When Children's Investment Fund Management LLP launched its activist campaign to seize board seats and make operational changes at railroad operator CSX Corp. last year, it seemed nothing more than a hedge fund's attempt to challenge management, common in today's securities markets.
But after a congressional hearing and a litigation battle instigated by CSX in New York, this tête-à-tête may have an unexpectedly far-reaching impact on the strategies hedge funds use to shake up companies.
Judge Lewis Kaplan of the District Court for the Southern District of New York ruled on June 11 that TCI violated securities laws by using so-called cash-settled equity swaps to get around Securities and Exchange Commission disclosure rules.
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TCI and other activist fund managers have been using swaps, which
are synthetic or virtual shares, to hike their stake in a target
company without crossing the SEC's disclosure threshold. The swaps are
thought to provide activists with influence over how counterparties
vote physical shares.
The agency, so far, only requires investors to make a disclosure by
submitting a Schedule 13D filing when they own 5% or more of the equity
of a stock. TCI employed a mix of swaps representing an 11% stake while
keeping its physical equity shares below 5%, in part to avoid 13D
disclosure and sneak up on CSX. Other activist fund managers have used
the strategy as well. Executives facing these strategies often don't
know how great is their opponents' voting leverage or economic
incentive to fight until it's too late to mount effective resistance.
CSX is appealing the decision because Kaplan left it to the SEC to
decide a penalty and the company wants the court to "sterilize" or
disqualify TCI's shares. That victory may be temporary but when it
comes to future attempts to use swaps surprises, the damage to activist
investors is already set. According to David Sirignano, partner at Morgan, Lewis & Bockius LLP,
the District Court's sanction is discouraging other fund managers from
swaps funny business. Sirignano says he expects some activist investors
to make "protective" 13D disclosures if the combination of their swaps
and stakes equals 5%, even though it's unclear now whether the court
ruling requires them to. "Since most activists that use swaps do
business in New York, they would follow the court's message," Sirignano
says.
The court proceeding is also putting pressure on the SEC to expedite
deliberations over possible changes to swaps rules. As one SEC staffer
put it, CSX's lawsuit took swaps off the back burner. The commission
may soon propose requiring activist fund managers to treat synthetic
shares used in swaps as equivalent to real shares for the purpose of
13D disclosure. The agency has been considering this possibility for a
while but so far hasn't shown where it wants to go. The commission may
temper the rules to target only insurgent hedge fund managers by
requiring disclosure of a swaps and equities mix above 5% only when the
investor is mounting an activist campaign against a company. Passive
investors, who typically file Schedule 13Gs when reporting a 5% stake,
would not need to make early swap disclosures. The agency could also
draft rules permitting other shareholders to bring 13D suits against
activist investors, but legislation may be required in this case. So
far, only corporations have been permitted to file lawsuits.
The agency may also bring an enforcement case against TCI. That
would further discourage use of synthetic shares for disguised
investments.
New transparency will give corporations a better chance, earlier on,
of responding to activists and getting other institutional investors to
back their candidates rather than the opponent's slate.
So while TCI appears to have won its contest at CSX -- the fund
reports that four of its five candidates have been elected -- its
strategy may be headed for extinction. For that, public corporations
everywhere can thank CSX.
Ron Orol covers activist investing for The Deal.
