Corporate Governance

Beneficial Ownership, Equity Swaps, and Proxy Contests: CSX v. The Children's Investment Fund (Part 10)

By J. Robert Brown

We are addressing the ongoing litigation between CSX, the railroad company, and a number of hedge funds, including The Children's Investment Fund (TCI) and 3G Capital Partners. The case revolves around the obligation of the Funds to disclose certain equity swaps involving shares of CSX.  The Funds have launched a proxy contest, with the annual meeting scheduled for June 25.  The district court issued an opinion in the case on June 9.  The opinion is posted on the DU Corporate Governance web site.  

The case is full if interesting tidbits of information.  One of them concerned the concern over the financial solvency of investment banking firms.  TCI originally entered into equity swap agreements with seven different banks and investment banks, including Citigroup, Credit Suisse, Deutsche Bank, Goldman, Merill, Morgan Stanley and UBS.  Ultimately, TCI abandoned the investment banks.  As the Fund describes on page 22 of its Post Trial Brief:

• During the latter half of 2007, TCI became increasingly concerned with the stability of investment banks as a result of the U.S. financial industry credit crisis.  Initially, during the summer of 2007 TCI sought parent company guarantees from its counterparties in the event of insolvency.  Later, beginning on November 12, 2007, TCI reduced its credit exposure to certain investment banks by terminating its Total Return Swaps with certain 'broker-dealer' counterparties and entering into Total Return Swaps with coutnerparites whose credit was backed by central banks, specifically Deutsche Bank and Citigroup.  The move was part of a fiirm-wide move of nearly all swaps to commercial banks.

Whatever other motivations might have existed for the consolidation, at least one of them was concern over the solvency of the counterparty. 

This is consistent with the view taken in my article, The "Great Fall":  The Consequences of Repealing the Glass Steagall Act, that the end of the separation between investment and commercial banking would eventually spell the demise of independent investment banking firms.  In this down cycle of the economy, Bear Stearns has already been acquired by JP Morgan.  Merill Lynch considered selling itself to Wachovia.  Commercial banks have inherent advantages that, over time, will result in their control of the investment banking business.  This was the case before the adoption of Glass Steagall in the 1930s and will be the case now that Glass Steagall has been repealed. 

This is illustrated by the facts in the CSX case.  In times of economic uncertainty, the hedge funds opted to do business with financial institutions supported by central banks.  The support provided greater assurance of financial stability.

Perhaps the domination of investment banking (and capital raising) by commercial banks will not be harmful to the US capital markets.  On the other hand, it may well.  Commercial banks have conflicts of interest (often preferring lending relationships to the sale of capital) and are arguably more conservative when it comes to capital raising decisions.  Independent investment banking firms do not operate under the same limitations. 

The committees studying the competitiveness of the US capital markets should perhaps consider these structural changes to the market and their long term effects.  Don't count on it.  It would mean the possibility of additional federal regulation and that, philosophically, is not on the agenda of most of these committees. 

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 17, 2008 (boomark / email).