Activists hope swaps stay stealthy
Jun 06, 2008
SEC sides against CSX in proxy fight court case
NEW YORK -- Hedge fund activists are worried they could lose the element of surprise if so-called stealth swaps become subject to disclosure rules. A court case prompted by a proxy fight produced a letter from the SEC yesterday and blasted the controversial issue wide open.
At issue are cash-settled equity swaps, a type of derivatives contract that gives investors economic exposure without having to own the underlying stock. A 5 percent equity stake normally triggers a Schedule 13D filing by the investor, which is an early warning to corporate management. But swaps don’t require disclosure because they don’t come with voting rights. Or do they?
The controversy arose around a boardroom fight at CSX Corp, a railroad company, waged by the Children’s Investment Fund (TCI) and 3G Capital Partners. The hedge funds declared a beneficial stake of 8 percent in December 2007 and launched a proxy fight. But they also revealed an 11 percent economic stake that they had been accumulating through swaps since October 2006. CSX says the hedge funds should have disclosed their interest much sooner. It wants the court to block the hedge funds’ board slate, bar them from voting some of their shares and force them to sell part of their stake. A decision in the case was expected this week, but the SEC’s letter to the judge is likely to delay it.
Who decides how to vote?
Any company worried about activists or entering a proxy contest needs to watch this issue, says Paul Schulman, executive managing director of the Altman Group, a proxy solicitor. ‘The question is who has the voting rights,’ he says. ‘A hedge fund with equity swaps doesn’t have the voting rights, but the natural inclination of the bank holding the underlying shares may be to vote with its client.’
Other times, says David Miranda, vice president of business development at Ipreo and a former NYSE specialist, the bank may not vote the shares at all. But just by abstaining it may help the activist shareholder and hurt management.
The SEC’s response, hastily issued by the division of corporation finance instead of the commissioners, sides against CSX. The letter from Brian Breheny, the division’s deputy director, says the swaps held by the hedge funds were not ‘sufficient to create beneficial ownership,’ which would have had to be disclosed.
Breheny acknowledges in his letter that the banks holding the underlying shares may vote with their hedge fund clients. ‘In our view, the conclusion is not changed by the presence of economic or business incentives that the counterparty may have to vote the shares as the other party wishes.’
Wall Street is also behind the hedge fund activists in this case. The International Swaps and Derivative Association and the Securities Industry and Financial Markets Association filed an amicus brief saying if swaps were included in beneficial ownership rules, it would ‘chill’ an important part of the market. Hedge funds are worried they’ll get bogged down in paperwork if they have to disclose swaps activity.
FSA to decide on CFDs
Cash-settled swaps are popular among many hedge funds, not just activists. Peter Juhng from Ilios Partners, a market intelligence firm, says they’re used for all kinds of reasons but especially to get exposure to dividend-paying companies because of tax incentives. ‘We have been paying attention to swaps for a long time. Hedge funds with swaps would tell our clients they owned their shares even though they didn’t appear on 13Fs,’ Juhng says.
Swaps are also used in complex hedging strategies, and sometimes for very short periods of time. Wall Street worries the growing swaps market will grind to a halt if every transaction has to be disclosed. But Juhng says a swaps stake of more than 5 percent is rare outside the world of activists, so making swaps subject to 13D disclosure shouldn’t be too burdensome.
Identifying the parties in stealth swaps is typically difficult for stock surveillance firms due to the lack of settlement information, and only a rules change would make them visible to issuers. But Miranda points out that the judge’s decision in the CSX case probably won’t change much. ‘It won’t be earth-shattering. It’s going to have to go to SEC and maybe Congress,’ he says.
The SEC was already on the case before it was pressed about the CSX case. In April Michele Anderson was appointed as the SEC’s new head of mergers and acquisitions, and 13D disclosure of swaps is said to be high on her to-do list.
The SEC may be influenced by the UK’s FSA when it rules on contracts for difference (CFDs), which are basically cash-settled swaps. The FSA floated two proposals in November 2007. The cheaper, more popular option would require disclosure of CFDs amounting to a stake of 3 percent or more, but only when the investor could exercise the voting rights or sell the underlying shares. The other possibility is to require investors to disclose CFDs representing an economic interest of 5 percent or more, no matter what the holder’s intentions. A decision is expected this month.
The CSX proxy fight itself will be debated in a special RiskMetrics governance forum on Monday, June 9. Representatives of CSX, TCI and 3G will participate in the webcast.
By Neil Stewart