The following post summarizes a comment letter to the SEC on its proposed rule to shorten the required filing time for disclosing the acquisition of more than five percent equity share in a public company. All comments can be found here.
Under the Modernization of Beneficial Ownership Reporting (proposed rule), the U.S. Securities and Exchange Commission (SEC) seeks to shorten the filing time of an acquisition of more than 5% of a cover class of equity securities from the current requirement of within 10 days to within 5 days.
This post respectfully identifies two fatal flaws in the proposed rule that would not allow it to survive a legal challenge in the U.S. Court of Appeals for the D.C. Circuit. First, by ignoring the “sole purpose” of the Williams Act, the protection of investors who are confronted with a cash tender offer, the proposed rule violates the Administrative Procedures Act (APA). Second, by ignoring the requirements of an adequate “cost-benefit analysis,” the proposed rule also violates the APA.
Standard of Review
If the proposed rule is challenged in court, the standard of review will be provided by the APA. The APA calls upon courts reviewing agency rulemaking to “decide all relevant questions of law, interpret constitutional and statutory provisions, and determine the meaning or applicability of the terms of an agency action”—as well as to review all “findings” and “conclusions” and rejecting those deemed to be “arbitrary,” “capricious,” “an abuse of discretion,” or “otherwise not in accordance with the law.” In addition, the U.S. Supreme Court has long determined to give agency rulemaking a “hard look,” under State Farm, though it has traditionally deferred to agency interpretations of ambiguous statutory language under Chevron.
Abuse of Discretion
As correctly stated in the proposed rule, the SEC has the statutory authority under Section 13(d)(1) of the Securities Exchange Act of 1934 (Exchange Act) to shorten the filing time of an acquisition of more than 5% of a cover class of equity securities from the current requirement of within 10 days to within 5 days. However, this does not mean that the SEC has unlimited discretion to do so. This discretion is restrained by what the U.S. Supreme Court has determined to be the “sole purpose” of the Williams Act, the Act that created Section 13D of the Exchange Act.
Very simply, the U.S. Supreme Court has repeatedly and unambiguously stated that the “sole purpose” of the Williams Act was for the protection of investors who are confronted with a cash tender offer. (A tender offer is where the offeror goes directly to the company’s shareholders with an offer to buy their shares.) For example, the Court in Piper et. al. v. Chris-Craft Industries, Inc. stated that:
The legislative history thus shows that the sole purpose of the Williams Act was the protection of investors who are confronted with a tender offer. As we stated in Rondeau v. Mosinee Paper Corp., 422 U. S. at 58: “The purpose of the Williams Act is to insure that public shareholders who are confronted by a cash tender offer for their stock will not be required to respond without adequate information. . . .”
Unfortunately, the proposed rule does not make the connection between a reduction in filing time and the “sole purpose” of the Williams Act. While the Act is mentioned eight times in the proposed rule, it: omits any reference to the Supreme Court cases where the “sole purpose” of the Williams Act is discussed; does not make an attempt to demonstrate a connection between a reduction in filing time and how it will impact the ability of investors to be adequately informed in a cash tender offer; and only mentions the term cash tender offer once, in footnote 35. Moreover, the proposed rule makes very clear it is not targeted to the plight of shareholders being confronted with a cash tender offer, but to shareholders who have sold their shares prior to a hedge fund activist, who is not making a cash tender offer or seeking control, announcing it has acquired more than a 5% position in the company.
In sum, since the proposed rule does not connect the proposed reduction in filing time with the purpose, the “sole purpose” of the Williams Act, the SEC’s implementation of this proposed rule would necessarily be considered to be beyond its statutory authority and an “abuse of discretion,” if not “arbitrary and capricious,” under the APA.
Business Roundtable
The D.C. Circuit Court of Appeals, in the extremely influential case of SEC v. Business Roundtable, stated that “the Commission has a unique obligation to consider the effect of a new rule upon ‘efficiency, competition, and capital formation,’ 15 U.S.C. §§ 78c(f), 78w(a)(2), 80a-2(c), and its failure to ‘apprise itself—and hence the public and the Congress—of the economic consequences of a proposed regulation’ makes promulgation of the rule arbitrary and capricious and not in accordance with law.” That is, the Commission has a “statutory responsibility to determine the likely economic consequences of” a proposed rule “and to connect those consequences to efficiency, competition, and capital formation.” Unfortunately, the proposed rule cannot do this and, to the Commission’s credit, the proposed rule admits to this. As stated in the proposed rule:
[W]here possible, we have attempted to quantify the benefits, costs and effects on efficiency, competition and capital formation expected to result from the proposed amendments. However, we are unable to quantify all potential economic effects because we lack information necessary to provide reasonable estimates for those effects. For example, the Commission is unable to reasonably quantify the potential harm to investors as a result of mispricing under the current rules, or the reduction in trading costs due to improvements to liquidity or capital formation that may arise from more efficient pricing under the proposed amendments. We also are unable to quantify, with precision, the increased costs for blockholders to initiate corporate change as a result of the shortened Schedule 13D filing deadlines and, therefore, the reduction of the costs and benefits the presence of such blockholders bring. To estimate such costs, we would need to know, for example, how many potential blockholders would reduce their share accumulation prior to disclosure after the proposed rule change, and the amount of any such reduction. The ability for blockholders to achieve their target accumulation level prior to disclosure depends on such target level, the liquidity of the targeted covered class, their acquisition plans and their ability to adapt the plans.
This acknowledged lack of information leads to a striking admission—“[b]ecause we do not have all the inputs for these variables, we cannot provide a reasonable estimate of the effects of the proposed amendments.” This admission is even more striking because the examples given – the potential benefits of a shortened filing deadline to shareholders who are contemplating a sale of their shares versus the harm caused to non-selling shareholders from the potential cooling effect on the efforts of blockholders to influence a company’s decision-making without taking control (hedge fund activists) – go to the heart of any required cost-benefit analysis.
Moreover, this intended or unintended attack on traditional hedge fund activism, without rigorous analysis to support such an attack, is extremely baffling. Traditional hedge fund activism “is characterized by taking a large but not controlling position in a target company’s stock, 5% to 10% of the stock outstanding, presenting value enhancing recommendations that are expected to correct managerial inefficiencies, spending the time and resources communicating their recommendations to other target company shareholders, and being provided a market confirmation of the value of this activism with a positive and significant impact on the value of the company’s stock at the time of or near announcement of the activism.” It is an empirically proven way to enhance shareholder value at a public company. The research is so compelling that it strongly supports the theory that “[i]n the context of public companies, hedge fund activism may constitute a valuable asset in and of itself if the goal of such activism is to enhance managerial efficiency.”
In sum, under Business Roundtable, until the SEC can provide “a reasonable estimate of the effects of the proposed amendments,” the proposed rule, if implemented by the Commission, would likely be found by a reviewing court to be “arbitrary and capricious,” thereby requiring the D.C. Circuit to vacate the rule.
Bernard S. Sharfman is a Senior Corporate Governance Fellow with the RealClearFoundation and a Research Fellow with the Law & Economics Center at George Mason University’s Antonin Scalia Law School. The opinions expressed here are the author’s alone and do not represent the official position of any other organization with which he is currently affiliated. Mr. Sharfman’s comment letter can be found here.
The views expressed in this post are those of the author and do not represent the views of the Global Financial Markets Center or Duke Law.
