The Securities and Exchange Commission plans to issue long-awaited rules requiring disclosure of short-sale positions by investment managers. The new rules may severely limit the ability of investment managers to protect their trading strategies and require frequent reporting of large portfolios on only a two-day delay from real-time holdings. The key question is how the SEC will interpret Section 929X of the Dodd-Frank Act.
The exact timing of the new rules is unclear, though the SEC continues to update a pending action chart, revised most recently July 10, which states its intent to issue “rules regarding public disclosure of information regarding short sales and, as the commission deems appropriate, as otherwise necessary pursuant to [Dodd-Frank].”
Under Section 13(f), investment managers who exercise discretion over at least $100 million in Section 13(f) securities must report their holdings on Form 13F. Form 13F is immediately disclosed to the public unless the investment manager formally requests confidential treatment for a specific filing, which, even if granted, would keep the Form 13F confidential only for a limited time.
Section 13(f) securities generally include equity securities that trade on an exchange (including the Nasdaq National Market System), certain equity options and warrants, shares of closed-end investment companies and certain convertible-debt securities. It has been more than three years since Dodd-Frank, which became law in July 2010, required the SEC to adopt new rules that would add at a minimum monthly disclosure of short-sale positions to the long equity securities positions already required to be disclosed on Form 13F.
In February 2011, the Managed Funds Association submitted a comment letter to the SEC urging the staff to adopt an interpretation of Section 929X limiting 13F's short-sale disclosure requirements to a public report by the commission of aggregate information from short sales, rather than publicly disclosing each individual investor's short-sale positions. The SEC hasn't commented publicly on whether it accepts or rejects the MFA's position.
Hedge fund managers, as implied by their namesake, often hedge risk by holding short positions in their portfolios. If the SEC adopts rules requiring public reporting of individual short-sale positions, an important component of fund managers' trading strategies would be made available to the public at large.
Even without disclosure of short-sale positions, investors have taken advantage of the information disclosed on Form 13F filings of large investors. For example, The Wall Street Journal's MarketWatch and trading blog Insider Monkey tout a 24.3% return on their Billionaire Hedge Fund Index, “beating the S&P 500 ETF by 8 percentage points” by tracking positions on 13F filings.
So how do investment managers protect the trading strategies they develop internally or acquire at no small price?
Before the Supreme Court's 2010 decision in Bilski v. Kappos, patent protection of trading strategies was dubious at best. Under Bilski, the court upheld the Patent Office's and the circuit court's refusal to grant patent protection to a commodities-trading strategy as a mere “abstract idea.”
The court stopped short of an outright prohibition on patent protection for trading strategies and other business methods, but it sent a clear signal that its decision “does not suggest broad patentability of such claimed inventions.”
And obtaining a patent is only the first step. Enforcing it against would-be infringers in less-than-transparent trading markets would be difficult without expensive discovery in litigation.
Investment managers have gone to great lengths to protect their proprietary strategies as trade secrets, requiring that their employees and contractors sign nondisclosure agreements and assign their intellectual-property rights, and enforcing those rights in court when rogue traders or quants abscond with the secret sauce. Unlike patent protection, trade secrets aren't registered with any governmental authority.
TRADE SECRET LAW
Trade secret law varies somewhat from state to state and country to country, but in general, protection of information always requires two important elements — that the information: (1) confers an economic benefit to its holder, and (2) is subject to efforts to maintain its secrecy from the public at large. Requiring public disclosure of investment positions on Form 13F arguably reveals the investment manager's underlying trading strategy, thus preventing its protection as a trade secret.
Proponents of disclosure point to the public's desire for market transparency, the broader goal of investor confidence and the usefulness of such information to companies for corporate governance.
And not all positions are required to be disclosed on 13F. For example, shares of open-end investment companies — for example, mutual funds — aren't included, nor are cash and foreign stock (non-American depositary receipts) positions.
Further, the delay in time (45 days after the end of each quarter) before positions are publicly reported has been thought to mitigate the concerns of investment managers. But the 45-day reporting delay may soon become two days.
A Feb. 1 petition for rule making submitted to the SEC by the National Investor Relations Institute, NYSE Euronext Inc. and the Society of Corporate Secretaries & Governance Professionals seeks amendment of Section 13(f) to shorten the reporting deadline from 45 days to two business days and the reporting period from quarterly to monthly or “some lesser period, as may be determined.”
The bottom line is that there is a realistic possibility that fund managers soon will need to disclose their portfolios, including short-sale positions, every few weeks, on only a two-day delay from a real-time picture of their holdings.
Michael D. Kurzer is a corporate technology associate at Ropes & Gray LLP.