Opinion ID: 221139
Heading Depth: 1
Heading Rank: 3

Heading: Investment Power

Text: CSX argues that it was inevitable that TCI's swap counterparties would buy CSX shares to hedge their short swap positions and then would sell those shares when TCI closed out its swaps. Brief of Cross-Appellee at 42. TCI had, CSX concludes, the economic ability to cause its short counterparties to buy and sell the CSX shares and therefore had investment power over those shares. Id. CSX asserts that expectations based on the incentives of counterparties to buy and sell shares qualify, for the purposes of Rule 13d-3(a), as the power to direct the disposition of those shares. 17 C.F.R. § 240.13d-3(a)(2). I disagree. Both literally and in the context of the term beneficial ownership and Section 13(d)'s concerns over control, this argument gives too much breadth to the term direct the disposition of. To direct something, or to influence it, even indirectly, one generally must have some measure of active control, and, in the context of Section 13(d) and swaps, that control must be exercisable in the interests of the long party. See Filing and Disclosure Requirements Relating to Beneficial Ownership, Securities Act Release No. 5925, Exchange Act Release No. 14,692, Investment Company Act Release No. 10,213, 43 Fed.Reg. 18,484, 18,489 (Apr. 28, 1978) (Section 13(d) disclosure is required from any person who has the ability to change or influence control); Interpretive Release on Rules Applicable to Insider Reporting and Trading, Exchange Act Release No. 18,114, 46 Fed.Reg. 48,147 n. 17 (Oct. 1, 1981) (beneficial ownership under Section 13(d) emphasizes the ability to control or influence the voting or disposition of the securities). Influence must also be interpreted in the context of Section 13(d)'s concern over control transactions. No one would dream that the author of a weekly column providing stock tips that reliably cause investors to buy and sell the stocks mentioned was the beneficial owner of the shares bought and sold even though the column influence[d], not to say caused, the purchases and sales. [9] A relationship that leaves short parties free to act in whatever way they deem to be in their self-interest with regard to purchases and sales of referenced shares also does not fit within the concept of beneficial ownership in the long party. Likewise, a swap agreement that accords complete freedom to the short parties to act in their self-interest with regard to purchases and sales of referenced shares does not confer beneficial ownership in the long party in any sense in which those words are commonly used. Rather, without an agreement or understanding with regard to hedging or unwinding, cash-settled total-return equity swaps leave the short counterparty free to act solely in its self-interest. Absent an agreement or informal understanding committing the banks to buy shares to hedge their CSX-referenced swaps or to sell those shares to the long party when the swaps terminated, the Funds possessed only the power to predict with some confidence the purchase of those shares as a hedge, not the power to direct such a purchase, much less to direct those shares' disposition. The long counterparties' act of entering into a swap, therefore, falls well short of directing the short counterparties to purchase the stock. Long counterparties may well expect short counterparties to hedge their swap positions by buying the shares involved in an amount roughly equal to those specified in the swap. However, as noted supra, alternative hedging methods exist and are sometimes used. See, e.g., Caiola v. Citibank, N.A., 295 F.3d 312, 315-18 (2d Cir. 2002); Hu & Black, 79 S. Cal. L.Rev. at 816, 837. As noted, see Note 9, supra, these alternative methods may lead to a third party, whose identity is unknown to the long-party, buying hedge shares. Had the banks chosen, for whatever reason, not to hedge their short swap positions with a purchase of shares, not to sell all their hedge shares once the swaps had terminated, to alter their hedging methods and sell the hedge shares before the swaps were unwound, or to sell those shares to a competing would-be acquirer of CSX, the Funds would have lacked any means, legal or moral, to compel the banks to alter that choice or even to inform the Funds of their actions. See Hu & Black, 79 S. Cal. L.Rev. at 839. Thus, the sort of power that CSX attributes to the Funds does not fit within the language to direct the disposition of the CSX shares. 17 C.F.R. § 240.13d-3(a)(2). CSX recognizes the need to establish a nexus between influencing a sale of the short party's hedge shares upon unwinding and the long party's control ambitions by arguing that, in the inducing of those sales, the Funds exercised investment power by materially facilitat[ing] [the Funds'] rapid and low-cost acquisition of a physical position upon the termination of the swaps. Brief of Cross-Appellee at 43. Whether or not the alleged material facilitation would run afoul of the Reliance Electric test, see supra, or would provide a sufficient nexus to the term investment power to constitute beneficial ownership, 17 C.F.R. § 240.13d-3(a)(2), the material facilitation claimed here substantially overstates the effect of acquiring long positions in cash-settled equity swaps. Cash-settled equity swaps allow the short party to retain its hedge shares or dispose of them at the highest price available. Thus, the long party's choices for acquiring actual shares in the referenced company are either to go into the open market or to pay the short party no less than the open market price. Buying or selling by the short party may affect the availability and price of shares, but hardly constitutes the claimed material facilitation. [10] If the market for the shares is liquid, as will often be the case, then rapid acquisition of those shares would be possible regardless of the sale of shares used to hedge swap positions. Thus, such a sale would have little practical effect on the long party's ability to acquire shares. If the market is highly illiquid, then potential short parties would find it very costly to acquire the shares and thus either would not acquire shares to hedge their short swap positions or, more likely, would refuse to enter into such swap agreements. [11] If the market's illiquidity is more moderate, then closing out swap agreements may provide a degree of confidence that a block of shares will go on the market. However, purchasing this confidence will be very expensive, because keeping individual short parties under Section 13(d)'s 5 percent threshold may require using several short counterparties, who will be competing with each other for limited available shares and will pass the resulting increased hedging costs on to the prospective long party. Moreover, if the long party's purpose is to ensure the availability of shares when making its acquisition move, the ultimate effect of these swap stratagems may be only to reduce market illiquidity for a competing acquirer  perhaps an acquirer that is in league with the firm's management or even management itself  who, having avoided the costs of the swaps, will be better positioned to make its own bid. Moreover, cash-settled total-return equity swaps will not lower a long party's costs of acquisition. The basis for CSX's claim that these swaps allow long parties to acquire shares at a low price is unclear. It may be based on the belief that unwinding the swaps will momentarily increase the market supply of shares and thus lower those shares' market price. However, if the swap unwinding is likely to lower the prices of the referenced shares, then the short party, who, as a seller, will suffer from that downward slippage in prices, will insist on passing those foreseeable extra hedging costs along to the long party in the form of higher interest payments, leaving long parties on the average in much the same (or worse) economic position as if they had simply bought the shares directly, without a detour through a cash-settled equity swap position. In other words, cash-settled total-return equity swaps, without more, are not a substitute for the ownership of shares by parties seeking to control a corporation. Control still requires the purchase of shares on the open market, as happened in the instant case, or from the short party at the open market price, thus causing the party seeking control to bear the costs of both the swaps and the shares. In the absence of some other agreement governing the disposition of shares purchased to hedge a swap position, merely having a long position in a cash-settled total-return equity swap does not constitute having the power, directly or indirectly, to direct the disposition of shares that a counterparty purchases to hedge its swap positions, and thus does not constitute having investment power for purposes of Rule 13d-3(a). 17 C.F.R. § 240.13d-3 (a)(2).