CSX/TCI Judgment – Some Thoughts on the SEBI Takeover Regulations

In a closely followed case, the U.S. District Court for the Southern District of New York issued its decision regarding the reporting requirements of a hedge fund (TCI) that had entered into “total return equity swaps” with counterparties in respect of the shares of CSX. Although TCI only entered into cash-settled swaps (without any obligations to obtain delivery of CSX’s shares), the counterparties to the swap in turn hedged their risks by acquiring shares of CSX. On the specific facts of the case, the court held that TCI should be treated as beneficially owning the shares under its cash-settled equity swaps under the anti-avoidance provisions of Rule 13d-3(b) of the Securities Exchange Act of 1934 and hence should have filed the requisite disclosures, which it failed to do so.

A memo by Gibson, Dunn & Crutcher LLP describes the gist of the transaction and the decision as follows:

“One of the main issues raised by the CSX case is whether, in calculating their beneficial ownership, investors are required to count shares in which they have an economic interest through swap or hedging transactions. In the CSX case, TCI held cash-settled “total return equity swaps” under which it obtained the economic risk of stock ownership, but no contractual rights in the underlying shares. While not contractually required under the swaps, the counterparty typically acquires some percentage or the full number of shares that are notionally covered by the swap.

The CSX ruling states that decisions by a person to enter into this type of swap arrangement or to terminate the swap can result in the counterparty buying or selling the shares that are notionally covered by the swap. The Court also stated that the counterparty may be likely to vote shares as its client would want in order to maintain a positive business relationship and to bolster the likelihood of obtaining business from the client in the future. …”

The relevant provisions of the Securities and Exchange Act Rules that the court relied on are as follows (as extracted from the Gibson Dunn memo):

Rule 13d-3(a):

For the purposes of sections 13(d) and 13(g) of the Act a beneficial owner of a security includes any person who, directly or indirectly, through any contract, arrangement, understanding, relationship, or otherwise has or shares: (1) Voting power which includes the power to vote, or to direct the voting of, such security; and/or, (2) Investment power which includes the power to dispose, or to direct the disposition of, such security.

Rule 13d-3(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.

While Rule 13d-3(a) deals with the question of beneficial ownership in securities for the purpose of disclosure, Rule 13d-3(b) is an anti-abuse provision that prevents the use of arrangements that avoid disclosure requirements. In this case, the court’s decision is largely based on an application of Rule 13d-3(b) to the facts of the case, whereby the court held that TCI shared voting or investment power over shares that its swap counterparties had purchased, on the theory that under the fact TCI had the ability to influence the counterparties’ actions. On this basis, it held that there was a failure by TCI to make appropriate disclosure of its shareholdings.

This decision could have some bearing on the interpretation of the relevant provisions of the SEBI Takeover Regulations (specifically Regulation 7 that provides for disclosures upon acquisition of shares or voting rights that exceed defined percentages). This applies to any person who is an acquirer (that is defined to include a ‘person acting in concert’). In an Indian situation, the primary question will relate to whether the hedge fund or other investor that enters into an equity swap arrangement (even if cash-settled) is said to be acting in concert with the counterparty who may acquire shares to hedge its own position under the swap. If they are indeed persons acting in concert, then the hedge fund or other investor’s shareholding (if any) will be aggregated with the shareholding of the counterparty thereby triggering disclosure requirements if the total shareholding exceeds the prescribed thresholds (e.g. 5%, 10%, 14%, 54% or 74%).

However, there are some key differences between the SEBI Takeover Regulations and the relevant provisions of the Securities Exchange Act Rules cited above. While the definition of ‘person acting in concert’ in Regulation 2(1)(e)(1) of the SEBI Takeover Regulations contains provisions on the same lines as Rule 13d-3(a), there is no anti-abuse provision (like Rule 13d-3(b)) in the SEBI Takeover Regulations. In Indian circumstances, in the absence of such an anti-abuse provision, for any such action to succeed under Indian circumstances, it would be necessary to show that the hedge fund and the counterparty had a ‘common objective or purpose of substantial acquisition or voting rights’, which may be a difficult proposition in a purely cash-settled option. Further, the Indian reporting requirements arise only when a person such as the hedge fund “acquires” shares or voting rights, while the anti-abuse provision imposes the obligation on a person who does not necessarily acquire shares or voting rights, but where such person has an ‘arrangement’ with any other person who has acquired shares (to evade the reporting requirements).

It is likely that the TCI/CSX case will go on appeal. But, it does provide some lessons on the manner in which similar situations are to be dealt with under the SEBI Takeover Regulation. At least, at a basic level, it provokes the debate on whether it is now time to include an anti-abuse provision (such as Rule 13d-3(b)) in the SEBI Takeover Regulations.