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The New Vote Buying: Empty Voting and Hidden (Morphable) Ownership*

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The New Vote Buying: Empty Voting and Hidden (Morphable) Ownership* THE NEW VOTE BUYING: EMPTY VOTING AND HIDDEN (MORPHABLE) OWNERSHIP* HENRY T. C. HU** & BERNARD BLACK*** ABSTRACT Corporate law generally makes voting power proportional to economic ownership. This serves several goals. Economic ownership gives shareholders an incentive to exercise voting power well. The coupling of votes and shares makes possible the market for corporate control. The power of economic owners to elect directors is also a core basis for the legitimacy of managerial authority. Both theory and evidence generally support the importance of linking votes to economic interest. Yet the derivatives revolution and other capital markets developments now allow both outside investors and insiders to readily decouple economic ownership of shares from voting rights. This decoupling, which we call the ∗ Copyright © 2006 by Henry T. C. Hu. All rights reserved. Permission is hereby granted for noncommercial reproduction of this Article for classroom use only in nonprofit academic institutions, subject to the condition that the names of the authors, a complete citation, and this copyright notice and grant of permission be included in the copies. This Article is also available at http://ssrn.com/ abstract=904004. ** Allan Shivers Chair in the Law of Banking and Finance, University of Texas Law School. We thank conference and workshop participants at the American Law and Economics Association annual meeting (May 2005); the Boundaries of SEC Regulation Conference (Financial Economics Institute, Claremont McKenna College) (February 2006); Stanford Law School (March 2006); University of Texas, McCombs School of Business (April 2006); the Weil, Gotshal & Manges Roundtable at Yale Law School (April 2006); and the Corporate Law Roundtable at University of Pennsylvania Law School (April 2006). We also thank Iman Anabtawi, Richard Craswell, Jeffrey Gordon, Larry Harris, Linda Hayman, Gérard Hertig, Jennifer Hill, Bruce Johnsen, Charles McCallum, Harold J. Mulherin, Jeffry Netter, Ian Ramsay, Edward Rock, Roberta Romano, David Skeel, Leo Strine, Janet Kiholm Smith, and anonymous peer reviewers of our companion articles for comments and suggestions. We thank Catherine Bellah and Ryan McCormick for their research assistance. *** Hayden W. Head Regents Chair for Faculty Excellence, University of Texas Law School, and Professor of Finance, University of Texas, McCombs School of Business. 811 812 SOUTHERN CALIFORNIA LAW REVIEW [Vol. 79:811 “new vote buying,” has emerged as a worldwide issue in the past several years. It is largely hidden from public view and mostly untouched by current regulation. Hedge funds have been especially creative in decoupling voting rights from economic ownership. Sometimes they hold more votes than economic ownership—a pattern we call “empty voting.” In an extreme situation, a vote holder can have a negative economic interest and, thus, an incentive to vote in ways that reduce the company’s share price. Sometimes investors hold more economic ownership than votes, though often with “morphable” voting rights—the de facto ability to acquire the votes if needed. We call this situation “hidden (morphable) ownership” because the economic ownership and (de facto) voting ownership are often not disclosed. This Article analyzes the new vote buying and its potential benefits and costs. We set out the functional elements of the new vote buying and develop a taxonomy of decoupling strategies. We also propose a near-term disclosure-based response and outline a menu of longer-term regulatory choices. Our disclosure proposal would simplify and partially integrate five existing, inconsistent ownership disclosure regimes, and is worth considering independent of its value with respect to decoupling. In the longer term, other responses may be needed: we discuss strategies focused on voting rights, voting architecture, and supply and demand forces in the markets on which the new vote buying relies. TABLE OF CONTENTS I. INTRODUCTION.................................................................................814 II. THE TECHNOLOGY OF THE NEW VOTE BUYING.....................823 A. THE FUNCTIONAL ELEMENTS OF THE NEW VOTE BUYING ..........823 TABLE 1 ....................................................................................827 B. EMPTY VOTING THROUGH COUPLED ASSETS ..............................828 1. Empty Voting Through Equity Derivatives.............................828 a. Perry-Mylan Laboratories and Similar Examples..............828 b. Liberty Media-News Corporation......................................830 c. Insider Hedging and Entrenchment....................................831 2. Empty Voting Through Record Date Capture .........................832 C. HIDDEN (MORPHABLE) OWNERSHIP.............................................836 1. Morphing from de Facto to Formal Voting Rights..................836 a. Access to Derivatives Dealers’ Matched Shares...............836 b. Avoiding Mandatory Bid Rules and Other Uses ...............839 2. Toeholds and the Social Virtues of Stealth..............................840 2006] NEW VOTE BUYING 813 3. Shedding Voting Rights...........................................................841 D. RELATED NON-HOST ASSETS .......................................................842 1. Mergers....................................................................................842 2. Indirect Hedges........................................................................844 E. INNOVATIONS UNDERLYING THE NEW VOTE BUYING.................844 F. THE EXTENT OF NEW VOTE BUYING ............................................846 TABLE 2 ....................................................................................848 III. LEGAL AND FINANCE THEORY AND EVIDENCE....................849 A. CLASSIC THEORY OF VOTING RIGHTS: INTRODUCTION................849 B. LITERATURE REVIEW: THEORY AND IMPLICATIONS FOR NEW VOTE BUYING...............................................................................851 1. Theory......................................................................................851 a. One-share-one-vote............................................................851 b. The Value of Votes: Individual Versus Collective Value .................................................................................852 c. Equilibrium Versus Nonequilibrium Models ....................853 2. Empirical Evidence..................................................................854 a. Divergence Between Insiders’ Voting and Economic Ownership .........................................................................854 b. The Value of Voting Rights...............................................855 c. Market for Corporate Control............................................856 d. Record Date Capture..........................................................856 C. ANALOGIES TO OTHER FORMS OF DECOUPLING ..........................857 1. Dual-class Common Stock, Pyramids, and Circular Control ..857 2. Dual-class Recapitalizations....................................................859 3. Voting by Record Owners .......................................................860 D. CLASSICAL VOTE DOCTRINE AND DECOUPLING ..........................861 E. TESTABLE HYPOTHESES ...............................................................862 IV. DISCLOSURE: CURRENT RULES AND REFORM PROPOSAL .......................................................................................864 A. GENERAL CONSIDERATIONS .........................................................864 B. EXISTING DISCLOSURE REQUIREMENTS.......................................864 TABLE 3 ....................................................................................866 1. Large Shareholder Disclosure (Schedules 13D and 13G) .......866 a. Basic Requirements............................................................866 b. Application to Hidden (Morphable) Ownership................867 c. Application to Empty Voting.............................................869 2. Reporting by Institutional Money Managers (Form 13F) .......870 3. Insider and 10% Shareholder Disclosure (Section 16) ............872 4. Mutual Fund Reporting ...........................................................874 C. REFORMING THE DISCLOSURE SYSTEM........................................874 814 SOUTHERN CALIFORNIA LAW REVIEW [Vol. 79:811 1. General Considerations............................................................874 TABLE 4 ..............................................................................881 2. Large Shareholder Disclosure (Schedules 13D and 13G) .......882 3. Institutional Money Managers and Mutual Funds...................883 D. DISCLOSURE OF LARGE EMPTY VOTING POSITIONS ....................885 E. SUMMARY.....................................................................................886 V. LONGER RUN RESPONSES TO EMPTY VOTING ......................886 A. GENERAL CONSIDERATIONS .........................................................886 B. STRATEGIES FOCUSED ON VOTING RIGHTS..................................888 1. Direct Limits on Voting Rights ...............................................888 2. Voting by Record Owners; Extension to Equity Swaps..........890 3. Corporation Opt-in ..................................................................890 4. State Corporate Law ................................................................893 C. STRATEGIES FOCUSED ON VOTING ARCHITECTURE.....................895 D. STRATEGIES FOCUSED ON SUPPLY AND DEMAND FORCES IN THE MARKETS ON
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