by Cydney Posner
Soon after the Wausau Paper Company was targeted by a hedge fund activist in 2011, Wausau’s paper mill in Brokaw, Wisconsin was shuttered by the embattled company. The mill had been established at the end of the 19th century and, since its founding, had provided employment for 450 people and largely built and sustained the surrounding village. As described by The Boston Globe in this compelling story, the hedge fund activist’s persistent criticism of the company regarding the mill and other assets, especially his disparagement of the CEO’s “troubling” efforts “to prioritize growth” in lieu of returning capital to the stockholders in the form of — surprise — a substantial stock buyback and dividend hike, undermined efforts to rescue and refocus the mill. The closing of the mill in 2012 devastated the residents of Brokaw, as well as the village itself, which is facing dissolution.
The struggle over Wausau may be representative of a larger controversy over whether hedge fund activism has pressured companies to return capital to shareholders in the form of buybacks and dividends at the expense of funding R&D, plant, equipment and other internal investments, thus curtailing innovation and long-term value creation to the detriment of shareholders and the U.S. economy. (See this PubCo post.) To address this issue — to “help ensure that no other small towns in America will fall victim to activist hedge funds” —Senators Tammy Baldwin and Jeff Merkley have introduced the “Brokaw Act.” The bill, S.2720, is co-sponsored by Senators Bernie Sanders and Elizabeth Warren. According to the press release, the bill is designed to enhance transparency, protect companies from “wolf packs” (by shortening the 13D filing period and expanding the definitions of “beneficial ownership” and “person”), end secret net short positions (by requiring more disclosure of derivatives), and address the larger problem of short-termism.
Currently, when a holder acquires beneficial ownership of 5% or more of a registered class of equity, the holder must file a Schedule 13D within 10 days. In addition, under Rule 13d-5, when two or more persons agree to act together for the purpose of acquiring, holding, voting or disposing of equity securities, all of those persons together form a “group” and are deemed to beneficially own all of securities owned by persons in the group. If the group together owns 5% or more of a company’s shares, all of the persons in the group may be required to make filings with the SEC.
Although Congress and the SEC have accelerated the due dates for many types of corporate filings — Forms 4, 10-K, 10-Q, 8-K — the timing for filing Schedule 13D remains, some would say, anachronistically untouched. As a result, Schedule 13D has become the object of some attention, and its long filing window has been viewed as something of a loophole. Last year, the WSJ reported that the SEC was investigating whether some hedge fund activists formed 13D “groups” but failed to make appropriate disclosure of their alliances. According to the report, SEC Enforcement had opened multiple investigations, sending requests for information to a number of hedge funds. The issue was whether, in targeting companies, they coordinated their efforts, or “acted in concert,” to target companies in a way that led to the formation of “groups,” but failed to make appropriate filings. (See this PubCo post.) In addition, as reported by the WSJ and discussed in this PubCo post, several watchdog groups sent a letter last year to the chairs and ranking members of the Senate Committee on Banking, Housing and Urban Affairs and House Committee on Financial Services urging Congress to shrink the reporting window from ten days to one, adopt a “cooling-off period” of two business days after filing of the initial Schedule 13D (during which acquirers would be prohibited from acquiring additional shares) and “modernize” the definition of “beneficial ownership” to preclude the use of stealth techniques and derivative instruments to acquire control and evade the reporting requirements. The letter observes that lawyers and academics have long sought to convince the SEC to shorten the window, but to no avail. In the absence of any regulatory action, the watchdog groups appealed to lawmakers to step in with a legislative solution.
That legislative solution may have finally arrived. The Brokaw Act would require the SEC to amend Rule 13d-1 to shorten the time to file a Schedule 13D from 10 days to two business days and to expand the definition of beneficial ownership in Rule 13d-3 to include, in addition to voting or investment power, a direct or indirect pecuniary interest in the security. “Indirect pecuniary interest” would include, among other things, an opportunity to profit, whether or not then exercisable, including securities held by family members who share the same household, the proportionate interest of a general partner and certain performance-based fees. (There is a fairly elaborate scheme provided for making calculations related to the derivatives, including proscription of netting of long and short interests.) The bill also would define the term “person” to include two or more persons acting as a group “or otherwise coordinating the actions of the persons” for purposes of acquiring, holding or disposing of securities, seeking to control or influence the board, management or policies of the issuer, “evading, or assisting others in evading, the designation as a ‘person’,” or a hedge fund or group of hedge funds or persons that are “working together to evade the requirements of” the Williams Act. Under the bill, Section 13 of the Exchange Act would be amended to add a broad concept of “short interest” and to require a filing similar to a Schedule 13D upon the acquisition of beneficial ownership of short interests aggregating 5% or more of the same class, regardless of the form of short interest.
But how would this bill address the problems targeted? One problem high on the list is the conduct of “wolf packs.” As discussed in this post from Columbia Law Professor John Coffee, a “wolf pack,” is “a loose association of hedge funds (and possibly some other activists) that carefully avoids acting as ‘group’ so that their collective ownership need not be disclosed on Schedule 13D when they collectively cross the 5% threshold.” Coffee observes that, for the past decade or so, wolf packs have often relied on “offensive” tactics (i.e., where the hedge fund purchases shares “specifically to challenge management”) that, in effect, seek to engineer stock price increases, such as through stock buybacks. One of the wolf pack tactics that Coffee identifies is the practice of “conscious parallelism.” As discussed in this PubCo post, citing a WSJ article, members of the pack often use the 10-day window prior to disclosure to tip their plans, profiting from the use of material nonpublic information. An analysis by the WSJ demonstrated that, in the “10 trading days before bullish activists revealed in regulatory filings that they had bought particular stocks, the stocks rose an average of 3.2% more than the overall market…. Similarly, an analysis of 43 announcements by bearish activists… found that in the preceding 10 trading days, shares of targeted companies fell by an average of 3.8% more than the market as a whole.” The hedge fund activist can then exploit these changes in share price. The practice of tipping other investors, the article charges, “is part of the playbook. Activists, who push for broad changes at companies or try to move prices with their arguments, sometimes provide word of their campaigns to a favored few fellow investors days or weeks before they announce a big trade, which typically jolts the stock higher or lower. In doing so, they build alliances for their planned campaigns at the target companies. Those tipped—now able to position their portfolios for price moves that often follow activist investors’ disclosures—benefit in a way that ordinary stockholders who are still in the dark don’t.”
As Professor Coffee points out, these wolf pack “profits are nearly riskless.” Coffee indicates that the market reaction to a 13D filing that announces formation of a wolf pack substantially exceeds that for 13D filings by other activists — a 14% abnormal gain as opposed to 6% — and attributes this reaction to a market perception of a higher likelihood of a takeover premium or a “bust-up” sale. He also cites two recent studies that show there is a more than 75% probability of success for wolf pack campaigns. As he contends in this post from January 2016, because an abnormal trading gain of 6% to 8%
“is a statistical near-certainty on the day the Schedule 13D is announced, others will join the wolf pack to get in on the profit. Some may leave soon thereafter, but most will stick around, at least long enough to see if a takeover bid is likely to be forthcoming. This riskless profit may generate an excessive incentive for activism, but it is dependent on three factors: (1) that tipping and trading on such information does not amount to unlawful insider trading; (2) that the long 10 day window between when a shareholder crosses the five percent beneficial ownership level and when it must file its Schedule 13D gives those in the activist community sufficient time to learn and trade on this information of a forthcoming Schedule 13D filing; and (3) that the informed players in this recurring ritual do not constitute a ‘group’ for purposes of the Williams Act (as poison pills would typically be triggered if the ‘wolf pack’ were a ‘group’). If any one of these three could be chilled or modified, the ‘wolf pack’ tactic would be less formidable.”
Can the three factors that, in Coffee’s view, support hedge fund activism be undermined? With regard to insider trading, Coffee dismisses as unlikely that insider trading charges related to wolf pack tipping would succeed under current legal standards. He also observes that, notwithstanding authority given to the SEC in Dodd-Frank to shorten the 13D filing period, the SEC has been reluctant to do so. (The reason, according to Coffee: The SEC “knows that to do so would expose it to outraged criticism from institutional investors and knee-jerk academics, who both believe that activists are doing the Lord’s work.”) The Brokaw Act, if passed and signed into law, would turn that reluctance into a mandate. But the most important reform, in Coffee’s view, would be a redefinition of “the concept of ‘group’ under Section 13(d)(3) of the Securities Exchange Act so as to reach the ‘wolf pack.’ Here, the justification would be that the ‘wolf pack’ is simply a device by which sophisticated parties can evade disclosure, and the SEC needs to respond to new developments…. Absent such a rule, shortening the 10-day window might accomplish little, because sophisticated hedge funds could each buy up to 4.99%, file nothing, and deny that any ‘group’ had ever been formed.” Although the new bill does not seek to amend Section 13(d)(3), it does shorten the 10-day window and attempt to expand the rules defining “person” and “beneficial ownership” in ways designed to have a similar effect on the formation of “groups.”
Whether the bill would address the problems it targets remains to be seen. Moreover, in this article, the WSJ predicts that the bill is unlikely to pass. Nevertheless, that conclusion may have been too facile, perhaps based on the likelihood of a Republican Congress favoring a bill supported by these particular sponsors (or maybe more realistically, based on the likelihood of this Congress passing anything.) However, many business interests are likely to favor the bill. In addition, as the WSJ observes, the bill also “taps into the populist sentiment that has defined much of the 2016 election.” And if anything has been true about this election season — and the populist sentiment that has fueled it — it is that all predictions have been wildly off the mark.