The way U.S. securities law works, if you buy more than 5 percent of a public company's stock, you have to disclose what you're up to. But you get 10 days from the time you cross over 5 percent until you have to make the disclosure on Schedule 13D. That gives you 10 days to keep buying in secret, so that when you actually disclose you might have 6 or 7 or 10 or 30 percent of the stock instead of just the 5 percent.
But a stylized fact is that you don't. Oh, sure, you take your time doing the disclosure -- the median 13D is filed around 8 days after the filer crosses over 5 percent -- but you don't typically do much buying after you get to 5 percent. Maybe you end up at 6 percent, but if you do, it's typically on the same day you get to 5 percent. Then you spend 8 days not buying stock, just hanging out, polishing the prose in that 13D filing before you ultimately make it public.
The Wall Street Journal has a pretty good story about what you might be doing during that time, at least if you're an activist investor or noisy short seller. You're telling all your little hedge-fund buddies1 about the stake you've built, so they can buy in too:
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.
Why would you do that? Here is a reasonable answer:
"Premarketing, that's what they are doing. This is all part of the campaign. They are building a constituency," said James Woolery, chairman-elect of corporate law firm Cadwalader, Wickersham & Taft LLP, who represents companies against activists. "Some are using, in effect, the pop in the stock price to help pay these people" for being on their side in a coming battle against the target company.
And so in fact stock prices tend to creep up (down) just before big activists announce long (short) positions, and then jump after the announcement. The creeping tends to come from the people who've been tipped off,2 and who then benefit from the jump.
Some lawmakers and others are calling on the Securities and Exchange Commission to cut the time that large investors can secretly amass shares in a company, following a Wall Street Journal investigation into leaks ahead of public filings.
Because of all the usual buzzwords:
"The SEC's job is to promote market fairness for all investors," said Sen. Charles Grassley of Iowa, the ranking Republican on the Judiciary Committee. "If the rules don't reflect how the markets work today and allow some investors an unfair advantage over others, the agency needs to update those rules" or else they can "become obsolete and lead to potential market unfairness."
I guess you could see this as a story of fairness, but, you know what? Everything is unfair. Financial markets are about information asymmetries. There's no general entitlement for you to know what everyone else is up to. If Warren Buffett (or Dan Loeb for that matter) takes a 4 percent long position in a company, he doesn't need to disclose it,3 but that's noteworthy information that is valuable if he leaks it. If Bill Ackman takes a 4 or 5 or 10 or 20 percent short position in a company, he doesn't need to disclose that, because the rules apply only to long positions. And in fact, for all the noise he's made about Herbalife, we have only the vaguest sense of what his position actually is.
So if your theory is "everyone should know what everyone else is up to," cutting the 13D deadline from 10 days to one day is sort of a weird approach. Because 13D is not about keeping everyone apprised of what everyone else is doing. It's about keeping corporate managements apprised of what activist shareholders and corporate raiders are doing. It's part of a package of rules passed in the 1960s because managers were worried that raiders had too much power to take over companies, and it was designed to give some power back to those companies. If you can't accumulate shares in secret, then you can't take over a company without giving its managers time to defend themselves.4
While discussion of the rule is framed in terms of fairness and disclosure, it's really about that balance of power between corporate boards on the one hand, and activist shareholders on the other.
Activists want to be able to profit from information about their own intentions. Most simply this means that they want to be able to buy in secret, so that they can capture as much of the benefit of their activism as possible.5
But you can think of the private information as a pot of value -- the value of knowing that Jana Partners or whoever is about to announce a big position in a company -- that the activist can use however he wants. If he wants to capture all the value for himself, great. If he wants to spend some of it on building a coalition, to maximize the likelihood that his activism will work out, then that's his call. If he wants to spend some of it on buying reciprocal value from his activist buddies -- I tip you off about my deals, you tip me off about yours -- then that's also his call.6
These arguments are going to be more persuasive the more you believe that activism is a good thing. If you want more activism -- if you think that it makes companies more efficient and adds value that is captured by all shareholders -- then you'll want hedge funds to be able to capture more value from their activism, to encourage them to do more of it. And you'll want them to be able to use that value freely, including to reward their partners and buddies, to make their activism more likely to succeed.
If, on the other hand, you want less activism, you'll want activists to capture as little value as possible, and to make as little use of that value as possible. This is fairly obviously the position of corporate boards. Conveniently for the boards, the way the activists get that value does kind of look like they're stealing it from the little guy and giving it to their hedge-fund friends. Even if an activist campaign ends up adding value for everyone, taking from the poor and giving to the rich may not be the best way to start it.
1 Really: "There also is a kind of buddy system among activist investors, some say." They trade stock tips at nap time.
2 Intentionally or otherwise; information leaks. Of course the creeping could come from the activists themselves buying more shares just before disclosing -- "It is impossible to know how much of the price change is due to activists' own trading or other factors," says the Journal -- but the stylized fact is that it mostly doesn't.
3 Except on a Schedule 13F, but he has basically forever to file that -- it's due 45 days after the end of the quarter when he bought the shares.
4 With, for instance, a poison pill -- a technology undreamt of in 1968, by the way.
5 The theory is that activism has free-rider problems: The activist, if he is right and successful, raises the value of the company by $X, but if he only owns 5 percent of the company he only captures $0.05X. Other lazy free-riding shareholders capture the $0.95X. This explains why the free-riders like activists, but it also explains why the secrecy is so important: If the stock runs up before you can finish buying, you might get only $0.04X, and you're giving away even more value to free riders.
6 Isn't that insider trading? Nope! Illegal insider trading is, roughly, trading on material nonpublic information that is disclosed to you "in breach of a fiduciary duty or other relationship of trust and confidence." Leaving aside materiality -- and I guess there's some question as to whether a court would find it material that Jana Partners is building an activist stake, though maybe not much of one -- there's no breach of a duty if Jana "officially" decides to leak its information to other hedge funds. (Is there? Is there a breach of a fiduciary duty to Jana's investors? Seems unlikely.)
To contact the writer of this article: Matt Levine at email@example.com.
To contact the editor responsible for this article: Tobin Harshaw at firstname.lastname@example.org.