August 18, 2011
Practice Group(s):
Corporate
Corporate
Governance
Mergers &
Acquisitions
Securities
Enforcement
Revisiting Poison Pills after Second
Circuit’s CSX Decision
The U.S. Court of Appeals for the Second Circuit recently issued its long-awaited opinion in CSX
Corporation v. The Children’s Investment Fund Management (UK) LLP, et al.[1] The case
involves two important disclosure issues under Section 13(d) of the Securities Exchange Act of
1934, each having significant implications for corporate control contests. The first issue relates to
whether the securities underlying certain derivative positions, or “synthetic securities,” are
“beneficially owned” by the long party (in this case, an investor seeking to influence control of a
company). The other issue is whether and when investors “acting in concert” become tantamount
to a “group” for Section 13(d) reporting purposes. Based on the court’s decision in the case,
public companies should consider several issues in connection with their takeover defense
planning, including the following:
1. A company generally should not expect to receive prompt information about significant
accumulations of its stock under Section 13(d)’s reporting requirements with respect to
acquisitions of synthetic securities and investors acting in concert.
2. A company should consider whether the terms of its shareholder rights plan (commonly
referred to as a “poison pill”) address accumulations of synthetic securities or investors
acting in concert because these tactics can be used to evade the triggering threshold in a
traditional poison pill, thereby eliminating or significantly diminishing the effectiveness
of the pill.
3. A company that has determined to put a poison pill “on the shelf” should consider
whether it should now formally adopt a poison pill to provide a more effective defense
against these tactics.
Citing disagreement among the judges, the CSX majority opinion declined to resolve the
“beneficial ownership” issue in the case—specifically, whether the long party to a cash-settled
[2]
total-return swap (“TRS”) should be deemed the beneficial owner of any underlying shares
[1]
CSX Corp. v. The Children’s Inv. Fund Mgmt. (UK) LLP, et. al, Docket Nos. 08-2899-cv (L), 08-3016-cv (XAP) (2d Cir.
July 18, 2011).
[2]
A derivative agreement is a contract that gives a party economic exposure to a referenced asset, such as a company’s
stock, without actually buying or taking title to the asset. A cash-settled total-return equity swap is a derivative agreement
in which the “long party” agrees to pay the “short party,” generally a bank, (1) interest on the dollar amount the long party
would have been required to borrow to purchase a referenced number of shares of a company’s stock, plus (2) an amount
required to cover any losses in the market value of such shares over the term of the swap. In exchange, the short party
agrees to pay the long party (A) an amount equal to any gains in the market value of the specified shares, plus (B)
dividends and other income paid on the shares. Thus, the long party receives a financial return equal to what it would
have received if it borrowed money to purchase the shares and the short party receives a return equal to what it would
have received if it sold the shares short and loaned the proceeds. Neither party is required to actually purchase or take
title to the underlying shares, but it is common industry practice for the short party to purchase the underlying shares as
hedge against its short position. Upon termination of a TRS, the short party generally sells the shares on the open market
or may agree to deliver them in kind to the long party. Consequently, a long party that is contemplating a tender offer or
corporate control contest, may be able to opportunistically time the unwinding of the swaps and have the practical ability
(although not the legal right) to quickly acquire the underlying hedge shares, either directly from the short party or on the
open market. In some cases, the short party may also have a business incentive (i.e., the long party is a client) to vote
Revisiting Poison Pills after Second Circuit’s CSX Decision
acquired by the short party as a hedge. The majority also remanded the “group” formation issue
for further consideration. Until these issues are sufficiently resolved by the courts or additional
SEC rulemaking (which is under consideration, but has not been proposed), companies will
remain vulnerable to takeover tactics involving the use of TRSs to quietly acquire influential
ownership stakes and to investors acting in concert without the need to publicly disclose their
concerted actions and aggregate accumulations. Consequently, the decision—or lack of
decision—in CSX underscores the need for companies to consider whether these threats should be
proactively addressed through defensive measures, including an appropriately crafted poison pill.
The CSX Facts
The Children’s Investment Fund Management (“TCI”), a hedge fund, concluded in mid-2006 that
CSX Corporation (“CSX”), one of the nation’s largest railroads, was undervalued and could
benefit from changes in corporate policy and possibly management. As a result, TCI
implemented a plan to acquire a large economic interest in CSX shares through TRSs while
actively pressing CSX to make corporate governance changes. Throughout 2007, TCI also had
various discussions with other hedge funds about CSX and proposed a leveraged buyout of CSX.
It also began preparations for a potential proxy contest.
By March 2007, TCI had amassed TRSs with respect to about 14.1% of CSX stock, and had
informed CSX management on several occasions that the swaps could be immediately converted
to actual, or “physical,” shares with voting rights. TCI was the long party to these swaps and
divided them among eight different short counterparties, primarily banks, to prevent the banks
from acquiring “beneficial ownership” of more than 5% of CSX’s shares and having to disclose
the swaps under Section 13(d).[3] The TRS agreements did not require the banks to purchase CSX
shares as a hedge against their short positions or give TCI any legal rights to vote or direct the
banks how to vote any underlying CSX shares purchased by the banks as a hedge. The banks,
however, did in fact purchase CSX shares to hedge their short positions, and TCI anticipated that
it would, as a practical matter, be able to acquire those shares when it decided to unwind the
swaps, either directly from the banks or on the open market. Additionally, some of the banks
were chosen by TCI because it believed it would be able to influence how they would vote their
hedge shares in a potential proxy fight with CSX.
In late 2006, 3G Capital (“3G”), another hedge fund with close relationships to TCI, also began to
take an interest in CSX. Between January and December 2007, 3G communicated with TCI on
numerous occasions regarding CSX and also began to accumulate a position in CSX shares, both
directly and through TRS agreements. In all, 3G purchased outright 4.1% of the outstanding
shares of CSX and entered into TRS agreements with respect to 0.8% of the shares outstanding.
This gave 3G exposure to 4.9 percent of the outstanding shares of CSX, just under the 5%
disclosure threshold for purposes of Section 13(d).
In October 2007, TCI and 3G both began searching for director nominees for a potential proxy
contest. TCI and 3G entered into nominee agreements with three potential directors on December
the hedge shares held by it as directed by the long party.
[3]
The purpose of Section 13(d) of the Exchange Act is to provide for disclosure alerting the markets and shareholders of
large accumulations of securities that might result in a change of control of a company. Section 13(d) generally requires
an investor to make various disclosures regarding its holdings through a Schedule 13D filing within ten days after
acquiring beneficial ownership of more than 5% of a registered class of a company’s shares. In general, Rule 13d-3
provides that a “beneficial owner” of a security includes any person who, directly or indirectly, has or shares the power to
(1) vote or direct the voting of such shares or (2) invest or direct the investment of such shares.
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Revisiting Poison Pills after Second Circuit’s CSX Decision
10, 2007 and filed a Schedule 13D nine days later. The Schedule 13D disclosed the formation of
a “group” under Section 13(d) and the group’s intent to conduct a proxy solicitation.
On January 8, 2008, the group notified the company of its intent to conduct a proxy contest to
elect a minority slate of directors to CSX’s board and approve a proposal to permit investors
holding over 15% of CSX shares to call special meetings.
The District Court Litigation
In March 2008, shortly after TCI and 3G filed their proxy statement, CSX filed suit in the
Southern District of New York alleging, among other things, that (1) TCI violated Section 13(d)
by failing to disclose its beneficial ownership of the CSX shares held by the banks as a hedge
under the TRSs, and (2) TCI and 3G violated Section 13(d) by failing to file a timely Schedule
13D disclosing the formation of a “group.”[4] CSX also sought to enjoin TCI and 3G from voting
their CSX shares at the 2008 annual meeting of stockholders.
With respect to the “beneficial ownership” claim, the District Court held that TCI was the
“deemed beneficial owner” of the referenced shares because it used the TRSs as part of a “plan or
scheme to evade” the disclosure requirements of Section 13(d). The District Court concluded,
based on the specific facts of the case, that TCI entered into the swaps with the purpose of
avoiding disclosure under Section 13(d).
The District Court also held that TCI and 3G violated Section 13(d) by not timely reporting the
formation of a “group.” In so holding, the District Court cited circumstantial evidence of
“concerted action” by the parties beginning no later than February 13, 2007, including the
existing relationship between TCI and 3G, various communications regarding CSX shares, and
parallel investing patterns following meetings between TCI and 3G.
Failing to find a threat of irreparable injury, the District Court concluded that it was “foreclosed”
under controlling Second Circuit precedent from enjoining TCI and 3G from voting the CSX
shares acquired by them while in violation of Section 13(d).
The Second Circuit Decision
As previously noted, the Second Circuit’s majority opinion declined to address the key issue of
whether TCI, as the long party to the TRSs, should have been considered the “beneficial owner”
of the CSX shares acquired by the short parties as hedges. In so doing, the majority noted that the
panel was “divided on numerous issues” regarding the question of beneficial ownership. In a
separate 51-page concurring opinion, however, Judge Winter expressed in detail his view that
TRSs should not, absent an agreement or understanding among the parties about acquiring or
voting the underlying shares, “render the long party a ‘beneficial owner’ of such shares with a
potential disclosure obligation under Section 13(d).” Judge Winter also noted that (1) at the time
of the District Court decision, the Commodity Futures Modernization Act of 2000 “not only
exempted security-based swaps from the securities law definition of a regulable ‘security’ but
also ‘prohibited’ the SEC from regulating security-based swaps...” and, (2) although the DoddFrank Wall Street Reform and Consumer Protection Act now provides the SEC with limited
rulemaking authority for security-based swaps, it also provides that, absent the exercise of such
[4]
Under Exchange Act Rule 13d-5(b)(1), the disclosure requirements of Section 13(d) apply to the combined holdings of
any “group” of two or more persons who “agree to act together for the purpose of acquiring, holding, voting or disposing of
equity securities of an issuer.”
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Revisiting Poison Pills after Second Circuit’s CSX Decision
authority by the SEC (which it has not exercised), TRSs should not be deemed to confer
beneficial ownership under Section 13(d).
On the “group” formation issue, the Second Circuit concluded that the District Court’s findings
were insufficient to permit appellate review and remanded the case for a “precise finding” of
whether a group existed. The majority noted that “even if the parties’ ‘activities’ were the result
of group action,” the existence of a group for purposes of Section 13(d) requires a finding of
whether a group was formed for the purpose of “acquiring, holding, voting or disposing” of a
company’s shares.
The Second Circuit affirmed the District Court’s holding that it could not “sterilize” the CSX
shares held by TCI and 3G because, even if their disclosures were untimely under Section 13(d),
the other shareholders of CSX received appropriate disclosure in time to cast informed votes at
the 2008 annual meeting.
On August 17, 2011, after the Second Circuit’s ruling, CSX voluntarily dismissed its lawsuit.
Implications for Poison Pills
The facts in the CSX case demonstrate how, in a hostile takeover attempt or corporate control
contest, the use of TRSs and investors acting in concert can pose a significant threat to corporate
control. Before the Second Circuit’s decision in CSX, some commentators suggested that the
District Court’s decision may diminish the risks to public companies from these tactics, either
because the standard formulation of “beneficial ownership” may cover them or the District
Court’s decision might lead to a more conservative approach to disclosure under Section 13(d).
Instead, however, the Second Circuit’s declining to rule on the TRS issue, Judge Winter’s
detailed rejection of the District Court’s holding on TRSs, and the court’s remand on the “group”
formation issue clearly indicate continuing vulnerability of public companies to these tactics.
Moreover, given the recent volatility in the markets and resulting share price declines, many
companies remain especially vulnerable to these threats and should consider appropriate
defensive measures, including an appropriately crafted poison pill.[5]
A number of companies have formally adopted poison pills, although many of these pills may not
specifically address the quiet (i.e., undisclosed under Section 13(d)) acquisition of an interest in a
company’s securities through TRSs or other derivative instruments or investors acting in concert.
The definition of “beneficial ownership” in a typical poison pill can generally be modified on a
relatively straightforward basis to address both TRSs and investors acting in concert, although
any modifications to a pill deemed to be a material adverse change by Institutional Shareholder
Services (“ISS”) may implicate its guidelines described below. Many other companies have not
adopted poison pills but have them “on the shelf” ready for adoption. The reluctance to formally
adopt a poison pill and rely instead on putting it on the shelf is frequently attributable to concerns
about shareholder activists and proxy-advisory firms, such as ISS, which have taken positions
against poison pills that do not meet certain requirements.[6] One principal ISS requirement, for
example, is that a poison pill should not have a term of 12 months or more without shareholder
approval.
[5]
The Delaware courts have issued a number of decisions upholding the validity of poison pills in various contexts. For
one such recent decision, see our Legal Insight entitled “The Delaware Chancery Court Upholds ‘Poison Pill’ Defense
Based on Price Inadequacy in Air Products and Chemicals, Inc. v. Airgas, Inc.”
[6]
Institutional Shareholder Services Inc. 2011 U.S. Proxy Voting Guidelines Summary, updated January 27, 2011
(http://www.issgovernance.com/files/ISS2011USPolicySummaryGuidelines20110127.pdf).
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Revisiting Poison Pills after Second Circuit’s CSX Decision
Public companies with a poison pill “on the shelf” might consider whether to formally adopt a pill
if the board of directors believes that the company is particularly vulnerable to an unwarranted
takeover attempt and that TRSs and acting in concert tactics pose a significant threat. The need to
formally adopt a poison pill, which is the most effective way to counter these tactics, would need
to be weighed against the concerns of institutional shareholders and proxy-advisory firms,
including the potential that they will recommend withhold/against votes for directors adopting
any poison pill that does not comply with their guidelines.
Lastly, many public companies with poison pills should also ensure that their current directors are
familiar with their pills and their related fiduciary duties because the directors’ review and action
regarding the pills may have taken place several years ago.
Conclusion
Given the uncertainties created by the CSX decision and the unlikelihood of a sufficient resolution
in the foreseeable future, companies will remain vulnerable to takeover tactics involving the quiet
acquisition of influential ownership stakes through TRSs and investors acting in a concerted
manner without the need to publicly disclose their coordinated actions and aggregate
accumulations. Accordingly, companies and their boards of directors should consider whether
these threats should be proactively addressed through defensive measures, including an
appropriately crafted poison pill.
Authors:
Michael J. Denny
mike.denny@klgates.com
+1.704.331.7488
Stephen K. Rhyne
steve.rhyne@klgates.com
+1.704.331.7441
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