Proposals to “Reform” the Section 13D Rules: Getting it Precisely Backwards

The current proposals to accelerate the timing of beneficial ownership disclosure under Section 13(d) of the 1934 Securities Exchange Act and to broaden the definition of beneficial ownership to include derivative positions that provide economic exposure to stock price movement but not a right to vote or acquire stock, gets the problem precisely backwards.  The mismatch of problem and solution is apparent when we focus on two dates:  1968, when the Williams Act adding Section 13 was adopted, and 2010, when Section 766 of the Dodd-Frank legislation gave the SEC the authority, but not the obligation, to consider whether derivative positions should be treated as beneficially owned stock for purposes of disclosure under Section 13(d).

We were all different in 1968 – the Beatles had released the Sgt. Pepper’s Lonely Hearts Club Band album just before Congress enacted the Williams Act.  One critical difference relates to capital markets. In 1968, U.S. stock ownership still resembled the Berle-Means image of equities held by widely dispersed individual investors, presumably buying and selling stock based on their own analysis.  When the Beatles sang “Lucy in the Sky with Diamonds”, institutions owned roughly 17 percent of U.S. public equities.  In contrast, when Congress adopted Dodd-Frank, institutions owned roughly half of the equity of U.S. public companies, and over 73 percent of the equity of the top 1000 U.S. public companies. Mutual funds alone hold over 25 percent of U.S. equities, roughly 75 percent of which are held by the 25 largest mutual funds.  Even these numbers understate the voting power of mutual fund advisors.  When the separate accounts managed by the fund advisors are included in the calculation, the percentage of the equity market they represent goes up significantly.

Thus, over the 42 years between the Williams Act and Dodd-Frank, the character of the U.S. capital markets and the resulting structure of U.S. corporate governance changed radically.[1]   As we have shown elsewhere, the U.S. has moved to a system of “Agency Capitalism,” an intermediated system where between the company and the beneficial owners of its equity stands institutional intermediaries, the vehicles through which we all save for retirement by holding diversified portfolios.[2]  In 1968, roughly 83 percent of equities were held directly and 17 percent were held through institutions; by 2010, those numbers were reversed.  Wayne Gretsky, one of the best hockey players in history, when asked why he was so good, responded that he “goes to where the puck is going to be.”  The petition to the SEC proposing changes to the operation of Section 13(d), stated that “[t]he purpose of the proposed rulemaking is solely to preserve the status quo ….”  And that is the proposal’s central problem.  It purports to improve the operation of today’s capital market by restoring a balance that once existed 45 years ago with respect to a radically different pattern of stock ownership.  Gretsky got it better than did Wachtell.

So what is the impact of Agency Capitalism and how does it bear on the current, rather than the historical, operation of Section 13(d)?  The short answer is that the intermediary institution’s business model stands between company management and the beneficial owner of the company’s equity.  In asset management markets, where profits increasingly depend on scale, and in which investment funds aim for superior relative performance, intermediaries will have little incentive to resort to governance to improve company strategy.  Rather, the intermediary is better off selling the underperforming stock than proactively engaging in governance activity that may be better for the beneficial owners but will not distinguish the intermediary’s performance from that of its competitors.  In other words, sophisticated intermediaries will be rationally reticent.  They will respond to the strategic proposals of others, but will be unlikely themselves to proffer one of their own.

The result is that under an Agency Capitalism structure, the governance rights of equity are chronically undervalued.  And it is at this point that activist investors enter the picture – they arbitrage the value of governance rights.  Their business model, symbiotic with that of the intermediary institutions, involves identifying companies whose business strategies could be significantly improved, buying a toe hold stake, and then going public with a plan to convince the company in the first instance, or the institutional shareholders  if the board disagrees and a proxy constant proves necessary, of the wisdom of the activist’s strategic proposal.  If intermediary institutional owners agree and if the proposal turns out to be sound, everyone makes money, including especially the beneficiaries of the intermediary institutions – those of us saving for retirement.

This combination creates a kind of market stewardship – activists propose, sophisticated intermediary institutions decide.  Activists cannot succeed, and cannot make money, unless the institutions vote for them.  And the institutions are sophisticated.  They will vote against the activist if  as Martin Lipton said only this June in a client letter,   the company presents the institutions “with a well-articulated and compelling plan for the long-term success of a company, [that can]  cut through the cacophony of short-sighted gains promised by activists touting short-term strategies.”[3]  All in all, this is a pretty sensible adaptation to the massive changes in shareholder ownership and the structure of corporate governance in the 45 years since the Williams Act was adopted.

So what is the problem?  Put simply, the proposal before the SEC would require earlier disclosure of the activist’s ownership, both by changing the way beneficial ownership is calculated to include derivative positions and by accelerating the time the activist must disclose its holdings after crossing the more inclusive ownership threshold.  The proposal is thus a clever defensive response to activists – go after their business model. Earlier disclosure limits pre-disclosure stock acquisition and, it follows, the activist’s ability to make money by arbitraging the value of governance rights.  The justification for more stringent limits is the claim that such reform is necessary to vindicate the legislative purpose behind the adoption of the Williams Act in 1968.[4]  But that brings us back to Wayne Gretsky – we have to go where the puck is.  It cannot make sense to regulate by reference to an ownership and capital market structure that has not existed for years.[5]

Proponents of the proposal before the SEC do make other claims.  They argue that the amount of stock that activists acquire before disclosure has gone up.  This appears to be empirically false.  Their pre-disclosure holdings seem to have stayed around 8 percent.[6]  And they argue, as did Mr. Lipton in his client letter, that activists tout “short terms strategies.”  But this claim also appears to be empirically false.  The gains that result from successful activist activity appear to remain in place for five years.[7]

That leaves a final question: would we design the Williams Act differently if we were starting from scratch.  That is the question that Dodd-Frank poses for the SEC: what should current regulation look like in light of current capital market conditions, not how can we roll the clock back to Sgt. Pepper.  For example, if there is a realistic fear that with a wink and a nod activist holders of total return swaps can quickly obtain the underlying stock or cause it be voted in the activist’s favor, the SEC might consider exempting total return swaps where a commitment is made that the underlying stock will be mirror voted with the rest of the outstanding stock.

In the end, the point is simple.  Proposals for regulatory change must be directed at the capital market we have now.  Otherwise, it is no more than exercise in anachronism.

[1] To get a sense of the span of time we are talking about, here is a different comparison.  The Williams Act was passed 39 years after Wyatt Earp, the center of the gunfight at the OK Corral, died in Los Angeles.

[2] Ronald J. Gilson & Jeffrey N Gordon, The Agency Costs of Agency Capitalism: Activist Investors and the Revaluation of Governance Rights, 113 Col. L.Rev. 863 (2013).

[3] Martin Lipton, Dealing with Activist Hedge Funds, Wachtell, Lipton, Rosen & Katz, Client Letter, June 21, 2013.

[4] Adam Emmerich, Theodore Mirvis, Eric Robinson & William Savitt, Fair Markets and Fair Disclosure: Some Thoughts on the Law and Economics of Blockholder Disclosure, and the Use and Abuse of Shareholder Power, forthcoming 3 Harv. Bus. L. Rev. (2013).

[5] In his response Prof. Coffee invokes “disclosure” as the universal cure.  But it is worth noting just how unusual section 13(d) is.  Disclosure is commonly required of sellers; rarely by open-market buyers.  The Williams Act was adopted to correct a market gone awry.  Where is the argument that in today’s market, not the retail-shareholder dominated market of 1967, even further disclosure is required?  We also wonder about the call for international harmonization on a two-day disclosure rule in the absence of an international rule proscribing poison pills or other managerial defensive measures or setting forth other elements of the shareholder/manager balance.  The point is precisely that Section 13(d) needs to be understood in its corporate governance context, not just as free-floating piece of securities regulation, and implemented in today’s market; not the markets of Sgt. Pepper or Disco, but Electronic Dance Music.

[6] Lucian Bebchuk, Alon Brav, Robert Jackson & Wei Jiang, Pre-Disclosure Accumulation by Activist Investors: Evidence and Policy, forthcoming 39 J. Corp. L (Fall 2013).

[7] Lucian Bebchuk, Alon Brav & Wei Jiang, The Long Term Affects of Hedge Fund Activism, July 2013, available at