Poison Pills Target Derivatives

Transparency advocates say that hedge funds have easy access to the shares underlying the derivative positions and should therefore report them, a claim that stood in a recent case that pitted CSX Corp. against the hedge funds Children's Investment Fund Management and 3G Capital Partners.

SEC rules require investors to disclose their holdings at the end of every quarter, and more frequently if they own over 5% of a company's voting shares. Most derivatives, such as the total-return swaps used by the hedge funds in the CSX case, are a cheap way to get economic exposure to a stock movement. They are usually cash-settled and don't afford their holders voting rights. The SEC therefore doesn't require investors to disclose their derivatives positions, unless they also own 5% or more of the actual shares.

Now, company executives are charging up their poison pills to prevent activists intent on doing a stealth takeover. According to FactSet SharkRepellent, a takeover defense and activism research firm that combs through regulatory filings, Louisiana-Pacific and Micrel are the only two known U.S. companies to have implemented such a plan to tackle derivatives.

"It appears that there are quite a few hedge funds that are using different mechanisms to have voting rights through either derivatives or some synthetic arrangement, so this was an attempt to pick that up," said Mike Kinney, director of investment relations for Nashville, Tenn.-based Louisiana-Pacific.

On May 23, the building-products manufacturer announced a renewal of its shareholder-rights plan for another 10 years, which included a broader definition of ownership.

If a Louisiana-Pacific investor increases his or her stake to 15%, the company will issue rights convertible into stock to all other holders, hence diluting the ownership of the major stakeholder. The 15% threshold hasn't changed from the company's previous 10-year plan, but the definition of ownership has.

"The only difference is just the fact that the derivatives or any synthetic arrangement that's defined in there would be included in the 15%; that's the piece that's new compared to our last shareholder's rights plan," said Mr. Kinney in an interview with Hedge Fund Trades.

The plan's definition of beneficial ownership goes beyond that of the SEC, which says the owner is a person who has the right to vote, buy or sell the securities. The only derivative the SEC considers to be beneficial ownership is stock options, because they are convertible into voting stock within 60 days.

On the guidance of its advisers and bankers, Louisiana-Pacific adopted the plan, which considers a holder anyone with a "synthetic long position," which it defines as any option, warrant, convertible security or other contract that uses the common shares as reference, and the value of which is determined by the shares.

Last week's ruling on the CSX's case against London-based Children's Investment Fund and New York-based 3G Capital may push the SEC toward more stringent regulation, experts and observers said.

After a lengthy and rowdy dispute between the Jacksonville, Fla., railroad operator and the hedge funds, Judge Lewis Kaplan of the Southern District Court of New York sided with CSX in finding that the hedge funds evaded disclosures of their ownership of shares and total return swaps.

Judge Kaplan also interpreted the SEC rules in a way that the hedge funds are deemed to be the effective owners of the shares held by their swaps' counterparties, a ruling that will test the use of derivatives in activist situations.

The judge said, however, that he is precluded from blocking the funds from voting their combined 8.3% stake in an election at CSX's June 25 annual general meeting. TCI and 3G are putting forward five nominees to a 12-member board. The funds' counterclaim -- that CSX's management was acting in its own interest by changing the meeting date -- was dismissed. In a news statement, the hedge funds said they will appeal the ruling.

Whether or not the CSX case ruling leads to an eventual change in disclosure rules, corporations broadening their view of ownership in the poison pill are one step ahead.

"Companies have been advocating [disclosure rules] changes, and they are doing it for their own protection," said Matteo Tonello, a senior researcher on corporate governance and activism at the Conference Board, a nonadvocacy group that issues recommendations to corporations and investors.

"It's very much possible that others will follow suit because of the CSX case."

The other known company that has implemented a shareholders' rights plan redefining ownership, Micrel, a San Jose, Calif.-based integrated-circuit company, included derivatives exposure in its plan implemented in March, after Obrem Capital Management had accumulated nearly 10% of its shares.

The New York-based hedge fund run by Andrew Rechtschaffen wanted to expand Micrel's board to six from five members, to elect a whole slate of directors at a May 20 meeting and to push the company to look for a buyer. His efforts didn't succeed, but the parties are in dialogue, according to a joint news statement. Micrel Chief Financial Officer Richard Crowley didn't return calls seeking comment. Obrem declined to comment.