The titanic clash for board control at CSX Corp. reached its climax last week, as the rail company gathered for its annual meeting. The exact outcome remains unknown for now; shareholder activists say they succeeded in electing four nominees to the board, and CSX says they failed.

What is clear: The courtroom battles leading up to the annual meeting will have a profound effect on other fights for control well into the future.

At issue were the questionable ways two activist funds, The Children’s Investment Fund and 3G Capital Partners, gathered enough votes to pressure CSX. On June 11, a federal judge in New York ruled that the two funds acted in concert without disclosing their alliance and were the beneficial owners of shares underlying derivative instruments the funds owned. TCI also violated Rule 13(d) of the Securities Exchange Act by not disclosing a 5 percent ownership position in CSX.

Despite those setbacks, the judge did say the hedge funds could still vote the shares at CSX’s annual meeting. He also stopped short of explicitly stating that derivative instruments based on shares automatically conferred beneficial ownership of the shares to the person holding those derivatives.

CSX promptly appealed the rulings, but on June 20 the powerful 2nd Circuit Court of Appeals allowed the two hedge funds to proceed with the voting. The appellate court also said a full hearing on the dispute would start July 3—lightning speed, as the federal judiciary goes.

The two rulings have shaken hedge fund managers and legal experts. The appeals court could well set new standards of what hedge funds must disclose as they circle target companies; any ruling that says the holders of derivative instruments are also beneficial owners of the underlying stock could have far-reaching consequences.

In a legal bulletin, the law firm White & Case warned that the original district court decision “is likely to frame a debate that continues on these issues, whether or not there is a ruling on the matter from the Second Circuit following appeal.”

CSX’s woes started when TCI and 3G Partners acquired a combined total of 8.7 percent of the company’s shares. They then obtained another 12.3 percent through cash-settled equity swaps—which typically give the holder a financial stake in the shares, but not any voting rights.


Below is an excerpt taken from the ruling in CSX v. The Children’s Fund.

Probability of Future Violations

In this case, defendants have committed two violations of Section 13(d) of the Exchange Act. Both failed to make a timely filing after forming a group. TCI failed to file within 10 days after being becoming, or being deemed to have become a beneficial owner of more than 5 percent of CSX’s shares.

These violations were not products of ignorance. There is evidence that the use of derivatives such as those at issue here is “a standard technique [in the hedge fund industry] to avoid disclosure of these big stakes.” In any case, TCI deliberately evaded disclosure obligations. Both defendants were more than cognizant of the obligation to file promptly upon forming a group and, in this Court’s view, knew full well, or recklessly disregarded the substantial likelihood, that they had

formed a group, this notwithstanding Hohn’s incantations and the lack of a formal written agreement. Both continue to maintain that their actions were blameless and, indeed, testified falsely in a number of respects, notably including incredible claims of failed recollection, to avoid responsibility for their actions. Both, moreover, are engaged in lines of endeavor in which future violations are far more than a speculative possibility.

In all the circumstances, the Court finds a substantial likelihood of future violations. Defendants have sought to control CSX for over a year. As obstacles to control surfaced, they adapted their strategy for achieving control, making disclosures only when convenient to their

strategy. Defendants’ latest strategy for control will be tested at the annual shareholder meeting. And if this strategy is not successful, the Court perceives a substantial likelihood that the defendants would

craft a new strategy for control without regard to their disclosure obligations.

Irreparable Injury

The fact that future violations are probable absent an injunction is highly pertinent to the irreparable injury question. Defendants’ past violations have advanced significantly the achievement of their objectives. They likely were able to acquire a larger position in CSX for a price lower than would have been required had all of the facts been disclosed as and when required. The motive for building on that position through concealment remains. The battle for CSX may not end with the June 25 annual meeting. Further Section 13(d) violations could allow defendants to increase their position to a point of working control. Remaining shareholders in that event would find themselves with shares in a corporation with a controlling shareholder and thus deprived of the opportunity to gain a control premium for their shares. Corrective disclosure could not remedy that harm because it would come too late. In any case, the legal remedy, if any, manifestly would be inadequate because it would be impossible to determine with any accuracy the price that the remaining shareholders could have realized if that fact that defendants were in the process of obtaining working control. A permanent injunction against future Section 13(d) injunctions therefore

is appropriate.


For the foregoing reasons, plaintiff is entitled to a permanent injunction restraining future violations of Section 13(d) of the Exchange Act and the rules thereunder. The counterclaims

are dismissed. The Court has concluded that it is foreclosed as a matter of law from enjoining defendants from voting the 6.4 percent of CSX’s shares that they acquired between the expiration of

10 days following the formation of the group no later than February 13, 2008 and the date of the trial. If, however, it were free to grant such relief, it would exercise its discretion to do so.

Counsel shall notify the Court no later than 11 a.m. on June 12, 2008 whether an application will be made to this Court for relief pending appeal. In the event that they wish to do so, any application will be heard orally that day in Courtroom 12D at 2:15 p.m.


CSX v. The Children’s Fund (June 11, 2008).

Swaps and other derivatives are a routine tool hedge funds use to build positions in their target companies. Jana Partners used them to acquire a 14.9 percent stake in Cnet; Pershing Square has used them to build up its holdings in McDonald’s, Wendy’s, and Sears Canada, among other companies. Acquiring stock through swaps is attractive for many reasons. They are generally cheaper to buy and let funds operate under the radar of other investors who might start bidding up the stock price. Jana Partners in particular used swaps to avoid triggering a poison pill at Cnet.

Above all, swaps let hedge funds avoid filing requirements with the Securities and Exchange Commission. For example if a fund owns at least 5 percent of a company, it must file a Form 13(d) or 13(g) and state its intentions. If the fund owns more than 9.9 percent of a stock, it is deemed a company insider under Section 16, which triggers a host of new disclosures.

The disclosure issues are what the CSX battle is really about. Hedge funds, shareholder activists, and investment banks are deeply opposed to new disclosure. Indeed, even the courts and the SEC are divided over whether holding derivatives could require a Form 13(d) filing.

The SEC’s formal position, as conveyed in a briefing to the district court, is that expanding Rule 13(d)-3 to include swaps and other derivatives “would be novel and would create significant uncertainties for investors who have used equity swaps in accordance with accepted market practices understood to be based on reasonably well-settled law.”

Judge Lewis Kaplan, however, stated that Rule 13(d)-3 defines beneficial ownership broadly. “It does not confine itself to ‘the mere possession of the legal right to vote securities,’ but looks instead to all of the facts and circumstances to identify situations in which one has even the ability to influence voting, purchase, or sale decisions of its counter parties.”

Kaplan added that the hedge positions of counter parties “hang like the sword of Damocles over the neck of CSX.”

Essentially, says Patrick Dooley of the law firm Akin Gump Strauss Hauer & Feld, the judge decided that parties holding the actual shares (usually investment banks) are inclined to support the position of the counterparties holding derivatives based on those shares—in this case, TCI and 3G Partners.


Others dispute Kaplan’s logic. “I have not seen total return swaps where the counter-party hedge fund directs the vote,” says Anna Pinedo, a partner at the law firm Morrison & Foerster who works with investment bankers and derivatives dealers. “Entering into swaps should not be determined to be beneficial ownership.”

The practical consequences of the CSX decision remain unclear. Critics in the hedge fund world argue that the decision applies only to CSX and the two funds fighting it, especially regarding whether the two funds acted in concert and formed a de facto group.

“On the group issue, this does not cut new ground,” Dooley insists. Other elements of the decision, however, can be interpreted more broadly, he warns.


“Funds need to be aware of the decision,” he says, because certain courts might now find that total-return swaps are part of an effort to avoid disclosure, and credit those shares as under the fund’s control—triggering an SEC filing obligation.

Ultimately, observers say, the SEC must reconcile its definition of beneficial ownership to the court’s seemingly opposite position. Indeed, in its letter to the court, the SEC said the commissioner will consider proposing rules “to address in a more direct way the use of equity swaps.” No such rule has been proposed yet.

Meanwhile, all eyes will be riveted on the appeals process, which will unfold later this summer. Stay tuned.