Archive

Archive for October, 2012

DECOUPLING OF ECONOMIC AND VOTING RIGHTS: EMPTY VOTING

October 7, 2012 1 comment

Some definitions

 

Generally speaking, Empty voting is a practice by which insiders hold more voting rights than shares, and the name refers to the fact that votes have been decoupled of their economic interest.

 

The Formal Voting Right is held by someone, (perhaps a broker), independently of who has voting rights or voting ownership, (that is, the power to instruct how to vote). The economic ownership (long or short), belongs to the holder of shares or the holder of coupled assets, (derivatives, for instance). Full ownership of shares combines voting and economic ownership. Net economic ownership is the total economic ownership through shares or coupled assets. Empty voting refers to voting rights exceeding the net economic ownership. Related non-host assets, are those of a different company, whose value is connected to the value of the analysed or host company. Hidden ownership refers to a non-disclosed one, when ownership method is indirect, and/or regulation does not force such a disclosure.

 

What`s Empty Voting and why it is relevant

 

Empty Voting could be simply said to be an efficient reaction from all participants, and no regulatory recommendation would arise if no case was made for the existence of market failures. Some perspectives can be anlysed in that sense:

 

a)      Principal-Agent relationship: the fact that a new participant appears that forces all others to bear some additional agency costs can be defended. The “majority rule or One Share-One Vote principle” arises from the assumption that all shareholders vote on an optimal relationship to the capital invested; but voters that do not bear the risk, could in some cases act in a very suboptimal manner. Easterbrook and Fischel in 1983 argue, first, shareholders with higher voting power than economic risk could eventually accept a certain risk, that those who will suffer the eventual cost cannot reject; thus, in fact, the efficiency in voting is distorted; and second, the practice can be used to protect managers from takeovers, by a minority against all other shareholders` interest. On the other hand, the decoupling strategy can help those who hold more votes than economic interest obtain the so called “private benefits of control”, another agency cost indicator. For example they can make the company approve transactions only profitable for them.

b)      Information costs: corporate law introduces a limited number of corporate forms, in all cases with shares being a commodity, so that acquiring shares in a public market does not imply a high information gathering cost. If shares are not any more a commodity, as a result of risk decoupling strategies, information cost would eventually increase.

c)      Corporate finance: given the fact that equity providers are residual claimers, they are compensated for the risk with the control tool, so that they can influence the destiny of the firm and their funds. Risk decoupled shareholders reject the risk, but they still keep the control, and can exerce it for selfish or abusive purposes.

 

What are the techniques used to reduce or eliminate the economic risk

 

There are different tools used by hedge funds and other participants so as to be Empty Voters:

 

a)      Derivative instruments: futures, forwards, options, equity swaps, …, can all be used for the purpose of eliminating the economic risk of one of the parties, (that is, a shareholder, such as a hedge fund, a manager with an equity stake, probably an incentive not designed to be hedged, etc.).

b)      Share lending: it usually consists on a share sale, with an agreed future repurchase. The lender remains in this case the beneficial owner of the share, but will not vote if the General Meeting is held in the meantime.

c)      Record Date Capture: although this is something usually happening, certain shareholders might buy shares only to hold them at a certain date, (the cut-off day for registering to the General Meeting, selling them inmediately, but keeping and exercing the voting right).

 

What are the regulatory options

 

The options are depicted in what follows:

 

a)      Doing nothing: the free trade of voting rights would be permitted, and some argue this would help solve the passive attitute of small investors towards vote, thus introducing a better management monitoring.

b)      Self regulation: some companies have introduced economic ownership disclosure clauses in their bylaws, for those shareholders acting in the General Assembly. The Hedge Fund can also subscribe to Best Practices Codes.

c)      Ban or restriction: banning decoupling practices would be both difficult to implement, and damaging for efficient market practices, (hedging or share lending).

d)      Transparency: information costs, the fact that decoupled shares are not correctly valued, are at least partly due to lack of disclosure; disclosure would disuade those seeking rents in agency costs or private benefits, as showed above. The object of disclosure, its frequency and thresholds should be determined.

e)      Disclosure and Disinfranchisement: a too drastic measure, it could be acceptable in a case by case resolution mode by national investment authorities, (Sec and others).

 

 

In this post I have only referred to negative decoupling, where shareholders want to reduce their risk exposure; but the opposite, that is “positive decoupling”, or “hidden ownership”, has also huge effects in the markets, and will be dealt with soon in this blog.

Advertisements