Appellate Court Decides CSX Total Return Swap Case


On July 18th, the U.S. Court of Appeals for the Second Circuit (the “Second Circuit”) issued its long-awaited opinion in CSX Corporation v. The Children’s Investment Fund Management (UK) LLP, et. al.[1] The issue that made the case so closely-monitored by derivatives market participants was whether, and under what certain circumstances, a total return receiver (i.e., the “long” party) under a cash-settled total return equity swap should be deemed to be the “beneficial owner,” for purposes of Section 13(d) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”),[2] of the underlying shares its counterparty (i.e., the “short” party) purchases to hedge its position.

CSX Corp. (“CSX”) had attempted to enjoin two hedge funds (collectively, the “Funds”) from voting their shares in a proxy contest to elect certain candidates to its board of directors. CSX claimed that the Funds acted together as a “group” and should have been deemed to have beneficially owned, in the aggregate, more than 5% of CSX’s stock, both outright and as long parties to cash-settled total return equity swaps with various banks. As such, the Funds should have disclosed that they had formed a “group” that owned more than 5% of CSX’s shares, as required by the Exchange Act. The U.S. District Court for the Southern District of New York (the “District Court”) concluded that: (i) the Funds failed timely to disclose that they had formed a “group” (based on evidence that the Funds communicated regarding their efforts to exert control over CSX and taking “concerted action”); and (ii) one of the Funds failed timely to disclose that it was the beneficial owner of more than 5% of CSX’s shares (based on evidence that it had violated Rule 13d-3(b) under the Exchange Act by engaging in a “plan or scheme” to evade Section 13(d) disclosure requirements).[3] However, the District Court did not conclude definitively that the Funds, as long parties to the equity swaps, obtained beneficial ownership in the shares acquired by their counterparties as hedges. The District Court also refused to enjoin the Funds from voting their shares because they had disclosed their share ownership for a sufficient period of time prior to the vote.

The Second Circuit only considered the issues concerning a “group” violation of Section 13(d)(3) with respect to the CSX shares owned outright by the Funds, without regard to any beneficial ownership they might have acquired as long parties to the equity swaps. As to that issue, the Second Circuit remanded the case to the District Court to make findings as to whether the Funds specifically formed a “group” for the purpose of “acquiring, holding, voting or disposing” of CSX shares owned outright and, if so, the latest date by which such a group was formed. The Second Circuit found that “[o]nly if such a group’s outright ownership of CSX shares exceeded the 5 percent threshold prior to the filing of a section 13(d) disclosure can a group violation of section 13(d) be found.”

The Second Circuit also affirmed the District Court’s denial of the voting injunction sought by CSX. However, significantly for the derivatives market, the Second Circuit did not address the issues that “would require decision as to the circumstances under which parties to cash-settled total-return equity swap agreements must comply with the disclosure provisions of section 13(d),” noting that the panel was divided on numerous issues relating to the treatment of equity swaps.[4]

[1] 2011 WL 2750913 (2d Cir. July 18, 2011).

[2] Section 13(d) generally requires that a party acquiring, directly or indirectly, the beneficial ownership of more than 5% of certain classes of equity securities, within ten days of such acquisition, send to the issuer of the securities and to each exchange where the securities are traded, and file with the Securities and Exchange Commission (the “SEC”), a statement containing certain specified information and such additional information as the SEC may prescribe as necessary or appropriate in the public interest or for the protection of investors.

[3] See CSX Corp. v. The Children’s Inv. Fund Mgmt., 562 F. Supp. 2d 511 (S.D.N.Y. 2008).

[4] Nevertheless, in a concurring opinion, one member of the panel stated that:
any agreement or understanding between long and short swap parties regarding: (i) the purchase of shares by the short party as a hedge; (ii) the sale of such shares to the long party when the swaps are unwound (as in settled-in-kind equity swaps); or (iii) the voting of such shares purchased by the short party, would cause the shares purchased as a hedge and any shares owned by the long party to be aggregated and counted in determining the 5 percent trigger.

2011 WL 2750913, at *27 (Winter, J., concurring).