(The article featured below is a selection from Hedge Funds and Private Equity: Risk Management and Regulatory Update, which is available to subscribers of that publication.)

Hedge Fund Groups File Amicus Briefs in Federal Court Appeal of 13(d) Case

Various hedge fund trade groups have filed amicus briefs in the appeal of a federal court ruling that activist hedge funds violated the Exchange Act in using equity swaps to amass a position in a target company. But, said a federal district judge (SD NY), their actions did not rise to the level of irreparable harm required to sterilize their shares. The court did, however, 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 court found that the hedge funds acted as a group without making the disclosure required of 5 per cent shareholders and groups by 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.

Importantly, the court concluded that 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.

In their brief to the Second Circuit Court of Appeals, ISDA and SIFMA argued that the district court misconstrued SEC Rules 13d-3(a) and 13d-3(b) and thereby created substantial uncertainties for the equity derivatives and capital markets that require correction on appeal regardless of the outcome of this particular case. ISDA contended that the court expanded the scheme to evade language of Rule 1 3d-3(b) in a way that the SEC has never intended. Despite the SEC's clear and long-standing position that cash-settled equity swaps do not confer beneficial ownership to the long party' to an equity swap, said the brief, the court read Rule 13d-3(b) to require Section 13(d) disclosures for certain of these swaps.

The court's interpretation is unsupported by the language of the Rule and improperly extends its application beyond the scope of Section 13(d). Amici do not claim that an equity swap can never be employed as part of a scheme to evade under Rule 1 3d-3(b). But they do claim that the use of swaps, without more, cannot by itself constitute such an evasion. There must be some additional act of deception that conceals the true ownership of the relevant equity security.

In its amicus brief, the Managed Funds Association said that the court's opinion contains a number of broad statements, principally in dicta, about the applicability of rules to transactions involving total return swaps that are contrary to widespread current industry and SEC understanding of the law. While taking no position on the outcome of the appeal, MFA asked only that the Court of Appeals reaffirm the principles identified in the brief and reject any contrary implications suggested by the district court's opinion.