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Kominers 45.Pdf ISSN 1936-5349 (print) ISSN 1936-5357 (online) HARVARD JOHN M. OLIN CENTER FOR LAW, ECONOMICS, AND BUSINESS FELLOWS’ DISCUSSION PAPER SERIES ON DERIVATIVES MARKETS AND SOCIAL WELFARE: A THEORY OF EMPTY VOTING AND HIDDEN OWNERSHIP Jordan M. Barry, John William Hatfield, & Scott Duke Kominers Discussion Paper No. 45 08/2012 Harvard Law School Cambridge, MA 02138 Contributors to this series are John M. Olin Fellows or Terence M. Considine Fellows in Law and Economics at Harvard University. This paper can be downloaded without charge from: The Harvard John M. Olin Fellow’s Discussion Paper Series: http://www.law.harvard.edu/programs/olin_center/ This paper is also a discussion paper of the John M. Olin Center's Program on Corporate Governance ON DERIVATIVES MARKETS AND SOCIAL WELFARE : A THEORY OF EMPTY VOTING AND HIDDEN OWNERSHIP Jordan M. Barry,* John William Hatfield, ** & Scott Duke Kominers † Abstract The prevailing view among many economists is that derivatives markets simply enable financial markets to incorporate information better and faster. Under this view, increasing the size of derivatives markets only increases the efficiency of financial markets. We present formal economic analysis that contradicts this view. Derivatives allow investors to hold economic interests in a corporation without owning voting rights, or vice versa. This * Associate Professor, University of San Diego School of Law. ** Assistant Professor, Stanford University Graduate School of Business. † Research Scholar, Becker Friedman Institute for Research in Economics, University of Chicago. We thank Emily Keifer, Larry Alexander, Robert Bartlett, Lucian Arye Bebchuk, Gary Becker, Abraham Bell, Tom Coleman, Robert Daines, Lynne Dallas, Eddie Dekel, Dhammika Dharmapala, Donald A. Dripps, Darrell Duffie, Steven Durlauf, Victor Fleischer, Ryan Ford, Jesse Fried, Greg Ihrie, Louis Kaplow, Michael Kelly, Michael Klausner, Charles Korsmo, Herbert I. Lazerow, Mark Lee, Katherine Litvak, Shaun Martin, Ian McKinley, Casey Mulligan, Kevin Murphy, Roger Myerson, Derek Neal, Stirling Newberry, Muriel Niederle, Frank Partnoy, Tom Phillipson, A. Mitchell Polinsky, Elizabeth Pollman, Alvin E. Roth, Steven M. Shavell, Tom Smith, Holger Spamann, James C. Spindler, Anthony Taranto, and E. Glen Weyl, as well as attendees at the University of Chicago Workshop on Applications of Economics, the National Business Law Scholars Conference, the Annual Meeting of the American Law and Economics Association, the Annual Meeting of the Econometric Society of North America, the Western Economics Association International Conference, the Annual Meeting of the International Society for the New Institutional Economics, and the University of San Diego Law School Faculty Colloquium for their helpful thoughts and comments. All errors are our own. This project was generously supported by a summer research grant from the University of San Diego School of Law. Kominers gratefully acknowledges the support of the National Science Foundation, a Yahoo! Key Scientific Challenges Program Fellowship, a Terence M. Considine Fellowship in Law and Economics funded by the John M. Olin Center at Harvard Law School, the American Mathematical Society, and the Simons Foundation. 1 leads to both empty voters—investors whose voting rights in a corporation exceed their economic interests—and hidden owners— investors whose economic interests exceed their voting rights. We show how, when financial markets are opaque, empty voting and hidden ownership can render financial markets unpredictable, unstable, and inefficient. By contrast, we show that when financial markets are transparent, empty voting and hidden ownership have dramatically different effects. They cause financial markets to follow predictable patterns, encourage stable outcomes, and can improve efficiency. Our analysis lends insight into the operation of securities markets in general and derivatives markets in particular. It provides a new justification for a robust mandatory disclosure regime and facilitates analysis of proposed substantive securities regulations. TABLE OF CONTENTS I. INTRODUCTION ............................................................................ 3 II. THE CLASSICAL THEORY AND THE MODERN WORLD ................. 9 A. The Classical Theory ........................................................... 9 B. Decoupling and Derivatives: The Small Picture ............... 11 C. Decoupling and Derivatives: The Big Picture ................... 15 D. The Problems of Decoupling ............................................. 20 E. The Classical Theory Revisited .......................................... 23 III. COMPETITIVE EQUILIBRIUM AND THE CHALLENGE OF CONTROL ............................................................................ 26 A. Competitive Equilibrium Generally ................................... 26 B. Competitive Equilibrium with Control Rights ................... 28 C. Competitive Equilibrium with Transferable Control Rights .............................................................................. 35 IV. THE CORE OUTCOME ............................................................... 37 A. Existence ............................................................................ 38 B. Efficiency ............................................................................ 41 C. Voluntariness and Stability ................................................ 41 D. Reasonableness .................................................................. 44 E. Predictive Power ................................................................ 44 V. IMPLICATIONS OF THE CORE OUTCOME FRAMEWORK ............... 48 A. Implications of the Growth of Derivatives Markets and Decoupling .................................................................... 48 B. Implications for Securities Regulation Policy ................... 53 1. Disclosure Rules ............................................................. 53 2. Substantive Intervention ................................................. 58 C. Relaxing Simplifying Assumptions ..................................... 60 1. Transaction Costs ........................................................... 60 2. Information ..................................................................... 62 VI. CONCLUSION ........................................................................... 64 2 I. INTRODUCTION In late 2005, Henderson Land made an offer to acquire all outstanding shares of Henderson Investments, its partially owned subsidiary, for a substantial premium. 1 Henderson Investments’ minority shareholders reacted favorably. 2 The transaction appeared highly likely to be consummated,3 and the market price of Henderson Investments shares rose 44% in response.4 However, in January 2006, market watchers were surprised to discover that Henderson Investments’ minority shareholders had cast enough votes against the deal to prevent it from happening.5 According to reports, a lone hedge fund surreptitiously acquired enough Henderson Investments shares to block the transaction.6 But what took this development from merely surprising to outright troubling was that this same hedge fund had also placed large bets that the price of Henderson Investments’ shares would drop. 7 As a result, even though this hedge fund held a significant percentage of Henderson Investments’ shares, it stood to profit if Henderson Investments decreased in value. In other words, the hedge fund voted to block the takeover because the takeover was 1 The exact offer was a share swap, in which shareholders of Henderson Investments could exchange 2.5 shares of Henderson Investments for 1 share of Henderson Land. Business Brief—Henderson Land Development Co.: Bid Is Sweetened for Proposal to Take Investment Unit Private , WALL ST. J., Dec. 13, 2005. We are grateful to Henry T.C. Hu and Bernard Black for unearthing this example, as well as many others that we discuss in this paper. See Henry T.C. Hu & Bernard Black, Equity and Debt Decoupling and Empty Voting II: Importance and Extensions , 156 U. PA. L. REV . 625, 661 tbl.1 (2008). 2 Florian Gimbel & Francesco Guerrera, Henderson Stock Lending Fears— Unusually Heavy Volumes of Borrowed Shares Ahead of Decisive Vote—Critics Claim the Practice Is a Form of Market Abuse , FIN . TIMES ASIA , Feb. 15, 2006, at 15. 3 Id. 4 Compare Jonathan Li, UPDATE: HK Henderson Investments Holders Reject 2nd Buyout Bid , DOW JONES NEWSWIRE , Jan. 20, 2006, with Henderson Investments Ltd., Joint Announcement—Proposed Privatisation of the Company by Henderson Land Development Company Limited (“HLD”) by way of a Scheme of Arrangement (the “Privatisation Proposal”) (Supplemental) (Nov. 18, 2005). 5 Hong Kong Shares Fall 0.1 Percent, But China-Related Issues Continue To Do Well , ASSOC . PRESS FIN . WIRE , Jan. 20, 2006. 6 Alex F. McMillian, Hong Kong Studying Voting Issues on Borrowed Shares, INFOVEST 21 NEWS , Jan. 25, 2006. 7 See id. 3 good for Henderson Investments and the hedge fund wanted to make Henderson Investments less valuable. This incident is an example of empty voting.8 Empty voting arises when an actor’s voting interest in a corporation is larger than her economic interest.9 It is an instance of a larger phenomenon, known as decoupling, in which the legal control rights and the economic ownership rights that accompany share ownership are separated from each other. Decoupling raises a host of issues because it turns the conventional logic for granting shareholders voting rights—their economic interest
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