How the SEC’s swap proposal could stifle shareholder activism

After all, the misuse of one type of swap, credit default swaps, was a major contributor to the global financial crisis of 2007-2008. And a second type, total return swaps, contributed to the multi-billion dollar collapse of Archegos Capital Management last year.

There is, however, a potential downside to the SEC’s proposal to increase disclosure of swap positions that might not be immediately apparent: if passed, the rules could severely restrict shareholder activism – a market mechanism key to holding corporate management accountable, improving governance and creating lasting value.

Securities swaps are financial contracts in which counterparties agree to exchange payments based on, for example, changes in the price of a stock. They allow investors to gain economic exposure to an asset without directly owning it and have beneficial uses such as hedging risk. The SEC’s proposed Rule 10B-1 would require additional disclosure of large positions in these instruments, so that counterparties and investors’ clients understand their full exposure. More transparency is always good, isn’t it?

Well, not always. The main obstacle to shareholder activism is that the activist bears the cost, but the benefits are shared by all other shareholders and, in many cases, society at large – the classic free rider problem. An activist’s earnings are limited to his stake in the business. And if the activist buys more than 5%, he is required to disclose his position, which moves the market and prevents him from buying more. A 5% stake, however, is often insufficient to make activism worthwhile, given that it typically takes six to 12 months of research before an activist investor even meets a company.

Swaps, however, allow a shareholder to increase their exposure without revealing it to the world, giving them an incentive to engage with a company to improve its performance. If the SEC forces investors to disclose these positions, activists might not be able to get enough exposure to make the engagement worthwhile.

There are good public policy reasons why equity positions should be disclosed, but swaps should not. Equity comes with voting rights and the potential ability to influence a business, but swaps do not. What swaps provide is an economic incentive for an investor to care about the future of a business – like an investment business that ties a fund manager paying more closely to long-term performance, without increase its stake in the company.

For its part, the SEC says it enjoys strong engagement with the public and will consider all comments submitted during the open comment period. Generally, although he responds to comments received as part of the development of the final rule and not beforehand, according to a spokesperson.

Benefits of Privacy

Why should we worry about reduced activism? Critics claim that activism inflates short-term profits at the expense of long-term value, but rigorous evidence suggests otherwise.

A seminal paper found that hedge fund activism drives a stock price up 7% in the short term, and even more in the long term. One concern is that these gains come from financial engineering rather than operational performance improvements. But a second study, which obtained confidential data on the productivity of individual factories from the US Census Bureau, found that hedge fund activism leads to increased factory productivity, primarily by increasing labor productivity. Workers’ wages are not falling and their hours are not increasing. A third paper, which studied investment, found that hedge fund activism leads to lower research and development spending, but increased innovation. More patents are generated and the quality of patents increases as hedge funds refocus innovation on the most promising projects. In terms of environmental outcomes, companies targeted by hedge funds are reducing emissions of toxic chemicals and closing heavily polluting factories. And the benefits are not limited to the company in question: they trickle down to peer companies, who improve their efficiency to avoid becoming targets themselves.

A positive-sum game

While some view stock trading as a zero-sum game – if one investor profits, another loses – activism is a positive-sum game in that it makes the pie bigger for shareholders and society. Turning around an underperforming business is a public good. To encourage the creation of public goods, the creator must obtain a return on his investment. We recognize this with patents. Once an innovation has been made, we would like it to be available for free, but that would remove the incentive to innovate in the first place. Patents allow innovators to generate a return sufficient to justify the investment in innovation. The private use of swaps plays a similar role for activists. If the SEC needs trade disclosures for its own oversight purposes, it may keep that information confidential.

Confidentiality is important not only to encourage activism, but also to help it succeed. Shareholder engagements are increasingly resolved privately, out of the public eye: 92% of activist board placements in 2021 were made by consensus. Private engagement often leads to more friendly and constructive resolutions. Once a situation becomes public, egos are often at stake. The company publicly defends the status quo and opposes the ideas of the activist. Then, if the discussions later lead to the company accepting the activist’s suggestions, management may be reluctant to implement them because it will lose face. Greater disclosure can increase the number of acrimonious public proxy contests, at great expense to shareholders and corporations, but to the great benefit of lawyers and other advisers.

Transparency has many benefits, but it’s often best to have constructive dialogues in private. As the SEC deliberates new rules, it should consider their impact on those discussions, which typically create long-term value for shareholders and society.

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