Hedge Fund Showdown

One government official has hedge funds very worried.

It's neither a regulator in Washington or London nor even Timothy Geithner of the Federal Reserve Bank of New York.

It is a federal judge in Manhattan who is presiding over a lawsuit by CSX against two hedge funds that are waging a proxy battle against the railroad giant.

CSX contends that the funds, the London-based Children's Investment Fund and 3G Capital Partners, gained "beneficial ownership" and voting control of stock through swaps contracts, which did not disclose as required by the rules of the Securities and Exchange Commission. The defense contends that swaps contracts are legal and dismiss CSX's "theory."

Early on in the proceedings, Judge Lewis Kaplan indicated that he was leaning in the direction of CSX's contention that "counterparties" to swaps contracts with the hedge funds would be compelled by economics to vote along with the hedge funds.

One crucial exchange came as Judge Kaplan interrupted the cross-examination of a CSX witness, as the defense was trying to establish that the witness had no personal knowledge that Deutsche Bank was recalling stock held on swaps on TCI's behalf. Judge Kaplan didn't particularly care: "As I understand it, Deutsche Bank has no financial interest whatsoever in the shares they held as a counterparty and they know which side of the bread the butter is on and they will do the right thing for their clients without having to be told what that is."

Those comments unleashed an avalanche of paper and PDF files that have come to persuade Judge Kaplan that swaps are legal and there is no "wink and nod" on voting by swap counterparties.

Brian V. Breheny, deputy director of the Securities and Exchange Commission's corporate finance division, wrote the judge that the division "disagrees" with CSX's "interpretation" that the economic incentives inherent in swaps contracts. "While such incentives may exist," Breheny wrote that the counterparty acting on its own "legal rights," and that violation of the S.E.C. rules would not be triggered by "merely by the presence of economic incentives."

The lawyers for the hedge funds thought they now had a powerful ally in their corner. But at a hearing today, Judge Kaplan disabused of them of least some of that notion.

"This is a disclosure case," said TCI's lawyer, Howard Godnick of Schulte Roth & Zabel. "This is not a case about swaps."

Kaplan cut him off. "The fact of the matter is that you changed the playing field, the judge said, "to provoke a movement of shares." Those shares, the judge observed, were "acquired at bargain basement prices in friendly hands."

When Godnick tried to point out that the S.E.C. was on his side, the judge shot back that the commission had made pains to take no position on the facts of the lawsuit.

Kaplan saved his most pointed zingers for Christopher Hohn, the reclusive founder of TCI, who testified at the trial. One key issue in the case is whether TCI and 3G formed a "group" to agitate toward a proxy context much earlier than they claimed. A February 2007 email from Hohn to an associate speaks about "our friend Alex in Brazil" -- Alexander Behring of 3G -- and excitement about movement in CSX credit default swaps.

The judge noted that Hohn could not recall who Alex was at his deposition, then recalled very clearly on the stand --- but said the email was about another topic. "What makes the least sense to me about that email was the attempt to explain it away on this witness stand."

The hearing today was on the question of the remedies that CSX is seeking if the judge rules in the company's favor. The railroad company is looking for something beyond mere corrective disclosure, and its lawyer, Rory Millson of Cravath, Swaine & Moore, pointed to case law suggesting there could be more than that to as a "deterrence:" measure against future egregious violations.

After the hearing, Millson explained CSX wants to "sterilize" the defendants' votes, and also the "friends and family" of the defendants. But Kaplan seemed disinclined to consider blocking votes beyond those of the defendants.

Millson has asked for a ruling from Kaplan by June 12. This afternoon, Kaplan mused that the losing side, in any event, will most likely seek immediate appeal to the Second Circuit, and pondered whether a ruling before the annual meeting on June 25 was indeed necessary.

"I believe we are entitled to some certainty, your honor," Millson said.

Karen Donovan