Last week, the SEC proposed new rules that would shorten the time periods for filing a Schedule 13D or 13G after acquisition of beneficial ownership of 5% or more of the voting stock of a public company from 10 days to 5 days. Other deadlines in the rules would be shortened as well. The proposed rules clarify, and in some respects expand, the ways that shareholders are considered part of a group for reporting purposes. The new rules, if adopted, will shift the balance between shareholder activists and corporate management.
The SEC titled Release No. 33-11028, “Modernization of Beneficial Ownership Reporting.” In it, the SEC notes that advances in information technology mean that less time is needed to compile the necessary data and prepare and transmit Schedule 13D. The SEC explains that the 10-day filing deadline contributes to “information asymmetries that could harm investors” involving “material information about potential change of control transactions.” It also quotes commentators who oppose shortening the deadline; they observe that those information asymmetries involve the private information of the shareholders contemplating a change of control transaction, which is quite different than the information asymmetries that management and other insiders may benefit from.
Shareholder activists building a position in the stock of a target company typically avoid driving up the stock price, so they tend to limit themselves to buying 10-15% of the daily trading volume. The proposed rule changes would meaningfully reduce the amount of time they have to acquire more stock before their Schedule 13D filing alerts other investors, by shortening that period – generally 5 to 8 trading days, depending on holidays and timing – to between 2 and 5 trading days.
The SEC also proposed to include shares underlying cash-settled equity derivatives in the calculation of beneficial ownership, if they are held with the purpose or effect of influencing or changing control over the issuer. This is based on the concept that holders of derivatives may have commercial power to cause counterparties that own the underlying shares to vote with them. As a result, holders of those derivatives would have to report as “beneficially owned” shares underlying some types of cash-settled equity derivatives on Schedule 13D, even though they do not own the underlying stock or control the vote or disposition of that stock.
Including shares underlying cash-settled equity derivatives as “beneficially owned” would be a fundamental departure from existing rules and practices. That will likely raise a number of issues for market participants that enter into equity derivatives with Schedule 13D filers, as well as reporting concerns for shareholders that enter into equity derivatives when a Schedule 13D filing is implicated. The new beneficial ownership calculations would also apply to Section 16 filers and, while cash-settled equity derivatives are already covered by Section 16, there could still be areas that require clarification or exemptions.
The SEC also proposes to codify some of its existing Staff interpretations and guidance on Schedule 13D and 13G topics. In particular, it would clarify situations where communications among existing shareholders of a public company, including with the issuer, will not cause those shareholders to be considered a group or trigger a filing. It would also make it more difficult for so called “wolf pack” members to avoid being part of a group for Schedule 13D filing purposes.
Not all of the proposed changes are aimed at activist investors. Passive investors would have deadlines shortened as well, including monthly reporting of material changes on Schedule 13G in place of the current requirement to report any changes on an annual basis.
Finally, the proposed rules would make some other technical changes and require that Schedule 13D and 13G be filed in a machine readable data language (XML).
In December 2021, the SEC proposed additional rules relating to security-based swaps that would also shift the balance between shareholder activists and corporate management. In Release No. 34-93784, the SEC proposed requiring public reporting of large security-based swap positions. The thresholds for equity securities would be $300 million and/or a security-based swap position representing 5% of the class of stock, with ownership of underlying stock included in the percentage calculation once the security-based swap position exceeds $150 million or 2.5%.
In a situation where a shareholder activist buys shares of stock up to just below the HSR threshold (to avoid alerting the issuer to its intentions) and then uses total return swaps to build its economic ownership of the target company, those proposed rules could require public disclosure at an economic stake of $300 million, which could be long before the 5% beneficial ownership threshold of Schedule 13D is reached. The larger the company, the smaller the percentage stake allowed before public disclosure would be required.
Interestingly, because the SEC does not have the statutory authority acting alone, security-based swaps (including total return swaps on a single security) are not included among the cash-settled equity derivatives proposed to be treated as beneficially owned for Schedule 13D purposes in Release No. 33-11028, even though total return swaps have been a focus of concerns about shareholder activists using cash-settled equity derivatives to influence corporate behavior.
While positioned as “modernizing” beneficial ownership reporting, these proposals are likely to be the focus of significant comment because they would shorten the time period in which shareholder activists can build a stake in a public company without public disclosure. Corporate boards and management will tend to favor the new rules, while shareholder activists and hedge funds are likely to favor the status quo.
Similarly, treating shares underlying cash-settled equity derivatives as beneficially owned for Schedule 13D purposes is likely to generate a lot of comments as market participants seek to understand how the rules would apply to them and how they might minimize their impact. One question is whether the detailed equity derivative contracts, which are rarely publicly disclosed, must be filed as exhibits. Also, because the new definitions of beneficial ownership will apply to Section 16, that will raise lots of issues about the potential effects on Section 16 reporting and short swing profits.
The shorter reporting window for Schedule 13D amendments, one business day (with no hardship exemption) instead of the current standard of “promptly,” even with the proposed extended filing hours until 10 pm Eastern, may draw comments as well. While in M&A contests Schedule 13D amendments are typically filed within one business day, outside that context it would make sense to allow more flexibility in the timing of filings, particularly if the changes are not driven by the actions of the Schedule 13D filer.
If you have any questions about these or related topics, your regular Locke Lord contact or any of the authors can discuss these matters with you.