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E-MailLizanne Thomas is partner at Jones Day. This post is based on a Jones Day memorandum by Ms. Thomas. Related research from the Program on Corporate Governance includes Pre-Disclosure Accumulations by Activist Investors: Evidence and Policy by Lucian Bebchuk, Alon Brav, Robert J. Jackson Jr., and Wei Jiang, and The Law and Economics of Blockholder Disclosure by Lucian Bebchuk and Robert J. Jackson Jr. (discussed on the Forum here).
Like any predator, a wolf must carefully time its strike when pursuing prey. Certain species of shareholder activists operate under a similar imperative. Flawed disclosure rules in the United States give them an unfair advantage.
A few years ago, hedge fund Pershing Square—which popped up on Oct. 9 with a 1.1 percent stake in coffee company Starbucks—went after retailer J.C. Penney. Along with its ally Vornado Realty, Pershing accumulated 11.6 million shares in August 2010, putting the fund just below a 5 percent effective ownership stake. That is the threshold that requires mandatory reporting to the Securities and Exchange Commission. Once crossed, the buyer must publicly disclose its stake within a leisurely 10-day window.
The fund run by Bill Ackman used that window of darkness to amass more shares. Pershing and Vornado then stunned the retail world by announcing that they had jointly accumulated more than 26 percent of the department-store chain. They secured seats on the company’s board and subsequently forced out Penney’s chief executive.
The problem was that the insurgents had no elixir to cure the company’s ills. After an initial spike in the stock’s price, shares plummeted nearly 60 percent before the activist gave up in 2013. The chain has posted positive earnings in only two quarters during the past four years. And its tribulations largely date back to the tenure of Chief Executive Ron Johnson, who Ackman strongly backed for the job.
Penney’s ongoing decline shows that the problem with activist shareholders arrives not when the wolf is at the door, but when the wolf is in the window.
The 10-day reporting lag time, which exists under a provision called Schedule 13D, is an anachronism dating from the pre-internet world of banker’s boxes and snail mail. Activists often use those 10 days to accumulate greater ownership. Others skirt the filing entirely, with one estimate pegging deadline violators at roughly 10 percent, according to the Journal of Corporation Law. As with Pershing and Penney, the activists’ short-term gains often augur no benefit to any stakeholders other than themselves.
When the window is open, the lead activist—let’s call them the alpha wolf—not only accumulates a formidable stake, but often tips off other funds, effectively amassing a wolf pack. Together, they purchase shares to engineer opportunistic and often unsustainable stock-price increases. Sotheby’s suffered from a parallel maneuver in 2013. Botox maker Allergan was similarly targeted in 2014. The list goes on.
Under this outdated regulation, some activism has wreaked havoc on responsible corporations. Gaining such leverage over management might be perfectly legal, but the outsiders’ plans can prove misguided. For activists abetted by the hidden 10-day window, the profit opportunity is nearly riskless. But it is rarely victimless. And the systemic opacity allows activists to benefit in a way that ordinary stockholders cannot.
Equally worrisome, companies sometimes respond by buying back shares, raising dividends, or slashing research and development. Those might constitute sensible reallocations of capital under certain circumstances, but such decisions should be driven by an enterprise’s strategic vision, not its reaction to financial legerdemain.
By contrast, the SEC requires companies to file disclosures within four business days of a “material” event occurring—and within one day under some circumstances. What’s more, U.S. corporations have largely accepted and taken to heart their duties to inform the marketplace in a timely way. It is only reasonable that those who wish to influence control over them should be required to meet similar standards.
Other countries maintain fairer reporting regimes. The United Kingdom grants no such 10-day license, requiring relevant reporting within two trading days once a shareholder has crossed a 3 percent effective ownership threshold. The same holds true for the European Union generally. In Australia and Hong Kong, the windows last from two to four days. All of these updated strictures give the accumulators much less time to build strength for a midnight raid.
Despite its flaws, the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 wisely gave the SEC the explicit authority to fix the 13D loophole. Alas, in a classic example of agency capture, histrionic fund activists and a cadre of academics persuaded regulators to leave the asymmetry unchecked.
A legislative solution that has received bipartisan support is the Brokaw Act. Among the bill’s many sensible proposals is one that would shorten the 10-day window to two days. After all, sophisticated investors today can report ownership stakes with little more than a keystroke.
To be clear, not all shareholder activism is unwarranted. Its practitioners and defenders can legitimately claim that outsiders often perceive imbalances or scleroses that “entrenched” executives do not. But those who seek to influence or control public companies should be required, at a minimum, to meet the timing and transparency requirements imposed on their targets. The current state of opacity merely invites shenanigans.
