In a long-awaited opinion, on July 18, 2011, the U.S. Court of Appeals for the Second Circuit ruled on certain Section 13(d) issues in the CSX case, CSX Corp. v. Children’s Investment Fund Management (UK) LLP, 562 F. Supp. 2d 511 (S.D.N.Y. 2008). The District Court had held that hedge funds seeking to elect a minority slate of candidates to CSX’s board of directors violated Section 13(d) by failing to report beneficial ownership of cash-settled total-return swaps and failing to report the formation of a group. It granted CSX a permanent injunction against the hedge funds prohibiting future violations of Section 13(d), but did not enjoin the hedge funds from voting the 6.4% of CSX shares that they acquired after forming a group.

The Court of Appeals addressed the issue of whether there was a group violation with respect to the shares owned outright (without regard to the beneficial ownership of the swap agreements) and whether the hedge funds should have been enjoined from voting their CSX shares. However, due to a disagreement on the panel, the Court of Appeals did not resolve the issue of when parties to cash-settled total-return equity swap agreements must comply with the disclosure provisions of Section 13(d).

With respect to the “group” violation under Rule 13d-5(b)(1), the Court of Appeals found that there were insufficient findings for proper appellate review. The District Court had identified activities and motives suggesting that the hedge funds’ activities were products of concerted action that resulted in a group with respect to CSX securities. The Court of Appeals noted, however, that two or more entities do not become a group within the meaning of Rule 13d-5(b)(1) unless they act as a group for the purpose of acquiring, holding, voting or disposing of securities of an issuer. The Court of Appeals remanded the case to the District Court to determine whether this standard was met.

The Court of Appeals agreed with the District Court that the hedge funds should not have been enjoined from voting the disputed shares. It noted that “in the case of a Section 13(d) violation, an injunction prohibiting the voting of shares is inappropriate when the required disclosures were made in sufficient time for shareholders to cast informed votes.” In this case, since the hedge funds’ Section 13(d) disclosures occurred in December 2007, approximately six months before the June 25, 2008 shareholders’ meeting, an injunctive share “sterilization” was not available.

In the concurring opinion, the judge specifically addressed whether cash-settled total-return swaps confer beneficial ownership on the long party. The judge noted that “cash-settled total-return swaps do not, without more, render the long party a ‘beneficial owner’ of such shares with a potential disclosure obligation under Section 13(d).” However, where there is an agreement or understanding between the parties regarding the short parties’ purchasing such shares as a hedge, selling the shares to the long party upon unwinding of the swap or the voting of such shares, renders the long party a beneficial owner under Section 13(d). He noted that at the time of the District Court opinion, the SEC had no authority to regulate such “understanding” – free swaps. Following the adoption of the Dodd-Frank Act, the SEC has such authority, but repromulgated the existing rules. Accordingly, he stated that there is no reason “for treating such swaps as rendering long parties subject to Sections 13 and 16 based on shares purchased by another party as a hedge,” absent alternative direction from the SEC.