A Loophole Lets a Foot in the Door

Date: Tuesday, January 15, 2008
Author: Andrew Ross Sorkin

The bad news reached Neil Ashe, the chief executive of CNet, as he lounged on the beach in Mexico on vacation with his family over the holidays. The company’s lawyer called to say that two hedge funds had secretly acquired the equivalent of a 21 percent stake in CNet and planned to mount a proxy contest to take over the board.

For Mr. Ashe this was surprising — and upsetting — on two counts. First, one of the funds, Jana Partners, had quietly approached the company earlier in the year and talked to Mr. Ashe about becoming a friendly, long-term shareholder.

“They indicated to us that they were a long-only deep-value hedge fund,” Mr. Ashe said at an investor conference. “I spent an hour with them on the phone answering questions about our business.” But in the aftermath of that conversation, “we didn’t hear anything from them again.” Mr. Ashe figured the firm had decided against making the investment.

And the other unhappy surprise? Jana and the second hedge fund, Sandell Asset Management, had magically acquired the equivalent of more than a fifth of the company without anybody knowing. Given the existence of the decades-old 13D rule, which requires investors to disclose stakes of more than 5 percent, and the Hart-Scott-Rodino Act, which requires activist investors like Jana to disclose when they invest more than about $60 million, how could it possibly be that the hedge funds could suddenly own the equivalent of 21 percent of CNet’s shares? How could it even be legal?

The answer: Hedge funds and other activists have quietly begun exploiting a loophole. Investors like Jana and others — including Carl C. Icahn, Nelson Peltz, and even the giant Canadian bank Toronto-Dominion — have begun entering into complex “swap” agreements with investment banks to get around the rules. The banks buy the shares on the investors’ behalf, but technically never transfer full ownership. Think of it as a pseudo-off-balance-sheet deal. Technically, these investors say, they don’t own the shares at all, just the “economics” of them.

It appears to be a legitimate version of the way Ivan Boesky “parked” stocks back in the 1980s by having a friend hold shares of the Unocal Corporation.

That maneuver concealed the ownership of the shares. The “seller” agreed to repurchase the parked shares at a prearranged time and price.

What today’s clever investors have noticed is that the law requires them to disclose only when they control more than 5 percent of the vote, not 5 percent of the economics in a company. So hedge funds use “swaps” to buy shares and — technically at least — strip out the voting power that comes with them.

All this is legal — though it’s so absurd it probably shouldn’t be. “The transparency that was supposed to be there just isn’t there anymore,” said Larry W. Sonsini, chairman of the law firm Wilson Sonsini Goodrich & Rosati. He is representing more than half a dozen companies flabbergasted by mystery shareholders, and is somewhat flabbergasted himself. “We have to take a new look at the rules.”

Of course, this isn’t the first time investors have found a legal way to skirt the rules — and in the process, created a corporate governance nightmare. A couple of years ago, several hedge funds did some fancy footwork to influence the outcomes of mergers and proxy fights by buying a voting stake in companies without actually holding the same economic interest in the business.

Now that idea has been turned on its head. Here’s a simplified version of how it works: An investor calls an investment bank and says, “Please buy 100 shares of company X. You can hold onto those shares in your name — and technically, you can do whatever you want with them. In six months, if the shares have gone up, you’ll owe me the difference. If they go down, I’ll owe you. And for all the cartwheels you’re doing for me, I’ll pay you a small fee.”

But here’s the rub: It is preposterous to believe that investors entering into such contracts have absolutely no influence over a company’s shares. The banks that put together these swaps are likely to take direction from their clients on how to vote, seeing as how those clients pay them millions a year in fees and commissions. Or, if the banks are holding the shares truly at arms-length as they say they are, they may decide not to vote at all — magnifying the importance of those who do vote, which, depending on which side of a proxy fight you’re on, can be a very good or very bad thing.

Even if the hedge funds do not have the ability to vote for themselves, their puffed-up “economic” stake gives them enormous sway over other shareholders and anxious boards.

In the case of CNet, Sandell justified its tactics by saying in a filing that the contracts did not give it “direct or indirect voting, investment or dispositive control over any securities” and therefore it disclaimed “any beneficial ownership in securities that may be referenced in such contracts.” Deutsche Bank and Lehman Brothers put together this swap.

As you can imagine, hedge fund investors like Jana did not want to comment when asked about the subject. One prominent investor called such swap arrangements “today’s third rail.”

A spokesman for the Securities and Exchange Commission said they were looking at the issue — but clearly they are not acting fast enough.

So why do investors go to such extremes to mask their trading? Money — lots of it. They can accumulate enormous stakes in companies without tipping their hand and driving up the share price. Once outed, the investors can then buy the shares on the open market — and thus gain the vote they didn’t have — at a hedged price. They also get the ability to play more easily with leverage, that is, debt. And they get what every would-be raider covets: the element of surprise.

To be fair, if everybody always played by the rules, all of this might not be a problem. In any case, the stealth swaps are legal, so the funds are doing nothing wrong. But given the possibility for abuse and the impact on other shareholders, this loophole should be closed.