DLA Piper: Expect Greater SEC Scrutiny Of Activist Hedge Funds That Share Information Or Collaborate In Advance Of Their Trades

By Perrie Michael Weiner and Patrick Hunnius

A recent Wall Street Journal article – “Activist Investors Often Leak Their Plans to a Favored Few” – focused attention on “activist” investors and stock analysts who (as part of their bullish or bearish campaigns for or against companies in their sights) “tip” other investors about their planned campaigns and their accumulation of long/short positions. 

While the article caused quite a splash, what seems to have gone unnoted is that the article appears to provide further confirmation that the SEC is turning more aggressive attention toward shareholder activists and the type of “tipping” described in the Journal article.  Moreover, the article itself has revived an issue that has been lying dormant for years – should, and will, the rules regarding the timing of filing Schedule 13Ds be revised by the SEC?

The SEC identified funds sharing information about trading as conduct that “crosses the line” three months before the Journal article

The Journal article focused on instances where “activists” “sometimes provide word of their campaigns to a favored few investors days or weeks before they announce a big trade, which typically jolts a stock higher or lower.”  According to the article, many lawyers, including ourselves, believe that this type of conduct would not raise insider-trading “risks … because this typically doesn’t involve a breach of a duty to keep the information confidential.”  The article goes further, citing information from an SEC spokesman who said “he couldn’t recall the agency having brought a case in the area.” 

Nevertheless, the article also says that “the SEC has increased its focus on activist investors’ moves, including whether there is proper disclosure” and that the SEC is investigating “whether some hedge funds were working together to try to profit ahead of public disclosure of an investment stake.”

While unnoted in the Journal article, the SEC’s Staff earlier this year explicitly warned hedge fund compliance officers that such conduct is a “risk to be mindful of” and may “cross the line.” In January 2014, the SEC presented its annual National Seminar as part of its Compliance Outreach Program.  (A webcast of the seminar can be found here.)  At the seminar, a presentation slide identified “Controlling Non-public Information about Clients/Funds (e.g., collaborating on ideas with other managers)” as a risk for hedge funds. 

Ashish Ward, an Exam Manager in the National Exam Program, explained during the seminar that “non-public information about clients/funds” that should be controlled includes: “information about your hedge funds themselves,” “what exactly they are holding,” and “what exactly that they are trading.”  Mr. Ward further elaborated:

We understand common practice in the hedge fund business is to share investment ideas about companies, but you want to make sure those conversations don’t go so far as to actually discuss what you are actually doing right now….that would be information that’s non-public.    

Mr. Ward further noted that while funds may make quarterly, backwards-looking filings that reflect their holdings, those filings do not show “what you held yesterday, today or what you intend to trade and that’s where you could cross the line and… disclose non-public information about your fund holdings.” (emphasis added)

If the view expressed by Mr. Ward is the prevailing view among SEC examiners or Enforcement staff, that is an aggressive read of the law and will clearly spawn investigative and enforcement activity (and an aggressive push-back by the funds in their sights). 

In addition to confirming the SEC’s heightened interest in collaboration, the Wall Street Journal article has revived the 13D debate

Ironically, given that the focus of the Journal article was largely on short sellers who had not acquired sizable blocks in issuers, the immediate fallout from the article, as subsequently reported by the Journal, was a new call “on the Securities and Exchange Commission to cut the time that large investors can secretly amass shares in a company.”  And this revived call for changes to 13D appears to have significant Congressional support.

In 2010, Congress amended – via Dodd-Frank – Section 13(d) of the Securities Exchange Act of 1934 to allow the SEC to use its rulemaking authority to shorten the time period during which a stockholder owning more than 5 percent of an issuer’s securities must report their ownership (by filing a Schedule 13D).  (Section 13(d) formerly had explicitly allowed up to 10 days for the shareholder to report the acquisition.) 

Thereafter, the SEC was formerly petitioned (in 2011) to revise the rules to require “that the initial Schedule 13D filing be made within one business day following the crossing over the five percent ownership threshold.”  At that time, the general concept of shortening the time period appeared to have had the tacit approval of the SEC’s former chairman, Mary Schapiro, who said in 2011, “We think it's important to modernize our rules, and we are considering whether they should be changed in light of modern investment strategies and innovative financial products,” and noted that “many feel that the 10-day window results in secret accumulation of securities” and "material information being reported to the marketplace in an untimely fashion.”

Then the issue essentially died.  The SEC, perhaps because of the nearly 400 rules Dodd-Frank required it to write, “didn’t have a chance to address this issue” during Ms. Schapiro’s tenure.

Now, however, as Mary Jo White celebrates her first anniversary as SEC Chair, the issue of revising the 13D timetable is alive once again, largely due both to the Journal article and its confluence with another event: the news that such a measure has the support of perhaps the preeminent juridical voice in American corporate law, Chief Justice of the Delaware Supreme Court Leo E. Strine, Jr. 

In a lengthy essay published recently in the Columbia Law Review, “Can We Do Better by Ordinary Investors?,” the Chief Justice offers several specific prescriptions for a “more sensible system of corporate accountability.”  One of the items he notes that is “needed” to improve the system is “The Need for the Voting Electorate to Know More About the Economic Interests of Activist Stockholders Proposing to Influence and Alter Corporate Business Strategies.”  In that section of his essay, the Chief Justice stated he did not want to “wad[e] into … the debate” about whether Section 13(d) should be amended in accordance with the 2011 petition (noted above).  Nevertheless, given the pointed questions he raises for those who oppose 13D reform it seems clear that he does support “requirements to make sure that up-to-date, complete information about [significant shareholders’] economic holdings and interests is available;” and the imposition of “filing standards consistent with current technological and market developments,” including “updating their filing within twenty-four to forty-eight hours if their ownership interest changes by one percent in any direction, long or short.”

Time will tell whether this new momentum will be sustained or whether there will be increased attention to other aspects of 13D (such as disclosures of “group” activity).  Alternatively, the focus may shift to other aspects of shareholder activism, such as potential restrictions on the types of proposals shareholders can raise, who can raise them (and how often), such as those proposed recently by SEC Commissioner Daniel Gallagher.  

Similarly, whether the SEC staff’s aggressive views regarding information sharing and collaboration, commonplace features of the new “activism,” will result in a new wave of SEC investigations and enforcement actions is anyone’s guess.  What is certain is that the vigorous debate will continue.

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