Last February, the Securities and Exchange Commission proposed to “modernize” the reporting of beneficial ownership of a company’s stock under section 13(d) of the 1934 Securities Exchange Act.  As I explained in a recent comment letter to the SEC, the proposal is flawed in several ways. First, it risks suppressing proxy contests, which are the principal, if not the sole, method for holding corporate managers accountable to shareholders. Second, to the degree the Commission is concerned about improper tipping of information related to activist engagements, that concern can and should be addressed by developing new rules specific to such tipping and trading rather than by the proposal’s ambiguous new definition of a “group.” Third, in light of the SEC’s concerns about the use of swaps to disguise potential control positions, I propose a “safe harbor” for parties entering into certain swaps that clearly do not implicate those concerns. Finally, the Commission’s proposed definition of “group” is theoretically untenable and practically unworkable and should be abandoned until the SEC can more carefully consider its implications.

The proposal’s biggest flaw is, perhaps, its likely threat to proxy contests. First, a framing point.  The Williams Act was enacted in 1968 to deal with the surge of a new form of control transaction, the hostile tender offer, which could result in a transfer of control through the accumulation of shares in a very short period.   The act had two elements: first, the creation of an “early warning system” under section 13(d) to alert the target and investors of an accumulation of stock that could precede a control transaction, and second, the regulation of the tender offer itself under section 14(d).   Hostile tender offers, however, are essentially a thing of the past, suppressed by the poison pill, a private-ordering creation licensed by state corporate law.  It would be perverse to the turn section 13(d) of the Williams Act against what was the preferred form of governance challenge prior to the hostile tender offer – the proxy contest – but this is what the SEC’s proposal risks doing. This point must be emphasized: Without a credible threat of maintaining a proxy contest an activist investor is simply a gadfly, noisy perhaps, but just a gadfly.  And if we suppress proxy contests, we close down the most important channel for managerial accountability and corporate legitimacy.

The proposal does this in at least three ways.  First, it shortens to five calendar days the “10-day window” following a party’s acquisition of 5 percent of an issuer’s securities.  Since purchases subsequent to a 13D filing will impound the expected gains from shareholder engagement, shortening the window will in many cases significantly reduce the activist’s potential economic return and thus will probably reduce the number of engagements, especially for smaller issuers.  Second, the proposal would classify the “underlying” shares of a cash-settled derivative as beneficially owned by the long party on the swap.  Combined with the shortened disclosure window, this will in in many cases significantly reduce the activist’s potential economic return and thus is likely to  reduce the number of engagements. Third, the proposal would create a nebulous definition of a “group” that would chill the kind of persuasive interactions that are essential to a successful proxy contest in light of the heavily institutional share ownership of many corporations.

Let me add some detail.  For activist challenges to large capitalization companies, the 10- day window may be of little importance because the activist stake does not exceed 5 percent.  But for medium-cap and small-cap companies the 10-day window is important because of its impact on the activist’s economic returns.  How so?  Given the current pattern of institutional ownership, the costs of an activist contest are relatively fixed.  The cost of a detailed analysis of a company’s business plan does not significantly increase with the size of the company.  Nor do the shareholder solicitation costs, since these days, a credible proxy battle depends on reaching a relatively small number of asset managers and institutional investors, not the willingness to mail out proxy materials to millions of shareholders. For an activist engagement with a large-cap firm, earning a 7 percent return on a small (in percentage terms) position will cover those fixed costs.  But for a mid-cap or small-cap firm, a larger percentage of ownership is required to cover those costs as part of the activist’s economic return.  For all but the largest firms, however, liquidity for significant stock purchases is somewhat limited. This means a party that seeks to accumulate a meaningful block without significantly affecting the market price needs a longer trading period.[1]  This where the 10-day window becomes important: It provides enough trading days for the activist to acquire an economically sufficient position in a company’s stock.

To be clear, the positions typically acquired by activists over the 10-day period do not amount to a control block, which was a concern of the Williams Act. Indeed, the Williams Act initially made 10 percent the triggering ownership threshold, intending thereby to add disclosure to the notice provision of section 16(a) of the 1934 Act. Although the legislative history is sparse, the change in 1970 to 5 percent was apparently triggered by the practice of prospective tender offerors of acquiring 9+ percent before then launching their bid. [2]  A 10 percent position is even less of a control threat today than in 1968 both because of the domination of institutional ownership and because of the poison pill, possessed in shadow form by all companies even if not formally adopted.  This generally has limited activist accumulations (except in the rare case) to less than 10 percent.

There are two objections to a 10-day window: first, that it enhances the extent of “information asymmetry” between the activist and uninformed market participants and, second, that it facilitates the formation of so-called “wolf packs.”  The “wolves” may be thought of as risk arbitrageurs who simply want the activist initiative to succeed so they can realize a short term gain.  Some believe that, after the activist has acquired its desired block, the activist facilitates the shift of stock into the hands of such outcome-motivated parties through strategic tipping.

The SEC seems very concerned about wolf packs because it would include tippees in the “group” whose stock ownership must be aggregated for other purposes under the proposed rule.

In my view, an activist is entitled to full economic return on the information that it has generated. As to information asymmetry in  transactions with an activist, the SEC ought not target it  any more than information asymmetry in transactions with a skilled and highly reputed investor whose 13F reports produce a market reaction.  This information asymmetry is bound up with an economic reward for activism, without which activism will cease.  Tippees are different.  I’ve argued that activists serve the useful role of “potentiating institutional voice;” teeing up questions about the company’s current strategy and operational skill for resolution by the longterm institutional holders whose business model makes them “rationally reticent.”[3]   Parties who are trying to capture the information asymmetry from an activist’s tip will have a different motivation from the longterm holders in this model.  They will be biased in favor of the activist’s proposal to realize the immediate gain and to gain a reputation as a reliable supporter, to keep the flow of tips coming.

I have serious doubts about the frequency of wolf packs and the purported practice of tipping such investors to gain supporters of the activist intervention.  But here is a substitute proposal that both preserves the activist’s ability to profit from information that it generates while reducing the risk that obviously troubles the SEC:  Leave the present 10-day window but impose a prohibition on tipping by an activist as soon as it reaches the 5 percent disclosure threshold until it files a 13D.  Such a rule would leverage the incentives of the activist in appropriate ways.  Until it has finished it own acquisitions, the activist is highly unlikely to tip any other party, because another’s substantial buying activity and the related information leaks will raise the activist’s own acquisition costs and thus reduce its rewards.  After it has finished its own acquisitions, until it has filed at 13D, the proposed rule would bar the activist from tipping others.[4]

Another piece of the proposal, Rule 13d-3(e), would deem the long party on a total return swap to be the beneficial owner of the underlying equity securities.  The argument against finding “beneficial ownership” is that this cash-settled arrangement gives the activist more “skin in the game,” which adds to the activist’s incentives “to get it right” in its activism campaign, without increasing the activist’s ability to directly affect the outcome through additional voting power.  Some contend that a total return swap works differently in practice: The securities industry counterparty will acquire target securities to hedge its swap obligation, will vote such securities in accord with its customer’s wishes, and stands ready to unwind the swap at its customer’s request.  This functionally gives the activist additional voting power and an option on the securities and thus the potential to assert voting rights directly.  Of course, industry participants have vociferously challenged these contentions as a factual matter.

One way out of these conflicting factual claims is a “safe harbor” that would exempt from beneficial ownership swaps and cash-settled derivatives that cannot obtain voting rights. For example, consider securities that are subject to a “qualifying swap agreement” pursuant to which (1) the securities industry counterparty agrees to vote shares acquired as a hedge in proportion to votes cast by other shareholders (“mirrored voting”) and (2) the parties agree that the swap may not be unwound until after the record date of the proxy contest linked to the activist campaign.  As to shares associated with such a “qualifying” total return swap, there can be no doubt that the activist has neither voting control nor a right to acquire, both of which have been traditionally associated with “beneficial ownership.” Such an arrangement isolates the economic upside of successful activism without reducing the decision-making power of the longterm holders.

As to the “group” concepts in the proposal, frankly there is little good to say.  If the SEC has a legitimate concern, it is with parties that have been drawn into the activism campaign by the lure of tip before the filing of the 13D, the so-called wolf pack. I have attempted to deal with that issue previously with an anti-tipping rule.  The commission seems to think that “group” formation should extend beyond an explicit or implicit agreement to all parties “that act as a group.”  I think the most natural reading of section13(d)(3) includes an explicit or implicit agreement.   The statute reads, “When two or more persons act as a partnership, limited partnership, syndicate, or other group….” (emphasis added).  So far as I am aware, “partnerships, limited partnerships, and syndicates” are founded on agreement, express or implied, so in embracing “or other group,” I think the statute embraces that essential feature. Any “group” concept that goes beyond “agreement,” explicit or implicit, sets a trap for the unwary and could chill legitimate activity.  The effort to provide additional guidance is likely to involve the SEC in either unsatisfying no-action practice or multiple enforcement actions that will take the definition outside of the commission’s purview into the courts.  This cannot be the best use of scarce commission resources.

The SEC’s rules (and its background explanations) would result in the phrase “act as” having two different meanings. One meaning, in the statute, is, limited to actions that involve partnerships, limited partnerships, syndicates, and other groups. But the rules (and explanatory gloss) seemingly use the same phrase, “act as,” to indicate something much broader, sweeping up other activities that involve actions and communications based on the vague notion of “influencing control” coupled with an ex post assessment of whether communications or actions were undertaken with this purpose or effect.  Frankly this second reading really means to reach parties who act “as [if they were] a group,” an impermissible extension of the statutory language to reach parties who have not created or joined a group.

The deep mischief of the SEC’s “group” definition is shown by the effort to create an “acting as a group” carve-out in proposed rule 13d-6(c) that would permit shareholders to communicate with one another, unless such communications “are undertaken with the purpose or the effect of changing or influencing control of the issuer and are not made in connection with … any transaction having such purpose or effect.”  This rule would chill the kind of shareholder communications that are central to a proxy contest.  Proxy contests, unlike tender offers, are about persuasion.  A shareholder facing a tender offer needs to decide only whether the offer is above the shareholder’s reservation price for the security. If the tender offeror’s business plan is unsound, that’s of little concern to an exiting shareholder.  A proxy contest is altogether different: The shareholder stays aboard for the ride. Consultation among fellow shareholders and discussion with the activist are an essential part of the story.  I do not think the SEC has been sufficiently careful in its “group” definition to avoid harm to the U.S. system of corporate governance.

With the rise of ESG activism, the next period is likely to see many proxy contests that put at issue the “purpose” of U.S. public companies and that may seek “change” through director election contests.  I think it unwise for the SEC to put in place rules that destabilize the existing and reasonably well-understood rules of behavior by shareholders, including institutional investors and asset managers.

ENDNOTES

[1] See Pierre Collin-Dufresne and Vyacheslav Fos, Do Prices Reveal the Presence of Informed Trading?, 70 J. Fin. 1555 (2015).  This consideration dominates the argument about technological advances in registering trading activity.

[2] See Note, Section 13(d) and Disclosure of Corporate Equity Ownership, 119 U. Pa. L. Rev. 853, 862-64, 865 n. 56 (1971).

[3] See Ronald Gilson and Jeffrey Gordon, The Agency Costs of Agency Capitalism: Activist Investors and the Revaluation of Governance Rights, 113 Colum. L. Rev. 863 (2013).

[4] This appears to be the intended result of proposed Rule 13d-5(b)(ii) et seq. that would make such a tippee a member of the activism “group” while imposing an unworkable burden on the tipper of monitoring the transactions in target securities of a party with which it has no agreement. Rule 14e-3 captures the spirit but imposes the obligation on the tippee not to trade rather than on the activism proponent to refrain from divulging information about the intended activist engagement to parties who it should reasonably believe will use that information to purchase target stock before the filing of a 13D.  Any rule should have a carve out for swap dealers who are purchasing securities to hedge a long swap position entered into by the activism proponent.

This post comes to us from Jeffrey N. Gordon, the Richard Paul Richman Professor of Law at Columbia University and co-director of the Millstein Center for Global Markets and Corporate Ownership.