Yizhou Feng

Executive Summary The case is about Porsche using cash-settled options to obtain control of Volkswagen silently and TCI and 3G using TRS to get control over ownership of CSX to initiate a meeting of changing the board members of CSX. In this report, I will detailed analysis how they processed their strategy using equity derivatives and what was the result. I will further discuss whether it is good thing to have CEO involved in equity derivative trading and whether the disclosure requirement should be mandatory for equity derivatives.

Porsche and Volkswagen Case Background The main players in this case are Porsche and Volkswagen, which had a very long and interwoven history back in 1931. The famous VW Beetle was created by Ferdinand Porsche in 1931, who was also the founder of the luxury car manufacturer Porsche and the grandfather to the board chairmen of both Porsche and Volkswagen. Around 2000, the political environment for foreign investors, who had held more than 5000 German firms, changed a lot due to German politicians vilifying them and clamouring for more domestic ownership.

Following this political pursuit, in 2005, to support a "German Solution" to the takeover dilemma and to match the 20% ownership held by the state of Lower Saxony, Wendelin Wiedeking, the CEO of Porsche, announced the intention of the company to purchase 20 percent of Volkswagen stock. In 2007, the company increased the holding to 30 percent, which gave a positive signal to German legislators to put pressure on Porsche to continue the buying action. Porsche said no in response surprisingly.

However, in a less than a year, the board backed its CEO's decision to increase its position in ownership of Volkswagen to 50%, and soon after this the company again denied rumours saying it will buy up to 75% of shares. This happened between March and October, and finished the prologue of this story, when the closed price for Volksawagen was €211.

The main chapter begun exactly on October 26, Porsche's board disclosed that it held 42.6 percent of Volkswagen shares along with cash-settled options accounting for 31.5 percent of the company. This was really bombshell in the market, since only 5.9 percent of shares can be used as offset by those short-sellers. As a result, Volkswagen's share price increased as five times as it was in two days and this costed billions of loss to those who betted against Volkswagen's stock.(See Exhibit 3 in Appendix)

Analysis and Conclusion Cash-settled options are option contracts in which settlement is completed by paying cash equal to the difference between the market value and the strike price of the underlying asset at the maturity or expiration. Comparing to physically settled options, the actual physical delivery of underlying assets is not required.

In this case, Porsche entered into a call spread option, which gave Porsche the right to receive a payment of cash for the difference between the lower strike price and the actual market value on the earlier of the date of exercise or maturity if the stock price increased. However, this cash payment is limited by a predetermined higher strike price and therefore, the higher the cap, the more this option costs. Moreover, Porsche can alternatively requested its investment banking counterparty deliver the shares of Volkswagen based on the value of payment Porsche could received. (See Exhibit 5 and 6 in Appendix)

The increase of Volkswagen's share was due to the fact that there were few shares remained in the market available for short-sellers to hedge their short position. This situation is called short squeeze, which implies when a heavily shorted stock's price will increase rapidly or has few remained in the market. In this situation, short-sellers must buy the underlying stock to close their short position and thus give upward pressure to the underlying stock.

According to the case, it is obvious that Volkswagen's equity was heavily shorted since many hedge funds including Greenlight Capital, SAC Capital, Glenview Capital, Tiger Asia, and Perry Capital betted against Volkswagen's equity prior to the release of the option news.

The way those hedge funds used to bet was pairing trading, which was a portfolio of long position in preferred shares of Volkswagen and short position in ordinary shares of Volkswagen, or alternatively, a portfolio of long position in Porsche common stock and short position in Volkswagen's common stock.

Whatever approaches they used, the mind behind this kind of hedging was that they did not believe Volkswagen's equity will appreciate, in contrast, they strongly thought a bearish market was await for Volkswagen's shares. In this case ,the demand of Volkswagen's share far exceeded the supply of its shares (only 5.9%), forcing investors in short position to buy Volkswagen's share even when they knew that the purchase would increase the price ulteriorly.

The cash-settled option Porsche purchased played a most important role in the fivefold increase of Volkswagen's share. Back in early 2005, Porsche had already started buying cash-settled options on Volkswagen's stock at a market value of €100. Along with the fact that German law did not require an investor to disclose ownership of any size holding of cash-settled options, Porsche was able to hold a large stake of shares of Volkswagen without making any noise to the rest of the market.

When the share price of Volkswagen reached €211, Porsche already held options accounting for 31.5% of the company's share silently. With the sudden release of this news, the short-sellers were dropped in situation called short squeeze, thus the announcement provoked a sour of Volkswagen's share price.

The success Porsche's board made of obtaining control of Volkswagen was undeniable and legendary. But whether the involvement of CEO in trading derivatives made sense worth to be discussed. Even though the success can not be denied, the potential risk of this strategy was not small. Apparently, Porsche never bothered to stop taking control over Volkswagen since 2005. It already began to purchase cash-settled options since 2005 and despite of whether they were going to accounting those options to shares, they at least had the alternative to do so.

However, the option was used to bet the market for Volkswagen's share was going to be bullish and once the market was going bearish, millions of Eurodollars could be swiped out. Moreover, the information that they bough those options may be whistled out by counterparties and alerted the rest of market including Volkswagen. After all, the risk they took finally paid off by taking control over Volkswagen.

The involvement of CEO in this case, in my opinion, was not unreasonable. Taking over control of a firm can be considered a company strategy and thus the leadership and scope guideline provided by CEO would be very important. Also, using derivative to obtain ownership is not like using it off-set risk: once it failed, it would mean a failure of strategy, which could lead to resign of CEO.

Finally, the CEO can understand better if he led the operation of this strategy and could provide flexibility to the implementation of this take over strategy. However, normally, derivatives, especially equity derivatives, are not used for the purpose of silently taking control, while they normally used for risk set-off, which is really a responsibility should be undertaken by CFO, instead of CEO. So, commonly, CEO involvement in derivative trading was not a good idea.

CSX, TCI and 3G case Background CSX was the result of Chessie's 1980 merger with seaboard Coast Line Industries and it delivered about 1.9 million carloads of coal, coke, and iron ore to electric utilities and manufacturers in 2007. It owned approximately 21000 route-mile rail network. The CEO of CSX was Michael Ward who was widely admitted as an innovator and leader in the transport industry. He delivered returns far exceeding the S&P during the five years prior to the GFC.

Christopher Hohn, was the founder of TCI hedge fund with $1 billion initially under management. The strategy TIC undertook was to take pubic stances against management at companies. This strategy went success in German in 2005 but failed in 2007 in Japan and lost $127.3 million. In 2006, TCI 's returns reached 40 percent and won itself a top award form EuroHedge, when the S&P Hedge Fund Index rose just 3.9 percent. 3G Capital was founded in 2004 with a firm-wide objective: to invest in good business, run by good management, and available at a good price.

TCI and 3G actively called for change at CSX, pushing for the railroad to improve performance by changing senior management, including separating the cahirman and CEO, both held by Michael in the end of 2007. In 2008, CSX wrote to TIC said the change they wanted was not for the good of railroad industry but for their own good of taking control of the company and only after a written request from shareholders representing more than 15 percent of its voting power was received by the company, a special meeting can be held.

After this letter, a series of lawsuits was initiated (see Exhibit 1 in Appendix) before TCI and 3G using TRS to gain control power and finally a court ruled that TIC and 3G had been illegally plotting a bid for control of CSX without disclosing their intentions. However, eventually, a federal appeals judge ultimately granted TCI and 3G a total of four seats in the board, since it was prohibited from denying shareholders the right to vote for a new board of directors.

Analysis and conclusion A TRS is a kind of equity derivatives named total return swaps. TRS are agreements in which one party makes interest payments based on a set rate-fixed or variable-while the other party makes payments based on the return of an underlying asset, which includes both the income it generates and any capital gains or losses. In this case TCI and 3G received total return on CSX's shares and paid an interest at LIBOR plus a spread on $2.8 billion.( See Exhibit 2 in Appendix) With the use of TRS, what TCI and 3G received gave them a synthetic long position in the market risk of the reference asset, which gave the right to them claiming they got about 14 percent of ownership in CSX.

The key benefit of TRS for TCI and 3G was that they gained equity exposure to CSX without actually owning the shares underlined TRS. The use of TRS to gain control power silently, however, violated Regulation 13D which requires stock ownership of greater than 5 percent must be disclosed. Also, it was risky. If the payments of return on CSX's shares were too small, TCI and 3G would go to illiquidity with paying a lump of cash , since the return on CSX's shares was mainly from dividend and capital gains, both of which CSX could partially control.

In both case, I do think the disclosure of synthetic shares should be absolute. Just like the court said, it only matters whether it is about ownership not whether it is a kind of equity derivatives. As long as the use of equity derivatives is for obtaining control over a company, the disclosure should always be mandatory. However, if the derivatives are used for diversifying or off-setting risk, then the rules for derivatives can be applied.

Moreover, I do think there should be more regulations on using equity derivatives to get control. Because we can see in the CSX case, even though TCI and 3G were ruled to illegally getting control, they grabbed four seats on the board eventually. It can not denied that both TIC and 3G and Porsche did a very good calculation, assuming the costs were far outweighed by benefit of their strategy.