TCI: Four of our Five Nominees Are Elected to CSX's Board

When a federal appeals court on Monday dealt CSX Corp. a major setback by refusing to block activist investor The Children's Investment Fund from voting its stock at the company's annual meeting, it was easy to see that a pending proxy contest between the insurgent investor and railroad operator could become messy. The meeting and proxy contest took place Wednesday, and it looks like the messy prognosticators were right.

TCI and another hedge fund were permitted to vote the disputed 6.4% of their 8.7% stake for their five-member slate of dissident candidates for positions on the company's 12-person board. Wednesday afternoon, TCI has issued a statement explaining gleefully that based on preliminary voting results, shareholders have elected at least four of their slate. The two sides are battling over the future of the railroad company and its operational and investment priorities.

However, the news from the CSX camp was very different: "The outcome of the election of directors at CSX's 2008 annual meeting of shareholders is too close to call at this time. The annual meeting will reconvene at 10 am ET on Friday July 25."

It's unclear at this stage exactly how close the election was, but CSX is likely banking on the possibility that the appeals court, the U.S. Court of Appeals for the 2nd Circuit in New York, will ultimately decide to "sterilize" or disqualify TCI's shares at some point down the road.

The court did provide for a middle-of-the-road type expedited hearing, leading observers to speculate that a ruling could come by August or September.

It's less likely, but a decision could still be made by the appeals court before July 25. Should the court decide to disqualify TCI's shares, the company could conceivably, retroactively, reinstall management-backed director candidates if they lost in Wednesday's election by a margin of less than 6.4% of TCI's 8.7% stake. That would be unprecedented, and many observers aren't so sure a recount would be permitted.

There is still a long way to go before the appeals court rules. It is weighing whether TCI violated securities laws by using the swaps to get around Securities and Exchange Commission disclosure rules. A lower New York district court ruled June 11 that that was exactly the case. The court already rejected CSX's petition to have TCI's shares disqualified at the meeting pending its ruling. It also rejected CSX's petition to have the whole court case expedited so that a ruling would have taken place before the annual meeting.

What the 2nd Circuit does now and when it does it are key questions that need to be answered. - Ron Orol

TCI: Winning the battle but losing the War

It looks like The Children's Investment Fund may be winning its battle over the future of railroad operator CSX Corp. But is the hedge fund losing the war when it comes to the future of its activist strategy?

Sure, things look good for TCI and its proxy contest next Wednesday. Advisory services company RiskMetrics Group Inc. is recommending that investors vote for four of TCI's five-person slate at the meeting. That's a big boost. The 2nd Circuit Court of Appeals in New York has already rejected CSX's request to expedite the railroad company's appeal so that a ruling takes place before the meeting. The court late Friday also rejected CSX's petition to have TCI's shares "sterilized," pending the ruling, in otherwords blocked from voting, at the annual meeting. Both these measures should only help TCI gain the support they need to seat their insurgents and effect the operational changes they are seeking. All these measures should only help TCI gain the support they need to seat their insurgents and effect the operational changes they are seeking.

But let's take a step back. CSX's litigation battle has brought TCI's strategy of using a mixture of synthetic and equity shares to sneak up on target companies to the attention of the Securities and Exchange Commission. The agency had been mulling over whether it would require new synthetic share-related disclosures, but there was no urgency to the matter. Now, one person familiar with the SEC says the issue of synthetic swaps is becoming a top priority for the commission in light of the court battle.

While the agency is waiting for an appeals court ruling, which could take place in September, staffers there are very aware that a lower court's ruling on June 11 is already discouraging activist fund managers from employing swaps (and even passive investors that combine swaps and equity shares) as part of their insurgency strategy. There suddenly is an urgency for the agency to step in and provide some clarity.

The end result might just be that the SEC proposes new Schedule 13D rules requiring investors to consider synthetic swaps the equivalent of real shares for the purpose of disclosure. That means an activist with 3% equities and 2% synthetic shares would need to disclose their investment in a filing with the SEC. The agency may also propose a whole new disclosure regime for synthetic swap shares. In other words: no more sneaking up on companies.

TCI may win its battle with CSX. But it may be the last time the London-based investor can accumulate a large economic stake -- double-digit swaps plus equity below 5% of shares outstanding -- without disclosing that to the SEC. Companies soon may no longer be in the dark when it comes to activists with large hidden economic investments.

Of course, this does nothing to hurt the large number of activists that just buy equity stakes and use public pressure campaigns for their strategies.

But those activists using synthetic shares to stay in the shadows might have to become more transparent. That will give companies a better chance of responding to activists. Already a couple corporations have adjusted their poison pills to consider synthetic securities the equivalent of physical securities. This could be good news for corporations in their war against activist investors.

And while TCI may win its insurgency at CSX, its swap/equity activist strategy may be going the way of the dodo bird. - Ron Orol

SEC, Swaps and Schumer

A battle over whether some activist hedge fund managers will be able to continue to sneak up on certain target corporations is being waged in the courts, the Securities and Exchange Commission and now even on Capitol Hill

Sen. Charles Schumer, D-NY, sent a letter June 17 to SEC Chairman Christopher Cox expressing his concern that no penalties or injunctions were connected to a district judge’s ruling on June 11 that activist investor, The Children’s Investment Fund, violated securities laws by forming a group with another investor, 3G Capital Partners, and not disclosing that partnership when it was required by SEC rules. (Schedule 13D rules).

The court also ruled that TCI used so called “cash settled equity swaps,” to get around SEC disclosure rules. Railroad operator CSX Corp., TCI’s target, argues that the violations did not give executives sufficient time to prepare for the incoming TCI campaign.

CSX, frustrated with the court’s decision not to issue a substantive penalty, is appealing it to the 2nd Circuit Court of Appeals. The railroad operator is seeking to have TCI’s 8.7% equity stake “sterilized,” so these shares can’t be voted in the proxy contest.

The court argues that it was hamstrung from giving CSX the relief it sought, leaving the issue of penalties to the SEC, which may not provide that relief.

Seeing that the SEC may remain mum, Schumer has decided to prod the agency a bit, while also taking matters into his own hands. In a letter to SEC Chairman Christopher Cox, Schumer said that legislation might need to be considered to make sure penalties are included with these kinds of rulings.

“I am considering introducing legislation to correct this gap in the law, and would be very interested in discussing potential remedies, including the implications of granting CSX’s request for voting rights sterilization and increased civil penalties, with the SEC,” Schumer wrote. “The uncertainty created by this ruling will likely have a detrimental effect on the financial markets.”

And Schumer isn’t the only lawmaker prodding TCI in favor of CSX. Five lawmakers including Sen. Evan Bayh, D-Ind., is chairman of the Senate Banking Committee's Security and International Trade and Finance subcommittee, are pushing the Committee on Foreign Investment in the U.S., an interagency panel that examines U.S.-foreign deals for national security threats, to review the deal.

That would be an unusual review.

Representatives from both CSX and TCI testified before Congress earlier this year. Having lawmakers on Capitol Hill respond to TCI’s insurgency looks like it’s becoming an integral piece of CSX’s response strategy. TCI might need to hire some Washington lobbyists before this all swaps out. -- Ron Orol

Dems and Hedge Fund Taxes

Hedge fund managers can take a big sigh of relief, but watch out for 2009. Legislation that would have eliminated a tax provision allowing some hedge fund managers to defer taxes on billions of dollars of compensation came close to passing the Senate Tuesday, but in the end it was blocked.

Sen. John Kerry, D-Mass., attached a deferred tax provision to a broader energy bill, all of which was rejected by a filibuster from Republican senators. The measure would, in a nutshell, make hedge fund managers pay taxes immediately on income that is now tax-deferred.

"This vote is proof positive that Senate Republicans are more interested in helping hedge fund managers avoid taxes than helping working families," Kerry said on the Senate floor.

And while Kerry and other Democrat lawmakers remain frustrated by the outcome, hedge fund lobbying groups assert that the end of the deferment would have stifled investment and hurt the liquidity that hedge funds provide to the markets.

Of course, should Democrats obtain or get near to a filibuster proof majority of 60 senators following the upcoming election, a similar rejection might be more difficult or impossible to achieve. A Senate with 58 Democrats would have an easier time convincing (or strong-arming) a couple Republicans to break ranks and back a bill. And if not, Senate Majority Leader Harry Reid, D-Nev., could offer a few "incentives" like a bridge to nowhere. - Ron Orol

Is Activist Hedge Fund TCI A National Security Risk?

The Committee on Foreign Investment in the U.S., an interagency panel that examines U.S.-foreign deals for national security threats, may just review the activist Children's Investment Fund's large minority stake in railroad operator CSX Inc. But it would be an unusual review, if CFIUS decides to take it on.

TCI, which is based in the U.K., together with 3G Fund LP, another investment fund, own an 8.7% CSX stake. The combo also has financial exposure to an additional 12.3% stake through "cash settled swap agreements" with eight investment banks. The funds are pressing CSX to find a buyer or complete a leveraged buyout.

The intergovernmental agency CFIUS has been under pressure from lawmakers, the public and pundits to review deals involving foreign companies gaining a "controlling interest" in U.S. assets that are well below a 51% stake. CFIUS recently went to great lengths to explain to dealmakers that "controlling interest" could mean a large minority stake, but it would have to look at each transaction on a case-by-case basis to figure out which stakes warrant a review. In other words, there is no minimum threshold below which CFIUS attorneys could count on to avoid a review.

CFIUS practitioners argue that the TCI investment in CSX fits the bill for a CFIUS review. They say the railroad operator falls under the interagency's purview as critical infrastructure because it ships hundreds of carloads of nuclear waste and services military installations. TCI's activist efforts to replace five incumbent directors on the company's 12-member board at its June 25 annual meeting along with its large minority stake could be enough to trigger foreign control.

In practicality, though, this review would be unusual because neither CSX nor TCI have any plans to submit an application to CFIUS for review. Typically, when a foreign company buys a U.S. asset, both companies decide to voluntarily submit a joint application for approval. In this case, CFIUS might send out messages that it wants both companies to submit applications. Since CSX and TCI are opponents, both parties would likely provide separate documents explaining their opposition opinions.

In any case, there is no way a CFIUS review would be completed before CSX's annual meeting.

There are some high-profile lawmakers pushing for such an examination. Sen. Evan Bayh, D-Ind., is chairman of the Senate Banking Committee's Security and International Trade and Finance subcommittee. He and five other senators want Treasury Secretary Henry Paulson to launch a review.

There is reason to make one important distinction regarding this insurgency. Many in Washington are pushing CFIUS to review deals involving sovereign wealth funds, the investment arms of foreign governments, which buy large minority stakes in U.S. assets. TCI is not a sovereign wealth fund, but rather it is an activist hedge fund, very much like the investment vehicles operated by U.S. investors such as Carl Icahn or Jana Partners' Barry Rosenstein , only TCI is operated out of the U.K. The insurgent's pre-eminent goal is for CSX to be sold or taken private. In either case, TCI cashes out with a profit, but most likely the railroad operator remains a U.S. entity by being sold to a U.S. railroad operator. If TCI gets its way and the company remains a U.S. entity, then any CFIUS review may not be warranted. - Ron Orol

Richard Breeden's Short Slates Usher In World of Activism

Former Securities and Exchange Commission Chairman Richard Breeden claims credit for the birth of the activist hedge fund movement. Breeden, who is chairman of the activist hedge fund Breeden Partners LP, may have a point.

Other regulators have done things to give activists leverage, but under Breeden's chairmanship, the agency did three things in 1992 that transformed the way activist fund managers operate today. (He was chairman during President George H.W. Bush's administration between 1989 and 1993.)

He approved rules freeing up communications among investors to talk about performance issues at companies of which they were stakeholders.
Under Breeden the commission also adopted executive compensation disclosure rules, which were the precursor to updated CEO pay regulations approved under SEC Chairman Christopher Cox.

Probably the most important change under Breeden involved the "short slate" regulation that allowed fund managers to nominate one or two candidates to a company's board rather than replace the whole slate of directors, or in cases of staggered boards, all the nominees up for election. "The only options before the short slate rule was the Wall Street walk or replace the whole board," Breeden told The Deal. "That is, leave, abandon your interests and give up in frustration or take control of the business. Shareholders had the atom bomb, but they didn't have anything as a lesser remedy to fix the situation."

Breeden added that frequently smaller changes to the board are necessary: "Too many boards have static membership. People burrow in, and maybe they were great directors in the first five years of their tenure, but in years 16, 17, they don't tend to be as involved as they might once have been," he said. - Ron Orol

Change Wants Broker Votes Out at WaMu

A large activist labor-backed institutional investor just isn't satisfied with Washington Mutual Inc.'s Kerry Killinger's decision to step down as board chairman at the country's largest savings and loan. CtW Investment Group, an organization that advises pensions for unions belonging to the Change to Win labor group, wants more.

Sure, CtW is excited that Killinger announced Monday that he will resign from his chairmanship position -- though he remains at WaMu as CEO. And it's also happy that WaMu director Mary Pugh, president of investment firm Pugh Capital Management, resigned from the WaMu board in April. But, it is still peeved that two directors on the WaMu board, James Stever and Charles M. Lillis, remain on the board. Both WaMu directors had been the target of a "just vote no" campaign orchestrated by the labor union fund.

At the WaMu annual meeting April 15, company tallies showed that 41% of shareholders opposed Stever's renomination, and 41% opposed Charles M. Lillis, a director who was targeted by another union-backed pension fund. But CtW, estimated that by counting only votes of actual shareholders, the tally for removing 50.9% for Stever and 51.2% for Lillis.

"The vote to name an independent chairman excluded uninstructed broker votes, but the disputed re-election of directors James H. Stever and Charles Lillis may have resulted from the inclusion of these phantom votes," said CtW Investment Group research director Richard Clayton in a statement. "The board needs to disclose whether Stever and Lillis received a majority of votes cast by shareholders and to request the resignation of any director who did not."

CtW asserts that Lillis and Stever were put over the top because of so-called broker nonvotes, also known as broker discretionary votes. For clients who never indicate how to vote their shares, stockbrokers are permitted to cast ballots for them in "routine matters," such as uncontested director elections, as the brokers see fit. Critics deride this practice as corporate ballot stuffing, because brokers typically back management initiatives. For CtW, the broker-nonvote issue is particularly relevant because WaMu has a majority vote policy in its corporate governance guidelines.

Paulson to the Soveriegn Rescue

Treasury Secretary Henry Paulson is taking his pro-investor message on the road to the Middle East.

On Monday he told participants in the U.S.-U.A.E. Business Council in Abu Dhabi that the U.S. is "open" to investments from sovereign wealth funds, the investment arms of governments mostly located in Asia or the Middle East.

"As we seek to open new markets abroad, America will keep our markets open at home to investment from private firms and from sovereign wealth funds," Paulson said. "We reject measures that would isolate us from the world economy."

Paulson's remarks come as some lawmakers in Washington raise concerns about possible political motivations of sovereign fund investment in the U.S. A small group of lawmakers in Washington, including Rep. Frank Wolf, R-Va., question whether sovereign funds, which recently made major investments in U.S. investment banks, could use those stakes as leverage for political goals down the road.

One key sovereign fund is based in Abu Dhabi, where Paulson made his speech. The Abu Dhabi Investment Authority reported a $7.5 billion investment in Citigroup Inc. in November. According to Paulson, that fund has taken a "constructive role on this important issue."

Paulson did temper his pro-investment comments by referring to an effort underway by the International Monetary Fund to develop a set of best practices for these funds. The IMF plans to make these recommendations, which are expected to require increased transparency and disclosure of decision-making plans and investment positions, by this fall.

"We are trying to quell calls for restrictions by urging sovereign wealth funds to endorse best practices to create a dynamic rise to the top and help allay concerns about opacity and systemic risks," Paulson said.

That may not ally fears of some lawmakers, who argue that codes of conduct and transparency will not discourage sovereign funds from making politically motivated investment decisions.

Expect more details about Washington's point of view on sovereign funds when Reps. Jim Moran, D-Va., and Tom Davis, R-Va., speak about the "Implications of Sovereign Wealth Funds for American Interests and U.S. Policies," at a National Council on U.S.-Arab Relations event on June 5. The two lawmakers, who are members of a House task force on sovereign funds, have just returned from a visit to meet sovereign fund managers and government officials in Abu Dhabi, Cairo, Dubai and Saudi Arabia, as part of an internal investigation. - Ron Orol