Should the SEC Tighten its 13(d) Rules?

The upcoming issue of the Harvard Business Law Review will feature our article The Law and Economics of Blockholder Disclosure. The article is available here, and PowerPoint slides describing the paper’s main points are available here.

The Securities and Exchange Commission is currently considering a rulemaking petition submitted by Wachtell, Lipton, Rosen & Katz (available here) that advocates tightening the rules under the Williams Act and, in particular, reducing the amount of time before the owner of 5% or more of a public company’s stock must disclose that position from ten days to one day. Our article explains why the SEC should not view the proposed tightening as a merely “technical” change necessary to meet the objectives of the Williams Act or modernize the SEC’s regulations. The drafters of the Williams Act made a conscious choice not to impose an inflexible 5% cap on pre-disclosure accumulations of stock to avoid deterring investors from accumulating large blocks of shares. We argue that the proposed changes to the SEC’s rules require a policy analysis that should be carried out in the larger context of the optimal balance of power between incumbent directors and these blockholders.

We discuss the beneficial role that outside blockholders play in corporate governance, and the adverse effect that any tightening of the Williams Act’s disclosure thresholds can be expected to have on such blockholders. We explain that there is currently no evidence that trading patterns and technologies have changed in ways that would make it desirable to tighten these disclosure thresholds. Furthermore, since the passage of the Williams Act, the rules governing the balance of power between incumbents and outside blockholders have already moved significantly in favor of the former—both in absolute terms and in comparison to other jurisdictions—rather than the latter.

Our analysis provides a framework for the comprehensive examination of the rules governing outside blockholders that the SEC should pursue. In the meantime, we argue, the SEC should not adopt new rules that would tighten the disclosure rules that apply to blockholders. Existing research and available empirical evidence provide no basis for concluding that the proposed tightening would protect investors and promote efficiency. Indeed, there is a good basis for concern that such tightening would harm investors and undermine efficiency.

Below is a more detailed account of the analysis in our article:

Our article begins by explaining why policy analysis weighing the advantages and disadvantages of tightening these rules is needed before the SEC proceeds with the proposed tightening. It might be argued that more prompt disclosure is unambiguously desirable under principles of market transparency and was the clear objective of the Williams Act, which first established these rules by adding Section 13(d) to the Securities Exchange Act in 1968. Thus, at first glance one might conclude that the SEC should tighten the rules without consideration of the costs and benefits of doing so. Unlike ordinary disclosure rules that require insiders to provide information to investors, however, the Williams Act imposed an exception to the general rule that outside investors in public-company stock are entitled to remain anonymous. Moreover, tightening is not needed to achieve the objectives of the Williams Act: The drafters of the Act made a conscious choice not to impose a hard 5% limit on pre-disclosure accumulations of shares, instead striking a balance between the costs and benefits of disclosure to avoid excessive deterrence of the accumulation of these outside blocks. Thus, in deciding whether to tighten the rules in this area, the SEC should be guided by the general requirement that any costs associated with changes to its rules should be outweighed by benefits for investors rather than general intuitions about the desirability of transparency.

The second part of our article therefore proceeds to provide a framework for the policy analysis that the SEC should conduct. We begin by considering the costs of tightening the rules on blockholders. We begin by explaining that certain benefits of blockholders for corporate governance may be reduced or lost if these rules are tightened. We review the significant empirical evidence indicating that the accumulation and holding of outside blocks makes incumbent directors and managers more accountable, thereby reducing agency costs and managerial slack. Tightening the disclosure requirements for blockholders, we argue, can be expected to reduce the returns to blockholders and thereby reduce the incidence and size of outside blocks as well as blockholders’ investments in monitoring and engagement—which, in turn, could result in increased agency costs and managerial slack.

The third part of our article considers the asserted benefits of tightening the rules that are described in the petition. We explain that there is no empirical evidence to support the petition’s contention that tightening these rules is needed to protect investors from the risk that outside blockholders will capture a control premium at the expense of other shareholders.

The final part of the article considers whether the proposed tightening is justified by changes in trading practices, changes in legal rules in the United States, or changes in legal rules in other jurisdictions that have occurred since the passage of Section 13(d). We first explain that there is no systematic empirical evidence supporting the suggestion that investors can now acquire large blocks of stock more quickly than they could when Section 13(d) was first enacted. We then show that changes in the legal landscape since that time, and particularly the emergence of the poison pill, have tilted the balance of power between incumbents and blockholders against the latter—and therefore counsel against tightening the rules in a way that would further disadvantage blockholders. We also explain why comparative analysis of the regulation of blockholders in other jurisdictions does not justify tightening the rules governing blockholders in the United States.

We conclude by recommending that the SEC pursue a comprehensive examination of the rules in this area along the lines we put forward. Such an examination should include an investigation of the empirical questions we identify. In the meantime, however, existing research and empirical evidence offer no basis for tightening the disclosure obligations of outside blockholders.