How the SEC’s swap proposal could stifle shareholder activism

After all, the misuse of one type of swap, the credit-default swap, was a major contributor to the global financial crisis of 2007–08. And a second type, the total return swap, contributed to Arcgos Capital Management’s multi-billion dollar collapse last year.

However, there is a potential downside to the SEC’s proposal for increased disclosure of swap positions that may not be immediately apparent: if passed, the rules could severely restrict the activism of shareholders — holding corporate management accountable. A key market mechanism for keeping, improving and building governance. sustainable value.

Security-based swaps are financial contracts in which counterparties agree to exchange payments based on a change in the price of a stock. They allow investors to obtain economic exposure without direct ownership of an asset and use leverage 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, isn’t it?

Well, not always. The main obstacle to shareholder activism is that the worker bears the cost, but the benefits are shared by all other shareholders and in many cases the wider society—the classic free-rider problem. An activist’s profit is limited to his stake in the company. And if the worker buys more than 5%, he is required to disclose his position, which moves the market and prevents it from buying more. However, a 5% stake is often insufficient to make activation worthwhile, given that it usually takes six to 12 months of research before an active investor meets a company.

Swaps, however, allow a shareholder to increase exposure without revealing it to the world, providing an incentive to engage with them to improve the company’s performance. If the SEC compels investors to disclose those positions, activists may not be able to obtain enough exposure to make the engagement worthwhile.

There are good public-policy reasons why equity positions should be disclosed, but swaps do not. Equity comes with voting rights and the potential to influence the company, but swaps do not. What swaps provide is an economic incentive for an investor to look after a company’s future—without increasing their holdings in the company, rather than an investment firm paying the fund-manager more closely for long-term performance. Similar.

For its part, the SEC says it benefits from a strong 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 final rulemaking and not already, according to a spokesperson.

benefits of privacy

Why should we worry about low activity? Critics claim that activism magnifies short-term gains at the expense of longer-term value, but hard evidence suggests otherwise.

A seminal paper found that hedge-fund activity drives up a stock’s price by up to 7% in the short term, and even more in the long term. One concern is that these benefits come from financial engineering rather than improving operational performance. But a second study, which obtained confidential data on the productivity of individual plants from the US Census Bureau, found that hedge-fund activism increases plant productivity primarily through increasing labor productivity. Workers’ wages do not fall, and their hours do not increase. A third paper, which studied investing, found that hedge-fund activism resulted in lower research and development expenditure but increased innovation. More patents are generated and patent quality increases as hedge funds refocus innovation on the most promising projects. When it comes to environmental consequences, firms targeted by hedge funds reduce toxic chemical emissions and shut down heavily polluting plants. And the benefits are wider than just the firm in question – they extend to peer companies, which themselves improve efficiency to avoid becoming the target.

a positive-sum game

While some view stock-market trading as a zero-sum game – if one investor gains, the other loses – activism is a positive-sum game in that it benefits both shareholders and society. Increases pie. Turning an underperforming company is a public good. In order to encourage the manufacture of public goods, the producer needs to get a return on his investment. We identify it with a patent. Once an innovation is made, we want it to be freely available—but doing so will remove the incentive to innovate in the first place. Patents enable innovators to generate sufficient returns to justify investing in innovation. Personal use of swap plays a similar role for activists. If the SEC requires swap disclosure for its own monitoring purposes, it may keep such information confidential.

Privacy is important not only to encourage activism, but also to help it succeed. Shareholder engagements are increasingly being resolved privately, out of the public eye—92% of activist board placements in 2021 were achieved by consent. Personal engagement often leads to more cordial and creative resolutions. Once a position becomes public, ego is often at play. The company publicly defends the status quo and opposes activist views. Then, if the company agrees to the worker’s suggestions because of later discussions, management may be unwilling to implement them as it will lose face. More disclosure could lead to an increase in the number of public proxy fights, at great cost to shareholders and companies but would greatly benefit lawyers and other consultants.

Transparency has many benefits, but constructive dialogue is often best done in private. As the SEC deliberates on the new rules, it must consider their impact on such discussions, which generally create long-term value for both shareholders and society.

This story has been published without modification to the text from a wire agency feed