Hedge Funds and Risk-Decoupling — The Empty Voting Problem in the EU

Posted by June Rhee, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Sunday September 30, 2012 at 10:05 am
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Editor’s Note: The following post comes to us from Wolf-Georg Ringe, Professor of International Commercial Law at Copenhagen Business School.

In my paper, Hedge Funds and Risk-Decoupling — The Empty Voting Problem in the European Union, I address the implications of negative risk-decoupling, otherwise known as empty voting, for corporate governance and corporate finance, and I develop suggestions for a regulatory response. These suggestions are framed for the European context, but the underlying policy considerations may prove useful for other regulators worldwide, including the SEC.

Empty voting is a popular strategy amongst hedge funds and other activist investors. In short, it is the attempt to decouple the economic risk from the share’s ownership position, retaining in particular the voting right without risk. This paper uses three perspectives to analyze the problems created by such negative risk-decoupling: an agency costs approach, an analysis of information costs, and a perspective from corporate finance. It shows how risk-decoupling is a type of market behavior that creates significant costs for market participants, in particular existing shareholders and potential investors. Risk-decoupling strategies create both agency and information costs for investors. Furthermore, they generate challenges for traditional categories of corporate finance, aiming to extract the “best of both worlds”, debt and equity.

Based on the insights developed from these policy perspectives, I then develop regulatory reform proposals. These are envisaged particularly for EU level lawmaking, but they raise underlying issues on a more general level. Whilst several proposed regulatory tools are rejected, the paper prefers a solution that uses continuous transparency obligations as the cornerstone. In addition, it suggests that in certain individual cases, national regulators should be empowered to suspend activists’ voting rights. The paper concludes by offering a concrete legislative proposal, amending the European Transparency Directive.

The jurisdictional scope of the paper is mainly on UK and US law. Particular emphasis is placed on developing a legislative solution for the EU context because the European institutions are currently proposing to adopt regulation at the EU level, in response to the risk-decoupling phenomenon. What about the US? Back in 2007, then SEC Chairman Christopher Cox already stated that risk-decoupling strategies are “almost certainly going to force further regulatory response to ensure that investors’ interests are protected. This is already a serious issue and it is showing all signs of growing.” Following up on this announcement, the SEC conducted a public consultation on the topic in 2010, in order to anticipate eventual regulation. [1] However, so far no regulatory activity has been adopted. It is the hope of this paper that any future regulation may be guided by sound underlying principles, and that this paper can help contributing to this goal.

The full paper is available for download here.

Endnote

[1] Securities and Exchange Commission, Concept Release on the U.S. Proxy System (Release Nos 34-62495, IA-3052, IC-29340; File No S7-14-10, 2010), (2010) 75 F.R. 42981, in particular at p. 43019 et seq. on the various regulatory options.
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