The Ferocious, Well-Heeled Battle Against the SEC’s New Rules on Hedge Fund Activism

Illustration by II (Evelyn Hockstein/Bloomberg)

Illustration by II

(Evelyn Hockstein/Bloomberg)

A new institute with hedge fund backing joins Elliott, Pershing Square, Third Point, and others in opposing tougher disclosure rules for stock and swaps positions.

After Gary Gensler was tapped to head the Securities and Exchange Commission last year, it quickly became apparent that under his watch the SEC would pursue an aggressive agenda unlike anything the world of finance had experienced in decades. One result has been a wave of new rule-change proposals that has stunned Wall Street insiders who fear the end of the easy money enabled by years of lax regulation.

Take, for example, two proposed rules that deal with the disclosure of shareholder activists’ stock and swaps positions — including the SEC’s attempt to broaden the definition of investors acting as a group, forcing even more public disclosure.

Elliott Management Corp.’s Richard Zabel, the firm’s general counsel and former deputy U.S. attorney for the Southern District of New York, set the stage for hedge fund activists’ outrage at these proposals with a 32-page comment letter criticizing the SEC’s new rules with arguments from constitutional issues to conflicts with judicial precedent.

“The commission has inexplicably decided to pursue new regulations that would effectively smother activism in the U.S. capital markets,” Zabel wrote.

In addition to writing letters, Elliott’s Zabel has met with SEC officials to press his case. So have executives from Third Point, Millennium Management, ExodusPoint Capital Management, D.E. Shaw, PDT Partners, Tiger Hill Partners, Marshall Wace, and Citadel, all of whom have met with the SEC as representatives for the Managed Funds Association and the Alternative Investment Management Association, the two hedge fund lobbying groups.


But the hedge funds aren’t fighting the SEC alone: A new organization, which Institutional Investor has learned has at least one hedge fund backer, has enlisted dozens of academics to argue against the proposals, creating something of a firestorm of criticism.

That effort is the brainchild of Frank Partnoy, a law and finance professor at the UC Berkeley School of Law, who decided the SEC’s new aggressiveness was a good reason to create a nonpartisan, nonprofit institute — he named it the International Institute of Law and Finance — that could influence policy by convincing other professors to sign on to comment letters that he, and his colleague Robert Bishop, would draft.

“There’s a gap in terms of academics connecting with policymakers,” says Partnoy, a highly regarded academic and prolific writer, whose work includes several nonacademic books, including F.I.A.S.C.O., his first-person takedown of the derivatives business in which he once toiled as a salesperson at Morgan Stanley. In part, that gap exists because there is no incentive for academics to get involved.

Wonky academic comments on proposed SEC rule changes typically fly under the radar. But Partnoy made them his mission. Now his work — in comment letters signed by himself, Bishop, and other academics — is taking some heat. In part, that’s because the financing of his institute, which pays Partnoy and Bishop for their letter writing, has been shrouded in secrecy.

As a result, the new institute has been thrust into a bigger brawl with the SEC about the activist shareholder proposals.

For the activists, the new rules come at a time when their strategy has become less popular. Last year, shareholders supported only 28 percent of director candidates proposed by activists in the U.S., down from almost 50 percent in the prior four years, according to Insightia, which tracks activism. Insightia also found that settlements with management ahead of proxy votes had also declined. Meanwhile, it noted that activist firms are managing more money than ever.

One of the most significant, and longest-debated, SEC rule changes that could affect activism is a proposed shortening of the period after which an activist investor who amasses a 5 percent control stake in a company’s shares must file a 13D disclosure form. Under the new rule, that window would shrink from ten days to five — and give the hedge fund fewer days to buy more shares or swaps before letting the world know it intends to agitate for change, often at the board level and in the C-suite.

Once activists disclose their position, shares of the target company rise on average about 10 percent, so the hedge funds want to make sure their buying is complete. “If the position is disclosed at a very early stage, it removes a lot of the economic incentive to do activism,” says an individual at one of the hedge funds that has criticized the proposals. “Some activist firms may leave the space entirely.” Those who target smaller companies are especially at risk of leaving the business, activists say.

But proponents of the new rule say that today’s world of instantaneous electronic communication makes the long lead time unnecessary, and a few advocates of shareholder activism say privately that they no longer oppose the change, as it’s widely viewed as an issue of market fairness. Moreover, hedge fund activists are quite busy in Europe, where not only are there lower disclosure thresholds, but once the threshold is reached, future purchases are forbidden until such disclosure is made.

Adds former SEC Commissioner Robert Jackson: “If you’re in a position where your business model is so rickety that going from ten days to five turns you from a profitable activist to an unprofitable one, maybe it’s not such a bad thing for you to find another business.”

The part of the proposed SEC rule that has become the most controversial, however, is its attempt to broaden the definition of a group of investors working together, triggering disclosure when the investors’ combined stake goes above or below 5 percent. Hedge funds say such a change would cast a chill on the entire activist market.

Under the current rules, investors have to reach some sort of an agreement — formal or informal — to be considered a group acting in consort for 13D filing purposes. Under the proposed rule, no explicit agreement need be reached, making the group definition somewhat nebulous. Investors could be deemed part of a group simply by buying securities after receiving information from another investor, according to a comment letter submitted by Pershing Square Capital Management.

“Investors would be extremely unwilling to talk to each other,” says the aforementioned hedge fund activist. “On a 13D they would have to report that trading every 1 percent up or down once the total reaches 5 percent. They’re not going to do it.”

The third major issue is timely public disclosure of swaps positions — a rule that Gensler has stated publicly is a response to the 2021 blowup of Archegos Capital Management, which secretively used total return swaps to amass $160 billion worth of stakes in companies, ultimately resulting in billions of dollars in losses for its counterparty banks and other market participants when Archegos collapsed.

Archegos is an extreme example of how undisclosed swap positions can wreak havoc in the markets. But hedge fund activists use swaps to give themselves an economic stake in a company without actually owning the shares at the time of their activist campaigns. In fact, they sometimes do not even have to disclose a 5 percent stake because most of the economics are in the form of the swaps. But since going public with their position typically causes the stock to pop, they want to do so — when they are done buying.

However, if the swaps are disclosed as the SEC has proposed, a hedge fund’s intentions could be known even before it hits the 5 percent stock-ownership threshold requiring disclosure, once again limiting the potential for profit.

The SEC’s intent is logical, says former Commissioner Jackson, who is now a professor at New York University School of Law: “I don’t think that you should have to be transparent in something you do in shares and be able to hide something you do with swaps.”

Whether the new rules are logical or not, the effort to stop the SEC is growing — with the opposition even spreading to Congress. A letter that quotes one of those drafted by Partnoy’s institute criticizing the proposed rules has been making its way through the House of Representatives in hopes of garnering congressional opposition to the SEC’s effort.

“We are deeply troubled by the concerns raised by advocates of corporate accountability and social responsibility regarding recently proposed rules at the commission that may impair the ability of engaged shareholders to seek important changes at America’s public corporations,” states the letter, a copy of which II has received. “As David Webber, respected labor scholar at Boston University School of Law and author of The Rise of the Working-Class Shareholder: Labor’s Last Best Weapon, noted in his comment letter, ‘Whatever problems we may face in America, we should all agree that an overabundance of corporate accountability is not one of them.’” The Webber letter was drafted by Partnoy’s institute.

Rep. Ritchie Torres, a Democrat from New York’s South Bronx — one of the poorest districts in the nation — whose top donors include Elliott, has been circulating the letter, according to an individual familiar with the effort. (Torres, whom OpenSecrets says is a top recipient of hedge fund cash in the current election cycle, did not return multiple requests for comment, nor did Elliott.)

Comments from hedge fund activists are par for the course, as is lobbying Congress. “You’re closing a profitable loophole, so there’s no surprise that we’re seeing the type of pushback that we see right now,” says Andrew Park, a senior policy analyst at investor advocacy group Americans for Financial Reform who was recently named to the SEC’s investor advisory committee and has written in support of the SEC’s new rule proposals.

But Partnoy’s International Institute of Law and Finance is trying to set itself above the fray by focusing largely on academics. The fact that 85 academics signed on to the letter about swaps and 65 signed the letter that deals with the 13D rule changes is often mentioned by hedge funds as independent proof that their criticisms are valid.

At the very least, the academic letters don’t oppose the hedge fund stance. Take the issue of shortening the 13D disclosure window, which is anathema to many activists. Even though Partnoy told II that he personally supports closing the window to five days, the numerous letters Partnoy and Bishop have written tend to hedge their bets.

Indeed, the letter signed by 65 professors that the two academics drafted says there is disagreement among the members of the group about that specific part of the proposal, adding that there is not enough data to support it. Then the letter adds that “it does not seem unreasonable to reduce the ten-day period somewhat.”

Those professors also say that there’s not enough data to support changing the definition of a group (a point on which Partnoy says he agrees).

The idea that the SEC can go out and do more research on these issues, however, was dismissed by former SEC general counsel John Coates, now a professor at Harvard Law School, who wrote in his comment letter that academics “seem to misunderstand the institutional autonomy the agency does and does not have to conduct original research.”

The apparent groundswell of academic opposition has led supporters of the SEC’s new rule — labor and investor interests — to suspect that Partnoy’s institute is representing the views of hedge funds. In large part their furor comes because Partnoy and Bishop attempted to portray the criticism of the SEC’s proposals as so widespread that it has captured not just academics, but also First Amendment advocates and what they termed “labor interests.” Indeed, the professors wrote “not many” are on the SEC’s side.

That’s something of an exaggeration. For one thing, the AFL-CIO has supported the SEC’s proposed rule changes and is furious about the attempt to suggest labor thinks otherwise.

“I find any potential confusion about the labor movement’s position on hedge fund disclosure surprising given that even a cursory search of the AFL-CIO’s website would find an executive council statement going back to 2007 that was highly critical of activist hedge funds and particularly the secrecy around it,” says Brandon Rees, deputy director of corporations and capital markets at the AFL-CIO.

More than a month after the comment period was closed, the AFL-CIO wrote a second letter supporting the SEC’s proposed disclosure rules that was also signed by 11 separate unions.

“The proposed rules are designed to require timely and complete disclosure of activist hedge fund ownership stakes in target companies. We view such disclosure as a matter of market transparency and fairness to prevent creeping takeovers and other abusive practices,” the letter stated. It added that the proposals “will benefit workers and long-term investors, including workers’ pension funds.”

Some argue, however, that there is a negative side effect to the dustup. “Because you have labor and shareholder activists fighting against each other here, the only winner is corporate managements,” says a hedge fund and SEC policy veteran.

While hedge fund activists and the academics talk about the importance of holding management accountable through activism, unions have a more complex relationship with the strategy. Some union pension funds may agree with hedge fund activists and profit from their activities, but unions have also long opposed some forms of activism because the corporate changes sought by hedge funds are often associated with job losses, as mentioned in the AFL-CIO letter.

“Activist hedge fund campaigns targeting public companies are associated with a reduction in jobs, R&D spending, and capital expenditures,” the AFL-CIO wrote. “Indeed, a comprehensive study of over 1,300 such campaigns conducted between 2000 and 2016 found that after activist hedge funds acquire ownership, the company’s workforce experiences a steady decline — 4.57 percent in the first year and 7.66 percent by the fifth year.”

Partnoy’s institute did get some labor support, but that is now being recanted.

“I made a mistake,” says Andy Stern, the now-retired, once-powerful head of the Service Employees International Union, who has walked back an April 11 letter he signed that was critical of the new rules.

Says Stern, “I got contacted by an acquaintance of someone I knew who claimed there were a certain number of labor groups or advocates who were concerned about a small piece of the rule, which was whether groups of labor people could actually communicate with activists.”

Stern says he received a draft of a letter from someone at Partnoy’s institute and signed it. “It was such a small favor.”

Now, he regrets his name being tossed around as opposing the rules. The institute, he says, “must be either a front for or supporter of hedge funds.”

Partnoy says that Stern is mistaken and that his donors are a “diverse group of individuals and institutions.” He also reached out to people on both sides of the issue, inviting academics and lawyers representing opposing interests to participate in a Washington, D.C., conference on the proposed rule changes. (Partnoy says he also invited Stern to the event, but he declined to participate.)

The Berkeley law professor says the views expressed in the letters are based on more than two decades of his published research in various areas of academic scholarship, as well as that of other academics. His letters disclose that he and Bishop receive compensation for drafting the comment letters, but the other academics who sign the letters do not.

But there is at least one hedge fund supporter that II can report: Pershing Square CEO Bill Ackman.

The chairman of the institute’s board is Stephen Fraidin, a corporate attorney and partner at Cadwalader who has also long worked for Pershing Square. He serves on the hedge fund’s advisory board and was the firm’s vice chairman between 2015 and 2018. (Fraidin also knows Partnoy from Yale University, where Fraidin is also a part-time law professor. Partnoy, it turns out, was one of his students.)

Fraidin, who receives no compensation from the institute, declined to comment.

Ackman told II that he has donated to the institute — which is not required by law to disclose its backers — but had no role in its creation. And although Ackman says he has forsworn activism, Pershing Square did submit a comment letter of its own that focused its criticism on the SEC’s proposed new definition of a group. That letter was written by Fraidin but signed by Pershing Square’s in-house general counsel.

If Partnoy’s intent was to find broad support for what he considers the deficiencies in the SEC’s proposals, his critics see something else. AFR policy analyst Park complains that the institute is “representing the interests of different groups that don’t want to put their face on what’s trying to be done here. And I think that’s what’s a bit irritating about this. It strikes me as not a genuine concern, but rather one that is driven by monetary interests.”

The only other labor supporter that Partnoy’s institute got onboard was Boston University’s Webber, whose comments were quoted in the letter making its way through Congress. Separately, the Council of Institutional Investors — a group that includes union pension funds — made clear in its comment letter that it broadly supports the proposed changes, while offering one specific suggestion for clarification on the group issue regarding communications “made in connection with” a control-related transaction or communications made “as a participant” in such a transaction. “It might be read too broadly and have an unintended chilling effect of the sort of communications that routinely occur today,” the council wrote, suggesting the SEC change the language.

Some of that group’s members are also part of the AFL-CIO, which sought to clarify the issue in its recent letter, saying that the proposed rules “will not, as some have argued, interfere with shareholder advocacy on environmental, social, and governance issues.” It also suggested that the SEC can better explain what it means by a group to avoid any confusion on the matter.

While the pension funds have been particularly concerned about communications they make regarding their support of shareholder ESG proposals, worries about the group definition — which admittedly is confusing — may be somewhat overblown. As long as shareholders are just putting forth proposals, casting “no” votes, and not agitating for change in control of management, shareholders communicating with each other would not be considered a group under the proposed rule.

Even if they are demanding a change of control, their joint ownership stakes are often so small as to not trigger the disclosure. In the most prominent case, activist investor Engine No. 1 mounted an aggressive proxy battle campaign against Exxon Mobil Corp., and three of the largest U.S. pension funds — the California Public Employees’ Retirement System, the California State Teachers’ Retirement System, and New York State Common Retirement Fund — announced their support for Engine No. 1’s plans. But they were not required to do so — the four investors did not together own 5 percent of the shares of Exxon Mobil.

The academics’ letters praise shareholder activism and seem to oppose doing anything that might limit it, even though the academic literature is mixed on its benefits. In fact, Bishop himself was a co-author of 2019 research paper that concluded that other shareholders may be hurt by hedge fund activism because of what it called “leakage” of information — which is precisely what tougher disclosure rules hope to prevent.

In the end, however, Bishop and Partnoy suggest that the SEC either scrap the proposed 13D rule entirely (and study the issues more) or get congressional approval to make the changes it wants. They also attack the swaps rule proposal as lacking legal authority, among other problems. And finally they say they are worried about a “wave of litigation” that would end with the rules being struck down. Indeed, hedge funds are already threatening, implicitly if not overtly, to sue.

“There’s no question if the SEC takes actions based on shoddy analysis, without explaining what market failure they are trying to address, they could be vulnerable to litigation in the future,” says an executive at one of the hedge funds involved in the lobbying effort. “It would be embarrassing for Gensler in particular to have a rule that he pushed through struck down by the court.”

The SEC is used to its rules being challenged in court, and it has lost a few important cases. But supporters of these proposals aren’t too worried, especially since they believe the most controversial of the proposals — the definition of a group — will be clarified before the final rule is released.

“Yes, the rules will get challenged. There’s no doubt in my mind because the same massive fund approach that’s pushing back against this rule is going to challenge this,” says David Katz, a partner at Wachtell, Lipton, Rosen & Katz, which has represented many of the companies targeted by activists and has long lobbied for the changes now being proposed. With regard to the litigation, he says, “I don’t believe that they’re going to be successful.”