Hedge funds, insiders, and the decoupling of economic and voting ownership: Empty voting and hidden (morphable) ownership

Abstract

Most U.S. public companies have a single class of voting common shares: voting power is proportional to economic ownership. Linking votes to shares is often thought to be desirable, because, as residual claimants, shareholders have an incentive to exercise voting power well. The linkage also facilitates the market for corporate control. On the other hand, decoupling is efficient in some situations. Equity derivatives and other capital market developments now allow shareholders to readily decouple voting rights from economic ownership of shares, often without public disclosure. Hedge funds are prominent users of decoupling. Sometimes they hold more votes than economic ownership (a situation we term “empty voting”). Sometimes they hold undisclosed economic ownership without votes, but often with the de facto ability to acquire votes if needed (a situation we term ‘‘hidden (morphable) ownership”). This Article analyzes empty voting and hidden (morphable) ownership, which we term the “new vote buying.” We offer a framework for unpacking its functional elements and assess its potential benefits and costs. Two companion legal articles (Hu, Henry T.C., and Bernard S. Black, 2006a. The New Vote Buying: Empty Voting and Hidden (Morphable) Ownership, Southern California Law Review 79, 811–908#, and Hu, Henry T.C., and Bernard S. Black, 2006b. Empty Voting and Hidden Ownership: Taxonomy, Implications and Reforms, Business Lawyer 61, 1011–1069.) provide more details on current disclosure rules and offer a disclosure reform proposal.

Introduction

The shareholder vote plays a central role in the theory of corporate governance and capital structure. Most U.S. public firms employ a one common share, one vote structure, which links economic interest to voting rights. Assigning voting rights to common shareholders, in proportion to number of shares held, places the power to oversee company managers in the hands of residual owners, who have an incentive to increase firm value. Linking shares to votes also facilitates the market for corporate control. Yet there can sometimes be advantages to decoupling shares from votes. Decoupling has traditionally been used by insiders to retain voting control. A dual-class common share structure, with one class having voting control, is a familiar example. This structure can let firms pursue growth opportunities which they might forego if doing so required diluting insiders' control, and can make it easier for firms to make long-term, positive NPV investments with unobservable payoffs. Decoupling can also potentially reduce shareholder collective action problems and reduce transaction costs in a contest for corporate control.

The derivatives revolution in finance, especially the growth in equity swaps and other privately negotiated (“over the counter” or “OTC”) equity derivatives, and related growth in the stock lending market, offer new, low-cost, often low-transparency ways for both outside investors and insiders to decouple economic ownership from voting power in public companies. Over the last few years, these decoupling techniques, which we call the “new vote buying,” have been employed worldwide in a variety of ways. This Article explores these new techniques and their potential benefits and costs.

Even if a firm has a one share, one vote capital structure, there are multiple ways to decouple votes from economic ownership. One method relies on share lending. Under standard share loan agreements, the borrower acquires voting rights but no economic ownership, while the lender has economic ownership without voting rights. A second common approach involves holding shares but hedging economic risk by holding a short equity swap position. In a typical cash-settled equity swap, the long equity side acquires the economic return on shares (but not voting rights) from the short side. The combined position (long shares, short equity swaps) conveys voting rights without economic ownership. Conversely, a long equity swap position conveys economic ownership without formal voting rights.

Sometimes, investors use these techniques to hold more votes than shares. We develop the term “empty voting” to describe this pattern, because the votes have been emptied of economic interest. Alternatively, investors can have more economic ownership than formal voting rights. This ownership is often undisclosed because ownership disclosure rules for outside investors generally address voting power rather than economic interest. Often, this economic ownership is combined with de facto ability to acquire voting rights at any time. We develop the term “hidden (morphable) ownership” to refer to undisclosed economic ownership plus informal voting rights. We refer to empty voting and hidden (morphable) ownership together as “the new vote buying” or simply “decoupling.”

The theoretical possibility of decoupling is not new. But supply and demand factors have changed in major ways. On the supply side, financial innovations (such as equity swaps and other OTC derivatives), coupled with massive growth in the share lending market, now permit large scale, low-cost decoupling. On the demand side, there is now a trillion dollar-plus pool of sophisticated, lightly regulated, hedge funds, which are largely free from the conflicts of interest and concerns with adverse publicity that may deter other institutional investors from using decoupling strategies.

Current U.S. law leaves the new vote buying largely unregulated and often undisclosed. Lack of disclosure means that we cannot offer quantitative data on its extent. We did, however, search for and compile over 25 recent public examples (see Table 1 below). How many additional instances remain undisclosed, we cannot say.

This paper proceeds as follows. Section 2 develops a taxonomy for the functional elements of empty voting and hidden (morphable) ownership, and offers examples. Section 3 discusses the theoretical and empirical literature on the benefits and costs of decoupling. Section 4 summarizes current disclosure rules and sketches a disclosure reform proposal. Section 5 concludes. Two companion legal articles (Hu and Black, 2006a, Hu and Black, 2006b) provide additional details on current disclosure rules, develop our disclosure reform proposal, and analyze possible reforms, some of which go beyond disclosure. An informal glossary at the end of this Article explains some commonly used terms. As far as we are aware, this Article and its companions are the first attempt to systematically address the new vote buying.¹