In Short
The Situation: The Securities and Exchange Commission ("SEC") has reopened the comment period for its proposed rule requiring public disclosure of security-based swap ("SBS") positions that exceed certain thresholds.
The Result: The public again has the opportunity to comment on proposed Rule 10B-1. But with the SEC also requesting comment, informed by recent staff analysis and data, on whether the proposed reporting thresholds should be higher or lower based on alternative approaches, the SEC may take on aggregation, control, offsets, and related securities.
Looking Ahead: If the proposed rule is adopted, persons or groups with SBS positions over the reporting thresholds would need to file a report publicly with the SEC disclosing those positions.
Proposed Rule 10B-1
On June 20, 2023, the SEC reopened the comment period for proposed Rule 10B-1. The SEC's Division of Economic and Risk Analysis staff also released a memorandum with additional data and analysis on the proposed reporting thresholds. The extended comment period for the proposed rule will close August 21, 2023.
The SEC initially published Rule 10B-1 in the Federal Register on February 4, 2022. Proposed 10B-1 is aimed at increasing transparency in the SBS market and preventing market participants, including net short activists, from influencing the markets without other participants' awareness of their true economic position. It would require any person or group with an SBS position that exceeds a certain threshold to publicly file a report (proposed Schedule 10B) on the first business day after the day of execution of the SBS transaction that results in exceeding the applicable threshold. The proposed reporting thresholds vary for credit default swaps, SBSs tied to debt securities, and SBSs tied to equity securities (generally, positions in excess of $300 million notional, but less in certain cases). Schedule 10B would disclose, among other things: (i) the applicable SBS position; (ii) positions in any security or loan underlying the SBS position; and (iii) any other instrument relating to the underlying security or loan, or group or index of securities or loans.
Reopened Comment Period
In the reopened comment period, the SEC is requesting comments on, among other things, whether the proposed reporting threshold should be higher or lower, and whether the reporting threshold calculation should: (i) include the value of related securities owned by the SBS position holder; (ii) allow offsetting of SBS positions with identical terms; (iii) aggregate SBS positions across separate entities or persons that are acting as a group with a common purpose; and (iv) aggregate SBS positions created by transactions for one person's own account and those SBS positions created for others when such person controls the other accounts or shares economic risk with those accounts.
Staff Memorandum
Because the SEC is required to conduct a cost/benefit analysis of any new or amended rule and analyze the impact of those rules on competition, and only limited cost and impact data relating to proposed Rule 10B-1 was available at the time of proposal, the SEC staff supplemented the regulatory record through submission of a memorandum containing data and analysis. The SEC staff memorandum analyzed whether market participants who have filed reports on Schedule 13D (which includes "activist investors") would have had to report equity SBS positions during a defined period under the proposed Rule 10B-1 reporting thresholds, had those thresholds been applicable during that period. It then analyzed positions reported under Regulation SBSR by individual legal entities that they identified (using third-party data and Schedule 13D filings) as potential activists to determine how many reports under proposed Rule 10B-1 such entities would be required to file. The analysis was limited to data reported to registered security-based swap data repositories for the period from November 1, 2021, through November 25, 2022.
Throughout the memorandum, the staff noted that its data and methodology were subject to significant limitations. Examples include such statements as the following:
- "The SBSDR data as submitted by security-based market participants has several data issues";
- "There are significant limitations to our ability to perfectly identify equity security-based swap positions associated with a Schedule 13D filing";
- "Further, because Schedule 13D filings and the SBSDR data do not use the same identifiers for reporting entities and reference securities for Schedule 13D issuers, we may not identify all holdings in the SBSDR data that are associated with Schedule 13D Reporting Persons";
- "Our analysis is subject to significant limitations in our ability to identify equity security-based swap positions associated with an activist investor";
- "Hence, the analysis may undercount the number of activist investors who might need to file Schedule 10B when aggregating both beneficial ownership and equity security-based swap positions"; and
- "The analysis is again limited to equity security-based swaps that reference U.S. listed securities, and it is subject to the same limitations we previously identified in our analysis of equity security-based swap positions associated with activist investors."
These limitations may have resulted in a significant undercounting of the transactions that would be subject to proposed Rule 10B-1 and therefore cast doubt on the SEC's cost-benefit analysis regarding the proposed rule.
In the study, the staff were unable to identify many Schedule 13D filings that referenced SBS positions that would have been reportable under proposed Rule 10B-1, finding only 11 Schedule 13D filings that referenced equity SBS positions at all, and between two and five filings that referenced positions that may have been reported under proposed Rule 10B-1. In addition to the various data and methodological issues, including relying on positions of the "lead" Schedule 13D filer, the comment letters cited by the staff help explain why one should expect this number to be low. Comment letters by activist hedge funds explained that SBS are often used to build a stake in a company without the disclosure that may be required by investing in the reference securities directly. Once an activist fund's beneficial ownership position has exceeded the Schedule 13D reporting threshold (which generally does not include SBS positions), the funds often replace their SBS position with a direct holding of the reference securities.
The staff also analyzed Regulation SBSR data from entities identified as potential activists because they had historically filed Schedule 13Ds and/or were identified as such by a third-party vendor. They used legal entity identifier ("LEI") data to identify SBSR filings that correspond to the list of potential activists or their affiliates. However, such LEI data would only identify parent-subsidiary relationships, and not "sister" funds or other affiliated or commonly managed investment vehicles, and neither the SBSR data or the list of potential activists would allow the staff to systematically identify when a fund managed by or affiliated with a potential activist holds a position that would be reportable under proposed Rule 10B-1. The SEC staff acknowledges this problem: "[T]o be included in our sample, the equity security-based swap position must be held by the GLEIF [Global Legal Entity Identifier Foundation] inter-affiliate entities, whose LEI we obtain and search for in the SBSDR database. However, many activist investors are associated with many different funds or other entities, any of which may be party to an equity security-based swap. We are aware of many cases in which activist investor has equity security-based swap exposure through an entity other than the parent or child entity." This may significantly understate the extent of this limitation, as activist funds are often not organized as parents/subsidiaries of other funds. Therefore, we would expect the staff's methodology to significantly undercount the number of SBS positions potentially in scope of Proposed Rule 10B-1.
Despite the staff acknowledging the many limitations of the memorandum's findings, the Commission nonetheless released it and cited to it when reopening the comment period for proposed Rule 10B-1. Given the staff's admission that the analysis in its memorandum likely undercounts SBS positions that would be subject to reporting requirements under proposed 10B-1 and is otherwise subject to "significant limitations," if the SEC relies on the staff's analysis to estimate the costs of proposed Rule 10B-1 in adopting a rule with a broad scope and low disclosure thresholds, then this flawed analysis may cause more harm than good and may fall short of the requirements of the Administrative Procedure Act. In light of the limitations of the findings, there is a risk of litigation challenging the adoption of a final rule that is purportedly supported by such findings.
Three Key Takeaways
- The SEC staff memorandum only identified two Schedule 13D filings with reportable equity SBS positions under the proposed Rule 10B-1 reporting thresholds and only three Schedule 13D filings with potentially reportable equity SBS positions, calling into question the need for the proposed rule.
- The SEC staff memorandum had a number of limiting factors that may have resulted in an undercounting of SBS positions that would need to be reported under the proposed reporting thresholds.
- Despite a lack of data clearly supporting its scope and costs, the SEC may nevertheless adopt Rule 10B-1 with the proposed low disclosure thresholds in part as a result of the SEC staff memorandum.
