Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

Takeover disclosures and cash settled derivatives

The New York District Court ruled
earlier this week that the hedge fund TCI should have disclosed its
cash settled derivatives (total return swaps) on CSX stock under the
takeover rules of the US SEC (Rule 13d-3). Hitherto, it was believed
that cash settled derivatives do not convey a “beneficial
ownership of any equity security” as required by the
statute. Rule 13d-3 defines the beneficial owner essentially as one
who has or shares voting power and/or investment power over the

The New York District Court took a different line. Based largely on
the expert report of Prof. Marty Subrahmanyam, the Court came to the
conclusion that the only practical way for the swap counterparty to
hedge its position was to buy the underlying stock. It also found that
this was what they actually did:

But the evidence is overwhelming that these counterparties in fact
hedged the short positions created by the TRSs with TCI by purchasing
shares of CSX common stock. … they did so on virtually a
share-for-share basis and in each case on the day or the day following
the commencement of each swap.

This is precisely what TCI contemplated and, indeed, intended. None
of these counterparties is in the business, so far as running its swap
desk is concerned, of taking on the stupendous risks entailed in
holding unhedged short (or long) positions in significant percentages
of the shares of listed companies. As a practical matter, the Court
finds that their positions could not be hedged through the use of
other derivatives. Thus, it was inevitable that they would hedge the
TCI swaps by purchasing CSX shares.

The Court interpreted this as investment power. Moreover, it
determined that TCI chose counterparties who were more likely to vote
the shares in accordance with its wishes. The Court relied on the SEC
position that “ability to control or influence the voting
. . . of the securities” constitutes voting power.

The Court also referred to provisions in UK law based on economic
interest rather than legal ownership and stated that “Yet there
is no reason to believe that the sky has fallen, or is likely to fall,
in London” as a result of such provisions.

Having come close to saying that cash settled derivatives meet the
definition of beneficial ownership under Rule 13d-3(a), however, the
Court refused to rule on this point at all, but proceeded to decide
the case under Rule 13d-3(b) which deals with “contract,
arrangement, or device … as part of a plan or scheme to evade the
reporting requirements”. The Court also allowed TCI to vote the
stock after making the requisite disclosures.

The Deal
is of the view that everything now depends on how the
the Second Circuit Court of Appeals deals with this case on

All this discussion is of great relevance in India because of the
large cash settled single stock futures market in India. Indian law
talks about acquisition of shares and voting rights. Shares
“includes any security which would entitle the holder to receive
shares with voting rights”, but this clearly does not cover cash
settled derivatives. Another issue that comes to mind in the context
of the US ruling is the issue of participatory notes as well as that
of the non voting ADRs and GDRs issued by Indian companies.


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