You can't keep these two apart.

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The SEC Doesn't Like It When Hedge Funds Talk to Each Other

Matt Levine is a Bloomberg View columnist. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz and a clerk for the U.S. Court of Appeals for the Third Circuit.
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So what is this story about?

The Securities and Exchange Commission is investigating whether some activist investors teamed up to target companies without disclosing their alliances, potentially in violation of federal securities rules, according to people familiar with the matter.

The SEC’s enforcement division has recently opened multiple investigations and sent requests for information to a number of hedge funds, according to some of the people. 

The relevant rule is that if you acquire more than 5 percent of a company's stock, you need to disclose your ownership and plans on Schedule 13D, so everyone can know how much you own and what you're up to. But also, if you and someone else "agree to act together for the purpose of acquiring, holding, voting or disposing of equity securities of an issuer," then you have to add your ownership together for the 13D rules. So if Hedge Fund A buys 3 percent of a company's stock, and Hedge Fund B buys 2 percent, and Hedge Fund C buys 1 percent, then none of them needs to do any 13D disclosure. But if they have an agreement with one another about "acquiring, holding, voting or disposing of" those shares, then they all need to disclose their ownership and purchase history and plans for the company and the fact that they're working together.  

So that's the rule, whose purposes seem to me to be a bit lost in the sands of time. I mean, here is the Wall Street Journal:

The rules are meant to keep hedge funds from exercising the influence that comes with a big stake without incurring obligations that are meant to level the playing field with smaller shareholders.

I mean ... oh? Here is my former employer, Wachtell, Lipton, Rosen & Katz, quoting a federal court: "Simply put, the purpose of the Section 13(d) disclosure rules has always been to 'alert investors in securities markets to potential changes in corporate control and to provide them with an opportunity to evaluate the effect of these potential changes.'" Sure. I do not entirely understand these sentences, but I sort of get the gist. So for instance Wachtell Lipton has argued that investors should have to make these disclosures faster -- currently they get 10 days from the time they cross over 5 percent to file their 13Ds -- so that other shareholders can find out about activist involvement sooner. Activist involvement tends to drive up stock prices, and activists like the delay because it lets them buy more shares at lower, pre-announcement prices. Other shareholders might prefer faster disclosure, because they'd prefer to sell to the activists at higher, post-announcement prices.  So this is a straightforward conflict between models for information use: Activists want to be able to profit from their private information; less informed investors would prefer that the activists share. "Level the playing field with smaller shareholders" and all that.

So is the current SEC focus -- on "whether certain investors coordinated their efforts without filing appropriate disclosures" -- about level playing fields? Well, maybe:

Activists sometimes tip potential hedge fund allies to their trading plans, a Wall Street Journal investigation found last year. The practice isn’t illegal as long as they don’t coordinate their trades.

We've talked about this a couple of times, including when that Journal report came out. This tipping seems unfair, in the trivial sense that the people who get the tips have an advantage over the people who don't, an advantage that comes from whom they know rather than from hard work and clean living. If a big activist is accumulating a position in a company, and tells another fund before he announces his stake, that other fund can buy at the pre-announcement price and make a quick paper profit when the big activist announces his stake. In exchange, the activist has a grateful ally in the company's stock, which he hopes will support his plans for the company. This seems like insider trading to some people, but it isn't, because insider trading is about theft, not fairness, and if the activist gives away his information then it's not illegal for the recipient to trade on it. As John Coffee has put it:

The key advantage of joining a “wolf pack” is that it offers near riskless profit. The hedge fund leading the pack can tip its allies of its intent to initiate an activist campaign because it is breaching no fiduciary duty in doing so (and is rather helping its own cause); thus, insider trading rules do not prohibit tipping material information in this context. If one can legally exploit material, non-public information, riskless profits are obtainable, and riskless profits will draw a crowd on Wall Street.

"Wolf pack," by the way, is a technical term for these ... I was going to say "groups of hedge funds," but I can't say that, because "group" is an even more technical term. A "group of hedge funds" is a collection of hedge funds who invest in the same company and have to make 13D filings together. A "wolf pack of hedge funds" is a collection of hedge funds who invest in the same company and don't. This is sort of awkward terminology, honestly; the SEC should replace the technical term "group" with a less generic collective noun, like "a murmuration of hedge funds," so that we can use "group" in its normal sense. 

Where was I. If there's one theme of my writing it's that people get really mad, in a sort of un-analyzed way, when other people have information that they don't. So this wolf pack thing makes people mad, because it looks like insider trading, but it's legal. But what if it wasn't legal? Because here's the thing: It's really hard to know what a "group" is. You're a group if you "agree to act together for the purpose of acquiring, holding, voting or disposing of" a company's stock, which is a pretty vague standard. So if Crocodile Capital tips Trochilus Partners about its upcoming campaign, and Trochilus buys some stock, and Crocodile announces its activist campaign and the stock goes up, and then Crocodile runs a proxy fight, and Trochilus votes for Crocodile's slate of directors out of a tacit sense of gratitude, that's fine. But if at any point Trochilus agrees to buy the stock, or agrees to vote for Crocodile's slate, then they're a group, and if they don't disclose that then everything they've done is illegal.  And that agreement doesn't have to be an explicit written contract; an understanding reached on a phone call might be enough at least for a nasty lawsuit. So if the SEC wanted to crack down on hedge funds tipping each other, tightening enforcement of the group rules would be an easy way to do that. No one wants an SEC investigation, and if tipping other funds is going to trigger an investigation then it probably isn't worth it. 

The other possibility is that this investigation is not about tipping or fairness to little investors. You can have a very simple model of the SEC's rules about shareholder disclosure, which is that those rules are mostly about the balance of power between corporate managements (who want more shareholder disclosure) and activist shareholders (who want less). The rules are just a dial that the SEC can turn to make activism harder or easier. So if you want activism to be harder, you would do things like make it harder for activists to talk to other shareholders about their campaigns. Just picking up a phone and calling a fellow shareholder is, in an activist situation, sort of a fraught activity. You can call them up and say, "I hope I can count on your support in a proxy fight," but if they say, "You sure can," then you're in a pickle. Do they now have an "agreement" with you on how to vote their shares? Does that make you and them a group? 

The answer is probably not, but there is a lot of room for interpretation here, and the SEC is the one doing the interpreting. If corporate America thinks that activist investors have too much power to affect corporate policies and cause short-term thinking and other bad results, and if the SEC agrees, then it might want to just make it harder and riskier for activists to discuss companies with each other, and to solicit support from other investors. Here's Phil Goldstein of Bulldog Investors, one of the targets of the SEC's inquiries:

Scrutiny from the SEC could chill legal discussions between investors, he said, adding that it isn’t surprising that underperforming companies would draw interest from several activists.

“If you go to a Grateful Dead concert, you’re going to find a lot of Grateful Dead fans,” he said. “They’re not a group. They just like the same music.”

Activists make their living by being persuasive, and the less they can talk to other investors, the less opportunity they have to persuade. Cutting down on those opportunities is a little weird for corporate democracy: Shareholders can vote, but they're afraid to talk to each other about how they'll vote. But if you worry that activists have too much influence, this is a pretty direct way to fix that.

  1. They still might need to make quarterly disclosures on Schedule 13F, but those are on a longer time lag and less informative.

  2. Here are the instructions for what you have to include in Schedule 13D. Also if the group gets above 10 percent of the company's stock, it becomes subject to Section 16, which is a real bear, requiring members of the group to disgorge short-term trading profits

  3. They might not, depending on time horizon. Your model, as a passive shareholder, might be that the more efficiently activists can accumulate positions, the more activism there will be, and that more activism is good for shareholder value. (Obviously that view is controversial.) Someone who sells to the activist before the activist announces his stake will be sad in hindsight, but it's hard to argue she was ripped off: She was a willing seller at the then-market price.

  4. This is a somewhat doubtful advantage: If you're an activist fund, tipping others to your trading might make you allies for your activist campaign, but on the other hand it might drive up the price of the stock before you finish buying, and why would you want to pay more for the stock? My general sense is that this sort of tipping doesn't happen very much, because most funds prioritize the hard measurable advantage of efficient stock execution over the vaguer advantages of accumulating grateful allies.

  5. These names are a dumb joke. Of course there seems to actually be a Crocodile Capital 1 Global Focus fund, because, as Skip McGee points out, "Every cool animal? Gone." But any resemblance between Crocodiles is purely coincidental.

  6. The remedies for this stuff are actually kind of odd. The SEC has fined people for 13D violations, but the real worry for activists is that a company might be able to prevent them from running a proxy fight by invoking these rules. That mostly doesn't happen, but the companies keep trying, and you never know.

  7. Hoo boy is that not legal advice. If you're an activist fund you should probably have a lawyer though.

  8. I've written about this before in the context of Bill Ackman's fake proxy fight for Allergan, which was intended in part to get around the "group" provisions of Allergan's poison pill. Those provisions were much harsher than the Section 13(d) rules; you're a group for purposes of Allergan's pill if you have an "agreement, arrangement or understanding to act together for the purpose of acquiring, holding, voting or disposing of any securities of the Company." The SEC requires an "agreement," not just an "understanding." But the pill had the effect of chilling conversations between shareholders, and the fake proxy fight was a (very technical) way around that.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Matt Levine at mlevine51@bloomberg.net

To contact the editor on this story:
Zara Kessler at zkessler@bloomberg.net