COMMENTARY: SEC needs scalpel instead of chainsaw in revising beneficial ownership rules

October 29, 2015

By Lawrence Hsieh, Practical Law

The U.S. Securities and Exchange Commission is considering whether and how to stop the regulatory arbitrage by shareholder activists of gaps in Securities Exchange Act disclosure requirements, which activists have exploited to gain significant stakes in public companies before incumbent management notices. Shareholders may be best served if the SEC takes a scalpel rather than a chainsaw to address the issue.

Section 13(d) of the Securities Exchange Act of 1934 requires any person or group that acquires more than five percent “beneficial ownership” of public company equity securities to disclose its position within 10 days of crossing the threshold. SEC rules currently define “beneficial owner” to include any person who directly or indirectly shares voting or investment power in (the power to sell) the security, even if the shares are held by somebody else.

Corporate management and their supporters often complain that current law allows activists to pass the 5-percent threshold and continue to secretly accumulate equity during the 10-day window. They also contend that the current beneficial ownership test fails to capture the myriad ways that activists use derivatives to exert their influence over management.

All of this is true. The question for policymakers, however, is whether the SEC should exercise its broad authority under the Dodd-Frank Act to amend the rules and tilt the balance of power in favor of management.

Pro-management commentators want the SEC to reduce the reporting window, with some advocating for a one-day window, because of advances in computer trading that they claim render the 10-day window obsolete. But investors never really needed 10 days to prepare their disclosures even decades ago when they prepared them on typewriters and delivered them by messenger.

A one-day window, together with the proposed two-day moratorium on the acquisition of additional shares after the investor crosses the 5 percent threshold would tilt the balance of power overwhelmingly in favor of management. It would do this by giving management more opportunity to respond quickly and prepare increasingly sophisticated state-law regulated poison pill and other defenses. That could chill even the constructive activism that provokes changes that enhance shareholder value.

The issue of beneficial ownership is a bit murkier. SEC rules already impute beneficial ownership to holders of physically-settled (that is, securities-settled) swaps because the instruments must be settled by physical delivery of the underlying shares. The rule captures options, warrants, convertible bonds and securities futures that can be converted into the underlying equity securities within the specified period of time (60 days under the current rules), as well as arcane instruments like securities-settled total return equity swaps (TRS).

Management has been alarmed by the increasing use by activists of cash-settled equity derivatives to promote their goals. Until recently, the orthodox view has been that cash-settled equity swaps do not automatically convey beneficial ownership because the swaps can only be settled in cash, and not by physical delivery of the underlying shares to the swap buyer.

Swap sellers, however, frequently purchase the underlying shares to hedge their obligation to pay any appreciation in stock price to the swap buyers.

Management is afraid that the close relationship between swap buyers (typically hedge funds, including activists) and swap sellers (typically banks) creates business incentives for swap sellers to vote the hedged shares as implicitly directed by swap buyers and to make the hedged shares available to the swap buyers when the swaps are unwound. Therefore, management and its supporters believe that swap buyers should automatically be deemed beneficial owners of any shares that swap sellers purchase to hedge their TRS obligations.

The most aggressive pro-management position advocates the broad expansion of the definition of beneficial ownership to automatically cover any derivative or technique that conveys the direct or indirect opportunity to profit from any movement in the value of the underlying security, including short-selling. This definition automatically captures all cash-settled equity derivatives, even if there is no agreement or understanding between the swap parties that the swap seller must hedge or vote the hedged shares a certain way and even if it decides not to hedge at all.

Wholesale action by the SEC to expand the beneficial ownership reporting requirements may very well deter outlier stake-building activity, such as the coordinated attempted effort by Valeant Pharmaceuticals and the hedge fund Pershing Square to acquire Botox-maker Allergan Inc. But it also likely will chill constructive activism, and perhaps in ways that nobody can predict, especially in the context of the concurrent reform that is taking place of the proxy and tender offer rules and corporate governance in general.

We have already seen in other markets like the credit market how overregulation has caused a gap between the rapidly growing appetite for corporate bonds and the contraction in the availability of credit default swaps that perform an essential hedging function. Nobody is seriously advocating for a total ban on equity derivatives like the current ban in some markets of naked credit default swaps. But if the SEC takes action on beneficial ownership, it must take care not to inadvertently chill the primary use of derivatives and short-selling techniques for routine and positive hedging purposes.

Furthermore, the SEC already has an “avoidance rule”, which confers beneficial ownership on anybody who uses a security-based swap (like a cash-settled TRS) as part of a “plan or scheme to evade the reporting requirements.” This is how the court found the TRS holder liable in one of the only cases to address the issue, the 2011 Second Circuit case CSX Corporation v. The Children’s Investment Fund Management. A divided court did not decide the baseline question whether cash-settled TRS automatically confer beneficial ownership in the underlying securities.

The avoidance rule as it exists might already cover the even newer techniques that activists have employed to combine an investment in equity or equity swaps and credit derivatives to target distressed public companies.

Shareholders of distressed companies are sitting ducks in bankruptcy and have the incentive to vote for corporate lifeline transactions. But shareholders who are also CDS holders might not have the same incentive. CDS holders (especially naked-CDS holders) are fully hedged against credit events and may believe that they are better off by coaxing the company towards bankruptcy. They might exercise their shareholder rights to vote down corporate lifeline transactions. Regulations that target a subset of behaviors might be unwieldy to enforce, but they are less likely to chill constructive activity than expanding the definition of beneficial ownership to automatically include credit default swaps, as some academics have suggested.

SEC Commissioner Daniel Gallagher indicated in October, 2014 that given its full plate, a change to the rules will likely not take place in 2015. Given the potential unintended consequences of dramatic action, this delay might be a good thing.

(Lawrence Hsieh is a senior legal editor for the Practical Law division of Thomson Reuters. The views expressed here are his own. Lawrence is a graduate of the University of Chicago Law School and holds an engineering degree from Cornell University. Lawrence is the author of the Corporate Transactions Handbook.)

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