Securities — Are Equity Swaps Subject to Section 13(d) Reporting?

Download associated file: CSX Equity Swaps Opinion.pdf 

Equity swaps confer on their owner all of the financial attributes of share ownership but not the right to vote shares. It has been received wisdom on Wall Street that these swaps do not confer beneficial ownership and thus need not be reported on Schedule 13D even if the swap owner acquires substantially more than a 5% interest in the issuer. Judge Lewis A. Kaplan’s impressive opinion in CSX Corp. v. The Children’s Invest. Fund Mgmt. (UK) LLP, 2008 U.S. Dist. LEXIS 46039 (S.D.N.Y. June 11, 2008), is the first to address whether, as a matter of law, equity swaps confer beneficial and thus, once they exceed the 5% threshold, must be reported under Section 13(d) of the Securities Exchange Act of 1934, 15 U.S.C. § 78m(d). The opinion’s conclusion: swaps must be reported, on the facts before the CSX Court, not because they confer beneficial ownership (although they might), but because they confer the power to influence the voting of shares. Highlights of the opinion:

● There are several color charts appended to, and referred to in, the opinion but they are not available on LEXIS. A copy of the opinion, with the charts, is annexed above.

● The opinion turns not on the statutory text nor even the relevant SEC Rule but an interpretation of that rule.

● The relevant Sec Rule 13d-3(b), 17 C.F.R. § 240.13d-3(b), provides: “(b) Any person who, directly or indirectly, creates or uses a trust, proxy, power of attorney, pooling arrangement or any other contract, arrangement, or device with the purpose of [sic] effect of divesting such person of beneficial ownership of a security or preventing the vesting of such beneficial ownership as part of a plan or scheme to evade the reporting requirements of section 13(d) or (g) of the Act shall be deemed for purposes of such sections to be the beneficial owner of such security.”

● The dispositive interpretation of Rule 13d-3(b) on which the Court rests the opinion is Interpretive Release on Rules Applicable to Insider Reporting and Trading, Exchange Act Release No. 34-18114, 46 Fed. Reg. 48,147 (Oct. 1, 1981), which the Court emphasizes was designed “to ensure discovery ‘from all those persons who have the ability to change or influence control.’”

● “In the last analysis, there are substantial reasons for concluding that TCI is the beneficial owner of the CSX shares held as hedges by its short counterparties. The definition of ‘beneficial ownership’ in Rule 13d-3(a) is very broad, as is appropriate to its object of ensuring disclosure ‘from all . . . persons who have the ability [even] to . . . influence control.’ It does not confine itself to ‘the mere possession of the legal right to vote [or direct the acquisition or disposition of] securities,’ but looks instead to all of the facts and circumstances to identify situations in which one has even the ability to influence voting, purchase, or sale decisions of its counterparties by ‘legal, economic, or other[]’ means.” [All brackets in the original.]

• Because the defendants barred all discovery into attorney-client privileged communications, the Court barred a principal of one defendant from testifying that he relied on advice of counsel and, therefore, did not act in bad faith in inducing a 13(d) violation by the second defendant. “Having blocked discovery of the existence and nature of any legal advice it sought, Hohn will not now be heard to assert that his actions were consistent with the advice of counsel and therefore in good faith.” Citing E.G.L. Gem Lab Ltd. v. Gem Quality Inst., Inc., 90 F. Supp. 2d 277, 296 n.133 (S.D.N.Y. 2000), aff'd, 4 Fed. Appx. 81 (2d Cir. 2001) (affirming judgment and finding of bad faith); Trouble v. Wet-Seal, Inc., 179 F. Supp. 2d 291, 304 (S.D.N.Y. 2001) (party waives advice of counsel defense by failing to disclose intention to assert that defense during discovery); In re Buspirone Antitrust Litig., 208 F.R.D. 516, 521-24 (S.D.N.Y. 2002) (similar); In re Worldcom, Inc. Sec. Litig., No. 02 Civ. 3288 (DLC), 2005 WL 600019 (S.D.N.Y. Mar. 15, 2005) (denying leave to amend to assert advice of counsel defense given lack of notice during discovery); In re Worldcom, Inc. Sec. Litig., No. 02 Civ. 3288 (DLC), 2005 WL 627721 (S.D.N.Y. Mar. 16, 2005) (same); see Bilzerian, 926 F.2d at 1292.

• The Court also ruled that, even if the defense of advice of counsel had not been forfeited, the defendant failed to prove that the principal had provided all essential information to counsel to permit it to give an informed opinion on which reliance would be reasonable: “In any case, Hohn's attempt to rely on the advice of counsel is not convincing given that he has failed to offer evidence sufficient to permit the Court to find that TCI fully disclosed all material facts to counsel, that any failure to do so did not make Hohn's reliance unreasonable, and that Hohn and TCI conformed their actions in all respects to the advice they received. In fact, Hohn testified at his deposition that TCI did not even ask counsel whether it needed to disclose its swaps because it thought it already knew the answer.”

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