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— Analysis —
Such swaps don't involve real shares but are contracts between investors and bank derivatives dealers where one party pays the other based on the performance of the underlying stock. So far, the Securities and Exchange Commission has not required that these large economic positions be disclosed. But CSX complains that by the time TCI took its campaign to elect directors public, it was too late for executives at the railroad operator to do a thorough job defending their incumbent board.
Browse other Special Report stories: Legal trends in M&A
It appears TCI's strategy worked: The railroad has conceded that the activist was victorious in electing four of its five candidates to the company's 12-person-board (although a court could overturn two of those). But now, a backlash has been taking shape against these hidden stakes. Taking a lesson from the campaign against CSX, corporate executives have been launching pre-emptive strikes on activist investors who sneak up on businesses by ownership of a mix of swaps and real stocks. Monsanto Co., Pfizer Inc., Coach Inc., Sara Lee Corp. and Kimco Realty Corp. are among more than 50 companies that have changed their corporate "advance-notice bylaws." They now require that investors seeking to nominate director candidates disclose their full economic interest in the company -- not just share ownership. That includes data about short positions, synthetic swap securities, borrowed shares and any other economic stakes they have in the company or related corporations. For example, activist investors sometimes buy the voting rights in the business seeking to purchase the corporation they are pressing to be sold. In this situation, the new bylaw provisions require activists to disclose their stakes in both target and acquirer. Most of the companies that have set up the bylaw provision don't expect to become the subject of an activist insurgency anytime soon. But, they argue, better safe than sorry. "We believe that bylaws requiring disclosure of hedging activities benefit all stockholders by providing insight into the motives behind a given proposal," says Coach general counsel Todd Kahn. Charles Elson, director of the John L. Weinberg Center for Corporate Governance at the University of Delaware, says companies are finally catching up to activists who use swaps. "We are seeing corporations collectively saying, 'You can fool me once, but you can't fool me twice,' " Elson says. "These economic stakes are a material fact that needs to be disclosed." Elson says he wouldn't be surprised if more than half of all U.S. corporations have the provision in place in time for the 2009 proxy season next March. Already, governance attorneys are spreading the word. A. Gilchrist Sparks III, a partner at Morris, Nichols, Arsht & Tunnell LLP in Wilmington, Del., spoke about the bylaw change in June to an audience of hundreds of securities attorneys at the Society of Governance Professionals in Boca Raton, Fla. Jim Hanks Jr., a partner at Venable LLP in Baltimore, says he expects many corporations will adopt the additional wording by next year and that companies will find it useful to discover additional details about a particular activist's investment strategy at their business. So far, none of the companies with the bylaws have been the recipient of an activist campaign. While Hanks says the language of his hedging disclosure provision will create greater transparency, he doesn't believe it will discourage activists from using swaps. Hanks began contemplating the concept of the bylaw amendment in 2006, and shortly after that Venable began to recommend requiring hedging disclosures to its corporate clients. Some early adopters included Glimcher Realty Trust and a series of Cohen & Steers Inc. funds in December 2007. "It occurred to me that it would be useful for boards receiving investor director nominations to know whether the shareholder proponent's interests in the company were aligned with the other investors," Hanks says. "One way of getting this information was to require a shareholder proponent of a nonmanagement nominee or other proposal to disclose the extent to which that fund was hedged in the company." Two lawsuits have raised the visibility of the swap issue. Hanks argues that a June 11 order by U.S. District Court Judge Lewis Kaplan in New York penalizing TCI for using cash-settled equity swaps to get around SEC disclosure rules sent a clear message to companies. "It certainly raised the visibility of the entire swap disclosure issue," Hanks says. But David Katz, a Wachtell, Lipton, Rosen & Katz partner, says he believes a March 13 Delaware Supreme Court ruling in Jana Master Fund Ltd. v. Cnet Networks Inc. had a more significant impact on companies installing the new provisions. In the Cnet Networks Inc. case, the court ruled that shareholders nominating directors on their own corporate proxy cards need not give a corporate board notice of their intent to nominate directors at an annual meeting. Rather, only shareholders making proposals on corporate proxy cards must comply with this so-called advance notice clause set up in corporate bylaws. In response, corporations have been building new provisions clarifying their rules by saying that investors must give advance notice whether or not they want to use the company proxy card or their own ballots to nominate directors. While making those changes, Katz says, a number of corporations are also adding the swap-related advance-notice provisions. "I think Cnet was a wakeup call to some," Katz says. But David Brown, partner at Alston & Bird LLP, argues that even with these new disclosure requirements, activist investors will be able to escape reporting requirements when investing in derivatives. "The bylaw is a snapshot," Brown says. "The activist could make changes and start investing in swap or borrowing positions after submitting the advance-notice bylaw to the company." Brown recommends that bylaws should require activists launching proxy contests to submit follow-up notices if they make substantial changes to their investments in derivatives or equities. Based on the existing language, corporate boards that identify noncompliant activist investors can hold the insurgent's nominee ineligible for election. Brown says that seeking to change a director election once it has taken place is trickier. Executives can file a lawsuit only if after the meeting they realize the shareholder didn't provide sufficient disclosure. So companies are taking additional initiatives to make sure they quickly are aware of their opponent's full investment strategy. One tactic involves working with stock surveillance programs. Thomson Reuters plc, for example, offers a program for client corporations that monitor trading activity, including investments in synthetic swap securities. "We illuminate the impact of derivative trading through the settlement process," says Frank Scaturro, managing director of corporate advisory services at Thomson Reuters. Scatorro says Thomson Reuters can not only help corporations locate activist investors early on, but the service also helps executives get a handle on how many other investors are likely to support their campaign for change. "We can help a board identify all the investments, equity and synthetic, of an activist investor as soon as they purchase their stake," Scatorro says. Even with the help of a stock surveillance program, companies say they need more time to do thorough due diligence of a particular activist. Wachtell's Katz says he believes advance-notice bylaws should require investors submitting director candidates to do so between 120 and 90 days before the meeting so that executives there have adequate time to review all the information and petition other shareholders with a response. Elson argues that 90 days before the meeting is sufficient notice for companies to prepare. "Activists would file suit at companies that set up advance-notice bylaws significantly longer than 90 days," says Elson. "Four months is a long time. Investors need some flexibility as well." In addition to altering their bylaws, some companies are amending their anti-takeover provisions, or poison pills, to dissuade potentially hostile shareholders from using derivatives or swaps to ambush the company. Poison pills, first adopted in the 1980s, sought to prevent a potentially hostile party from accumulating more than a certain number of shares in the company, usually 15%. If a shareholder crosses that threshold, the company has the right to issue low-cost stock to every other shareholder, thus diluting the aggressor's stake. Micrel Inc., a San Jose, Calif., analog chipmaker, recently broadened its definition of "beneficial ownership" for the purpose of triggering its pill, also known as a shareholder rights plan, to consider cash-settled equity swaps along with physical equity toward its 15% limit. Katz says he believes that in the right situations this change of definition could be appropriate, but he also expressed some concern about the drafting of these pills. One concern, he says, is that passive investors using swaps with no activist intentions at the company, nor any equity position, could find themselves tripping up the pill. "There could be some unintended consequences here," Katz says. Will all of this take the element of surprise away from activists? Jeremy Jennings-Mares, a partner at Morrison & Foerster LLP in London, argues that some activist shareholders will discover other mechanisms to stay in the shadows. "There are some activists who believe anonymity is so important that they will find some clever way to achieve that by use of one or more other instruments," he says. Comments |
On Oct. 16, 2007, the Children's Investment Fund Management (UK) LLP sent a letter to CSX Corp. detailing that it 
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