Financial Innovation and Governance Mechanisms: The Evolution of Decoupling and Transparency via SSRN
University of Texas at Austin – School of Law
March 20, 2015
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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.
Financial Innovation and Governance Mechanisms: The Evolution of Decoupling and Transparency – Introduction
Financial innovation as we know it-the new financial products themselves and the process through which they are invented, introduced, and diffused-is only a generation old. Yet financial innovation is now critical to markets and economies. The first over-the-counter (OTC) derivative product, the currency swap, appeared around 1976.1 The first model to value derivatives appeared in 1973, sparking a new, model-based process for the creation, pricing, and hedging of a continuing flow of new financial products.2 With financial innovation, risk and cash flows could be reconfigured, sliced, and transferred in ways precisely calibrated to the hedging, investing, and speculative needs of market participants. The promise has proven irresistible. Today, the market for OTC derivatives products stands at roughly $700 trillion notional,3 and model-based processes inform not only the analysis of new financial products but also the risk assessments used by both financial and non-financial entities.
Financial innovation also has a dark side, including the challenges it can pose to financial stability. These challenges, however, were not widely appreciated for many years, much less responded to.4 The near-collapse of the world financial system in 2008 concentrated minds wonderfully. Among other things, the Dodd-Frank Act of 2010,5 the most important piece of financial legislation since the 1930s, brought OTC derivatives into the regulatory fold and took a few steps to address asset-backed securities (ABS). Implementation of Dodd- Frank continues, even as the statute itself is modified.
The potential for transforming risk and cash flows and the challenges posed to financial stability largely frame the conventional analysis for how governments and markets should respond to financial innovation. This is understandable, given the enduring importance of this potential and these challenges. Certain other transformations and challenges are at least as important for banking, bankruptcy, and corporate lawyers and academics; the Delaware judiciary and legislature; and the U.S. Securities and Exchange Commission (SEC).
This Article focuses on one such transformation-the “decoupling” of rights and obligations of equity and debt—and one such challenge—the inability of the long-standing public disclosure system to capture highly complex realities, most notably those that can be created by financial innovation. This decoupling transformation and this informational challenge implicate some core mechanisms of corporate governance.
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