Takeover disclosures and cash settled derivatives

The New York District Court ruled earlier this week that the hedge fund TCI should have disclosed its cash settled derivatives (total return swaps) on CSX stock under the takeover rules of the US SEC (Rule 13d-3). Hitherto, it was believed that cash settled derivatives do not convey a “beneficial ownership of any equity security” as required by the statute. Rule 13d-3 defines the beneficial owner essentially as one who has or shares voting power and/or investment power over the security.

The New York District Court took a different line. Based largely on the expert report of Prof. Marty Subrahmanyam, the Court came to the conclusion that the only practical way for the swap counterparty to hedge its position was to buy the underlying stock. It also found that this was what they actually did:

But the evidence is overwhelming that these counterparties in fact hedged the short positions created by the TRSs with TCI by purchasing shares of CSX common stock. ... they did so on virtually a share-for-share basis and in each case on the day or the day following the commencement of each swap.

This is precisely what TCI contemplated and, indeed, intended. None of these counterparties is in the business, so far as running its swap desk is concerned, of taking on the stupendous risks entailed in holding unhedged short (or long) positions in significant percentages of the shares of listed companies. As a practical matter, the Court finds that their positions could not be hedged through the use of other derivatives. Thus, it was inevitable that they would hedge the TCI swaps by purchasing CSX shares.

The Court interpreted this as investment power. Moreover, it determined that TCI chose counterparties who were more likely to vote the shares in accordance with its wishes. The Court relied on the SEC position that “ability to control or influence the voting . . . of the securities” constitutes voting power.

The Court also referred to provisions in UK law based on economic interest rather than legal ownership and stated that “Yet there is no reason to believe that the sky has fallen, or is likely to fall, in London” as a result of such provisions.

Having come close to saying that cash settled derivatives meet the definition of beneficial ownership under Rule 13d-3(a), however, the Court refused to rule on this point at all, but proceeded to decide the case under Rule 13d-3(b) which deals with “contract, arrangement, or device ... as part of a plan or scheme to evade the reporting requirements”. The Court also allowed TCI to vote the stock after making the requisite disclosures.

The Deal Professor is of the view that everything now depends on how the the Second Circuit Court of Appeals deals with this case on appeal.

All this discussion is of great relevance in India because of the large cash settled single stock futures market in India. Indian law talks about acquisition of shares and voting rights. Shares “includes any security which would entitle the holder to receive shares with voting rights”, but this clearly does not cover cash settled derivatives. Another issue that comes to mind in the context of the US ruling is the issue of participatory notes as well as that of the non voting ADRs and GDRs issued by Indian companies.

Posted at 6:12 pm IST on Sat, 14 Jun 2008         permanent link

Comments