Beneficial Ownership, Equity Swaps, and Proxy Contests: CSX v. The Children's Investment Fund (Part 5)
In response to an invitation from the trial judge, a segment of the SEC staff filed a letter with the court setting out positions on the beneficial ownership issue. We turn to the legal analysis in the letter submitted by the Deputy Director of the Division of Corporation Finance.
One question asked by the judge was the following: "In light of these background market conditions, is it the SEC's view that an investor who acquires a long equity swap position thereby becomes the beneficial owner of the shares referenced in the swap, to the extent that the dealer had hedged with matched shares?"
The staff recast the question, noting that CSX argued that "regardless of whether the investment fund had any arrangement, understanding or relationship with any of the counterparty banks concerning voting power or investment power, the investment fund was the beneficial owner of the shares held by the counterparty banks because it had voting power and/or investment power over those shares by virtue of certain economic incentives." In response to that question, the staff of the Division of Corporation Finance disagreed.
As the staff opined:
- As a general matter, economic or business incentives, in contrast to some contract, arrangement, understanding, or relationship concerning voting power or investment power between the parties to an equity swap, are not sufficient to create beneficial ownership under Rule 13d-3.
The letter noted that the swaps did not actually confer voting or investment authority over the shares purchased by the counterparty as a hedge.
- In our view, the conclusion is not changed by the presence of economic or business incentives that the counterparty may have to vote the shares as the other party wishes or to dispose of the shares to the other party. While such incentives may exist, when the counterparty chooses to act in these circumstances where it is unconstrained by either legal rights held by the other party or by any understanding, arrangement, or restricting relationship by the other party, it is acting independently and in its own economic interests. The more reasonable interpretation of the terms "voting power" and "investment power" as used in the Rule, which are based on the concept of actual authority to vote or dispose or the authority "to direct" the voting or disposition, is that they are not satisfied merely by the presence of economic incentives.
The analysis is accurate as a general matter but lacks any kind of nuance. The separation between economic incentive and economic coercion can be a very fine line. What if the party to a swap makes it clear (in other words states it openly) that all future business with the swap dealer will be contingent upon the willingness of the counterparty to vote shares in the expected fashion? The step would be unilateral and not, therefore, an agreement. The counterparties would simply know the economic consequences of not voting accordingly.
Similarly, what if the party indicated a willingness to buy any shares purchased as a hedge upon termination of the swap arrangement at an above market price? Again, there would be no compulsion and the swap dealer would merely be acting in its economic self interest. Nonetheless, this type of arrangement would result in only one predictable outcome.
The position of the Division of Corporation Finance deals with none of these issues. Moreover, to the extent that the letter can be viewed as addressing only ordinary equity swaps, the equity swaps in this case were not ordinary. The size of the positions (over 10% of the shares of CSX) and the concentration (almost entirely in the hands of two commercial banks) alone suggest that there were likely economic incentives present that are not typical of all swaps.
First, the liquidation of a position of that size (at the time the swaps are terminated) could put downward pressure on share prices, imposing on the swap dealer market risk. To the extent the swap dealer can sell the entire position to one investor (the party to the swap), it avoids any of this risk. Second, with hedge positions that size, the commercial banks had greater incentive to want to act in a way that retained the business. Third, the likelihood that the shares would be purchased as the method of hedging was almost certain. It seems unlikely that the commercial banks would have found an alternative, cost effective, hedging method for a position that size other than actually purchasing the shares. As a result, the Funds would know that each time they increased their swap position with the commercial bank, there would be an attendant increase in the number of shares held by the commercial bank (and concomitant reduction when swaps were terminated).
Nothing in the letter addressed any of these more difficult issues. Moreover, to the extent they suggested that economic incentives were never enough to give rise to beneficial ownership, that was a hard to defend, dangerous, and to some degree inconsistent position to take. The parking cases essentially involved deals where brokers and others would accumulate shares on behalf of a third party in return for economic incentives. While there may have been agreements to that effect, there was nothing that stopped the brokers from selling to anyone else if the right set of economic inducements came along. In other words, they accumulated the positions because of the economic inducements.
The analysis of this issue in the letter from the Division of Corporation Finance was a disappointment. Fortunately, it is not entitled to legal deference.
Numerous documents filed in the case, including the complaint, various motions and legal memorandum, and an assortment of amicus briefs (including one from the Division of Corporation Finance at the SEC) and legal opinions, can be found at the DU Corporate Governance web site.