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Schedule 13D Rules Should Be Revised

January 2008

Investors and investor activists are using a loophole in the acquisition disclosure rules to acquire larger positions without the need to disclose their actions. Such disclosure could drive up the stock price, and eliminates the element of surprise that any would-be raider certainly desires.

Here is how it works. Investment banks acquire the shares of the target on the investor’s behalf, but do not transfer voting rights to the investor. The investor owns the economic interest of the shares. However, the lack of voting rights means that the acquisition need not be disclosed (or at least this is what the investors contend). Of course, despite the formal agreement, an investment bank will certainly accept informal input from its client regarding how to vote.

Decoupling voting rights with economic interests could also benefit a corporate activist in a proxy battle. Holding more votes than economic interest (called empty voting) allows one to have a disproportionate effect on matters requiring shareholder votes.

The Schedule 13D and its accompanying rules require filing an ownership report within ten days once five percent or more of a company’s stock has been acquired. Schedule 13D must also be filed whenever there is a material change, and includes disclosure of the owner’s intentions. Any collection of acquirers are required to file Schedule 13D if they are acting together “for the purpose of acquiring, holding, voting, or disposing” of the shares.

Several changes have lessened the impact of Schedule 13D. In 1998, the SEC added a new category, “passive” investors, who could file an abbreviated disclosure on Schedule 13G. Schedule 13G requires updating only once per year, generally within 45 days from the end of each calendar year. Schedule 13G requires no disclosure at all regarding an owner’s intentions. As with anything involving intent, there is plenty of uncertainly regarding when an investor’s intentions change from being passive to active. Of course, at the point when one’s intentions “change”, the shares are already owned.

Court decisions have generally favored shareholder activism without the need for additional disclosure. For example:

1. In Hallwood Realty Partners vs. Gorham Partners, (286 F.3d 613 (2d Cir. 2002)), the Court refused to classify two Schedule 13D filers and a Schedule 13G filer as a group even though all three discussed what to do with their investments, two purchased stock at roughly the same time, and one was a known corporate raider.
   
2. In meVC Draper Fisher Jurvetson Fund I vs. Millennium Partners, (260 F. Supp 2d 616 (SDNY 2003) numerous emails and a joint slate of directors was insufficient for the Court to find that investors had formed a group.

If ownership disclosure is necessary at all, it should be consistently enforced. Here are some suggestions for improvement:

1. The rules should be changed to cover both voting and economic ownership.
   
2. The various disclosure possibilities should be simplified. Currently, ownership disclosure is required for active 5% shareholders (Schedule 13D), passive 5% shareholders (Schedule 13G), institutional investors and mutual funds holding $100 million of more in securities (Form 13F), and insiders (directors, officers and 10% shareholders) (Forms 3, 4, 5, or 16(b)). These various forms and related rules should be made more consistent, with integrated disclosures between the various possibilities.