Hedge Funds Violate 13(d) in Amassing Positions But May Vote Their Shares

Activist hedge funds violated the Exchange Act in using equity swaps to amass a position in a target company, ruled a federal judge (SD NY), but their actions did not rise to the level of irreparable harm required to sterilize their shares. But the court did enjoin the hedge funds from further violations of Section 13(d) of the Act. Any additional penalties would have to come by way of an SEC action, noted the court. (CSX Corp. v. The Children’s Investment Fund Management (UK) LLP, et al, SD NY, June 11, 2008).

The hedge funds acted as a group without making the disclosure required of 5 per cent shareholders and groups by the Section 13(d), a statute enacted to ensure that other shareholders are informed of such accumulations and arrangements. They then launched a proxy fight that, if successful, would result in their having substantial influence and even practical working control of the company.

The equity swaps the hedge funds employed are a type of derivative that gave them the indicia of stock ownership but not the formal legal right to vote the shares. The court did not have to decide the general question of whether holders of equity swaps are the beneficial owners of the underlying stock. Rather, the court deemed the hedge funds to be beneficial owners of the stock by reference to SEC Rule 13d-3(b), which provides that one who creates an arrangement preventing the vesting of beneficial ownership as part of a plan to avoid the disclosure that would be required if the actor bought the stock outright is deemed beneficial owner of those shares. The Exchange Act is concerned with substance, said the court, not incantations and formalities.

The hedge funds created and used the equity swaps with the purpose and effect of preventing the vesting of beneficial ownership in the funds as a plan to evade the reporting requirements of Section 13(d) and conceal precisely what 13(d) was designed to force into the open. They can thus be deemed beneficial owners of the shares held by their counterparties to hedge their short exposures created by the equity swaps. For example, the court pointed to e-mails from the hedge funds discussing the need to make certain that its counterparties stayed below the 5 percent share ownership reporting threshold in order to avoid triggering disclosure obligations.