Monday, May 4, 2015
Hu on Financial Innovation
Henry T. C. Hu has posted Financial Innovation and Governance Mechanisms: The Evolution of Decoupling and Transparency on SSRN with the following abstract:
Financial innovation has fundamental implications for the key substantive and information-based mechanisms of corporate governance. “Decoupling” undermines classic understandings of the allocation of voting rights among shareholders (e.g., “empty voting”), the control rights of debtholders (e.g., “empty crediting” and “hidden interests”/“hidden non-interests”), and of takeover practices (e.g., “hidden (morphable) ownership” to avoid Schedule 13D blockholder disclosure and to avoid triggering certain poison pills). Stock-based compensation, the monitoring of managerial performance, the market for corporate control, and other governance mechanisms dependent on a robust informational predicate and market efficiency are undermined by the transparency challenges posed by financial innovation. The basic approach to information that the SEC has always used — the “descriptive mode,” which relies on “intermediary depictions” of objective reality — is manifestly insufficient to capture highly complex objective realities, such as the realities of major banks heavily involved with derivatives. Ironically, the primary governmental response to such transparency challenges — a new system for public disclosure that became effective in 2013, the first since the establishment of the SEC — also creates difficulties. This new parallel public disclosure system, developed by bank regulators in the shadow of Basel and the Dodd-Frank Act and applicable to major financial institutions, is not directed primarily at the familiar transparency ends of investor protection and market efficiency.
As starting points, this Article offers brief overviews of: (1) the analytical framework developed in 2006-2008 for “decoupling” and its calls for reform; and (2) the analytical framework developed in 2012-2014 reconceptualizing “information” in terms of three “modes” and addressing the two parallel disclosure universes.
As to decoupling, the Article proceeds to analyze some key post-2008 developments (including the status of efforts at reform) and the road ahead. A detailed analysis is offered as to the landmark December 2012 TELUS Corp. opinion in the Supreme Court of British Columbia, involving perhaps the most complicated public example of decoupling to date. The analytical framework's "empty voter with negative economic exposure" concept is addressed in a dual class share context. The Article discusses recent actions on the part of the Delaware judiciary and legislature, the European Union, and bankruptcy courts — and the pressing need for more action by the SEC. In addition, at the time the debt decoupling research was introduced, available evidence as to the significance of empty creditor, related hidden interest/hidden non-interest matters, and hybrid decoupling was limited. This Article helps address that gap.
As to information, the Article begins by outlining the calls for reform associated with the 2012-2014 analytical framework. With revolutionary advances in computer- and web-related technologies, regulators need no longer rely almost exclusively on the descriptive mode rooted in intermediary depictions. Regulators must also begin to systematically deploy the “transfer mode” rooted in “pure information” and the “hybrid mode” rooted in “moderately pure information.” The Article then shows some of the key ways that the new analytical framework can contribute to the SEC’s comprehensive and long-needed new initiative to address “disclosure effectiveness,” including in “depiction-difficult” contexts completely unrelated to financial innovation (e.g., pension disclosures and high technology companies). The Article concludes with a concise version of the analytical framework’s thesis that the new morphology of public information — consisting of two parallel regulatory universes with divergent ends and means — is unsustainable in the long run and involve certain matters that need statutory resolution. In the interim, however, certain steps involving coordination among the SEC, the Federal Reserve, and others can be taken.