How the SEC’s Swaps Proposal Could Choke Off Shareholder Activism
More transparency sounds good. But advocates might be ignoring the downside
A push by the U.S. Securities and Exchange Commission for more transparency around security-based swap positions might seem, on its face, to be a no-brainer.
After all, the misuse of one type of swap, credit default swaps, was a major contributor to the global financial crisis of 2007-08. And a second type, total return swaps, contributed to the multibillion-dollar collapse of Archegos Capital Management last year.
There is, however, a potential downside to the SEC’s proposal for increased disclosure of swap positions that might not be immediately apparent: If passed, the rules could severely restrain shareholder activism—a key market mechanism for holding corporate managements accountable, improving governance and creating sustainable value.
Security-based swaps are financial contracts in which counterparties agree to exchange payments based on, say, changes in a stock’s price. They allow investors to obtain 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 such instruments, so that investors‘ counterparties and clients understand their full exposure. More transparency is always good, right?
Well, not always. The main barrier to shareholder activism is that the activist bears the cost, but the benefits are shared by all other shareholders and in many cases wider society—the classic free-rider problem. An activist’s gains are limited to its stake in the company. And if the activist buys more than 5%, it is required to disclose its position, which moves the market and hinders it 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 with a company.
Swaps, however, allow a shareholder to increase exposure without revealing it to the world, raising the incentive to engage with a company to improve its performance. If the SEC forces investors to reveal those positions, activists might not be able to obtain enough exposure to make engagement worthwhile.
There are good public-policy reasons why equity positions should be disclosed, but not swaps. Equity comes with voting rights and the potential ability to influence a company, but swaps don’t. What swaps do provide is an economic incentive for an investor to care about a company’s future—similar to an investment firm tying fund-manager pay more closely to long-term performance, without increasing its holdings in the company.
For its part, the SEC says it benefits from robust engagement with the public and will review all comments submitted during the open comment period. Generally, though it responds to comments received as part of the final rule-making and not beforehand, according to a spokesperson.
Benefits of privacy
Why should we worry about reduced activism? Critics claim that activism inflates short-term profit at the expense of long-term value, but rigorous evidence suggests otherwise.
A seminal paper found that hedge-fund activism boosts a stock price by 7% in the short term, and even more in the long term. One concern is that these gains come from financial engineering rather than improvements in operating performance. But a second study, which obtained confidential data on the productivity of individual plants from the U.S. Census Bureau, found that hedge-fund activism leads to increased plant productivity, primarily through raising labor productivity. Workers’ wages don’t fall, and their hours don’t rise. A third paper, which studied investment, found that hedge-fund activism results in lower research-and-development expenditures but increased innovation. More patents are generated and patent quality increases because hedge funds refocus innovation on the most promising projects. When it comes to environmental outcomes, firms targeted by hedge funds reduce toxic chemical emissions and close heavily polluting plants. And the benefits are wider than just the firm in question—they spill over to peer companies, which improve efficiency to avoid becoming targets themselves.
A positive-sum game
While some see stock-market trading as a zero-sum game—if one investor profits, another loses—activism is a positive-sum game in that it grows the pie for both shareholders and society. Turning around an underperforming company is a public good. To encourage the creation of public goods, the creator needs to obtain a return on its investment. We recognize this with patents. After an innovation has been made, we would like it to be freely available—but doing so would remove the incentive to innovate in the first place. Patents enable innovators to generate a sufficient return to justify the investment in the innovation. The private use of swaps plays a similar role for activists. If the SEC needs swap disclosures for its own monitoring purposes, it could keep such information confidential.
Privacy is important not just to encourage activism, but also to help it succeed. Shareholder engagements are increasingly resolved privately, outside the public eye—92% of activist board placements in 2021 were achieved consensually. Private engagement often leads to more amicable and constructive resolutions. Once a situation becomes public, egos are often at play. The company publicly defends the status quo and opposes the activist’s ideas. Then, if discussions later lead to the company agreeing with the activist’s suggestions, management may be unwilling to implement them as it will lose face. Greater disclosure may increase the number of acrimonious public proxy fights, at great cost to shareholders and companies but at great benefit to lawyers and other advisers.
Transparency has many benefits, but constructive dialogues are often best had in private. As the SEC deliberates new rules, it should consider their impact on such discussions, which typically create long-term value for both shareholders and society.
