Democrats’ Gift-Wrapped Cloak of Secrecy for Wall Street

On July 29, 2021, the House Financial Services Committee voted to advance H.R. 4618, The Short Sale Transparency and Market Fairness Act, a well-intentioned bill with a misguided provision that was likely the product of hurried drafting.  The legislation would require investors managing over $100 million in assets to provide ongoing portfolio disclosure on Form 13-F on a monthly rather than quarterly interval and extend disclosure to short positions and derivatives.

There is much to praise in H.R. 4618.  Current periodic disclosure rules require the reporting of long positions alone, which is partial at best and outright misleading at worst.  Consider a fund following a hedged long-short strategy.  Reporting only the long side of that portfolio is not just incomplete—in the sense that it omits certain securities—but also misleading, because the economic exposure of the short positions may partially or fully offset the long positions.  The same reasoning applies to derivatives.  Instruments like swaps and options can partially or completely reverse the exposure implied by the long side of a portfolio.  And the current quarterly reporting frequency allows hedge funds to strategically hide portfolio positions.  Monthly reporting would be more difficult to manipulate.

Yet buried within H.R. 4618 is a poison pill: Section 4(a) directs the SEC to conduct a study to evaluate whether confidential treatment should be available for Form 13-F filings.  And section 4(c) requires the SEC to enact rules consistent with findings of this study.  The sum of the two sections would give the SEC authority to declare Form 13-F filings confidential.  It goes without saying that if this option were available, every hedge fund would ask for it.  A future SEC might end up exempting the entire fund industry from portfolio transparency.

This is bad policy and bad politics all wrapped up in one.  Let’s start with the policy.  As commentators noted in response to the SEC’s ill-advised proposal to raise the Form 13-F reporting threshold, the public disclosure of portfolio positions on Form 13-F serves a number of important policy goals.  For one, institutional ownership transparency enhances the effectiveness of shareholder engagement with public companies, making it easier to identify stakeholders for debates over corporate strategy, mergers and acquisitions, and activism on environmental, social, and governance issues.  Put simply, it is hard to build a consensus among a company’s shareholders without knowing who they are.

Another critical justification for public disclosure of Form 13-F reporting is that certain derivative positions, such as cash-settled total return swaps, impose a kind of systemic risk that can only be identified by observing the totality of positions opened among market participants.  As the collapse of Archegos Capital Management vividly illustrated, swap positions have a kind of embedded leverage that can lead to margin calls that ricochet throughout the financial system when unexpected volatility hits.  Public disclosure of swaps would shed the spotlight on the systemic risks imposed by derivative positions like these for ordinary investors.

Greater public disclosure of derivatives positions like cash-settled total-return swaps can also enhance the functioning of the market for corporate control.  In the seminal CSX case, Judge Winter called on the SEC to impose greater transparency on the swaps market.  More recently, in the Brookfield case, the Alberta Securities Commission stated in an oral decision that a hostile bidder’s use of and disclosure relating to the Total Return Swaps was clearly abusive to [target] shareholders and the capital market, and therefore contrary to the public interest,” and that “[bidder’s] limited disclosure regarding the Total Return Swaps adversely affected [target] shareholders and the [target] auction process.”  Public disclosure of swaps positions would promote shareholder value maximization in change-of-control transactions.

The politics of H.R. 4618 are quite bizarre.  The legislation inexplicably emerged from committee on a party-line vote, with Democrats voting as a block to potentially exempt the entire hedge fund industry from portfolio transparency.  One has to wonder if a staffer simply made a mistake by not explaining to committee members what they were voting on.  In any event, it hardly seems like smart politics to come down on the side of giving Wall Street a cloak of secrecy.  The best approach is to swallow the watermelon while spitting out the seeds.  A simple amendment to remove section 4’s grant of confidential treatment would do the trick.

This post comes to us from Joshua Mitts, associate professor of law and Milton Handler Fellow at Columbia Law School.