The following is an unlikely sentence: Nothing arouses the humours like mandatory disclosure thresholds for share ownership. But it's also a true sentence – if you don't believe me, I direct you to the seventy-odd comment letters that the Canadian Securities Administrators (CSA) received last year when they proposed, among other things, lowering the "early warning report" (EWR) threshold from 10 per cent to 5 per cent.
Not only is that a lot of comment letters, but they are surprisingly passionate for comment letters, ranging from an unflattering comparison of Canada to Latvia and Pakistan (in Norton Rose Fulbright Canada LLP's letter) to the suggestion that the "only winners" from such a reduction would be "underperforming managers" (from a thorough survey prepared by Davies Ward Philips & Vineberg LLP for the Managed Funds Association and the Alternative Investment Management Association). Ouch, burn.
Of course, the comment letters aren't just witty repartee, they're also trying to win a debate. And, for the time being, the debate over EWR disclosure thresholds appears to be over. The CSA handed the anti-reduction side a knock-out victory last week, rejecting the most substantive changes to the policy. In addition to maintaining the EWR threshold at 10 per cent, the CSA declined to include derivatives in any ownership calculation, even if those derivatives are convertible into equity.
This is the kind of debate that sounds like it's about something narrow and technical (and, to be honest, much of the debate is narrow and technical) but is really a large battle in an important war: the battle between managers and activist investors over who should run Canada's largest companies.
Under current rules, investors have to file an EWR within two days of accumulating a 10 per cent ownership interest in a company. During that period, the filing investor is barred from trading in the company's shares and increasing the size of its holdings. The EWR forces the investor to declare its intentions – namely, whether the investor plans on using its ownership stake as a toehold to launch a takeover, or whether it plans on engaging in activism, such as launching a proxy fight, to influence corporate policy. Traditionally, EWRs were most relevant in the takeover context but, with the rise of activist hedge funds, companies want to know who their shareholders are as soon as possible, in order to pre-empt activism.
There is a certain elegance to the 5 per cent threshold. Not only do most other countries operate at the 5 per cent level, but Canadian law requires that 5 per cent of shareholders can requisition a special meeting to challenge a board of directors. A 5 per cent EWR threshold would close the gap in which an activist could purchase enough shares to launch a proxy fight but does not have to disclose its intentions to do so.
From the activist investor's perspective, a 5 per cent decrease in the EWR threshold is a big deal. When an activist files an EWR, the share price of the company it has invested in usually appreciates. Thus, the activist's reward for engaging in activism is the difference between the price it paid for the shares and the appreciated share price when it discloses its intentions (less the not-insubstantial costs of activism, of course). Decreasing the disclosure threshold makes activism more expensive and less lucrative. Indeed, because of the moratorium on trading once an investor crosses the threshold, a move to 5 per cent would have given Canada one of the toughest early warning regimes in the world, as other countries tend to have longer filing deadlines and no moratorium, allowing investors to accumulate shares during the interim period.
The easy answer to this debate is that we should prefer a regime that encourages activism. If we believe that the share price is the correct barometer of the value of a company, and activists increase the share price, then a policy that promotes activism is a good thing. Even if earlier disclosure catches more investors, and thus causes markets to more efficiently price companies, the chilling effect on activism is a net loss.
This is a good story, but it's not the only one. Some, including Delaware Supreme Court chief justice Leo Strine, remain unconvinced that share price is entirely reflective of the long-term economic value of a company. Instead, share price may reflect the willingness of activists to engage in risky, short-term strategies that increase the risk of firm failure and decrease investment. Justice Strine argues that shareholders have reason to be skeptical of activists who argue that a company would be more valuable with a different business strategy but are unwilling to buy the company or even commit to holding its stock for any period of time. Those arguments suggest that more and earlier disclosure at the expense of activism may be a much better thing for the real economy.
In short, there's a lot to fight over in that 5 per cent.
While much of the debate revolves around legal and economic minutiae – how do you define an "equity equivalent derivative"? Does the relative lack of liquidity in Canada's markets leave Canada's investors unwilling to cross disclosure thresholds due to the risk of front-running? – the fundamental question is both straightforward and complex: Exactly who is best positioned to make Canada's companies the most valuable they can be?
That's going to take a lot more than 70 comment letters to resolve.