Disclosure Is Still the Best Policeman!

In a delightful essay, Ron Gilson and Jeff Gordon remind us that the times have changed and the Williams Act belongs in their view to the era of the Beatles. (Personally, I have trouble believing that Sgt. Pepper was really that long ago.  Next, they will try to tell me that John Lennon is dead).  Even if they are right, I must respond with a counter-truism.  Plus ca change, plus la meme chose.  And I will raise their bid, by invoking two other familiar maxims:  First, power corrupts, and absolute power is at least within view for institutional investors.  Second, sunlight is the best disinfectant, electricity the best policeman.  These are verities that do not change simply because the balance of power shifts in the financial markets (as it clearly has).  If there are new problems accompanying this shift (as I would contend), the safest, least intrusive reform is disclosure, not direct governmental intervention.

The irony underlying the Gilson/Gordon essay is that it moves the clock forward only from the Age of the Beatles to the Age of Disco.  Their essay announces that institutional investors have power and prefer to act through proactive hedge funds.  Frankly, it is hard to call this breaking news, as it has been true for more than a decade.  But they seem to think that corporate managements still have the upper hand, because they can invoke the all-powerful poison pill.  Here, their view may also be dated, as the poison pill is becoming a paper tiger.[1]  At most, it converts a tender offer battle into a proxy fight.  If we look at today’s reality, we see that this is the heyday of the proactive hedge fund.  Across the corporate landscape, they are forcing corporations to repeal staggered boards, change their corporate governance, and redeem poison pills, and they are regularly winning proxy fights.  Nor at any point do Gilson and Gordon acknowledge the appearance of the major new actor since the time of the Williams Act:  namely, the proxy advisers.  The power of I.S.S. is sufficient to make even the boldest CEO shiver a little in his boots.

Predictably, with the ascension to power of the proactive hedge fund have come new conflicts of interest.  “Empty voting” is one example; and the new practice of some hedge funds in compensating their own director nominees poses another area where disclosure is needed; proxy advisors are subject to a host of conflicts.  Finally, the longer the “window” under Section 13(d), the greater the likelihood of insider trading by third parties—because information predictably leaks.  An SAC or another hedge fund focused on market-moving information will find ways of discovering when “groups” have crossed 5%, but not yet filed under Section 13(d).  None of this means that this brave new world of proactive investors is undesirable, but more transparency is needed to preclude such misbehavior.

Internationally, most developed nations appear to be converging on a two business day deadline for the disclosure of significant beneficial ownership (and some nations, including the U.K., use a much lower threshold than 5%).  Although Gilson and Gordon see such an earlier deadline as a clever defensive strategy by corporate managements (and their law firms) to deprive hedge funds of their opportunity to profit, I see it as a reasonable attempt to harmonize disclosure policy across the major markets.  The U.S. is here lagging behind the rest of the financial world, and the SEC should catch up.

Gilson and Gordon will probably respond that early disclosure of a 5% stake would curtail the ability of hedge funds (and others) to acquire a large equity position if they must disclose their position quickly after crossing the 5% level.  Their premise is that closing the “Section 13d”window reduces the size of the position that activist investors can feasibly assemble.  Here, they need to focus more closely on what is still permissible.  A proactive hedge fund could still quietly assemble up to just below 5% without alerting the market.  Then, it could enter into a very large equity swap with a major bank, giving it all the upside profit potential that it wants.  No incentive shortfall thus results, even if this equity swap had to be disclosed shortly thereafter.

Moreover, before assuming that activists will be chilled, we need to look at the actual language of the Dodd-Frank Act.  Although it is clear that Section 929R authorizes the SEC to close the “Section 13d” window, Section 766(o) probably does not permit the SEC to deem equity swaps a form of beneficial ownership.  Pardon me for talking about law in this high level discussion, but Section 766(o) of the Dodd-Frank Act only permits the SEC to deem a person to acquire beneficial ownership of the shares underlying an equity swap if the equity swap “provides incidents of ownership comparable to direct ownership of the equity security.”  Yet virtually all equity swaps do not give the holder on the long side of the swap control over the voting rights on the shares typically held by the short side.  Thus, this is a finding that the SEC probably cannot make.  As a result, although the SEC can shorten the “Section 13d” window, it is much less likely that the SEC can attribute beneficial ownership of the shares referenced by the equity swap to the holder of the long side of that swap.  This largely mitigates the incentive problem that Gilson and Gordon rely on.

To return to the higher level on which they wish to conduct this debate, Professor Gilson and Gordon are predicting the future, identifying proactive hedge funds as the “good guys” and managements as the “bad guys.”  They may be correct, but they are likely overgeneralizing.  Virtue is not all on one side.  Even more importantly, the end does not justify all means.  Transparency has been the key principle around which our securities markets have been, and should continue to be, organized.  Subordinating transparency to allow your preferred “good guys” to win is a dangerous precedent.  Transparency, as implemented through mandatory disclosure, plays the same protective role in our securities markets, as the First Amendment does in protecting our political marketplace.  The SEC therefore should join the rest of the world in favoring greater transparency of beneficial ownership.

[1] I anticipate that some may reply that because hostile takeovers are few, the poison pill has retained its toxicity.  That would truly be “Age of Disco” thinking, as that era did equate the number of hostile takeovers with the extent of shareholder power.  That mode of analysis ignores, however, that hostile takeovers are often inefficient, because the bidder overpays and the transaction costs are high.  It may be more efficient for shareholders to compel their managements spin off non-core assets (as has happened repeatedly in response to hedge fund pressure).  Those who look only to the number of takeovers and mergers are doomed to hear the BeeGees as background music for eternity.