Corporate Governance

Beneficial Ownership, Equity Swaps, and Proxy Contests: CSX v. The Children's Investment Fund (Part 2)

By J. Robert Brown

How did this legal battle come about?

TCI began entering into equity swaps that referenced shares of CSX in October 2006, eventually providing "significant economic exposure to CSX"  Defendant's Post Trial Brief at 18.  This "economic exposure" was conveyed to CSX but management declined to "meet with TCI to discuss CSX's business, ostensibly because TCI was not a shareholder."  Id.  Thereafter, TCE begain acquiring shares.  In April and May of 2007, TCI purchased 4.1% of the shares of CSX.  TCI disclosed ownership of the shares in a Schedule 13F filed on May 15, 2007.  Id. at 21.  The shares were not purchased from swap counterparties.  Id. at 20. 

TCI ultimately consolidated 99% of the swap agreements in the hands of two commercial banks, Deutsche Bank and Citigroup (small positions were maintained in the other counterparties "in an effort to not allow other investors to identify where TCI's Total Return Swaps were held").  The reasons for doing so weren't entirely financial.  As the post-trial brief noted, "TCI was aware that Deutsche Bank's London-based proporiety hedge fund, Austin Friars, was invested in CSX."  Id. at 22.  Deutsche Bank, therefore, was in a position to support TCI, both with the hedged shares and the shares in its own hedge fund.  Diplomatically put, TCI:  

• hoped that if Austin Friars concluded that voting for the TCI/3G slate was in the economic best interest of Deutsche Bank and if the swaps desk was inclined to vote its CSX shares held as a hedge, it too would conclude that voting for the TCI/3G slate was in Deutsche Bank's best interests.

The Funds filed a Schedule 13D on December 19, 2007 disclosing that they had formed a group and had collectively acquired more than 8% of CSX or over 35 million shares.  In the all important Item 4 of the Schedule, the Funds disclosed efforts to alter the corporate governance structure of CSX.  As the Schedule noted:  

• After multiple unsuccessful attempts to engage the management or the Board in a constructive dialogue regarding the operations of the Issuer, on October 16, 2007, the TCI Reporting Persons delivered a letter to the Board setting forth numerous failings in the Issuer's operations, corporate governance and management, and asking the Board to take the following actions: separate the Chairman and CEO roles; refresh the Board with new independent directors; allow shareholders to call special shareholder meetings; align management compensation with shareholder interests; justify the capital spending plan to shareholders; and provide to shareholders a plan to improve operations.

A copy of the letter is here.  The Schedule further disclosed that the Funds intended "to propose nominees for election to the Board at the Issuer's 2008 Annual Meeting," with a formal notice of an intent to nominate directors submitted to the board on January 8, 2008.  The Funds also subsequently submitted a shareholder proposal that would allow shareholders with 15% or more of the voting shares to call a special meeting.  (The board did adopt a bylaw to allow shareholders some right to call a special meeting but included limitations unacceptable to the Funds).  

On March 10, the Funds filed a preliminary proxy statement seeking proxies for a minority of directors, five out of the twelve positions on the board.  The proxy (and the Schedule 13D filed in December) disclosed the swap arrangements with assorted counterparties.  As the proxy statement for the Funds described:    

• TCI currently has contractual agreements with eight credit counterparties: Citigroup Global Markets Limited, Deutsche Bank AG, Goldman Sachs International, Merrill Lynch International, UBS AG, Credit Suisse Securities (Europe) Limited, JP Morgan Chase Bank and Morgan Stanley & Co. International plc (f/k/a Morgan Stanley & Co. International Limited), with regard to cash-settled equity swaps (the "TCI Total Return Swaps") that reference Shares of CSX. The TCI Total Return Swaps constitute economic exposure equivalent to approximately 11.5% of the Shares. 

Similarly, with respect to 3G Capital, the Fund entered into equity swaps with Morgan Stanley International involving an "exposure  equivalent to approximately 0.8% of" CSX shares. The Funds noted that the arrangements did not give them "direct or indirect voting, investment or dispositive control over any securities of the Company and do not require the counterparties thereto to acquire, hold, vote or dispose of any securities of the Company."  As a result, both disclaimed beneficial ownership of the shares.  

What the proxy statement did not reveal was the concentration of positions.  While the proxy statement listed Deutsche Bank as a principal shareholder (with over 9% of the shares of CSX), the proxy statement did not reveal the concentration of swaps in the hands of Citigroup and Deutsche Bank.  Shareholders, therefore, were told that swaps arrangements were held by eight investment/commercial banks and that the total exposure was 11.5% of the voting shares of CSX but were not told in the proxy statement that 99% of the swaps were concentrated in the hands of two firms, Deutsche Bank and Citigroup.  Similar disclosure occurred in the Schedule 13D.

In the next post, we will examine the response by CSX.

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.

Full post as published by The Race to the Bottom on June 12, 2008 (boomark / email).