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Jun 09, 2022

All change: A look at how rule changes at the SEC might affect IR

The modernization of disclosure rules may see the US finally close in on global peers but there is still a shortfall in the era of Elon Musk's Twitter takeover

The SEC is consulting on a range of proposals designed to give issuers more timely information about who owns and is trading in their shares and related derivatives. While companies and commentators welcome the proposals’ sentiment, some argue the mooted provisions do not go far enough.

One of the proposals concerns section 13D of the Securities Exchange Act of 1934, which requires investors that secure 5 percent or more of a public company’s shares to disclose this information to the market through an SEC filing within 10 days of reaching the 5 percent benchmark. The proposal would reduce this to five days.

It’s worth noting that the US is the outlier globally with regards to the length of time investors have to disclose a material interest in a stock. In the UK and Australia, the equivalent is two days, in Hong Kong it’s three and in Germany it’s four.

‘The 10-day rule was made at least 50 years ago, in a time without the technological advances we have now, when trading was much slower than it is today,’ explains Holch & Erickson attorney Niels Holch, who has advised NIRI and the US’ Society for Corporate Governance on these issues.

He has also been directly involved in the SEC’s working groups on shareholder transparency. Holch supports the five-day rule, which would mean the market has information sooner when an investor is acquiring a large volume of stock.

NIRI’s outgoing president Gary LaBranche says the information asymmetry the existing rules facilitate when a party is building up a material interest in a stock behind the scenes is not fair to the remaining 95 percent of the owners in a company.

‘It means the activist investor has the opportunity to buy shares cheaply and then benefit from an increase in value of those shares,’ he points out. ‘This disenfranchises the vast majority of the shareholders.’

There are reasons companies want to see the rules modernized, says Ted Allen, vice president for policy and advocacy at the Society for Corporate Governance.

‘It will make it easier for the executive team to engage with existing investors and find out whether they agree with the hedge fund’s demands – such as a sale of part of the company, job cuts or large share buybacks. Often, the hedge fund will want the company to take action that may raise the share price in the short term, but may not be in the best long-term interest of the firm.’

More relevant info sooner

The SEC is also canvassing amendments to section 10b-1 of the Securities Exchange Act of 1934, which relates to cash-settled equity swaps investors buy through financial institutions. Swap holders achieve the same exposure to a stock as they would have as a shareholder, minus voting rights. ‘They still enjoy any share price increases and receive dividends. They receive most of the benefits of being a shareholder, without actually being a shareholder,’ says Holch.

Under existing rules, cash-settled equity swaps don’t count toward the 5 percent threshold under which investors must disclose their holding in a company. So activist investors such as hedge funds use these derivatives to get around these rules, giving them more time to accumulate shares before they need to go public. This also gives them discretion as to when they want to convert the swaps into shares and trigger the 5 percent threshold. By the time they go public, the fund may have already built up a 6.5 percent or 7 percent stake in the firm without the company being aware.

This rule hit the headlines when Tesla founder Elon Musk first acquired a large position in Twitter shares. It’s understood that although Musk had built up a 5 percent position in the stock by the middle of March, he was able to secure an almost 10 percent position in Twitter shares by buying cash-settled equity swaps, without the market being aware he was accumulating stock.

‘The loopholes in 13D have been used as an opportunity for hedge funds to collect an interest of more than 5 percent of stock in a way that can surprise the market and the company,’ says Holch.

‘So the SEC is proposing to have cash-settled equity swaps count toward the 5 percent limit. We also support this rule, which I think has a very good chance of being finalized, although we’re just at the proposed rule stage now.’

Should the proposed rules be approved, listed businesses will have information about hedge fund positions in their stock sooner. This will give issuers more time to prepare to engage with the shareholder building a material position in their stock and potentially understand the reason behind the move.

This is an extract of an article that was published in the Summer 2022 issue of IR Magazine. Click here to read the full article.