A Theory of Empty Voting and Hidden Ownership

Posted by June Rhee, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Friday November 2, 2012 at 9:14 am
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Editor’s Note: The following post comes to us from Jordan M. Barry, Associate Professor of Law at the University of San Diego School of Law, John William Hatfield, Assistant Professor of Political Economy at the Stanford Graduate School of Business; and Scott Duke Kominers, Research Scholar at the Becker Friedman Institute for Research in Economics at the University of Chicago.

In our recent paper, On Derivatives Markets and Social Welfare: A Theory of Empty Voting and Hidden Ownership, we build and explore a formal theoretical framework to understand interactions between derivatives markets and shareholder voting behavior.

Ownership of stock in a corporation entails two types of rights with respect to that corporation. First, shareholders have economic ownership rights that entitle them to share in corporate profits. Second, they have certain legal rights of control over the corporation. These economic and control rights come bound together with each share of stock, but they can be separated, or decoupled. Decoupling can result in empty voting, in which an actor’s voting interest in a corporation is larger than her economic interest. It can also lead to hidden ownership, in which an actor’s economic interest in a corporation exceeds her voting interest. Decoupling raises a host of concerns because it turns the conventional logic for granting shareholders voting rights—their economic interest in the corporation—on its head. (See references here.)

Most decoupling incidents have arisen through the use of financial derivatives, and the explosive growth of derivatives markets has spurred a surge in empty voting and other decoupling behavior. Although some of these incidents are quite troubling, there are instances in which decoupling may be socially beneficial. For example, if managers misbehave, observant shareholders can use decoupling strategies to acquire additional voting rights more cheaply than would otherwise be possible. These shareholders can then use their additional (empty) voting power to pressure management to improve its behavior. Similarly, one might wish to give managers a significant economic interest in the corporation in order to increase their incentives to raise profits. At the same time, one might be wary of giving management as many control rights, out of concern that doing so will discourage takeover attempts. Such an arrangement would make managers hidden owners. To appropriately respond to decoupling, regulators must have a framework that allows them to assess when decoupling is good for society and when it is detrimental.

The framework that economists typically use to analyze markets is based on a concept known as competitive equilibrium. Competitive equilibrium analysis chiefly focuses on prices. The heart of the competitive equilibrium framework is the idea that, if each actor acts to maximize her own well-being, there is a set of prices at which the market will clear. In other words, at the prices in question, everyone who wishes to purchase or sell items may do so.

The competitive equilibrium framework is powerful, and works well in many settings. Unfortunately, as we show in our Article, the competitive equilibrium framework fails in the decoupling context. Decoupling is fundamentally linked to the power of a firm’s shareholders to affect corporate behavior through control rights. Our work demonstrates that once control rights are introduced into a market, competitive equilibria lose their normative appeal and may fail to exist altogether. This problem gets much worse when control rights over corporations can be bought and sold independently of economic interests in those corporations. When corporate ownership and control can be fully decoupled—as modern derivatives markets increasingly allow—competitive equilibria essentially never exist.

As an alternative to the concept of competitive equilibria, we propose a different solution concept, the core outcome. The hallmark of a core outcome is that no group of actors can change its behavior in a way that makes the group as a whole better off. We demonstrate that the core outcome framework has numerous attractive properties that make it well-suited for analyzing markets with control rights: In contrast to competitive equilibria, core outcomes always exist and are always efficient. Core outcomes can always be achieved through voluntary trading among self-interested actors, and are stable—once the market reaches a core outcome, no group of actors has both the capability and the desire to move the market to a different outcome. Finally, the core outcome framework enables us to predict how all significant control rights will be exercised and what types of portfolios actors will hold. (Predicted core outcome portfolios closely resemble the diversified portfolios that most investors hold in the real world.) Even when ownership and control are fully decoupled, all of these features persist.

Our analysis has significant implications for the importance and effects of derivatives markets. We illustrate how large, opaque derivatives markets can render financial markets unpredictable, unstable, and inefficient. On the other hand, if derivatives markets are transparent, they can help the market to reach a core outcome. Our model suggests that, in transparent markets, decoupling should only occur in those situations in which it is socially beneficial. However, private parties left to their own devices will generally not have the proper incentives to ensure the requisite amount of market transparency. Our analysis therefore provides a justification for a comprehensive, effective mandatory disclosure regime for securities markets, including derivatives markets. We also use our model to evaluate several substantive regulatory interventions that have been proposed to address decoupling.

The full article is available for download here.

  1. Thank you for your contribution to the debate. For other readers’ interest I am enclosing a link to the European Securities & Markets Authority (ESMA) which earlier this year (June 2012) issued a detailed paper on this subject.
    http://www.esma.europa.eu/system/files/2012-415.pdf

    As with a number of issues which appear to share a common vocabulary, I do think that we have problems of definition that should be clarified as a matter of urgency. One of which is the difference in nature between shareownership and voting in the US and the rest of the world. In Europe, voting is a property right and without proof of title there is no voting. Derivative’s have no voting power until the securities are delivered.

    In the US we see that securities are fungible, they are treated as cash, they are not property at all. This is demonstrated in the differences in how bank failure is treated and why European investors insist on having designated securities accounts to ensure that their property is registered in their name such that in the event of bank failure they can retreive their property directly, not merely rank parri passu with other creditors.

    “Empty Voting” may indeed be a coercive market influence but that is not voting. We would agree that it is entirely undemocratic to exert or to attempt to exert influence without ownership, however that is the daily nature of the securities market. Indeed ESMA concluded that what in the US is called “empty voting” was more likely to be “market abuse”.

    In the US it is more likely that CEOs will lose their jobs because of extreme share price gyrations, not because the shareholders defenestrate her at the AGM. Few US legal scholars appear to be aware that in EU shareholders do have the ultimate and binding control over corporate structure without the need for intervention from securities lawyers or markets regulators, that is because we have preserved the distinction between securities markets law and fundamental company law. We should therefore never speak of Anglo-American governance standards as they are, in effect, chalk and cheese.

    One of the key factors which would help avoid empty voting is to have an ownership/record date requirement which is as close to the meeting as possible, which in the case of the UK is 48 hours. The current US proxy plumbing would not be able to cope with this, which is perhaps why certain stakeholders in the US markets appear reluctant to grasp the nettle of reform.

    It is worth considering that Adolf Berle was heavily influenced by the concepts underpinning English company law and I would commend this SSRN paper by Fenner L. Stewart Jr. of
    Capital University Law School if you have a mind for history. http://ssrn.com/abstract=1651286

    The financialisation of shareownership has flipped many of the basic ownership concepts around and we appear to be in danger of losing sight of some basic truths.

    Comment by Sarah Wilson — November 5, 2012 @ 7:00 am

 

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