The Dodd-Frank debacle, takeover edition

Larry Ribstein —  21 March 2011

The so-called “Dodd-Frank Wall Street Reform and Consumer Protection Act” was supposed to fix the problems that led to the financial bust.  Of course, that would require some understanding of what, exactly, those problems were, which Congress lacked.  The Act did little to fix the credit raters or the derivatives market that surely had something to do with the crash.  But it did include countless ill-considered provisions and rules lying in wait behind studies.  I’ve already commented (here and here) on the Act’s unwarranted federal intrusion into aspects of corporate governance that had little to do with the meltdown. And I’ve noted the Act’s contribution to hobbling initial public offerings.

Yale’s Jon Macey comments in today’s WSJ on the potential fallout from one of D-F’s most buried little gems:  Section 929R(a)’s authorization to the SEC to reduce the period for reporting 5% share acquisitions from ten days to “such shorter time as the Commission may establish by rule.”  Marty Lipton’s takeover defense firm, Wachtell, Lipton, Rosen & Katz, has seized on this provision to propose that the SEC reduce that period to one day. 

Alerting the market to a potential impending bid raises share prices and therefore the takeover’s overall cost. This would add to the effects of a long-term trend at both the state and federal level of allocating increasing shares of the potential gains from takeover-induced governance reforms to the incumbent shareholders and away from the bidder. This is fine for the shareholders, given the existence of a bid.  But if you increase the price of bids you’re likely to decrease the supply.  Fewer bids = more power to incumbent managers. 

As Macey notes:

Shareholders benefit from the reforms of corporate governance initiated by these activist investors. So does the economy generally, because the overall economy performs better when companies perform better. But managers are not so fond of this process because activist investors push incumbent senior managers hard to improve their performance. Occasionally they even fire them.

Since incumbent managers sometimes lose to activist investors in fair corporate elections, their preferred strategy for dealing with them is to hire legal talent and team up with friendly regulators to make new rules and to concoct anti-takeover devices like poison pills.

Macey observes that the success of these efforts explains “why the market for corporate control is relatively moribund, particularly when compared to the robust markets of the past.”

One would think that true financial reform would seek to have the opposite effect — to increase the pressure on incumbent managers, whose comfortable entrenchment helped them ignore huge risks that ended up destroying some big companies.

The roots of the W-L initiative lie in two other developments. First, as Macey notes, “changes in technology and other advances have made it possible for investors to buy shares and to file reports with the SEC in less time than before.”  Thus, incumbent managers fear losing some of the edge they’ve accumulated over bidders.  But this just returns to the question of how great that edge should be.

Second, and more important for present purposes, Steve Davidoff notes the role here of yet another formerly obscure Dodd-Frank provision, §766(e), which empowers the SEC to count cash-settled derivatives in their holdings for 13D purposes.  Davidoff suggests the real problem here isn’t reporting, but the fact that bank parties to these transactions hedge their positions by buying target shares. They can then vote those shares although they lacks a real economic interest in the company — i.e., the “empty voting” problem.  Davidoff suggests the solution is simply preventing the hedged parties from voting these shares.  Of course this would open for analysis the large can of “empty voting” worms.  As Kobayashi and I have written, this problem is much less obvious and more complex than meets the eye.  

Davidoff has discussed the interest group battle over the W-L proposal:

Corporate America is divided over the Wachtell petition. According to people close to the firm, an earlier draft of the petition was circulated among seven law firms, a working group of well-known corporate law firms commenting on Dodd-Frank initiatives. But the other law firms begged off signing the petition. * * * Wachtell portrays itself as a firm that favors management. It actively represents companies against hostile takeovers and activist shareholders but appears to have only one large hedge fund activist client* * *

Wachtell appears to have the ear of the S.E.C. Michele M. Anderson, the agency’s chief of mergers and acquisitions, said last month that the S.E.C. staff was planning to recommend that the reporting period be shortened.

The more basic issue here is the battle for control of corporate governance law between the states, who compete for business, and the federal legislators and regulators, who collect rents from powerful interest groups.  On the other side of the takeover argument from Wachtell are those who are pushing increased application of federal law to restrict state law regulation of takeovers.  I’ve argued that these moves are also ill-advised.

And then there is what Davidoff refers to as the “larger war against hedge funds.”  He sees the SEC as

desperately struggling for relevance. Hedge funds are rich but often unpopular. Wachtell, through its focus on protecting shareholders rather than corporate boards, is using the agency’s struggles to push through its agenda.

This might have something to do with a certain insider trading trial going on in NYC.

To make a long story short, rather than solve the problems that led to the financial crisis, Dodd-Frank included myriad buried treasures that are now serving as platforms on which interest groups and federal agencies can battle for control of large corporations.  In the case of 929R and 766(e), “financial reform” may well lead to more federalization of corporate governance law and more power for incumbent managers — exactly what the financial crisis demonstrated we do not need.

Larry Ribstein


Professor of Law, University of Illinois College of Law

3 responses to The Dodd-Frank debacle, takeover edition

    Walter Sobchak 21 March 2011 at 6:34 pm

    Before you get excited about this one, I suggest reading the old Millstein case, which is, AFAIK, still good law. The family formed a “group” by talking at Sunday bunch, the “group”, by its formation “acquired” the group members shares at that moment. Your next exercise is to read some real 13-Ds and maybe draft one. We will see if you can get it done in one day.

    My vote would be to repeal the Williams Act. I would also vote to repeal all of the innovations in the Securities laws since 1934. They have only made things worse.

    “Wachtell, through its focus on protecting shareholders rather than corporate boards,”

    Not the Wachtell, I know and love. They were always pro management.

    north fork investor 21 March 2011 at 9:04 am

    This a long blog touches on many subjects of interest to me.
    It is rare that I agree with anything out of Wachtell Lipton but in this case I agree at least to one of its proposals. If you agree that the Williams Act does way more good than harm, reducing the reporting period for 13d filings makes a lot of sense given the electronic communication and reporting technology we use today. Macey’s thinking that reducing the reporting period will lead to higher takeover costs is simply not grounded in the real world. As both a banker and an arb for thirty years, I am sure that the data will support the position that (very few as a percentage of) unsolicited transactions begin with a surreptitious accumulation of a reportable 5% plus position. And the economics of an even lesser percentage of unsolicited transactions require the accumulation of a low cost toehold position. Perhaps the percentages increase if we just look at the set of unsolicited transactions initiated by Carl Icahn or Pershing Square or similar activists, but even then I am doubtful they cannot get the toehold position they want with a two day reporting period. Swaps are not difficult to arrange. And these guys don’t always tend to be real buyers. It’s hard to imagine but sometimes they just want someone else to take them out of their position and that second party doesn’t get the benefit of the toehold position.
    On the other hand the Williams Act made certain share accumulations reportable for a very good public policy reason. That the non-accumulating public ought to know on a timely basis that an investor has accumulated a threshold position for the purposes of influencing the management of the issuer (or if he has decided to no longer be a passive investor for a threshold position he has held for a time). With that public policy goal in mind, ten days seemed to be an appropriate period to check numbers, settle trades, and get the paperwork done when the act was passed. Today it can be done much quicker. Two days seems good enough for me.
    But I think that is far enough. I do not think derivative positions should trigger the reporting requirement because they are voteless. And in my opinion the empty voting problem if it is one is intractable or very very costly to solve. The empty voting problem is much more complicated and larger than the swap-related voting situation. One can hedge (perhaps imperfectly) a votable position in countless ways. In fact I think substantially most of all institutional voting (excepting hedge funds) is empty or even worse conflicted (see pension funds) since so many institutions farm out their voting to the proxy advisors and pension funds may vote more as.
    One suggestion to reducing empty voting (although not attacking the problem at hand) is to change state laws regulating the period between record dates and voting dates. There is no need any more for such long periods with internet and telephonic voting and electronic dissemination of proxy statements. If that leads to more federalization of corporate governance, I got no problem with that. The “race to the bottom” blog exists for very obvious reasons.

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