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CSX Corporation v. The Children’s Investment Fund Management (UK) LLP, et al., 08 Civ. 2764 (SDNY, June 11, 2008), currently on appeal to the Second Circuit, could have significant consequences for activist and other investors who build their stakes by acquiring derivatives referenced on a target’s shares. The appeal is scheduled for argument in early August of this year.

In CSX, the district court found that a hedge fund’s conduct in accumulating swaps on a target’s shares constituted a scheme to evade the reporting provisions of Section 13(d) of the Exchange Act. In a highly fact-based decision, the court held that the hedge fund was deemed the beneficial owner of the target’s shares by reason of the anti-evasion provisions of Rule 13d-3(b) and violated Section 13(d) by failing to timely file a Schedule 13D when its ownership passed the five percent threshold. Perhaps even more important was the court’s dicta, which suggested a person’s derivative holdings may make it a beneficial owner of the target’s shares regardless of any scheme or intent.

The underlying facts of the case began with a series of equity swap transactions, entered into by The Children’s Investment Fund Management (UK) LLP, a London-based fund, and its affiliates that referenced shares of CSX Corporation, a publicly-traded operator of US rail systems. By the end of 2006, TCI had aggregated swaps referencing 8.8 percent of CSX’s shares outstanding. While continuing to increase its position, TCI proposed, and continued to pursue, a leveraged buyout offer of CSX. In August 2007, 3G Capital Partners L.P., a Cayman Islands-based hedge fund owning more than four percent of CSX’s outstanding shares, adopted a similar strategy, acquiring swaps referencing an additional 0.8 percent of outstanding shares.

As CSX continued to reject TCI’s buyout offer, TCI and 3G converted a portion of their swap positions into actual ownership of shares and, soon after, collaborated to launch a proxy contest to win control of the CSX board. In December 2007, the funds filed a Schedule 13D with the SEC, disclosing their intent to conduct a proxy solicitation to nominate directors for five of the company's twelve board seats. In the Schedule 13D, the funds disclosed a joint ownership of 8.3 percent of the company’s shares, with economic exposure through equity swaps to an additional 11.8 percent of shares outstanding. At the same time, the funds disclaimed beneficial ownership of the underlying shares referenced by the swaps.

CSX sued the funds in response, arguing that TCI beneficially owned the underlying shares referenced in the swaps and that, accordingly, TCI had failed to timely report its ownership stake and had thereby purposefully evaded the reporting requirements of Sections 13(d) and (g) of the Exchange Act. In reply, TCI argued that its exposure to the equity swaps carried none of the established indicia of actual ownership, such as voting or selling rights, and that TCI could not be considered the owner of sufficient shares to trigger the applicable disclosure provisions. The SEC staff, which addressed this issue at the district court’s request, largely supported TCI’s position.

After a two-day bench trial, Judge Lewis Kaplan found in favor of CSX, ruling that TCI had become the beneficial owner of the referenced shares under Rule 13d-3(b). Under Rule 13d-3(b), any person who uses a contract, arrangement or other device to prevent the vesting of beneficial ownership as part of a scheme to evade the disclosure required by outright ownership will be deemed to be the beneficial owner. TCI had fallen under the provisions of Rule 13d-3(b) by entering into equity swaps to evade the disclosure requirements of Section 13(d).

In light of this finding, the district court found it unnecessary to rule more generally on whether the use of equity swaps could convey beneficial ownership under Rule 13d-3(a). Nonetheless, in dicta the district court suggested that a focus on legal rights under swap contracts “exalts form over substance.” Any determination of beneficial ownership that failed to account for the practical effects of derivatives transactions, the district court wrote, would open the system to the gravest abuse.

Despite the district court’s findings, it declined to grant any meaningful relief to CSX in its ongoing proxy contest with 3G and TCI. Instead, the district court only entered a permanent injunction barring the funds from engaging in further violations of Section 13d. Although the district court held that TCI violated Section 13(d) by failing to timely report its Rule 13d-3(b) based “beneficial ownership,” it ruled that TCI's swap position had been disclosed subsequently through a corrective filing and was thus known to the market. As a result, the district court found no basis for voiding the proxies obtained by TCI. Moreover, the district court concluded that in light of Second Circuit precedent it lacked the legal authority to "sterilize" (ie strip of voting rights) the 6.4 percent of shares the funds acquired during the period they were non-compliant with Section 13(d). Nonetheless, the district court called upon the SEC to refine its interpretation of beneficial ownership and noted in dicta that it would have granted sterilization had it been free to do so.

As the district court denied CSX’s request for more extensive relief, CSX moved for an expedited appeal to the Second Circuit and sought an injunction that would have held the referenced shares in escrow pending the appellate court’s decision. The Second Circuit granted CSX’s motion for an expedited appeal, now scheduled to be argued on or after August 4, 2008, but denied the injunction. Consequently, the shares referenced in the swaps may be voted at CSX’s annual meeting on June 25, 2008.

No far-reaching regulatory reform was established by the district court’s decision. The district court did not hold that under Rule 13d-3(a) beneficial ownership necessarily includes the long side of cash-settled total return swaps. Nonetheless, the court’s dicta contains an extensive analysis that provides considerable support for such a position. If the district court decision is upheld or not forcefully reversed, it is likely to stand as a significant deterrent against excluding derivatives holdings from any beneficial ownership count for Section 13(d) reporting and other purposes.

In response to these events, Senator Charles Schumer (D-NY), a member of the Senate Banking Committee, is considering introducing legislation to punish disclosure violations with stiffer civil penalties. In a letter to SEC Chairman Christopher Cox, Senator Schumer called for the SEC to clarify its treatment of equity swaps to ward off litigation arising from issues of derivative ownership.

In light of the district court’s decision and Senator Schumer’s letter, investment funds that through derivative positions have economic ownership comparable to ownership of more than five percent of a public company’s outstanding shares should carefully consider whether to promptly make such disclosures as would be required for outright owners of an equivalent stake in the company.

We will continue to closely monitor developments at the appellate stage of this case, and a subsequent alert will discuss the broader implications of the decision for activist shareholders and the market generally.