Corporate Governance Update: 13D Reporting Inadequacies In An Era Of Speed And Innovation by Wachtell, Lipton, Rosen & Katz
David A. Katz and Laura A. McIntosh
The Securities and Exchange Commission and other market regulators confront a challenging issue: How to effectively monitor and regulate activity in an environment that is both fast-moving and highly complex? The principles and architecture of the Securities Exchange Act of 1934 were created for a much simpler financial world—an analog world—and they struggle to describe and contain the digital world of today. The lightning speed of information flow and trading, the constant innovations in financial products, and the increasing sophistication of active market participants each pose enormous challenges for the SEC; together, even more so. The ongoing controversy over Section 13D reporting exemplifies the many challenges facing the SEC in this regard.
In 2011, then-SEC Chair Mary L. Schapiro announced a broad review of the beneficial ownership rules governing the ownership reporting requirements for equity securities. The SEC had been formally petitioned that year to update the Schedule 13D reporting requirements to shorten the reporting window—specific authority for which had been provided by the Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010—and broaden the definition of beneficial ownership. Unfortunately, Section 13D reform was delayed by the over-whelming volume of rule-making required under Dodd-Frank. A recent letter to Congress signed by several ethics and watchdog groups renewed the call for intervention by lawmakers on this important issue. Though the requirements of Section 13D related to the timing of required disclosure unfortunately appear unlikely to be revised in the near future,
5 the SEC appears to be keenly aware of the rules’ regulatory shortcomings. The SEC announced eight settlements of Section 13D enforcement actions in March 2015, and it is reportedly investigating a number of situations in which activist funds appear to have informally coordinated their market activity. Section 13D is an essential tool for promoting transparency and market integrity. While judicious enforcement in the short term may be helpful, comprehensive reform should be accomplished as soon as practicable.
Reporting Is Not Timely or Thorough
The reporting regime under Section 13D of the Securities Exchange Act is, as it stands, woefully inadequate. Section 13D fails to require timely or thorough disclosure. In a world of instant information, the deadline for filing a Schedule 13D remains 10 calendar days after crossing the 5 percent ownership threshold.6 This window is large enough for material developments to occur in secret, undermining the regulatory goals of investor protection and market efficiency. Exacerbating this issue is the fact that the investor can continue to make acquisitions during the 10-day period even after crossing the 5 percent ownership threshold. Hedge funds and other activists have, in recent years, used this gap to accumulate large positions and gather support among fellow investment funds. The target company, the other shareholders, and the market have been none the wiser until the activists had amassed positions and influence well in excess of 5 percent. Though the 5 percent threshold is recognized as an important trigger for market disclosure, the 10-day window permits accumulators to continue acquiring additional shares without the market price reflecting the impact of such accumulation.
Clearly, technological advances have made short filing deadlines practical and desirable. Moreover, since crossing the 5 percent threshold is rarely a surprise to the beneficial owner of the securities, there is no reason that the Schedule 13D cannot be prepared in advance and filed almost immediately upon acquisition of the reportable interests. Currently, if there is a material change to a Schedule 13D, an update must be filed “promptly,” which—at least when the material change involves 1 percent or more of the subject securities—is generally understood to mean within one or two business days, and in many circumstances, the SEC staff’s view has been that disclosure should be made the same day as the triggering event. There is no reason that the initial report cannot be filed within one or two business days as well. Delaware Supreme Court Chief Justice Leo Strine Jr., speaking at a conference in March 2015, added his voice to those calling for reform of Section 13D. Chief Justice Strine recommended requiring “real time” disclosures, possibly within 24 hours, as well as reducing the stock ownership threshold to 2 percent and including options and derivatives in the required disclosures.
As Chief Justice Strine suggested, another significant shortcoming of Section 13D is that it does not currently require full disclosure of an investor’s significant positions. A sophisticated investor can accumulate a variety of influential interests in a target stock and complex, dynamic combinations of economic and voting power without having to publicly report any of them. Disclosure of derivatives such as options, warrants, and convertible securities is required only in limited circumstances, while non-traditional, synthetic arrangements generally are not covered, and short positions, even very large ones, are not disclosable at all. This leaves a vast universe of securities beyond the reach of Section 13D. Earlier this year, SEC Commissioner Luis Aguilar noted that the size of the global derivatives market is currently estimated at $630 trillion, with approximately $14 trillion representing transactions in securities-based swaps regulated by the SEC.
Derivatives and synthetics—which are not a limited set of products but the subject of constant innovation and, moreover, easily customizable-can serve to “decouple” the traditional bundle of rights and obligations of stockholders and thereby separate voting from economic interest. The challenge for U.S. governance and regulatory mechanisms, which are largely predicated on disclosure requirements as a means of promoting market efficiency, is to capture the complexities of these arrangements.9 As it now stands, financial innovation has undermined transparency. As Professor Henry T.C. Hu eloquently states:
The [public disclosure] system is manifestly insufficient to capture the complex objective realities that are now being created by financial innovation…. This informational challenge undermines the panoply of transparency-dependent corporate governance mechanisms, including equity-based compensation systems to align management and shareholder interests, the market for corporate control, and the monitoring of management behavior and performance.”
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