Financial Derivatives and the Intrinsic Separation of Ownership and Control

8/6/2019 Financial Derivatives and the Intrinsic Separation of Ownership and Control

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Financial Derivatives and the Intrinsic Separation of Ownership and Control

Eugenio S. de Nardis

Studi e Note di Economia, forthcoming

1. Introduction; 2. The Separation of Ownership and Control: - 2.1 The Functional Separation of Ownership and Control -; 2.2 The Intrinsic Separation of Ownership and Control-; 2.2.1 IntrinsicSeparation and Financial Derivatives; 3. The Regulation of Financial Derivatives in the UnitedStates: - 3.1 Financial Derivatives as Securities; 4. Regulating Intrinsic Separation of Ownershipand Control in the United States: - 4.1 The (New) Vote Buying Doctrine-; 4.2 The DisclosureRegimes-; 4.2.1 The Corporate Governance Disclosure Regime-; 4.2.2 Briefly on the EuropeanTransparency Directive and its Implementation in Italy-; 4.3 The Fiduciary Duty of Loyalty; 5.Concluding Remarks

1. IntroductionIn a recently often cited excerpt from The General Theory of Employment,

Interest and Money , J. M. Keynes distinguishes speculation , defined as the activitythat consists in forecasting the psychology of the market, and enterprise , defined asthe activity that consists in forecasting the yield of assets over their whole life.Keynes concluded that [w] hen the capital development of a country becomes a by -

product of the activities of a casino, the job is likely to be ill-done . () to make the purchase of an investment permanent and indissoluble () might be a useful remedy for our contemporary evils .1

Some years after Keynes, in Italy, F. Caff took a negative stance with regard

to the increased participation of retail investors in the stock market. Caff probablyhad in mind a speculation-driven stock market, such as the one Keynes refers to,when he wrote that he had been convinced for some time that the financial market supra-structure, with the characteristics it presents in countries with a developed capitalism, favors not competitive vigor but a predatory game that systematicallyoperates to damage categories of innumerable and undefended investors in aninstitutional framework that, in practice, allows and legitimates the recurring takingor the de facto expropriation of their moneys .2

The current global financial crisis has echoed these propositions, indicatingthat there may still be some gist to them and, less obviously, that they might still beof fundamental prescriptive importance. Indeed the affluent society has been at

Doctoral candidate in Law and Economics, University of Siena.1 J. M. Keynes, The General Theory of Employment, Interest and Money , Harvest, 1991 reprint, at 158-160.2 F. Caff, Economia di Mercato e Socializzazione delle Sovrastrutture finanziarie , in UnEconomia inRitardo, Boringhieri, 1976, at 18.


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least put on hold 3, as the boom-and-bust cycle aggressively demonstrates not only itsexistence, but its great health as well. 4

In a regulatory perspective, the current financial crisis indicates the need torethink corporate governance from its most fundamental principles. 5 The Berle andMeans public corporation, shareholder primacy, fiduciary duties, agency costs,incentive structures and monitoring mechanisms, need to be rethought in the contextof a new study of corporate governance.

The origins of the recent financial crisis have signaled that the starting pointof this new analysis should be the financial derivatives industry. The increasedsophistication of financial derivatives, coupled with stock market and tradingplatform developments 6, have made derivatives available - to sophisticated and retailinvestors alike - at lower transaction costs.

Financial derivatives are of course not a new phenomenon; what is new is theease and large scale in which they can be used to decouple voting rights andeconomic ownership, achieving an intrinsic separation of ownership and control. Hu

and Black 7

find over eighty confirmed or publicly rumored cases of decouplingthrough the use of financial derivatives, most of which have occurred after 2002.Moreover, numerous cases remain undetected because of the complexity of certainderivatives and overall transactions, their commonplace usage among sophisticatedinvestors, and the habitual absence of an ad hoc regulation.

In this paper we examine the intrinsic separation of ownership and controlachieved through financial derivatives when used to decouple voting rights andeconomic ownership. We begin from traditional theory regarding the functionalseparation of ownership and control in the Berle and Means public corporation, uponwhich most modern corporate governance analysis is explicitly and/or implicitlybased. We then distinguish this traditional functional separation from the developingintrinsic separation of ownership and control, as achieved at the individual level of each shareholder through decoupling transactions with financial derivatives.

3 J. K. Galbraith, The Affluent Society , Mariner, 1998 reprint.4 P. Krugman, The Return of Depression Economics and the Crisis of 2008, Norton, 2009 at 9-10,recalls how illustrious economists such as R. Lucas and B. Bernanke had recently given publicspeeches on how the boom-and-bust cycle had become only a minor issue in the developed U.S.economy.5 H. G. Manne, Corporate Governance Getting Back to Market Basics , CONSOB Seminar,November 10, 2008, available at www.consob.it; G. Rossi, Quale capitalismo di Mercato? , Rivistadelle Societ, 2008/5, at 905; G: Soros, The New Paradigm for Financial Markets , Public Affairs,

2008.6 S. Micossi, La Direttiva MIFID e la Nuova Struttura dei Mercati Regolamentati , Assonime, 2008; E.S. de Nardis, L. Giani, R. Vannini, Diamonds and Pearls Among Financial Markets: the Keys toSucceed in Regulatory Competition , 2008, available at http://www.side-isle.it/ocs/viewabstract.php?id=266&cf=2.7 H. T. C. HU, B. Black, The New Vote Buying: Empty Voting and Hidden (Morphable) Ownership 79S. Cal. L. Rev. 811,819 (2005-2006), at 819: The theoretical possibility of decoupling votes fromeconomic ownership is not new. What is new is investor ability to do so on a large scale, decliningtransaction costs due to financial innovation, and a trillion-dollar-plus pool of sophisticated, lightlyregulated, hedge funds .


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Further on we examine the current legislation applying to financial derivativesin the United States - among the most sophisticated and developed legal systems withregard to corporate governance and financial instruments. Finally, we brieflyexamine some of the possible regulatory responses or changes vis--vis the intrinsic separation of ownership and control, and evaluate them in light of the need to rethink

the fundamentals of traditional corporate governance analysis.

2. The Separation of Ownership and Control

Until recently, when academia referred to the separation of ownership andcontrol, it essentially had the Berle and Means public corporation in mind. In thepublic corporation par excellence , shareholders - the providers of capital - werepassive owners who most often voted with their feet, while managers - theentrepreneurs and exploiters of capital - actively controlled the corporation.

In this model, conflict of interest problems arose between shareholders andmanagement. The legislative framework aimed at preventing such conflicts and atachieving an efficient incentive structure within the corporation, was mostly based onfiduciary duties and market monitoring.

Continental European models of corporate governance, due to their pathdependencies, have taken a different form. In these models, the separation of ownership and control has been essentially viewed as the separation between amajority shareholder or block-holders on the one side, and minority shareholders onthe other. Conflict of interest problems thus arose between majority and minorityshareholders, and bright line rule prohibitions were more frequent in bank-orientedsystems with poorly developed stock markets. 8

Both the Anglo-Saxon and the continental European models have beenexamined profusely by scholarship, and some authors have hypothesizedconvergence toward the apparently prevailing Anglo-Saxon model. 9 Recent historyhas of course made a number of such claims conditional but, furthermore, a differentseparation of ownership and control has slowly manifested itself in all corporategovernance models, and has come to blur previous analysis.

The Berle and Means corporation - as well as its European counterparts - withits functional separation of ownership and control between managers andshareholders - or majority and minority shareholders -, has given way to an intrinsic separation of ownership and control, as individual shareholders are able decouple

8See for example the Law and Finance scholarship, starting from R. La Porta, F. Lopez-de-Silanes,

A. Shleifer, R. W. Vishny, Law and Finance , Journal of Political Economy, vol. 106, 1998.9 For example, A. R. Pinto, G. Visentini The Legal Basis of Corporate Governance in Publicly Held Corporations, A Comparative Approach , Kluwer, 1998; G. Visentini, Compatibility and Competition

Between European and American Corporate Governance: Which Model of Capitalism? , 23 Brook. J.Int'l L. 833 (1998); H. Hansmann, R. Kraakman, The End of History for Corporate Law , GeorgetownLaw Journal, Vol. 89, 2001; T. Clarke, Theories of Corporate Governance. The PhilosophicalFoundations of Corporate Governance , Routledge, 2004; R. Kraakman, P. Davies, H. Hansmann, G.Hertig, K. Hopt, H. Kanda, E. Rock, The Anatomy of Corporate law: A Comparative and Functional

Approach , OUP, 2004.


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economic ownership (risk) and control (voting rights) of the shares they hold with anincreasing ease and frequency.

Academia has studied the effects of deviations from the one share - one voteprinciple, although it has not focused extensively on financial derivatives as animplicit deviation mechanism. Nonetheless, even the most common hedging strategy- leaving aside other uses of financial derivatives - distorts the common assumptionsin a corporations incentive structure.

The fundamental tenet that no servant can serve two masters , is thus calledinto question by the increasing ease with which an intrinsic separation of ownershipand control can be enacted. Furthermore, the recent financial crisis questions anumber of fundamental principles of the current legal framework, and the futurelegislative stance will have to be based on a new corporate governance analysis thatexpressly considers intrinsic separation.

2.1 The Functional Separation of Ownership and Control

The functional separation of ownership and control was first cited by AdamSmith: [t] he directors of such companies, however, being the managers rather of other peoples money than of their own, it cannot well be expected, that they should watch over it with the same anxious vigilance with which the partners in a privateco-partnery frequently watch over their own .10

In 1921, F. Knight distinguished between risk and uncertainty: the formerbeing measurable and the latter not being measurable. 11 According to Knight,uncertainty prevents the perfect working of competition, giving rise toentrepreneurial organizations: uncertainty leads to specialization of functions andthus the enterprise form, as individuals are prepared to accept fixed wages in returnfor their labor, while managers carry out a coordination function. Functional separation of ownership and control is implicitly central to Knights construction of the entrepreneurial organization, as resulting from specialization.

In 1933 Berle and Means published their seminal work on the functional separation of ownership and control. The authors portray the splitting of the atom of property in the developing public corporation, where passive owners have given upactive control on their property, in favor of weakly-monitored managers. 12

Economists also began to study the inner workings of the firm - no longerviewed as a black box - and the principal-agent paradigm was developed.Fundamental to principal-agent analysis is the metering problem in team production,

which occurs when several types of resources are used, the product is not a sum of separable outputs of each resource, and not all resources belong to one person.

Alchian and Demsetz concentrated on shirking, as they believed economicorganization resolves the team production problem by allowing a better detection of

10 A. Smith, An investigation into the Wealth of Nations , Bantam, 2003 reprint, at 941.11 F. H. Knight, Risk, uncertainty, and profit , New York, 1964 reprint.12 A. Berle, G. Means, The Modern Corporation and Private Property , Harcourt, 1967 reprint.


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individual members performance. 13 Market competition can in principle monitorteam production, although new challengers for team membership do not know towhat extent shirking is a problem; moreover, detection of shirking by observation of team output is costly and the incentive of the new team member to shirk is at least asgreat as the incentive of the inputs replaced. Accordingly, to reduce shirking an

individual should specialize as a monitor of input performance of team members andshould be given title to the earnings of the team, net of payments to other inputs. Themonitor itself would be monitored through a market for monitors.

In their 1976 article, Jensen and Meckling concentrated on agency costswithin the firm. The authors used the contractual theory of the firm as a startingblock: contractual relations are the essence of the firm, not only with employees but with suppliers, customers, creditors, and so on. The problem of agency costs and monitoring exists for all of these contracts .14 The firm is described as a nexus of contracts:

It is important to recognize that most organizations are simply legal fictions which serve as a nexus for a set of contracting relationships amongindividuals... The private corporation or firm is simply one form of legal

fiction which serves as a nexus for contracting relationships. (A)gencycosts arise in any situation involving cooperative effort by two or more

people even though there is no clear-cut principal-agent relationship .15

Agency costs are defined as the sum of monitoring expenditures by theprincipal (the principal may seek to limit divergences from its interest throughincentive schemes and other mechanisms such as budget constraints and financialauditing), bonding expenditures by the agent (the agent might also seek to show thatit will not take any action directed at harming the principal), and residual loss(physiological diversions between the agents choices and maximization of the

principals welfare). With specific reference to the manager-shareholder relationship,agency costs are constrained by capital markets, product markets, and the market forcorporate control, acting as outside monitors of managers performance.

In their 1983 article, Fama and Jensen asserted that [a] n important factor inthe survival of organizational forms is control of agency problems .16 Withincorporations, risks borne by most agents are limited by ex ante specification of eitherfixed payoffs or incentive payoffs tied to performance. The residual risk is borne bythe shareholders, who contract for the rights to net cash flows, as residual claimants.

13A. A. Alchian, H. Demsetz, Production, information costs, and economic organization , The

American Economic Review, 1972, at 777.14 M.C. Jensen, W. H. Meckling, Theory of the firm: Managerial behavior, agency costs, and ownership structure , J. Fin. Econ. 3, n. 305, 1976; also available athttp://papers.ssrn.com/sol3/papers.cfm?abstract_id=94043, at 8 . 15 At 8. An agency relationship is defined as a contract under which one or more persons (the

principal(s)) engage another person (the agent) to perform some service on their behalf which involvesdelegating some decision making authority to the agent , at 5.16 E. F. Fama, M. C. Jensen, Agency problems and residual claims , Journal of law and economics, vol.XXVI, 1983, at 327.


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Through common stock, corporations spread residual risk across numerousresidual claimants, which choose how much risk to bear through diversification onthe stock market. This lowers the cost of risk bearing and equity financing. Inpractice this leads to functional separation of ownership and control throughspecialization of decision functions (management) and residual risk bearing

(shareholders).In more recent years, further analysis has developed the functional separation

of ownership and control, for example with regard to the incompleteness of contracts,characterized by the opportunistic behavior of the parties, bounded rationality,asymmetric information, and the resulting need to engage in specific investments.Asymmetric information problems have also led to the further study of the principal-agent paradigm using the moral hazard and adverse selection notions. 17

Most modern corporate governance analysis is implicitly or explicitly basedon this framework and, unexpectedly, often takes the functional separation of ownership and control as a given.

2.2 The Intrinsic Separation of Ownership and Control

The notion of intrinsic separation of ownership and control, as we have used itin this article, refers to the separation of economic ownership (of shares) and control(voting rights) at the individual level of each shareholder. Intrinsic separation of ownership and control allows each shareholder to hold either ownership or votingrights, separately. Intrinsic separation may thus also lead to conflict of interestproblems.

From a different perspective, this topic involves the recently much debatedone share - one vote principle. Indeed, traditional financial theory asserts that votingrights should generally be proportionate to share ownership. Accordingly, cash flowsshould be proportionate to risk borne in the corporation. The seminal and often citedarticle supporting this view is co-authored by Easterbrook and Fischel. 18

The authors assert that, empirically, almost all shares have one vote, and only shares possess votes . Cumulative voting is almost unheard of in publicly-held corporations, as is nonvoting stock or stock with seriously limited voting rights .19 They recognize that because all relational contracts are incomplete and specificationcan be costly, inefficient, and ultimately impossible, voting rights serve the functionof filling in the gaps of the initial contract. By voting, shareholders decide on allmatters not set forth by the initial contract, and the right to make decisions alsoincludes the right to delegate them.

As to why shareholders have the right to vote, the authors argue that [a] s theresidual claimants, the shareholders are the group with the appropriate incentives

17 See for example, A. Nicita, V. Scoppa, Economia dei Contratti , Carocci, 2005.18 F. H. Easterbrook, D. R. Fischel, Voting in corporate law , 26 J. L. & Econ. 395, 1983, The right tovote (that is, the right to exercise discretion) follows the residual claim , at 404.19 But see F. Partnoy, Encumbered shares , U. Ill. L. Rev., 2005, arguing differently.


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(collective choice problems to one side) to make discretionary decisions .20 If votingrights are not matched with economic ownership, agency costs will increase. 21 Asresidual claimants, shareholders have the best incentives to maximize firm value. 22

The one share - one vote principle is generally seen as efficient in minimizingagency costs and entrenchment problems, as it allocates discretionary decision powerto entities with the best incentives to pursue firm value maximizing decisions, andprevents distortions in investment decisions, tunneling, inefficiencies in the marketfor corporate control 23, and the formation of monopolies. 24 Correspondingly,disproportional ownership - i.e. , decoupling of share ownership and voting rights -has been generally perceived as exacerbating agency costs by allowing controllingshareholders to extract private benefits and thus ultimately lowering firm value.

This traditional view endorsing the one share - one vote principle has comeunder attack in recent years. 25 The findings in the economic literature often disagreeon the effects of disproportional ownership. A recent study has found that the oneshare - one vote structure is not always optimal. 26 Differently, the optimal security -voting structure depends on numerous factors such as the degree of competition andthe extent of private benefits involved. The study concluded: the claim that oneshare - one vote - or any other specific structure - is generally most conducive to anefficient control allocation of widely held firms is not justified . 27

Contestability of control has long been considered a major goal of financialregulation, with a view to stimulating the market for corporate control and thusexternal monitoring of management. Nonetheless, the overall impact of controlcontestability is also debated: greater monitoring by insiders could prove moreefficient and thus allowing block-holders disproportional ownership could be

20 F. H. Easterbrook, D. R. Fischel, Voting in corporate law , cited, at 403.21 F. H. Easterbrook, D. R. Fischel, Voting in corporate law , cited, at 409.22 B. S. Black, R. R. Kraakman, A self-enforcing model of corporate law , Harv. L. R. 109, 1996; B. S.Black, The Legal and Institutional Preconditions for Strong Securities Markets , 48 UCLA L. Rev. 781,2001. For a critique of these justifications see M. Burkart, S. Lee, The one share one vote debate: atheoretical perspective , ECGI Finance working Paper N. 176/2007, at 4. F. Partnoy, Addingderivatives to the corporate law mix , cited, gives interesting examples regarding the application of option theory to the corporation, pointing out that the representation of shareholders as owners of thecorporation is merely a convention.23 S. J. Grossman, O. D. Hart, One share / one vote and the market for corporate control , NBERWorking Paper Series n. 2347, 1987.24 R. Adams, D. Ferreira, One share one vote: the empirical evidence , Rev. of Fin., 52, 2008, whereample reference can be found to the specific literature.25

See for example F. Partnoy, Encumbered shares , cited, for example at 778: Shareholders areneither necessarily nor commonly in the residual claimant position that the literature has heretoforeassumed. (referring to the use of financial derivatives).26 M. Burkart, S. Lee, The one share one vote debate: a theoretical perspective , cited, at 17 theoptimal security-voting structure depends on a variety of factors, notably the extent of competition and the (assumed) correlation between the parties private benefits and security benefits .27 M. Burkart, S. Lee, The one share one vote debate: a theoretical perspective , cited, at 17.Similarly, A. Khachaturyan, The one share one vote controversy in the EU , ECMI Paper N. 1/2006,at 1, The conditions for 1share1vote being the optimal choice are highly contestable, and dependingon the circumstances and the nature of corporate actions, 1share1vote may be value-decreasing .


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optimal; conversely, one share - one vote makes majority ownership of a corporationcostly to obtain, and thus discourages it. 28

A recent survey commissioned by European Commission found thatcorporations around the world use numerous instruments to deviate from the oneshare - one vote principle. 29 The report found that 44% of the companies in thesample have at least one control enhancing mechanism . The most frequent controlenhancing mechanisms are pyramid structures among corporate groups and dual-class shares. The determinants of control enhancing mechanisms remain unclear,although there is some robust evidence that the protection of private benefits and the desire to keep control in the family are reasons [for example] for choosing adual-class structure .30

Using different methodologies, two seminal articles examine private benefitsof control on a cross - country basis. 31 Both studies have found private benefits to bevery low in the United States, around 2%. This would seem to suggest that controlenhancing mechanisms are uncommon. Indeed numerous pyramid structures amongcorporate groups were expunged by the harsh trust-busting policies of the past, aswell as the Public Utilities Holding Act. 32 With regard to law specifically endorsingthe one share - one vote principle, there is however some debate. 33

Partnoy has written that the one share - one vote requirement stemmed froma populist uprising and the worries of the New York Stock Exchange about possible

federal regulation (and related damage to its reputation) .34 Indeed after theNineteen Twenties the New York Stock Exchange generally refused to listcompanies with non-voting shares, with only minor exceptions. One of theseexceptions was the Ford Motor Company, which was allowed to list in 1956. 35

The stance of the New York Stock Exchange changed in the NineteenEighties, as voting practices became more important due to the continuous threats of

28 M. Burkart, S. Lee, The one share one vote debate: a theoretical perspective , cited, at 28.29 Institutional Shareholder Services, Shearman & Sterling, ECGI Proportionality between ownershipand control in EU listed companies: external study commissioned by the European commission , Reporton the proportionality principle in the European Union, 2007, at 24. Recently on the subject M.Bennedsen, K. Nielsen, The principle of proportional ownership, investor protection and firm value inWestern Europe , ECGI, Finance Working Paper N. 134-2006; A. Pajuste Determinants and consequences of the unification of dual-class shares . European Central Bank, Working Paper 465-2005.30 R. Adams, D. Ferreira, One share one vote: the empirical evidence , cited, at 62.31 T. Nenova, The Value of Corporate Voting Rights and Control: A Cross-country Analysis , J. Fin.Econ. , 68(3): 32551, 2003; A. Dyck e L. Zingales Private Benefits of Control: An International

Comparison , J. Fin , 59(2): 537600, 2004.32 W. E. Kovacic, C. Shapiro Antitrust Policy: A century of economic and legal thinking, J. Econ.Persp. 14, 2000; R. Morck How to eliminate pyramidal business groups the double taxation of inter-corporate dividends and other incisive uses of tax policy, NBER WP, 2004.33 See Easterbrook and Fischel, Voting in corporate law , cited.34 F. Partnoy, Encumbered shares , cited, at 784. See J. Seligman, Equal protection in shareholder voting rights: the one common share one vote controversy, 54 Geo. W. L. Rev. 687, 712-713, 1986,stating the primary motivation for the NYSEs initial decision on nonvoting common stock wasconcern about public opinion .35 See F. Partnoy, Encumbered shares , cited, at 784.


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hostile takeovers, as well as increased competition between Stock Exchanges. TheNew York Stock Exchange thus liberalized its approach.

In 1988 the Securities and Exchange Commission promulgated Rule 19c-4,requiring Stock Exchanges to bar the listing of corporations that reduced votingrights of any class of shareholders. Rule 19c-4 was applied for only two years, as theCourt of Appeals of the D.C. circuit held that it was beyond the Securities andExchange Commissions authority, and improperly intruded on state corporate law. 36

The Securities and Exchange Commission has nonetheless sought to pressureStock Exchanges to limit the issuance of non-voting shares or shares with limitedvoting rights. Stock Exchange rules now allow listed companies to issue non-votingor limited voting shares only under certain conditions. 37

2.2.1 Intrinsic Separation and Financial Derivatives

Academia has concentrated almost exclusively on traditional control

enhancing mechanisms that deviate from the one share - one vote principle. Financialderivatives can also create an intrinsic separation of ownership and control byallowing individual shareholders to separate economic ownership and voting(control) rights. In a different perspective, this too is a deviation from the one share -one vote principle. Moreover though, this intrinsic separation can occur at theindividual level of each shareholder, it is not structural, and often remains undetected.

A first type of intrinsic separation may occur when a shareholder hedges itsequity position through equity swaps or other derivatives. Insiders can, for example,hedge their economic exposure, as is commonly done through zero-cost collars. 38 The press reported in 2008 that Goldman Sachs had shorted securities related to thesubprime industry, which it was underwriting. A spokesman at Goldman Sachs saidthat the company routinely shorts the securities it underwrites and said that this hadbeen disclosed. 39

A shareholder may even come to hold voting rights though it carries anegative economic interest. By way of example, let us imagine that a hedge fundholds shares in a company X. X is being sold to another company, Y, in a stock-for-stock merger at a premium, but its share price drops sharply when the deal is

36 Bus. Roundtable v. S.E.C. , 905 F.2d 406, 416 (D.C. Cir. 1990).37 See F. Partnoy, Encumbered shares , cited, at 786, specifically note 58. A different query, beyond thescope of this paper, concerns the ways to render corporate voting more incisive. Academia hasengaged in a long debate. The authoritative Delaware courts have recognized that (t) he shareholder

franchise is the ideological underpinning upon which the legitimacy of the directorial power rests ( Blasius Industries, Inc. v. Atlas Corp. , 564 A.2d 651 Del. Ch. 1988). In the cited case, formerChancellor Allen opines that shareholders have two general protections against perceived inadequatebusiness performance: they can sell their stock (vote with their feet) or they can vote to replace theboard.38 This common strategy involves buying a put option to limit losses, while simultaneously selling acall option, thus reducing potential gain. This preserves voting rights and reduces economic ownership.39 B. Stein, The Long and Short of it at Goldman Sachs ,http://www.nytimes.com/2007/12/02/business/02every.html?pagewanted=1&ei=5088&en=cb27663f771ef3d3&ex=1354251600&partner=rssnyt&emc=rss


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announced. To help Y obtain shareholder approval, the hedge fund buys 9.9% of Y,becoming its largest shareholder. The hedge fund fully hedges the risk associatedwith the shares in Y and thus controls 9.9% voting rights with no economicownership. Considering its position in X, the hedge fund has an overall negativeeconomic interest in Y, as the more Y pays for X, the more the hedge fund stands to

profit.40

Decoupling strategies are often used by corporations themselves. Corporations

may use decoupling techniques to protect against changes in control, by allowinginsiders or friendly third parties to vote shares with partial or no economic risk. Atypical example can be seen when a corporation acquires economic ownership of itsshares through an equity swap, but no formal voting rights. The dealer will haveusually hedged its position by holding matched shares on which it can vote, usuallyas directed by the corporation. 41

A second type of intrinsic separation may occur through the use of the sharelending market. In general, shareholders who hold shares at the close of business onthe record date have the right to vote at the shareholder meeting. It is thus possible toborrow shares only for short periods, around the record date: voting rights aretransferred to the borrower although economic ownership is left with the lender. 42

A third type of intrinsic separation may occur when derivatives are used tocircumvent legal obligations and hide ownership and/or voting power. For example,the press reported in 2008 that the Jana and Sandell funds purchased derivatives thateffectively gave them a noticeable interest in CNet, although they did not purchase itsstock and thus no disclosure under Securities Exchange Act Section 13D wasrequired. 43

Similarly, in 2005 the Agnelli family entered into an equity swap for Fiatshares with Merrill Lynch, without any disclosure. Fiat had a forthcoming debt-for-equity swap with major Italian banks that would have diluted the stake of the Agnellifamily. The Agnelli family thus wanted to retain control of the company withoutlaunching a mandatory bid or disclosing acquisitions that would have influencedshare price. After the debt-for-equity swap was completed, the Agnelli familyimmediately unwound its equity swaps, obtaining the dealers matched Fiat shares,and keeping a controlling stake of Fiat without launching a mandatory bid. 44

40 This is the substance of the Perry-MyLan Laboratories case cited by H. T. C. HU, B. Black, The newvote buying: empty voting and hidden (morphable) ownership , cited, at 828.41 See H. T. C. HU, B. Black, Equity and debt decoupling and empty voting II: importance and

extensions , cited, at 643, where soft parking strategies are discussed. The authors point out that thisstrategy appears not to be used in the U.S. yet, although it has been used quite extensively in Europe.42 See H. T. C. HU, B. Black, The new vote buying: empty voting and hidden (morphable) ownership ,cited, at 833, and specifically note 50, where reference is made to literature describing share lendingagreements.43 A. R. Sorkin, A Loophole Lets a Foot in the Door ,http://www.nytimes.com/2008/01/15/business/15sorkin.html44 See H. T. C. HU, B. Black, The new vote buying: empty voting and hidden (morphable) ownership ,cited, at 840. In an equity swap, the dealer will usually hedge its exposure by holding matchedshares, to offset gains or losses on the equity swap.


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To date few academic articles have focused extensively on this newphenomenon. 45 Nonetheless, the sophistication and growth in equity swaps and otherderivatives, as well as the development of the share lending market, now allowcorporate insiders and outsiders to decouple voting and share ownership withunprecedented ease.

3. The Regulation of Financial Derivatives in the United States

Financial derivatives that can be used to achieve an intrinsic separation of ownership and control include a number of standard contracts, the most commonbeing options 46 and swaps 47, as well as new, esoteric hybrid financial instruments. 48

Financial sophistication has reached considerable peaks in the United States,where two main competing federal statutes - and corresponding federal agencies - areinvolved 49: the Securities Acts 50 and the Commodity Exchange Act.

After the 1929 Wall Street crash, the Securities Acts introduced a disclosure

regime aimed at protecting all investors unable to fend for themselves in theirfinancial transactions and overall activities. 51 The Securities and ExchangeCommission was committed to regulate the securities industry and enforce theSecurities Acts.

The fulcrum of the Securities Acts is of course the definition of a security. 52 Throughout the years, the statutory definition has been developed by the case law,

45 Most recently: H. T. C. HU, B. Black, The new vote buying: empty voting and hidden (morphable)ownership , cited; H. T. C. HU, B. Black, Equity and debt decoupling and empty voting II: importanceand extensions , 156 U. Penn. L. R. 625 (2008); M. Burkart, S. Lee, The one share one vote debate: atheoretical perspective , cited; A. Khachaturyan, The one share one vote controversy in the EU , cited;F. Partnoy, Encumbered shares , cited; F. Partnoy, Financial innovation and corporate law , 31 J. Corp.L. 799, 2006.46 The right to purchase (a call option) or to sell (a put option) a certain number of securities at anagreed price.47 In an equity swap a set of future cash flows (legs) is exchanged between two parties: one stream of cash flows will usually be based on a reference interest rate, while the other will depend on theperformance of a certain stock. It can be used to hedge risks such as interest rate risk, or to speculateon changes in the underlying prices.48 See F. Partnoy, D. A. Skeel Jr., The promise and perils of credit derivatives , U. Cin. L. Rev. 1019,2006, where the authors examine two growing markets of credit derivatives: the credit default swapmarket and the collateralized debt obligation market.49 This is true only in broad terms. Not all derivatives disputes with federal statutory claims involveeither the Commodities or the Securities Statutes. Other legal bases have been argued, includingviolations of the Racketeer Influenced and Corrupt Organizations Act, and the Employee Retirement

Income Security Act. Other federal regulatory agencies such as the Federal Reserve Board also play arole in the regulation of derivatives. See for example F. Partnoy, The shifting contours of globalderivatives regulation , cited, at 430, notes 24 and 25.50 In particular the Securities Act of 1933, and the Security Exchange Act of 1934.51 S.E.C. v. Ralston Purina Co. , 346 U.S. 119, 73 S.Ct. 981, 97 L.Ed. 1494 (1953).52 Section 2(a)1 of the 1933 Securities Act states that unless the context otherwise requires, The term"security" means any note, stock, treasury stock, security future, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, pre-organization certificate or subscription, transferable share, investment contract,voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or


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although some uncertainty still exists. This uncertainty has recently been exacerbatedwhen ascertaining the exact extent of applicability to financial derivatives.Nonetheless, some bright line rules do exist: options are expressly included, pursuantto Section 2(a)-1 of the 1933 Securities Act, while Section 2A of the same Actexpressly excludes swap agreements.

The main competing federal statute is the Commodity Exchange Act, pursuantto which the Commodity Futures Trading Commission assures that futures marketsoperate correctly and encourages their competitiveness and efficiency. The main roleof the Commodity Futures Trading Commission is to protect market participantsagainst fraud, manipulation, and abusive trading practices, while ensuring thefinancial integrity of the clearing process.

All derivatives not expressly regulated by one of the two main competingfederal statutes - usually hybrid financial instruments - are hard to categorize and thusto regulate. Indeed financial derivatives may even be economically equivalent,serving the same economic purpose, and yet fit under different statutory regimes. 53

If the financial instrument is not a security or a commodity, and no otherfederal regulatory regime applies, the claims become state law claims. Noticeableuncertainty regarding regulation of derivatives is also present at state-level. Indeedstate judges have decided derivatives cases by applying either state statutes - such asthose prohibiting gambling -, or common law. Plaintiff lawyers have often arguedviolations such as breach of fiduciary duty, common law fraud and negligentmisrepresentation, lack of authority, and contract-based claims. 54

3.1 Financial Derivatives as Securities

In theory, financial derivatives could fit in the definition of a securitypursuant to the 1933 Securities Act. In practice though, this may only occur if,pursuant to Article 2(a)-1 of the 1933 Securities Act, such financial derivatives canbe included in the definition of an investment contract or be considered a note.

Section 2(a)-1 of the 1933 Securities Act, after enumerating a list of investment contracts that are per se securities, establishes a broad, catch-all,investment contract notion. The case law has developed a four-part test todetermine when a contract is an investment contract pursuant to the Act.

other mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit,or group or index of securities (including any interest therein or based on the value thereof), or any

put, call, straddle, option, or privilege entered into on a national securities exchange relating to

foreign currency, or, in general, any interest or instrument commonly known as a "security", or anycertificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of,or warrant or right to subscribe to or purchase, any of the foregoing .53 F. Partnoy, The shifting contours of global derivatives regulation , cited, at 432.54 See F. Partnoy, The shifting contours of global derivatives regulation , cited, at 444, 447. Theauthor analyzes some cases and finds that The drawbacks of common law in this area are enormous.

It is extraordinarily expensive to resolve these disputes, and there are few published decisions to guide future parties, Facts are difficult to ascertain. Complaints often do not describe the underlyingtransaction accurately and neither do the paltry number of judicial opinions The result is anexpensive, inefficient, unfair, and uncertain process , at 449.


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SEC v. W.J. Howey Co. 55 involved the offering of units of a citrus grovedevelopment, along with a service contract for cultivating, marketing and distributingproceeds to the investors. The court found that the contract was an investmentcontract pursuant to the 1933 Securities Act - and thus a security - as theproponents were offering more than simple interests in the land. Indeed the offer was

made to investors residing far away, with no technical expertise, and attracted solelyby the prospects of a return on their investment. De facto , the investors were beingoffered the participation in a large citrus fruit management enterprise.

The four-part Howey test to establish when a contract is an investmentcontract requires that: (i) a person invests value - future legal consideration maysuffice, for example a future service -; (ii) there is a common enterprise - pooling of money, proceeds and opportunities as well as sharing of profits between investors 56 -;(iii) there is an expectation of profits or change in economic status - i.e. , a motive toinvest and not to consume 57 -; and (iv) this occurs solely (or predominantly) throughthe managerial efforts of others. 58

Section 2(a)-1 of the 1933 Securities Act, also considers a note as asecurity. The leading case in the definition of a note, Reves v. Ernst & Young ,involved demand notes issued by a farmers cooperative. 59 The Supreme Courtapplied a family resemblance test and concluded that such notes were securities.

As stated in Reves v. Ernst & Young , the analysis to determine whether acontract is a note pursuant to the 1933 Securities Act must begin with therebuttable presumption that all notes with a term of more than 9 months aresecurities. The presumption does not apply if the note is or bears a family

55 328 U.S. 293 (1946).56 Commonality can be horizontal : pooling of funds, sharing of losses and profits related to thecommon pool. Intent to pool may be enough, even if no one else participates. Profits should be basedon the collective pool of investments. There should usually be nothing anyone above the participantshas to do. At times courts have also found commonality to exist when it is vertical : investor (a) andinvestee (b) have their fortunes tied as each ones profits depends on the relationship (i.e. profitsharing). Strict vertical commonality is less likely to be found by courts. It exists between two persons,directly tied. See SEC v. Koscot Interplanetary Inc. , 497 F.2d 473 (1974), involving a pyramidscheme.57 See SEC v. Life Partners 87 F.3d 536 (1996): the difference between buying a note secured by a car and a car . No distinction should be made between promises of a fixed return and promises of variablereturns for the purposes of the Howey test. See SEC v. Charles Edwards 157 L.Ed.2d 813 (2004): aninvestment scheme promising a fixed rate of return can be an investment contract.58

Steinhardt v. Citigroup 126 F.3 D 144 (1997): the need to rely substantially on others. LimitedPartnerships are usually an investment contract, as the limited partner is a passive investor. In this casethough, the limited partner had substantial involvement and control.; SEC v. Life Partners 87 F.3d 536(1996): dependence on others managerial efforts - and not ministerial services - must be afterinvesting; pre-investment managerial efforts are not enough for the relying on efforts of others test,if after investing only ministerial acts are carried out; Great Lakes Chem Corp v. Monsanto Comp 96F.Supp.2d 376 (2000): members of an LLC have limited liability and are usually less participant thanin a partnership. Great lakes could remove the managers without just cause: no security was involvedbecause Great Lakes had control over management (i.e. not exclusively from the efforts of others ).59 494 U.S. 56 (1990).


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resemblance to a category of instruments such as notes of consumer finance. 60 If thenotes do not bear any family resemblance with such instruments, then the courts mustapply a four-part test to determine whether the financial instrument is not a security.

The Reves four-part test looks at whether: (i) the purpose of the buyer/seller isto raise money for a business enterprise or rather to finance the purchase of anitem/improvements, (ii) there is a plan of distribution or common trading/speculationversus a face to - face transaction, (iii) the investing public reasonably expects thenote to be considered a security, and (iv) there are other factors or alternativeregulatory regimes that reduce risks for investors. 61

Procter & Gamble Co. v. Bankers Trust 62 clearly exemplifies the uncertaintyregarding the rules applicable to most financial derivatives. Procter & Gamble filed acomplaint alleging both state and federal causes of action, in connection with twointerest rate swap transactions it had entered into with Bankers Trust Company. Theclaims included fraud, misrepresentation, breach of fiduciary duty, negligentmisrepresentation, violations of the Federal Securities Acts and the CommodityExchange Act, the Ohio Blue Sky Laws, and the Ohio Deceptive Trade Practices Act.

The litigation involved two different swaps. One swap was a leveragedderivatives transaction whose value was based on the yield of five-year treasury notesand the price of thirty-year treasury bonds. The other swap was also a leveragedderivative based on the four-year German deutschemark rate. The Court concludedthat - like most other derivatives - these swaps fell under general common law. Theanalysis through which the Court arrives at this conclusion is interesting.

The Court first applied the Howey test to verify whether the swaps wereinvestment contracts and thus a security pursuant to the 1933 Federal SecuritiesAct. In finding that they were not, the Court stated:

While the swaps may meet certain elements of the Howey testwhat is missing is the element of a "common enterprise." P&G did not poolits money with that of any other company or person in a single businessventure. How BT hedged its swaps is not what is at issue -- the issue iswhether a number of investors joined together in a common venture.Certainly, any counterparties with whom BT contracted cannot be lumped together as a "common enterprise." Furthermore, BT was not managingP&G's money; BT was counter-party to the swaps, and the value of the

60The same resemblance test applies for: notes used in consumer lending; notes secured by a mortgage

on a home; short-term notes secured by an assignment of accounts receivable; consumer financing;commercial bank loans for current operations; short-term open-account debts incurred in the ordinarycourse of business.61 Marine Bank v. Weaver 455 U.S. 551 (1982): certificates of deposit should be securities but sincethere are other federal regulatory regimes to reduce risks, they are not considered securities; Bass v.

Janney Montgomery Scott 210 F.3d 577 (2000): if the note is not collateralized and not subject tosecurities regulations it is most likely a security; if the note is secured or otherwise regulated byanother regime it is most likely not a security.62 925 F.Supp. 1270 (1996).


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swaps depended on market forces, not BT's entrepreneurial efforts. Theswaps are not investment contracts .63

The Court then applied the Reves test to determine whether the swaps couldbe considered notes pursuant to the 1933 Federal Securities Act. Bankers TrustCompany aimed at making a profit by generating a fee and commission, whileProcter & Gamble wanted, most of all, to reduce its funding costs. The Courtbelieved these motives leaned more toward a commercial rather than an investmentpurpose, and yet it considered the first prong of the Reves test not to be determinativeon its own.

Applying the second prong of the test, the Court found that the swaps werenot widely distributed, as they were customized for Procter & Gamble and could notbe sold or traded to another counterparty without the agreement of Bankers trustCompany. Balancing all remaining factors of the Reves test , the Court concluded thatthe swaps were not notes for purposes of the 1933 Securities Act. 64

4. Regulating Intrinsic Separation of Ownership and Control in the UnitedStates

Scholarship and financial regulators have begun to focus only recently on theincreasing ease with which intrinsic separation of ownership and control can beachieved through financial derivatives. Numerous different regulatory responses havebeen proposed: a per se prohibition, the extension of the vote-buying doctrine, amore aggressive disclosure regime, and the application of fiduciary duties.

In general, while the most effective regulatory response seems to be to adopt acorporate governance disclosure regime that includes all hypotheses of intrinsicseparation, in the long run, this response may not yield the stabilizing outcomesought. The recent crisis has indeed shown that market mechanisms - as stimulatedby disclosure obligations - may prove ineffective, especially when related tosophisticated financial instruments.

The future legislative framework will thus have to posit an expressrecognition of the intrinsic separation of ownership and control. Furthermore, in themedium term it might well be necessary to distinguish and specify ex ante prohibitions in all those cases in which intrinsic separation may become undetectableand thus lead to hidden conflicts of interest.

In this Section we examine only some of the different regulatory responsesproposed in the United States vis--vis the increasing ease and diffusion of the

intrinsic separation of ownership and control. Specifically, we will look at thepossible extension of the vote buying doctrine, the corporate governance disclosureregime, as well as make some brief reference to the fiduciary relation paradigm.

63 Id. at 17-18.64 Further arguments regarding Federal Statutes and state law were also presented by the plaintiff. TheCourt concluded that the swaps were exempt from the Commodity Exchange Act and that BankersTrust owed no fiduciary duty to Procter & Gamble Co. Moreover, Procter & Gamble Co.'s claims of negligent misrepresentation and negligence were considered redundant.


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4.1 The (New) Vote Buying Doctrine

Hu and Black have concentrated extensively on the use of financialderivatives and its effects on corporate governance. They have called thisphenomenon new vote buying because of its ability to decouple votes andeconomic ownership. 65 The authors find over 80 cases of vote buying in over 20countries, and distinguish two sub-categories.

Empty voting occurs when votes are emptied of their economic stake, as ashareholder has the power to cast more votes then her actual ownership of thecorporation. Hidden (morphable) ownership occurs when an investor appears tohave fewer votes than those she can actually exercise, usually informally, through anintermediary.

Considering the intrinsic separation of ownership and control as new vote-buying and thus attempting to frame this new phenomenon within the traditionalvote-buying doctrine may prove helpful if the abuse and fraud potentially perpetratedthrough certain forms of intrinsic separation can be prevented. Nonetheless, it isgenerally agreed that current State law on vote-buying does not apply to intrinsicseparation.

The leading modern case on vote buying remains Schreiber v. Carney ,decided by the Delaware Court of Chancery in 1982. 66 Before this case, the standardapplicable to vote buying was uncertain. In general two principles could haveapplied: vote buying could have been considered illegal per se, if its object orpurpose was to defraud or disenfranchise the other stockholders, or vote buying couldhave been considered illegal per se as a matter of public policy, as each shareholdershould be entitled to rely upon the independent judgment of her fellow stockholders.

The Schreiber case involved a loan by the corporation to a shareholderdetaining virtual veto power on a merger, in order to render the operationeconomically viable for her. Chancellor Hartnett found that this constituted votebuying, although the agreement was not per se void because its object and purposewas to further the interest of all stockholders. The agreement was thus voidable,subject to a test for intrinsic fairness. Ultimately though, the ratification of thetransaction by a majority of independent shareholders - after full disclosure -precluded any further judicial inquiry.

Vote buying has been defined as a voting agreement supported byconsideration personal to the stockholder, whereby the stockholder divorces his

65 See most recently H. T. C. HU, B. Black, The new vote buying: empty voting and hidden(morphable) ownership , cited, and H. T. C. HU, B. Black, Equity and debt decoupling and emptyvoting II: importance and extensions , cited. On the same subject, although apparently limited tooptions and their effects on corporate governance, S. Martin, F. Partnoy, Encumbered shares , cited,who define as economically encumbered those shares held by stockholders who lack the otherwisehomogenous incentives generated by pure share ownership (e.g. own shares plus short positions) andas legally encumbered those shares held by stockholders who have a legal impediment to voting suchshares (e.g. loaned out shares).66 447 A.2d 17 (1982).


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discretionary voting power and votes, as directed by the offeror .67 This definitionfocuses specifically on a vote-seller and a vote-buyer. Furthermore, a votingagreement is necessary, the shareholder must be given personal consideration, andshe must vote as directed by the offeror.

Intrinsic separation usually does not seem to contain the elements envisagedby the traditional vote-buying doctrine. Indeed it does not involve either a sale or apurchase of votes and there is usually no ex ante voting agreement. 68 Due to theabsence of a purchaser and a seller, no buyer can direct the voting of any seller. Votelending, for example, by definition does not entail a purchase or a sale, but a loan.Common hedging transactions fall outside the scope of the definition for much thesame reasons.

The traditional vote-buying doctrine thus does not appear to provide asufficient regulatory response to intrinsic separation of ownership and control.Nonetheless, one of the positive aspects of common law systems is that they reactquickly to changes in the social and economic context. 69 The specific nature of theCourts of Equity provides even greater flexibility to the legislative framework.Regulatory competition between federal and state legislators could also encourage anexpansive interpretation of vote buying by State Courts. 70

Future State law may thus adapt the traditional vote buying doctrine toprohibit or limit pernicious manifestations of the intrinsic separation of ownershipand control, for example when a shareholder de facto carries a negative economicinterest in an operation vis--vis her corporation. This expansive interpretation wouldrequire a shift from a formal approach to vote-buying, to a more substantial approachand does not seem unlikely. 71

4.2 The Disclosure Regimes

67 Schreiber v. Carney , 447 A.2d 17, 23 (Del.Ch. 1982).68 Similarly, H. T. C. HU, B. Black, The new vote buying: empty voting and hidden (morphable)ownership , cited, at 862.69 See the analysis provided by the dynamic law and finance view, T. Beck, A. Demirguc-Kunt, R.Levine, Law, Politics, and Finance , World Bank Policy Research Working Paper No. 2585, (April 12,2001), available at SSRN: http://ssrn.com/abstract=269118.70 See for example M. Roe, Delawares Competition , 117 Harv. L. Rev. 588, 2003; L. E. Strine, The

new federalism of the American corporate governance system: preliminary reflections of two residentsof one small state , 152 U. Pa. L. Rev. 953, 2003; R. S. Karmel, Realizing the dream of William O.

Douglas the Securities and Exchange Commission takes charge of corporate governance 30 Del. J.Corp. L. 79, 2005; M. W. Ott, Delaware strikes back: Newcastle partners and the fight for statecorporate autonomy , 82 Ind. L. J. 159, 2007.71 Justice Jack Jacobs has for example stated that (s)hould an egregious case of empty voting abusearise, that in turn may lead to legislation and to court decisions that would result in a new paradigm

for share voting , J. Jacobs, Paradigm shifts in American Corporate Governance law: a quarter century of experience , Corp. Governance Advisor, Sept.-Oct. 2007, at 1,4, quoted in H. T. C. HU, B.Black, Equity and debt decoupling and empty voting II: importance and extensions , cited.


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The United States disclosure regimes pursuant to the Federal Securities Actsare complex, contain at least four discrete ownership disclosure systems, and do noteffectively address intrinsic separation of ownership and control. 72

Hu and Black have found that the current disclosure rules are highly complex,treat substantively identical positions inconsistently both across and withindisclosure regimes, do not effectively address either empty voting or hidden(morphable) ownership, and for the most part do not cover share lending and borrowing. 73

By way of example, institutional money managers must disclose theirholdings at the end of each quarter through Form 13F, to be filed with the Securitiesand Exchange Commission. Form 13F requires the disclosure of holdings of morethan $100 million of securities appearing on a list prepared by the Securities andExchange Commission. No disclosure is required for securities that are not publiclytraded, short positions are not reported, and share lending is irrelevant. Positionsacquired through the use of OTC derivatives also escape disclosure requirements.

The academia that has focused on intrinsic separation of ownership andcontrol has concentrated mainly on the disclosure regime. 74 The main problemregulators must confront themselves with - in the immediate future - is believed to betransparency. Indeed capital markets will only operate efficiently if they areadequately informed. Moreover, greater transparency would allow regulators toascertain the exact extent to which these new decoupling techniques are being used inthe market place. 75

Table 1 which follows, reproduces Table 3 prepared by Hu and Black in theirdiscussion of current disclosure requirements with regard to decoupling usingderivatives 76.

72 This brief discussion is meant only to frame the background to the fundamental problem of transparency which is posed by the new intrinsic separation of ownership and control. We have oftenrelied on the specific analysis provided in H. T. C. HU, B. Black, The new vote buying: empty votingand hidden (morphable) ownership , cited.73

H. T. C. HU, B. Black, The new vote buying: empty voting and hidden (morphable) ownership , cited,at 876.74 H. T. C. HU, B. Black, The new vote buying: empty voting and hidden (morphable) ownership , cited.75 H. T. C. HU, B. Black, Equity and debt decoupling and empty voting II: importance and extensions ,cited, at 654, have found that the public visibility of decoupling strategies - and maybe its use - has forthe moment been far less in the United States than in Europe, although it is not clear why.76 H. T. C. HU, B. Black, The new vote buying: empty voting and hidden (morphable) ownership ,cited, Table 3, at 866.


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4.2.1 The Corporate Governance Disclosure Regime

Section 13(d) of the Exchange Act sets forth the fundamental corporategovernance disclosure regime. It provides that any person who is, directly orindirectly, beneficial owner of more than five percent of a class of securitiesmust, within ten days after such acquisition, file a report with the issuer, theexchange where the security is traded, and the Securities and ExchangeCommission. Furthermore, when two or more persons act as a partnership,limited partnership, syndicate, or other group for the purpose of acquiring,holding or disposing of securities of an issuer, such syndicate or group shall bedeemed a person pursuant to Section 13(d).

The Securities and Exchange Commission has defined the notion of beneficial owner, pursuant to the Exchange Act. Indeed under Rule 13d-3 abeneficial owner of a security includes any person who, directly or indirectly,

through any contract, arrangement, understanding, relationship, or otherwise hasor shares: (1) voting power, which includes the power to vote or to direct thevoting of such security, and/or (ii) investment power which includes the power todispose or to direct the disposition of such security.

Furthermore, Section 13(d) applies to any person who, directly orindirectly, creates or uses a trust, proxy, power of attorney, pooling arrangementor any other contract, arrangement or device with the purpose or effect of divesting such person of beneficial ownership or preventing the vesting of suchbeneficial ownership as part of a plan or scheme to evade the reportingrequirements of section 13(d) or (g) of the Act.

Beneficial ownership also includes the right to acquire beneficialownership within sixty days, including through the exercise of an option orwarrant. Moreover, Item 6 of Schedule 13D requires disclosure of any contractor arrangement relating to any securities of the issuer.

This regime does not cover some cases of intrinsic separation through theuse of financial derivatives. Short positions do not trigger disclosurerequirements, while share lending might require disclosure. 77 Equity swaps alonewould not trigger disclosure requirements: it is generally believed that disclosureof cash-settled equity swap positions is not necessary. 78 If an investor holds astake in both an acquirer and a target, affecting its economic interest in theacquirer, this does not need to be disclosed as Item 6 of Schedule 13D requires

77H. T. C. HU, B. Black, The new vote buying: empty voting and hidden (morphable) ownership ,cited, at 868 argue that borrowing shares brings voting power and thus would probably triggerdisclosure.78 H. T. C. HU, B. Black, The new vote buying: empty voting and hidden (morphable) ownership ,cited, at 868.


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disclosure of arrangements or contracts with respect to securities of the issuer ,not of other companies.

The recent CSX case tested the notion of beneficial ownership underSection 13 (d) of the Exchange Act, in the perspective of intrinsic separation of ownership and control, with specific reference to an equity swap context. Theparties involved were CSX Corp., a publicly traded railway and transportationcompany on one side, and the Childrens Investment Fund and 3G CapitalPartners, two hedge funds, on the other. At the time of the suit, each hedge fundowned about four percent of CSX Corp., as well as certain equity swap positionsgiving them a greater economic interest in CSX Corp.

At the June 25, 2008 CSX Corp. annual meeting, the ChildrensInvestment Fund and 3G Capital Partners planned to elect their own nominees tothe board and amend CSX Corp.s by-laws. On March 17, 2008, CSX brought an

action against the two hedge funds alleging violations of their reportingrequirements under Section 13(d) of the Exchange Act, and thus seeking toenjoin their vote at the annual meeting. The case went to trial (Judge Kaplan) onMay 21 and 22, 2008, and was decided on June 11, 2008.

CSX Corp.s position was that the power of influence the hedge funds hadvis--vis the equity swap counterparties gave rise to beneficial ownership underRule 13d-3(a). This Rule refers to the power to influence the disposition or thevoting of securities. Indeed, CSX Corp. argued that the Childrens InvestmentFund and 3G Capital Partners controlled the investment power relating to thesecurities underlying the equity swaps, as their counterparties in the equity swapwould buy and sell the underlying securities - to hedge their positions - in

accordance with the entering into and termination of the equity swap. Moreover,the swap counterparties had strong economic incentives to vote their shares inaccordance with the hedge funds interests, in order to maintain and reinforcetheir client relationships.

The Court found that the Childrens Investment Fund and 3G CapitalPartners should have been deemed beneficial owners under Rule 13d-3(b) as theyhad engaged in some concerted action vis--vis CSX Corp. Moreover, JudgeKaplan seemed to recognize, albeit only incidenter tantum , the relevance of equity swaps under Rule 13d-3(a). An express change in the regulatoryframework may nonetheless be necessary for such equity swaps transactions tobe caught by the corporate governance disclosure regime.

4.2.2 Briefly on the European Transparency Directive and itsImplementation in Italy


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The European Community recently adopted a Transparency Directive 79,with a view to stimulating economic growth and development through moreefficient and transparent capital markets 80 and, inter alia , achieving a greater

harmonization in the disclosure obligations regarding holdings in listed issuers.81

The Transparency Directive contains disclosure rules directly applicable

to the intrinsic separation of ownership and control. Under Article 10, disclosureobligations apply to any natural person or legal entity entitled to acquire, disposeof, or exercise, voting rights in a number of different situations expressly setforth. 82

Furthermore, pursuant to Article 13, disclosure obligations also apply toany natural person or legal entity holding, directly or indirectly, financialinstruments that result in an entitlement to acquire, on such holders owninitiative, under a formal agreement, shares to which voting rights are attached,

already issued, of an issuer whose shares are admitted to trading on a regulatedmarket.

The Level 2 Directive enacted by the European Commission has furtherspecified, under Article 11, that the holder of the financial instrument mustenjoy, on maturity, either the unconditional right to acquire the underlying sharesor the discretion as to his right to acquire such shares or not. Furthermore, aformal agreement means an agreement that is binding under the applicable law.

The regime set forth in the Directive provides investors with conspicuousinformation regarding the ownership, quasi -ownership, and control structure of

79 Directive 2004/109/EC of the European Parliament and the European Council. Pursuant to theLamfalussy method, the European Commission also adopted a level 2 Directive 2007/14/EC, andthe Committee of European Securities Regulators (CESR) has performed some level 3 work.80 Considerando 1.81 Consideranda 5 and 18.82 Specifically, (a) voting rights held by a third party with whom that person or entity hasconcluded an agreement, which obliges them to adopt, by concerted exercise of the voting rightsthey hold, a lasting common policy towards the management of the issuer in question; (b) votingrights held by a third party under an agreement concluded with that person or entity providing for the temporary transfer for consideration of the voting rights in question; (c) voting rightsattaching to shares which are lodged as collateral with that person or entity, provided the personor entity controls the voting rights and declares its intention of exercising them; (d) voting rightsattaching to shares in which that person or entity has the life interest; (e) voting rights which are

held, or may be exercised within the meaning of points (a) to (d), by an undertaking controlled bythat person or entity; (f) voting rights attaching to shares deposited with that person or entitywhich the person or entity can exercise at its discretion in the absence of specific instructions fromthe shareholders; (g) voting rights held by a third party in its own name on behalf of that personor entity; (h) voting rights which that person or entity may exercise as a proxy where the personor entity can exercise the voting rights at its discretion in the absence of specific instructions fromthe shareholders.


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listed companies. It is nonetheless debatable whether, for example, cash settledequity swaps such as the one enacted in the CSX case would be included in thedisclosure regime under the Directive. Furthermore, disclosure obligations

related to financial instruments only include those instruments resulting in theright to buy voting shares and not those resulting in the right to sell votingshares: investors are thus provided only a partial view.

Italian disclosure obligations for material holdings in the voting sharecapital of listed companies are among the most rigorous in the EuropeanCommunity, as they require extensive and detailed disclosure of the ownershipstructure of individual companies and corporate groups. The disclosureobligations are set forth in Legislative Decree no. 58 of 1998 and CONSOBRegulation no. 11971.

CONSOB has recently published a draft of new rules regarding disclosure

obligations for material holdings in listed companies, with a view toimplementing the Transparency Directive. 83 Adoption of these new rules is notexpected before the end of the first semester of 2009.

As a result of these proposed rules, Italy appears to have adopted a morerestrictive - and thus transparent - stance vis--vis the Directive, with specificregard to intrinsic separation of ownership and control. Specifically, theproposed rules consider, separately, both financial instruments that confer theright to buy and to sell shares of a company. Furthermore, in the proposedregime, financial instruments - expressly considered potential holdings - will becounted separately from effective holdings, when ascertaining whether ashareholders interest has reached, exceeded, or reduced below relevant

thresholds.The proposed Italian rules, even though more restrictive than the

Directive, focus - inter alia - on financial instruments that result in theentitlement to buy or sell shares with voting rights. In its comment to theproposed implementing rules, CONSOB has stated that cash settled equity swapsmay not fit within the current disclosure regime, but it will evaluate whether toextend disclosure requirements to these derivatives transactions whenreconsidering rules regarding tender offers. 84

4.3 The Fiduciary Duty of Loyalty

83 CONSOB proposed new rules implementing the Transparency Directive on July 7, 2008 andcomments were due by September 20, 2008.84 CONSOBs Comment to its proposed new rules, available (in Italian) athttp://www.consob.it/main/documenti/Regolamentazione/lavori_preparatori/consultazione_emittenti_20080707.htm?hkeywords=&docid=5&page=0&hits=91, p. 129.


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The fiduciary duty of loyalty has traditionally been one of thefundamental pillars of corporate law and governance. What has been calledfiduciary rhetoric has often reminded academics and practitioners that: [m] any

forms of conduct permissible in a workaday world for those acting at arm'slength, are forbidden to those bound by fiduciary ties. A trustee is held tosomething stricter than the morals of the market place. Not honesty alone, but the punctilio of an honor the most sensitive, is then the standard of behavior .85

The importance and role of the fiduciary duty of loyalty in the corporatecontext has come under attack in recent years. 86 Academia has acknowledged theimportance for directors to pursue the interests of corporate constituencies otherthan the shareholders, in a stakeholder perspective. 87

The intrinsic separation of ownership and control presents a fundamentalproblem of fiduciary duty of loyalty within the corporation, which goes beyond

the traditional agency problem. Ultimately, intrinsic separation questions towhom the fiduciary duty of loyalty should be owed: by way of example, to thelender or to the borrower of shares; to the shareholder that has hedged her risk inthe company or to the counterparty to the derivatives transaction.

Furthermore, there may be cases where imposing directors fiduciaryduties towards shareholders that have intrinsically separated ownership andcontrol, is inefficient. Conversely, there may be cases where it is efficient toimpose fiduciary duties on corporate directors vis--vis non-shareholders in theperspective of an intrinsic separation of ownership and control.

In a sense, financial innovation may have eroded the fiduciary dutyconcept from within: the increased sophistication and possibility of large scaleuse of financial instruments may have indeed made the term shareholder lessmeaningful, especially when thought of in connection with the idea of a residualclaim.

85 This is of course the well-known citation by Benjamin Cardozo in Meinhard v. Salmon , 249N.Y. 458 (1928), at 464. Most recently regarding this case, R. B. Thompson, The Story of

Meinhard v. Salmon and Fiduciary Duty's Punctilio , Vanderbilt Public Law Research Paper No.08-44, Available at SSRN: http://ssrn.com/abstract=1285705, October 2008.86

See, inter alia , H. Marsh, Jr., Are Directors Trustees? Conflict of Interest and Corporate Morality , 22 Bus. Law. 35, 1966; A. Bulbulia & A. R. Pinto, Statutory Responses to Interested Directors' Transactions: A Watering Down of Fiduciary Standards? , 53 Notre Dame L. Rev. 201,1977; F. H. Easterbrook, D. R. Fischel, Contract and Fiduciary Duty , 36 J.L. & Econ. 425, 1993.87 In an economics perspective, L. Sacconi, A Social Contract Account for CSR as Extended Modelof Corporate Governance (I): Rational Bargaining and Justification , Journal of Business Ethics,Special Issue on Social Contract Theories in Business Ethics, 259-281, 2006.


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Accordingly, some scholars have recently proposed to change one of thetraditional terms of reference of fiduciary duties. 88 In this view, directors of thecorporation should no longer pursue the best interests of the shareholders, or the

shareholders as a whole. Instead, directors should maximize the value of the firm as a whole .89 Similarly, the fiduciary duty of loyalty could give way infavor of a duty of good faith of corporate directors, with a view to imposing theobligation to balance the interests of the different constituencies.

As one of the fundamental pillars of traditional corporate law andgovernance analysis, the fiduciary duty of loyalty and, as a consequence, theprincipal-agent paradigm, need to be reconsidered in light of the intrinsicseparation of ownership and control.

5. Concluding Remarks

The increasing ease with which financial instruments can be used todecouple voting rights and economic ownership, achieving an intrinsic separation of ownership and control at the individual level of each shareholder,disrupts traditional corporate governance analysis. By way of example, if ashareholder hedges its position, it may de facto no longer be a residual claimantof the corporation and yet still exercise the corresponding voting rights.

Some authors have suggested, for example, to limit the voting rights of shareholders who hold more votes than economic ownership. 90 Nonetheless, it isgenerally agreed that [o] ne possible explanation for the persistence of the oneshare/one vote rule, regardless of economic encumbrance, is that the process of

deciding which shareholders should be entitled to receive a vote would be toocostly under most circumstances .91

Academia has also proposed per se prohibitions, the extension of thevote-buying doctrine, and the need to reconsider the fiduciary duty of loyalty. Todate, disclosure has been the most acclaimed regulatory response to the intrinsic

88 S. Martin, F. Partnoy, Encumbered shares , cited; F. Partnoy, Financial innovation and corporate law , cited, at 811; F. Partnoy, Adding derivatives to the corporate law mix , cited, at603, The put option and call option perspectives demonstrate that the legal rule could be theopposite: corporate law could assign control to debt and force equity to bargain for contractual

protection .89

D. G. Baird, M. T. Henderson, Other Peoples Money , 60 Stan. L. Rev. 1309, 2007, at 1311 and1313.90 S. Martin, F. Partnoy, Encumbered shares , cited, at 793 At a minimum, shareholders withsubstantial short positions should not be entitled to vote . In general the authors argue thatshareholders are not necessarily residual claimants, and thus under certain conditions it may bemore efficient if votes are given to actual economic owners. 91 S. Martin, F. Partnoy, Encumbered shares , cited, at 793.


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separation of ownership and control 92: the fundamental principle seems to remainthat [s] unlight is said to be the best of disinfectants; electric light the most efficient policeman .93

Traditional theory asserts that an opaque system of corporate governancefacilitates the extraction of private benefits of control. Accordingly, investorprotection through disclosure obligations pursues the general aim of stimulatingcapital market development and thus, in turn, economic growth. 94 The law andfinance literature has indeed shown a correlation between investor protection andcapital market development. 95

The regulatory focus on disclosure - and generally on financial marketinformation - facilitates the operation of financial market mechanisms. 96 Moreover, an effective disclosure regime stimulates greater competition betweenthe banking system and the stock market. 97

Greater transparency would allow market mechanisms and monitoring tooperate effectively, reducing the risk of fraudulent activity through derivatives.Indeed share prices would discount any abnormal or fraudulent manifestations of the intrinsic separation of ownership and control. Reputation sanctions and the

92 This has for example been the Swiss response: prior to 2007 disclosure rules were similar tocurrent U.S. rules. The Swiss federal Banking Commission then amended its rules, on July 12007, to require disclosure of cash-settled call options. New legislation was also adopted onDecember 1 2007, to reduce the disclosure threshold to 3% and require disclosure of holdings of any financial product that would enable the holder to acquire voting rights with respect to apotential public takeover. Regulators have acted similarly in the United Kingdom and in HongKong. For specific reference see H. T. C. HU, B. Black, The new vote buying: empty voting and hidden (morphable) ownership , cited; H. T. C. HU, B. Black, Equity and debt decoupling and empty voting II: importance and extensions , cited, at 684.93 L. D. Brandeis, Other Peoples Money and How The Bankers Use It , 1914, reprint 2003, at 92.94 A. Demirgu-Kunt, R. Levine, Financial Structure and Economic Growth , MIT, 2001.95 For example R. La Porta, F. Lopez-de-Silanes, A. Shleifer, R. W. Vishny Law and Finance ,cited.96 The theory is of course well-known. See E. F. Fama Efficient Capital Markets: A Review of Theory and Empirical Work in 25 J. Fin. 2, Papers and Proceedings of the Twenty-Eighth AnnualMeeting of the American Finance Association New York, N.Y. December, 28-30, 1969, at 383-417.97 I am referring to the ongoing debate on the convergence of different economic and legal modelsas well as corporate governance systems. The literature on the topic has become extremely vast.

See for example A. R. Pinto, G. Visentini, The Legal Basis of Corporate Governance in Publicly Held Corporations, A Comparative Approach , cited; G. Visentini , Compatibility and Competition Between European and American Corporate Governance: Which Model of Capitalism? , cited;R.A.G. Monks, N. Minow, Corporate Governance , Wiley, 2003; T. Clarke, Theories of corporategovernance. The philosophical foundations of corporate governance , cited; R. Kraakman, P.Davies, H. Hansmann, G. Hertig, K. Hopt, H. Kanda, E. Rock The Anatomy of Corporate law: AComparative and Functional Approach , cited.


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media would also have a role in policing the efficient functioning of corporategovernance. 98

Furthermore, increased compliance costs would probably be offset by theadvantages of a transparent stock market with high investor confidence andtrust. 99 This new disclosure policy could increase the bonding effect from crosslisting in the United States, and may actually attract foreign company listings. 100

Nonetheless, the underlying assumption of this proposed disclosure-driven regulatory stance is that the market - i.e. , the qualified investors on it -will be able to absorb, evaluate and process the information provided. Indeed thisregulatory response moves within the same regulatory paradigm as currentregulation; in essence the same paradigm that demonstrated its shortfalls in therecent financial crisis.

In light of these considerations, a targeted corporate governancedisclosure regime may well be the best regulatory response to intrinsic separationin the short term. However, in a medium term perspective, it will also benecessary to re-think corporate governance from some of its fundamentalprinciples.

New corporate governance analysis will have to consider explicitly theintrinsic separation of ownership and control. It will have to focus on how the

98 See for example M. M. Blair, L. A. Stout, Trust, Trustworthiness, and the BehavioralFoundations of Corporate Law , http://papers.ssrn.com/paper.taf?abstract_id=241403, 2000; J. C.Coffee, Jr., Do Norms Matter?: A Cross-Country Examination of the Private Benefits of Control ,http://papers.ssrn.com/paper.taf?abstract_id=257613 , 2001; A. Dyck, L. Zingales The CorporateGovernance Role of the Media , CRSP Working Paper No. 543, 2002; A. Dyck e L. ZingalesPrivate Benefits of Control: An International Comparison , 59 J. Fin. , 2, 2004; R. H: McAdams,E. B. Rasmusen, Norms in law and economics,papers.ssrn.com/sol3/papers.cfm?abstract_id=580843, 2004; T. Frankel, Court of Law and Court of Public Opinion: Symbiotic Regulation of the Corporate Management Duty of Care , BostonUniv. School of Law Working Paper No. 07-03, 2007; H. Hong, M. Kacperczyk, The price of sin:the effects of social norms on markets , papers.ssrn.com/sol3/papers.cfm?abstract_id=766465,2007.99 There has been a lively debate on the effects of the increased compliance costs imposed by theSarbanes Oxley Act, on the listing of foreign corporations. Most recently, C. Doidge, G. A.Karolyi, R. M. Stulz, Has New York become less competitive in global markets? Evaluating

foreign listing choices over time , 2007. L. Zingales Is the U.S. Capital Market Losing itsCompetitive Edge? , ECGI - Finance Working Paper No. 192/2007, available at SSRN:

http://ssrn.com/abstract=1028701, 2007.100 A. Karolyi, Why Do Companies List Shares Abroad? A Survey of the Evidence and its Managerial Implications , Financial Markets, Institutions & Instruments 7, New York UniversitySalomon Center, 1998; M. Pagano, A. A. Rell, J. Zechner, The Geography of Equity Listing:Why Do Companies List Abroad? , 57 J. Fin., 6, 2002; C. G. Doidge, A. Karolyi, K. V. Lins, D. P.Miller, R. M. Stulz, Private Benefits of Control, Ownership, and the Cross-listing Decision ,available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=668424, 2006.


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move away from, or combination of, the functional and intrinsic separation of ownership and control within the corporation, affect theory, incentives, policyconsiderations and thus, most importantly, regulatory approach.

Documents

Financial Derivatives and the Intrinsic Separation of Ownership and Control