Naked Short Selling Would Live On

One day after the Securities and Exchange Commission ended its pilot project to clamp down on naked short selling, at least one academic says any decision to extend the plan to the broader market would have some unintended consequences.


Columbia Law School professor John Coffee says he believes that if the SEC chooses to extend the temporary naked short-selling rule to the entire market, it would have the effect of driving short sellers to migrate their investments to single stock futures, the options market and cash settled equity securities, all strategies that could also drive a company stock down. The last option, also known as total return swaps, don't involve real shares but are agreements between investors and bank derivatives dealers where one party pays the other based on the performance of the underlying stock price.

"I'm not saying it's a complete substitution but people who want to avoid preborrowing stock might be able to achieve these things through these other means," Coffee says.

The agency in July set up emergency restrictions on short sales in the shares of 19 financial institutions including mortgage giants Fannie Mae and Freddie Mac through Tuesday. The emergency restrictions required short sellers in these institutions to either arrange formally to borrow shares, "preborrow." Previously, it was enough if the broker could determine that it had a reasonable basis to deliver the securities when an investor sought to borrow shares for a short sale.

It's not clear what the SEC will do after it collects all the data from this effort, but Coffee adds that he believes those investors seeking to engage in naked short selling, the practice of selling a stock short without first borrowing the shares or ensuring that the shares can be borrowed, will use these other mechanisms that fulfill the same functions. Coffee does add that even with short sellers finding these other means, he expects broad restrictions similar to those set forth in the emergency order to have some impact on discouraging the naked short- selling practice.

"It would succeed at putting some sand in the gears," Coffee said. - Ron Orol

What Happened to Fiduciary Duty?, asks TCI

ailroad company CSX Corp. still refuses to seat two of four dissident director nominees, partly because the company hopes an appeals court ruling will disqualify a block of shares voted by the activist dissident investor Children's Investment Fund Management (UK) LLP.

But now the independent inspector of elections has put out its report detailing that four of five TCI nominees won election to the board at the company's June 25 annual meeting.

If the appeals court upholds the District Court finding that TCI violated securities laws, it could disqualify many votes TCI cast in favor of the dissident slate by "sterilizing" or disqualify the portion of shares TCI owned while it was allegedly in violation of the disclosure rules. In total, that means 6.4% of TCI's stake could be ruled ineligible.

That would mean dissident directors Christopher Hohn, TCI founder, and Timothy T. O'Toole would have lost the election. According to the inspector of elections, Hohn received 130,506,157 votes, edging out incumbent director Frank Royal, who only got 129,715,745, a margin of about 0.3%. Hohn would definitely not have won had 6.4% of his TCI stake been removed. O'Toole also won with less than 6.4%.

The court isn't likely to rule until September, with oral Arguments scheduled for Aug. 25.

CSX is betting that if the court decides to sterilize those TCI shares it will be easier to keep Hohn and O'Toole off if they are never seated in the first place than if they have to remove them from their seats retroactively.

But until the court acts, what happens to fiduciary duty to shareholders? Hohn and O'Toole could end up losing up to 20% of their term as directors. Will the two dissidents receive an extra few months at the end of their 12 month term if the court doesn't decide to disqualify the votes? Also, what about the two directors Hohn and O'Toole are set to replace? Are Royal and William Richardson off the board yet? - Ron Orol

Activist Labor Fund Wants Citi Split

A five-year-old effort to press for changes at Citigroup Inc. by a major activist labor union just went into high gear.

In a letter sent to Citigroup's board late Friday, shareholder the American Federation of State County and Municipal Employees, or AFSCME, said it wants the bank to complete a strategic plan that includes splitting the company into two units in light of its financial problems stemming from the subprime mortgage credit crunch. AFSCME director Richard Ferlauto says he doesn't want to dictate specific terms, but thinks Citigroup should divide its commercial banking division from its investment banking unit.

"We want to see Citigroup spin off its Citi Smith Barney division," says Ferlauto.

AFSCME's letter follows an effort by the labor union fund to have shareholders vote to remove Citigroup directors at the megabank's April annual meeting. According to Ferlauto, between 25% to 30% of shareholders voted against the re-election of some Citigroup directors at the meeting.

"This is a strong indication of unhappiness of the company's direction," Ferlauto says.

Additionally, Citi, which has lost roughly $54 billion due to the credit crisis, has already raised more than $40 billion of new capital mostly from sovereign wealth funds. - Ron Orol

InBev's Anheuser Proxy Contest: No Annual Meeting Necessary

When beer titan Anheuser-Busch Cos. set up its bylaws to allow shareholders to act by "written consent," it probably did not expect the measure would be used by a rival in a campaign to take control of the brewer in an expedited manner. But, in fact, that is exactly what appears to be happening with InBev SA's plan released Monday to use the measure to replace 13 board members, according to a Securities and Exchange Commission filing.

Some corporations permit written consent provisions in their bylaws because they want procedures in place to give investors the ability to quickly endorse debt refinancing programs in cases when shareholder approval is required for those actions. But having such a provision in place also makes the company vulnerable to dissident shareholders seeking to bring in their own director candidates.

Unlike most corporations, Anheuser-Busch has a bylaw provision permitting "written consent solicitation."

To employ written consent solicitations, the activist distributes proxy documents to other shareholders asking them to sign a card saying they want to vote their shares to remove certain directors from the board and replace them with candidates nominated by the dissident. Typically, if investors with more than half of the total shares outstanding vote to remove the incumbent directors, the activist wins and his nominees are installed on the board. The campaign is different from a traditional proxy contest because it does not take place on the day of the company's annual meeting. As a matter of fact, no meeting must take place for the consents to be approved and for the directors to be removed and replaced.

It's likely Anheuser-Busch set up its bylaws to permit written consent solicitations thinking its double-digit billion dollar stock market capitalization would discourage hostile bidders and proxy contests.

But after removing its classified board, it looks increasingly like Budweiser should have killed the written consent solicitation bylaw a long time ago. The majority of other public corporations already recognize why that bylaw shouldn't be in place. - Ron Orol

Insurgent Investor Mark Schwarz Isn’t Taking No for an Answer

After specialty property and casualty insurance company Specialty Underwriters Alliance Inc. rejected his Hallmark Financial Services Inc.’s $6.50 a share, or $115 million, bid to buy the company, Schwarz on July 1, Tuesday, sent a letter to the company’s directors outlining benefits of such a deal.

“Hallmark senior management stands ready to meet with members of the board to answer questions regarding the proposal,” Schwarz wrote in a letter attached to a Securities and Exchange Commission filing.

The specialty property and casualty insurance company last week rejected Schwarz’s unsolicited takeover bid. Schwarz owns 9.9% of Specialty Underwriters.

In the filing, Schwarz points out that his offer represents a 31% premium on the $4.96 a share Specialty Underwriters Alliance was trading at on Friday June 20, the last business day before the company made Schwarz’s offer public, Monday, June 23. Schwarz also argues that SUAI’s business model will be improved by the addition of Hallmark’s strong financial position. This transaction will allow SUAI shareholders to enjoy a much higher return on their pro-rata share of invested capital in a combined company,” Schwarz added.

Schwarz’s investment vehicle, Newcastle Partners is the controlling shareholder of Hallmark Financial. -- Ron Orol

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