Hedge Funds Win Round in CSX Battle

A proxy battle at CSX took a turn in favor of two hedge funds that are trying to take control of the board of the nations largest railroad, when a federal judge ruled that they could vote their shares, despite the fact that they had failed in the past to file necessary disclosures, according to an article in The New York Times.

Judge Lewis A. Kaplan of Federal District Court in Manhattan ruled that the funds--the Children's Investment Fund of Britain and 3G Capital Partners of Brazil--could vote their shares and that there was nothing legally that he could do to stop them, although he admitted that they had skirted the law.

"Some people deliberately go close to the line dividing legal from illegal if they see a sufficient opportunity for profit in doing so,” Judge Kaplan wrote in his 115-page decision.

“A few cross that line and, if caught, seek to justify their actions on the basis of formalistic legal arguments even when it is apparent that they have defeated the purpose of the law. This is such a case.”

The judge noted that it was the jurisdiction of the Securities and Exchange Commission or the Department of Justice to penalize the funds for the failure to make the required disclosures. Although, as the Times reported, he all but invited CSX to appeal the case. The annual shareholder meeting is planned for June 25.

The decision is sure to have corporate governance minds buzzing as the case has already caused governance scholars to take sides in the case. A former member of the SEC., Joseph Grundfest, who is now a law professor at Stanford, argued that a victory by the hedge funds “would render compliance” with the disclosure requirements “essentially voluntary.”

At issue: equity swaps. If hedge funds enter into swaps to gain the economic benefits of a rise in the stock, does that constitute ownership? Does the brokerage who wrote the swaps and holds the shares have an incentive to vote as the hedge funds wish? This is a tricky question. It certainly suggests that in some cases, traditional securities laws need to be updated to account for new security types. This is not the last word on this case. An appeal is likely.