Asking 'fundamental' questions about the basis of corporate governance

Here's a thought experiment, courtesy of the IRRC Institute and Stanford University: Imagine an investor holds a million shares of a company's equity. How might it mess around with the company and make money? "It is today quite easy for investors to construct portfolios that increase in value as a corporation's stock price declines while retaining the right to cast large blocks of votes in shareholder elections," according to the report, sent to the US Securities and Exchange Commission as a guide to its rule-making under the Dodd-Frank Act. It works this way: The shareholder – remember, this could be a "long-only" investor, not a short-seller – enters into what the wizards of Wall Street call a "total return equity swap". The swap contract, a rather simple derivative strategy, creates, in effect, and insurance policy against losses. The swap protects against losses but requires the investor to forgo gains. So the investor is neutral on the company's fortunes but still gets to vote the shares, and under Dodd-Frank maybe even nominate directors. That's called empty voting and it's a puzzling notion of rights. Now imagine that instead of writing a swap for a million shares, the investor writes one for two million. It now has an incentive – quite a powerful one – to see the share price decline, and it retains its right vote and perhaps to nominate directors. That's called negative voting and it's not just puzzling – it's perverse.

The report, commissioned by the Investor Responsibility Research Center Institute and conducted by the Rock Center at Stanford, raises concerns that the financial markets now have the ability to divorce economic interests from ownership rights in ways that have outpaced both corporate governance approaches and bankruptcy law. "Ironically, we just enacted a massive reform of the financial system. The underlying presumption, however, was that economic and ownership interests are inseparable. We know this is not true," said Jon Lukomnik, IRRC Institute program director. "[I]f those who control ownership rights can be incentivized towards value destruction rather than value creation, it is only a matter of time until the real economy is affected due to a large-scale impact on corporations." So, what should directors and policy-makers do?

• Accept there's a problem: The report says the potential – as well as the reality – for of decoupling transactions that generate empty or negative voting can present challenges to shareowner and creditor governance practices.
  
• Recognise its impact: Because rights and interests may be easily decoupled, regulators, directors, other shareowners and creditors run the risk of making decision on a less-than-informed basis.
  
• More than disclosure: "Policy makers may therefore wish to consider substantive measures that might address the rights of shareowners or creditors to cast votes without regard to their participation in decoupling transactions that can give rise to empty or negative voting," the report concludes.

The report summarises 19 research studies and several key judicial opinions indicating in growing concerns in litigated transactions in a bid to inform the detailed rules that the SEC will produce to put Dodd-Frank into action. What the study make clear, if it weren't clear already, is that the concept of "shareholder value" needs to be rewritten or abandoned as a guide to what directors should do.

Source document: The IRRC-Stanford research report "Identifying the Legal Contours of the Separation of Economic Rights and Voting Rights in Publicly Held Corporations" is a 52-page pdf file.