert Jay Brown:
The CSX Corporation (NYSE:CSX) case is the first decision to find that shareholders must sometimes disclose the shares acquired by investors as part of equity swap transactions. This holding makes it harder for activist shareholders - trying to acquire or influence control of a public company - to keep their holdings secret.
Brown should know. As a securities law professor (University of Denver Sturm College of Law) and lead contributor to The Race to the Bottom (a widely read legal blog), he and colleagues have penned no fewer than 16 posts about the ongoing litigation between CSX Corporation and several CSX investors - 3G Capital Partners ("3G" or "3G Capital") and The Children's Investment Master Fund ("TCI").
By way of background (and this is a summary only), a letter was sent to CSX by TCI on February 7, 2008, stating its intentions to acquire effective control. In response, CSX filed a lawsuit against the two funds. The Q1-2008 quarterly SEC filing for CSX states:
- On March 17, 2008, the Company filed a lawsuit against The Children’s Investment Master Fund (together with certain of its affiliates, “TCI”), 3G Capital Partners Ltd. (together with certain of its affiliates, “3G”) and certain of their affiliates (collectively, the “TCI Group”) in the United States District Court for the Southern District of New York alleging violations of federal securities laws, including violations of Sections 13 (d) and 14 (a) of the Securities Exchange Act of 1934. The lawsuit alleges, among other things, that TCI and 3G have undisclosed plans with respect of CSX. The lawsuit further alleges that TCI and 3G have employed swap agreements in order to evade the filing requirements of Section 13 (d) and that their Section 14 (a) and Section 13 (d) filings concerning their collective 12.3 percent swap position in CSX shares are materially misleading. The lawsuit further alleges that TCI’s and 3G’s disclosures in their Section 14 (a) and Section 13 (d) filings concerning their formation of a Section 13 (d) group are false and misleading.
Click to access the CSX 10-Q, filed on 4/16/08. Click to read the complaint for "CSX Corporation v. The Children's Investment Management [UK] LLP et al," filed with the U.S. District Court, Southern District of New York.
Following various motions (in limine, opposition and so on), the two funds (owning about 20 percent in direct form and via equity derivative contracts) sent a letter to other CSX shareholders on June 20, 2008 in which they explain why five nominees should be elected to the CSX board. Citing support for their slate from RiskMetrics Group - ISS Governance Services, they wrote:
- If you believe CSX cannot afford to rest on its laurels in favorable pricing and market environments, if you believe that CSX should strive to achieve its full operating potential, if you believe that CSX can and should be the best railroad in America and, finally, if you believe the board of CSX will benefit from the railroad experience of our nominees, along with the perspectives of large shareholders who are engaged because they have made a significant investment in CSX stock using their own money, we urge you to join with us in electing our five nominees to the board of directors of CSX by voting on the BLUE TCI/3G proxy card today.
On June 20, 2008, Judges Hall, Livingston and McMahon opine that TCI and 3G Capital Partners can vote their shares, additionally setting up a briefing schedule to include a July 25, 2008 date by which reply briefs in each appeal must be filed. Click to read the ruling.
The "TCI and 3G Comment on Circuit Court Ruling" (dated June 20, 2008) is short and sweet, expressing confidence in the then future June 25, 2008 vote to elect "five highly qualified director nominees." Following that vote, CSX declares the June 25, 2008 board vote "too close to call." In its June 25, 2008 press release, CSX states that the "annual meeting will reconvene at 10 am ET on Friday, July 25, 2008.
Courtesy of Knowledge Mosaic, we know that many large pension funds likewise invest in CSX (at least as of the end of Q1-2008). Regardless of the election results, the corporate governance impact is real. A partial list of funds is included below:
- CALIFORNIA PUBLIC EMPLOYEES RETIREMENT SYSTEM
- CALIFORNIA STATE TEACHERS RETIREMENT SYSTEM
- CANADA PENSION PLAN INVESTMENT BOARD
- ELCA BOARD OF PENSIONS
- EMPLOYEES RETIREMENT SYSTEM OF TEXAS
- IBM RETIREMENT FUND
- NEW MEXICO EDUCATIONAL RETIREMENT BOARD
- NEW YORK STATE COMMON RETIREMENT FUND
- NEW YORK STATE TEACHERS RETIREMENT SYSTEM
- ONTARIO TEACHERS PENSION PLAN BOARD
- PUBLIC EMPLOYEES RETIREMENT ASSOCIATION OF COLORADO
- PUBLIC EMPLOYEES RETIREMENT SYSTEM OF OHIO
- PUBLIC SECTOR PENSION INVESTMENT BOARD
- STATE BOARD OF ADMINISTRATION OF FLORIDA RETIREMENT SYSTEM
- TEACHER RETIREMENT SYSTEM OF TEXAS
- VIRGINIA RETIREMENT SYSTEMS ET AL
Not being an attorney, this case caught my eye because of the numerous and complex investment and governance implications, including the concept of"beneficial ownership" and use of financial derivative instruments. Several things come to mind.
- When a defined benefit invests in a particular stock (or selects such stock for its defined contribution plan participants), are plan fiduciaries doing sufficient homework with respect to identifying "large" ownership stakes and assessing possible corporate governance implications?
- For those defined benefit plans allocating monies to activist hedge funds, are investment fiduciaries taking into account a potential diversification "offset" that could occur if the plan invests directly in the same stock that represents a concentrated hedge fund position? (This is predicated on the notion that many pensions invest in alternatives for portfolio diversification reasons.)
- Are pensions (endowments and foundations too) asking enough questions about their external money managers' use of derivatives? Always a critical exercise, this case illustrates that equity exposure can be material through both direct buys and indirect trades, i.e. equity swaps. Though not germane to this case, equity futures or options facilitate exposure to an individual stock and/or a particular sector of the equity markets. Will their use connote "beneficial ownership" and is the exposure deemed significant? (Note that in their June 2, 2008 amici curiae brief, the International Swaps and Derivatives Association, Inc. and Securities Industry and Financial Markets Association argue against the notion that equity swaps evidence "beneficial ownership," adding that to conclude otherwise would disrupt derivative market activity. In an unrelated case, "Securities and Exchange Commission v. Larry P. Langford et al" (filed with the U.S. District Court for the Northern District of Alabama, Southern Division, on April 30, 2008), the issue as to whether swaps (interest rate) are securities appears again. See "SEC Plan for Swaps 'Securities' Gets Alabama Rebuff" by Bloomberg reporter Joe Mysak (July 3, 2008).
- In the event that a fund manager is known to use equity derivatives (because the pension fund or consultant inquires), should plan fiduciaries be carefully tracking whether the derivatives represent a hedge, a cross-hedge or an anticipatory price/volatility trade? In the case of a hedge, yet another question goes to how best to measure effectiveness.
The CSX case is sure to be the beginning of a lively debate among financial market participants and corporate issuers.