Change-of-control provisions in high-yield indentures typically define beneficial ownership by reference to Rule 13d-3, promulgated under Section 13(d) of the Securities Exchange Act of 1934 (the “Exchange Act”). Proposed legislation in Congress would broaden the rule’s definition of “beneficial ownership” beyond voting or investment power to include a pecuniary interest arising out of certain derivatives transactions. In light of this development, it may be prudent to consider amending indentures to exclude from the definition of beneficial ownership voting stock deemed beneficially owned solely by reason of possession of a pecuniary interest in such voting stock. More generally, it seems that a broader reconsideration of beneficial ownership definitions in indentures may be appropriate.
The Section 13(d) reporting system originated in 1968 with the enactment of the Williams Act in response to a wave of attempts at hostile takeovers of public companies. These takeover attempts were often structured as sudden and coercive tender offers. The Williams Act was designed to give shareholders of a target company adequate time and information to evaluate a third-party tender offer, and to allow both the bidder and management a reasonable time to present their respective cases to shareholders. Any person who acquires beneficial ownership of more than 5% of the outstanding shares of certain classes of equity securities registered under the Exchange Act must file disclosure within 10 days of the acquisition. The disclosure must report, among other things, the identity of the beneficial owner and the nature of that person’s beneficial ownership, the source and amount of funds or other consideration used in purchasing the securities, and any plans or proposals to make major changes in the issuer’s business or corporate structure.
The definition of beneficial ownership in Rule 13d-3 has always focused on voting and disposition power. However, the proposed Brokaw Act, which is sponsored by Sens. Tammy Baldwin (D-Wis.), Jeff Merkley (D-Ore.), Elizabeth Warren (D-Mass.) and Bernie Sanders (D-Vt.), would expand Rule 13d-3’s definition of beneficial ownership to include an investor’s possession of a “pecuniary or indirect pecuniary interest.” “Pecuniary interest” would be defined as the opportunity to profit from, or share in any profit from, a transaction in the relevant security, including by ownership of a derivative instrument.
This change is a response to criticism that Rule 13d-3’s current definition of beneficial ownership ignores synthetic derivative instruments (usually cash-settled equity total return swaps, or “TRSs”) that confer economic exposure to securities without voting or disposition power. This criticism came to a head in CSX Corp. vs. Children’s Investment Fund Management LLP (2d Cir. July 18, 2011). That case involved two hedge funds that built up economic exposure to CSX through TRSs in anticipation of a proxy contest for control of the company. As is typical, the counterparties to the TRSs held a corresponding hedging position in the actual stock itself. CSX sued the hedge funds for violating 13(d), claiming that through their bank hedges, the hedge funds had a reportable interest in CSX. As support for its claim, CSX argued that the hedge funds could likely influence the banks’ voting of these hedged shares. Although neither the district court nor the Second Circuit on appeal reached a conclusion on this claim, CSX’s argument reflected broader sentiment that excluding synthetic derivatives from the definition of beneficial ownership undermines investor confidence and market transparency. Specifically, critics contend that hedge funds can skirt disclosure of significant economic exposure to a company’s stock, even when a hedge fund accumulates that exposure in anticipation of acquiring actual ownership and/or control over corporate affairs.
However, CSX is not the only case to consider that beneficial ownership can exist “uncoupled” from voting or dispositive power. Wilmington Savings Fund Society, FSB v. Foresight Energy L.P. (Del. Ch. December 4, 2015) involved senior notes issued by subsidiaries of Foresight Energy, L.P. (“Foresight”). Under the indenture, a change of control was defined to include any transaction that resulted in any person acquiring beneficial ownership of at least 35% of the voting stock of Foresight’s general partner, Foresight Energy GP, LLC (the “General Partner”). In 2015, Murray Energy Corporation (“Murray”) purchased 34% of the General Partner, hoping to avoid triggering the 35% change of control under the indenture. Murray also purchased an option (the “Option”) to acquire an additional 46% of the General Partner, subject to a 61-day advance notice provision. The notice period was specifically set at 61 days to avoid a provision of Rule 13d-3 that the right to acquire a security within 60 days constitutes beneficial ownership. As a further means of deferring beneficial ownership under existing case law, the Option contained a third-party refinancing condition that was beyond Murray’s control. Foresight also granted Murray various blocking rights, including the right to veto any attempt by Foresight to transfer its voting interests in the General Partner to a third party, and authorized a subsidiary of Murray to oversee all of its day-to-day business and operations. The CEO of Foresight and the General Partner were also replaced with a Murray executive.
The trustee sued on behalf of the noteholders, contending that a change of control had occurred. The Delaware Chancery Court (the “court”) agreed, partly basing its conclusion on the anti-evasion provisions of Rule 13d-3. That provision states in its relevant part that:
Any person who, directly or indirectly, creates or uses a … contract, arrangement, or device with the purpose or effect of divesting such person of beneficial ownership of a security or preventing the vesting of such beneficial ownership as part of a plan or scheme to evade the reporting requirements of section 13(d) … of the Act shall be deemed for purposes of such sections to be the beneficial owner of such security.
Based on the anti-evasion provision, the Court held that Murray had acquired de facto control of Foresight.
The Brokaw Act’s proposed changes to Rule 13d-3 are more far-reaching in scope than CSXand Wilmington Savings Fund, but all of them consider beneficial ownership as potentially “uncoupled” from voting or dispositive power. Collectively, they highlight a fundamental mismatch in using Rule 13d-3 as the definition of beneficial ownership in high-yield indentures. Section 13(d) and Rule 13d-3 thereunder are securities law provisions which require the filing of disclosure with the SEC, while change-of-control provisions in indentures trigger an immediate offer to repurchase all outstanding notes. If the Brokaw Act becomes law, it will become necessary to exclude from change-of-control definitions in indentures all positions of beneficial ownership resulting solely from holding a pecuniary interest by reason of owning a derivative, in order to avoid inadvertent and innocuous triggering of an offer to purchase notes. (The proposed Brokaw Act has been referred to the Senate Committee on Banking, Housing and Urban Affairs, but no hearings on the bill have yet taken place.) In addition, the uncertainty regarding the circumstances under which the anti-evasion provisions of Rule 13b-3 might be applied to confer unintended beneficial ownership, as demonstrated in Wilmington Savings Fund, should also prompt careful consideration of excluding the anti-evasion provisions of Rule 13d-3 from the definition of beneficial ownership in high-yield indentures.