Tuesday, June 17, 2008

CSX/TCI Judgment – Some Thoughts on the SEBI Takeover Regulations

In a closely followed case, the U.S. District Court for the Southern District of New York issued its decision regarding the reporting requirements of a hedge fund (TCI) that had entered into “total return equity swaps” with counterparties in respect of the shares of CSX. Although TCI only entered into cash-settled swaps (without any obligations to obtain delivery of CSX’s shares), the counterparties to the swap in turn hedged their risks by acquiring shares of CSX. On the specific facts of the case, the court held that TCI should be treated as beneficially owning the shares under its cash-settled equity swaps under the anti-avoidance provisions of Rule 13d-3(b) of the Securities Exchange Act of 1934 and hence should have filed the requisite disclosures, which it failed to do so.

A memo by Gibson, Dunn & Crutcher LLP describes the gist of the transaction and the decision as follows:

“One of the main issues raised by the CSX case is whether, in calculating their beneficial ownership, investors are required to count shares in which they have an economic interest through swap or hedging transactions. In the CSX case, TCI held cash-settled “total return equity swaps” under which it obtained the economic risk of stock ownership, but no contractual rights in the underlying shares. While not contractually required under the swaps, the counterparty typically acquires some percentage or the full number of shares that are notionally covered by the swap.

The CSX ruling states that decisions by a person to enter into this type of swap arrangement or to terminate the swap can result in the counterparty buying or selling the shares that are notionally covered by the swap. The Court also stated that the counterparty may be likely to vote shares as its client would want in order to maintain a positive business relationship and to bolster the likelihood of obtaining business from the client in the future. …”
The relevant provisions of the Securities and Exchange Act Rules that the court relied on are as follows (as extracted from the Gibson Dunn memo):

Rule 13d-3(a):

For the purposes of sections 13(d) and 13(g) of the Act a beneficial owner of a security includes any person who, directly or indirectly, through any contract, arrangement, understanding, relationship, or otherwise has or shares: (1) Voting power which includes the power to vote, or to direct the voting of, such security; and/or, (2) Investment power which includes the power to dispose, or to direct the disposition of, such security.

Rule 13d-3(b)

Any person who, directly or indirectly, creates or uses a trust, proxy, power of attorney, pooling arrangement or any other contract, arrangement, or device with the purpose of [sic] effect of divesting such person of beneficial ownership of a security or preventing the vesting of such beneficial ownership as part of a plan or scheme to evade the reporting requirements of section 13(d) or (g) of the Act shall be deemed for purposes of such sections to be the beneficial owner of such security.
While Rule 13d-3(a) deals with the question of beneficial ownership in securities for the purpose of disclosure, Rule 13d-3(b) is an anti-abuse provision that prevents the use of arrangements that avoid disclosure requirements. In this case, the court’s decision is largely based on an application of Rule 13d-3(b) to the facts of the case, whereby the court held that TCI shared voting or investment power over shares that its swap counterparties had purchased, on the theory that under the fact TCI had the ability to influence the counterparties’ actions. On this basis, it held that there was a failure by TCI to make appropriate disclosure of its shareholdings.

This decision could have some bearing on the interpretation of the relevant provisions of the SEBI Takeover Regulations (specifically Regulation 7 that provides for disclosures upon acquisition of shares or voting rights that exceed defined percentages). This applies to any person who is an acquirer (that is defined to include a ‘person acting in concert’). In an Indian situation, the primary question will relate to whether the hedge fund or other investor that enters into an equity swap arrangement (even if cash-settled) is said to be acting in concert with the counterparty who may acquire shares to hedge its own position under the swap. If they are indeed persons acting in concert, then the hedge fund or other investor’s shareholding (if any) will be aggregated with the shareholding of the counterparty thereby triggering disclosure requirements if the total shareholding exceeds the prescribed thresholds (e.g. 5%, 10%, 14%, 54% or 74%).

However, there are some key differences between the SEBI Takeover Regulations and the relevant provisions of the Securities Exchange Act Rules cited above. While the definition of ‘person acting in concert’ in Regulation 2(1)(e)(1) of the SEBI Takeover Regulations contains provisions on the same lines as Rule 13d-3(a), there is no anti-abuse provision (like Rule 13d-3(b)) in the SEBI Takeover Regulations. In Indian circumstances, in the absence of such an anti-abuse provision, for any such action to succeed under Indian circumstances, it would be necessary to show that the hedge fund and the counterparty had a ‘common objective or purpose of substantial acquisition or voting rights’, which may be a difficult proposition in a purely cash-settled option. Further, the Indian reporting requirements arise only when a person such as the hedge fund “acquires” shares or voting rights, while the anti-abuse provision imposes the obligation on a person who does not necessarily acquire shares or voting rights, but where such person has an ‘arrangement’ with any other person who has acquired shares (to evade the reporting requirements).

It is likely that the TCI/CSX case will go on appeal. But, it does provide some lessons on the manner in which similar situations are to be dealt with under the SEBI Takeover Regulation. At least, at a basic level, it provokes the debate on whether it is now time to include an anti-abuse provision (such as Rule 13d-3(b)) in the SEBI Takeover Regulations.

1 comment:

Ami de Chapeaurouge said...

Dear Sir,

I am writing from Germany today, having conferred and confirmed with my colleagues in Singapore (from where we conduct our India-Practice) and Hong Kong (from where we conduct our China-Practice) with respect to the ramifications of the CSX-decisions for Asia. We believe that according to the latest writings of U Texas Professors Henry Hu and Bernard Black on the matter of empty voting and the new vote buying, the CSX decision is somewhat poorly reasoned. We do not know the appellate reasoning yet. Why do we feel so inclined? It is because the fact pattern in the CSX case conjures up a scenario where two hedge funds stir things up a bit so as to be in a position to assume board seats and eventually prompt a change-of-control. It is a matter of construing this coordination between two such funds a 13D group under the 1934 Securities and Exchange Act. In our world-wide experience in these matters, however, we view a different factual pattern as more important and believe that anti-hedge fund sentiments and measures do not actually capture this trend and might, actually, be misplaced. We see scenarios most often where hedge funds simply create some noise so as to provoke senior management of a target company to undertake certain share-value enhancing measures, notably share buybacks, dividend distributions, etc. In connection with change-of-control scenarios in Europe and the U.S., we view them acting as instigators rather than predators. It is actually strategic buyers or consortiums consisting of a mix of strategic and private equity purchasers that undertake the actual takeover. While it may be instigated through hedge funds, they rather act in the shadow and under the umbrella of giants.

The issue therefore turns from a single or group of hedge funds and alleged "acting in concert" on their part to the relationship between a corporate strategic raider and their banking relations with whom they engage in equity swaps. Here, the New Zealand appellate case Perry Corporation vs Ithaca (Custodians) Ltd dating November 3, 2003 and the Australian appellate decision Glencore International AG (CAN 114 271 055) v Takeovers Panel [2006] FCA 274 seem more pertinent. While there may be rare incidences from time to time where a fact pattern like the one before Federal Judge Kaplan in the CSX case are germane (two hedge funds vying for a control change of a target), worldwide the phenomenon is more realistically assessed when and as hedge funds operate as instigators but it is a large corporate actor or consortium (that my well contain a private equity player or two) goes for the kill and goes for the jugular. Judge Kaplan and the Cravath firm in New York have isolated what they call a "control scheme" between two hedge funds as overriding point of departure. In distinction, the New Zealand case operates on far more subtle assumptions and slices with a finer blade: An unwritten "understanding" or "arrangement" between the corporate raider and its banks with whom such raider is engaged in separate total return equity swaps (holding the economic rights) where the banks exercise the separated voting rights is what that decision is looking for. This 2003 case from New Zealand is highly recommended reading, it's one of the best-reasoned decisions I've ever come across in my career.


Dr. Ami de Chapeaurouge, LL.M. (Columbia)
S.J.D. (Harvard)
Rechtsanwalt (Frankfurt am Main)
Member of the New York Bar

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