• Consider Revising Rights Plans to Include Accumulations of Derivative Securities
  • July 17, 2008 | Authors: Frank M. Placenti; Ryan J. Kretschmer
  • Law Firm: Squire, Sanders & Dempsey L.L.P. - Phoenix Office
  • Beneficial Ownership and Rights Plans

    Shareholder rights plans or "poison pills" generally are triggered when any single shareholder or group of shareholders acquires beneficial ownership of more than a specified amount of the company's outstanding stock, often 10 or 15 percent.

    Traditionally, the definition of "beneficial ownership" in these plans mirrors the definition of that term in Rule 13d-3 of the Securities Exchange Act of 1934 (Exchange Act). The Exchange Act states that a beneficial owner includes any person who, directly or indirectly, has or shares (i) the power to vote, or to direct the voting of, the shares or (ii) the power to dispose, or to direct the disposition of, the shares.

    Although the Exchange Act addresses the use of contracts and other devices to avoid the vesting of beneficial ownership, it does not expressly include interests created through the use of derivatives in its definition of beneficial ownership. This has created a loophole that many shareholder activists have used to amass a significant economic interest in a company without triggering its rights plan.

    Derivatives

    Derivatives are purely economic interests created through various mechanisms that allow an investor to reap the economic benefits of stock ownership without actually owning any stock. Although derivatives take many forms, essentially they all work by tying the return paid to the investor to the performance of the underlying stock; if the underlying stock appreciates, the investor earns a return based on that appreciation, and if the underlying stock depreciates, the investor must pay the amount of the depreciation. However, investors in derivatives do not actually own any stock, nor do they have the power to vote or direct the voting of, or dispose of or direct the disposition of, the underlying shares. Thus, these holdings generally have not fallen within Rule 13d-3's definition of a beneficial owner and have not been subject to the reporting requirements of Section 13(d) of the Exchange Act.

    Potential Threat

    Although theoretically derivative positions are purely economic in nature, investors with significant economic interests in a company held through derivatives tied to its stock may have the ability to influence the company. This influence can come in several forms. First, the parties who offer derivatives to investors often hedge the derivatives by purchasing the underlying common stock in proportion to the derivative offered. Although the owners of derivative positions cannot expressly direct the voting of the underlying stock, these investors may be able to leverage their significant economic interest to influence the party offering the derivative to vote the underlying stock in a manner favorable to the investor. Some parties who offer derivatives also have a policy that stock held as a hedge to derivatives will not be voted. In these situations, the party investing in the derivative has the advantage of knowing that the underlying shares will not be voted against any proposal it may make.

    In addition to influencing the voting of shares held by the party offering the derivatives, investors in derivatives typically can choose to settle their derivative holdings "in kind," meaning that at the expiration of the derivative agreement, the investor can receive the underlying shares of stock rather than cash. In this situation, upon settlement the investor quickly acquires a large number of shares without any prior disclosure of its intent to do so. Although following settlement the investor will be subject to Section 13(d) reporting requirements (if it owns more than 5 percent of the outstanding shares), the company in question may find itself with a large activist shareholder about which it had no prior warning. Even when derivatives are settled in cash, upon settlement the party that offered the derivative often will sell the underlying shares it had used to hedge the position, creating a ready supply of shares for the investor to purchase if it desires.

    CSX Corp. v. The Children's Investment Fund

    The United States District Court for the Southern District of New York recently addressed the issue of whether the holding of derivatives constitutes beneficial ownership requiring disclosure under the Exchange Act.1 The court analyzed the disclosure obligations of the defendant, which had an economic interest in the stock of CSX Corporation (CSX) through total return equity swaps (TRS), a type of derivative. The court indicated in its decision that it would be reasonable to conclude that economic interests in stock created through derivatives do constitute beneficial ownership under Rule 13d-3(a) and that requiring disclosure of such interests would be consistent with the intent of the rule. Although the court ultimately chose not to rule on the legal question of whether the defendant's interest in the derivative constituted beneficial ownership for purposes of Rule 13d-3(a) pursuant to the voting power and investment power tests described above, based on the facts of the case, the court ruled that the defendant had entered into the TRS contracts with an intent to avoid the disclosure requirements of Section 13(d) of the Exchange Act, and that, as a result of this intent, the defendant was deemed to be a beneficial owner of the shares held by other parties in connection with the TRS contracts under Rule 13d-3(b) and therefore was subject to the disclosure requirements of Section 13(d).

    Recent Changes to Rights Plan Definitions

    Perhaps in response to the CSX case described above, at least two companies have revised the definition of beneficial ownership in their shareholder rights plans to expressly include interests in derivatives.2 The effect of the revisions is that interests in derivatives now are taken into account when calculating beneficial ownership for purposes of triggering these companies' rights plans. Thus, these companies' rights plans would be triggered by an investor who does not beneficially own any shares of such company's common stock according to the Rule 13d-3 definition, but who nevertheless obtains a significant economic interest in one of the companies' common stock through derivatives.

    Recommended Action

    Companies with a rights plan already in place should consider revising the plan's definition of beneficial ownership to expressly include interests held through derivatives when the rights plan is renewed. Companies that do not yet have a rights plan in place, or that have a rights plan drafted that has not yet been adopted, should consider expressly including derivatives within the plan's definition of beneficial ownership when adopting the rights plan.

    1 See CSX Corporation v. The Children's Investment Fund Management (UK) LLP, et al. (08 Civ. 2764 (LAK), June 11, 2008.

    2 See the rights plans of Louisiana-Pacific Corp. and Micrel, Inc., available on the SEC's website. [www.sec.gov]