Financial Derivatives and the Intrinsic Separation of Ownership and Control Eugenio S.

de Nardis♣
Studi e Note di Economia, forthcoming

1. Introduction; 2. The Separation of Ownership and Control: - 2.1 The Functional Separation of Ownership and Control-; 2.2 The Intrinsic Separation of Ownership and Control-; 2.2.1 Intrinsic Separation and Financial Derivatives; 3. The Regulation of Financial Derivatives in the United States: - 3.1 Financial Derivatives as “Securities”; 4. Regulating Intrinsic Separation of Ownership and Control in the United States: - 4.1 The (New) Vote Buying Doctrine-; 4.2 The Disclosure Regimes-; 4.2.1 The Corporate Governance Disclosure Regime-; 4.2.2 Briefly on the European Transparency Directive and its Implementation in Italy-; 4.3 The Fiduciary Duty of Loyalty; 5. Concluding Remarks

1. Introduction In a recently often cited excerpt from The General Theory of Employment, Interest and Money, J. M. Keynes distinguishes speculation, defined as the activity that consists in forecasting the psychology of the market, and enterprise, defined as the activity that consists in forecasting the yield of assets over their whole life. Keynes concluded that “[w]hen the capital development of a country becomes a by product of the activities of a casino, the job is likely to be ill-done. (…)to make the purchase of an investment permanent and indissoluble(…) might be a useful remedy for our contemporary evils”.1 Some years after Keynes, in Italy, F. Caffé took a negative stance with regard to the increased participation of retail investors in the stock market. Caffé probably had in mind a speculation-driven stock market, such as the one Keynes refers to, when he wrote that he had been “convinced for some time that the financial market supra-structure, with the characteristics it presents in countries with a developed capitalism, favors not competitive vigor but a predatory game that systematically operates to damage categories of innumerable and undefended investors in an institutional framework that, in practice, allows and legitimates the recurring taking or the de facto expropriation of their moneys”.2 The current global financial crisis has echoed these propositions, indicating that there may still be some gist to them and, less obviously, that they might still be of fundamental prescriptive importance. Indeed the ‘affluent society’ has been at

Doctoral candidate in Law and Economics, University of Siena. J. M. Keynes, The General Theory of Employment, Interest and Money, Harvest, 1991 reprint, at 158160. 2 F. Caffé, Economia di Mercato e Socializzazione delle Sovrastrutture finanziarie, in Un’Economia in Ritardo, Boringhieri, 1976, at 18.
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least put on hold3, as the boom-and-bust cycle aggressively demonstrates not only its existence, but its great health as well.4 In a regulatory perspective, the current financial crisis indicates the need to rethink corporate governance from its most fundamental principles.5 The Berle and Means public corporation, shareholder primacy, fiduciary duties, agency costs, incentive structures and monitoring mechanisms, need to be rethought in the context of a new study of corporate governance. The origins of the recent financial crisis have signaled that the starting point of this new analysis should be the financial derivatives’ industry. The increased sophistication of financial derivatives, coupled with stock market and trading platform developments6, have made derivatives available - to sophisticated and retail investors alike - at lower transaction costs. Financial derivatives are of course not a new phenomenon; what is new is the ease and large scale in which they can be used to decouple voting rights and economic ownership, achieving an intrinsic separation of ownership and control. Hu and Black7 find over eighty confirmed or publicly rumored cases of decoupling through the use of financial derivatives, most of which have occurred after 2002. Moreover, numerous cases remain undetected because of the complexity of certain derivatives and overall transactions, their commonplace usage among sophisticated investors, and the habitual absence of an ad hoc regulation. In this paper we examine the intrinsic separation of ownership and control achieved through financial derivatives when used to decouple voting rights and economic ownership. We begin from traditional theory regarding the functional separation of ownership and control in the Berle and Means public corporation, upon which most modern corporate governance analysis is explicitly and/or implicitly based. We then distinguish this traditional functional separation from the developing intrinsic separation of ownership and control, as achieved at the individual level of each shareholder through decoupling transactions with financial derivatives.

J. K. Galbraith, The Affluent Society, Mariner, 1998 reprint. P. Krugman, The Return of Depression Economics and the Crisis of 2008, Norton, 2009 at 9-10, recalls how illustrious economists such as R. Lucas and B. Bernanke had recently given public speeches on how the boom-and-bust cycle had become only a minor issue in the developed U.S. economy. 5 H. G. Manne, Corporate Governance – Getting Back to Market Basics, CONSOB Seminar, November 10, 2008, available at www.consob.it; G. Rossi, Quale capitalismo di Mercato?, Rivista delle Società, 2008/5, at 905; G: Soros, The New Paradigm for Financial Markets, Public Affairs, 2008. 6 S. Micossi, La Direttiva MIFID e la Nuova Struttura dei Mercati Regolamentati, Assonime, 2008; E. S. de Nardis, L. Giani, R. Vannini, Diamonds and Pearls Among Financial Markets: the Keys to Succeed in Regulatory Competition, 2008, available at http://www.sideisle.it/ocs/viewabstract.php?id=266&cf=2. 7 H. T. C. HU, B. Black, The New Vote Buying: Empty Voting and Hidden (Morphable) Ownership 79 S. Cal. L. Rev. 811,819 (2005-2006), at 819: “The theoretical possibility of decoupling votes from economic ownership is not new. What is new is investor ability to do so on a large scale, declining transaction costs due to financial innovation, and a trillion-dollar-plus pool of sophisticated, lightly regulated, hedge funds…”.
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Further on we examine the current legislation applying to financial derivatives in the United States - among the most sophisticated and developed legal systems with regard to corporate governance and financial instruments. Finally, we briefly examine some of the possible regulatory responses or changes vis-à-vis the intrinsic separation of ownership and control, and evaluate them in light of the need to rethink the fundamentals of traditional corporate governance analysis. 2. The Separation of Ownership and Control Until recently, when academia referred to the separation of ownership and control, it essentially had the Berle and Means public corporation in mind. In the public corporation par excellence, shareholders - the providers of capital - were passive owners who most often voted with their feet, while managers - the entrepreneurs and exploiters of capital - actively controlled the corporation. In this model, conflict of interest problems arose between shareholders and management. The legislative framework aimed at preventing such conflicts and at achieving an efficient incentive structure within the corporation, was mostly based on fiduciary duties and market monitoring. Continental European models of corporate governance, due to their path dependencies, have taken a different form. In these models, the separation of ownership and control has been essentially viewed as the separation between a majority shareholder or block-holders on the one side, and minority shareholders on the other. Conflict of interest problems thus arose between majority and minority shareholders, and bright line rule prohibitions were more frequent in bank-oriented systems with poorly developed stock markets.8 Both the Anglo-Saxon and the continental European models have been examined profusely by scholarship, and some authors have hypothesized convergence toward the apparently prevailing Anglo-Saxon model.9 Recent history has of course made a number of such claims conditional but, furthermore, a different separation of ownership and control has slowly manifested itself in all corporate governance models, and has come to blur previous analysis. The Berle and Means corporation - as well as its European counterparts - with its functional separation of ownership and control between managers and shareholders - or majority and minority shareholders -, has given way to an intrinsic separation of ownership and control, as individual shareholders are able decouple
See for example the ‘Law and Finance’ scholarship, starting from R. La Porta, F. Lopez-de-Silanes, A. Shleifer, R. W. Vishny, Law and Finance, Journal of Political Economy, vol. 106, 1998. 9 For example, A. R. Pinto, G. Visentini The Legal Basis of Corporate Governance in Publicly Held Corporations, A Comparative Approach, Kluwer, 1998; G. Visentini, Compatibility and Competition Between European and American Corporate Governance: Which Model of Capitalism?, 23 Brook. J. Int'l L. 833 (1998); H. Hansmann, R. Kraakman, The End of History for Corporate Law, Georgetown Law Journal, Vol. 89, 2001; T. Clarke, Theories of Corporate Governance. The Philosophical Foundations of Corporate Governance, Routledge, 2004; R. Kraakman, P. Davies, H. Hansmann, G. Hertig, K. Hopt, H. Kanda, E. Rock, The Anatomy of Corporate law: A Comparative and Functional Approach, OUP, 2004.
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economic ownership (risk) and control (voting rights) of the shares they hold with an increasing ease and frequency. Academia has studied the effects of deviations from the one share - one vote principle, although it has not focused extensively on financial derivatives as an implicit deviation mechanism. Nonetheless, even the most common hedging strategy - leaving aside other uses of financial derivatives - distorts the common assumptions in a corporation’s incentive structure. The fundamental tenet that no servant can serve two masters, is thus called into question by the increasing ease with which an intrinsic separation of ownership and control can be enacted. Furthermore, the recent financial crisis questions a number of fundamental principles of the current legal framework, and the future legislative stance will have to be based on a new corporate governance analysis that expressly considers intrinsic separation. 2.1 The Functional Separation of Ownership and Control The functional separation of ownership and control was first cited by Adam Smith: “[t]he directors of such companies, however, being the managers rather of other people’s money than of their own, it cannot well be expected, that they should watch over it with the same anxious vigilance with which the partners in a private co-partnery frequently watch over their own.”10 In 1921, F. Knight distinguished between risk and uncertainty: the former being measurable and the latter not being measurable.11 According to Knight, uncertainty prevents the perfect working of competition, giving rise to entrepreneurial organizations: uncertainty leads to specialization of functions and thus the enterprise form, as individuals are prepared to accept fixed wages in return for their labor, while managers carry out a coordination function. Functional separation of ownership and control is implicitly central to Knight’s construction of the entrepreneurial organization, as resulting from specialization. In 1933 Berle and Means published their seminal work on the functional separation of ownership and control. The authors portray the ‘splitting of the atom of property’ in the developing public corporation, where passive owners have given up active control on their property, in favor of weakly-monitored managers.12 Economists also began to study the inner workings of the firm - no longer viewed as a black box - and the principal-agent paradigm was developed. Fundamental to principal-agent analysis is the metering problem in team production, which occurs when several types of resources are used, the product is not a sum of separable outputs of each resource, and not all resources belong to one person. Alchian and Demsetz concentrated on shirking, as they believed economic organization resolves the team production problem by allowing a better detection of
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A. Smith, An investigation into the Wealth of Nations, Bantam, 2003 reprint, at 941. F. H. Knight, Risk, uncertainty, and profit, New York, 1964 reprint. 12 A. Berle, G. Means, The Modern Corporation and Private Property, Harcourt, 1967 reprint.

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individual members’ performance.13 Market competition can in principle monitor team production, although new challengers for team membership do not know to what extent shirking is a problem; moreover, detection of shirking by observation of team output is costly and the incentive of the new team member to shirk is at least as great as the incentive of the inputs replaced. Accordingly, to reduce shirking an individual should specialize as a monitor of input performance of team members and should be given title to the earnings of the team, net of payments to other inputs. The monitor itself would be monitored through a market for monitors. In their 1976 article, Jensen and Meckling concentrated on agency costs within the firm. The authors used the contractual theory of the firm as a starting block: “contractual relations are the essence of the firm, not only with employees but with suppliers, customers, creditors, and so on. The problem of agency costs and monitoring exists for all of these contracts”.14 The firm is described as a nexus of contracts: “It is important to recognize that most organizations are simply legal fictions which serve as a nexus for a set of contracting relationships among individuals... The private corporation or firm is simply one form of legal fiction which serves as a nexus for contracting relationships…”. “(A)gency costs arise in any situation involving cooperative effort… by two or more people even though there is no clear-cut principal-agent relationship”.15 Agency costs are defined as the sum of monitoring expenditures by the principal (the principal may seek to limit divergences from its interest through incentive schemes and other mechanisms such as budget constraints and financial auditing), bonding expenditures by the agent (the agent might also seek to show that it will not take any action directed at harming the principal), and residual loss (physiological diversions between the agent’s choices and maximization of the principal’s welfare). With specific reference to the manager-shareholder relationship, agency costs are constrained by capital markets, product markets, and the market for corporate control, acting as outside monitors of managers’ performance. In their 1983 article, Fama and Jensen asserted that “[a]n important factor in the survival of organizational forms is control of agency problems”.16 Within corporations, risks borne by most agents are limited by ex ante specification of either fixed payoffs or incentive payoffs tied to performance. The residual risk is borne by the shareholders, who contract for the rights to net cash flows, as residual claimants.

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A. A. Alchian, H. Demsetz, Production, information costs, and economic organization, The American Economic Review, 1972, at 777. 14 M.C. Jensen, W. H. Meckling, Theory of the firm: Managerial behavior, agency costs, and ownership structure, J. Fin. Econ. 3, n. 305, 1976; also available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=94043, at 8. 15 At 8. An agency relationship is defined as “a contract under which one or more persons (the principal(s)) engage another person (the agent) to perform some service on their behalf which involves delegating some decision making authority to the agent”, at 5. 16 E. F. Fama, M. C. Jensen, Agency problems and residual claims, Journal of law and economics, vol. XXVI, 1983, at 327.

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Through common stock, corporations spread residual risk across numerous residual claimants, which choose how much risk to bear through diversification on the stock market. This lowers the cost of risk bearing and equity financing. In practice this leads to functional separation of ownership and control through specialization of decision functions (management) and residual risk bearing (shareholders). In more recent years, further analysis has developed the functional separation of ownership and control, for example with regard to the incompleteness of contracts, characterized by the opportunistic behavior of the parties, bounded rationality, asymmetric information, and the resulting need to engage in specific investments. Asymmetric information problems have also led to the further study of the principalagent paradigm using the moral hazard and adverse selection notions.17 Most modern corporate governance analysis is implicitly or explicitly based on this framework and, unexpectedly, often takes the functional separation of ownership and control as a given. 2.2 The Intrinsic Separation of Ownership and Control The notion of intrinsic separation of ownership and control, as we have used it in this article, refers to the separation of economic ownership (of shares) and control (voting rights) at the individual level of each shareholder. Intrinsic separation of ownership and control allows each shareholder to hold either ownership or voting rights, separately. Intrinsic separation may thus also lead to conflict of interest problems. From a different perspective, this topic involves the recently much debated one share - one vote principle. Indeed, traditional financial theory asserts that voting rights should generally be proportionate to share ownership. Accordingly, cash flows should be proportionate to risk borne in the corporation. The seminal and often cited article supporting this view is co-authored by Easterbrook and Fischel.18 The authors assert that, empirically, “almost all shares have one vote, and only shares possess votes. Cumulative voting is almost unheard of in publicly-held corporations, as is nonvoting stock or stock with seriously limited voting rights”.19 They recognize that because all relational contracts are incomplete and specification can be costly, inefficient, and ultimately impossible, voting rights serve the function of filling in the gaps of the initial contract. By voting, shareholders decide on all matters not set forth by the initial contract, and the right to make decisions also includes the right to delegate them. As to why shareholders have the right to vote, the authors argue that “[a]s the residual claimants, the shareholders are the group with the appropriate incentives
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See for example, A. Nicita, V. Scoppa, Economia dei Contratti, Carocci, 2005. F. H. Easterbrook, D. R. Fischel, Voting in corporate law, 26 J. L. & Econ. 395, 1983, “The right to vote (that is, the right to exercise discretion) follows the residual claim”, at 404. 19 But see F. Partnoy, “Encumbered shares”, U. Ill. L. Rev., 2005, arguing differently.

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(collective choice problems to one side) to make discretionary decisions”.20 If voting rights are not matched with economic ownership, agency costs will increase.21 As residual claimants, shareholders have the best incentives to maximize firm value.22 The one share - one vote principle is generally seen as efficient in minimizing agency costs and entrenchment problems, as it allocates discretionary decision power to entities with the best incentives to pursue firm value maximizing decisions, and prevents distortions in investment decisions, tunneling, inefficiencies in the market for corporate control23, and the formation of monopolies.24 Correspondingly, disproportional ownership - i.e., decoupling of share ownership and voting rights has been generally perceived as exacerbating agency costs by allowing controlling shareholders to extract private benefits and thus ultimately lowering firm value. This traditional view endorsing the one share - one vote principle has come under attack in recent years.25 The findings in the economic literature often disagree on the effects of disproportional ownership. A recent study has found that the one share - one vote structure is not always optimal.26 Differently, the optimal security voting structure depends on numerous factors such as the degree of competition and the extent of private benefits involved. The study concluded: “the claim that one share - one vote - or any other specific structure - is generally most conducive to an efficient control allocation of widely held firms is not justified”. 27 Contestability of control has long been considered a major goal of financial regulation, with a view to stimulating the market for corporate control and thus external monitoring of management. Nonetheless, the overall impact of control contestability is also debated: greater monitoring by insiders could prove more efficient and thus allowing block-holders disproportional ownership could be

F. H. Easterbrook, D. R. Fischel, Voting in corporate law, cited, at 403. F. H. Easterbrook, D. R. Fischel, Voting in corporate law, cited, at 409. 22 B. S. Black, R. R. Kraakman, A self-enforcing model of corporate law, Harv. L. R. 109, 1996; B. S. Black, The Legal and Institutional Preconditions for Strong Securities Markets, 48 UCLA L. Rev. 781, 2001. For a critique of these justifications see M. Burkart, S. Lee, The one share – one vote debate: a theoretical perspective, ECGI Finance working Paper N. 176/2007, at 4. F. Partnoy, Adding derivatives to the corporate law mix, cited, gives interesting examples regarding the application of option theory to the corporation, pointing out that the representation of shareholders as owners of the corporation is merely a convention. 23 S. J. Grossman, O. D. Hart, One share / one vote and the market for corporate control, NBER Working Paper Series n. 2347, 1987. 24 R. Adams, D. Ferreira, One share – one vote: the empirical evidence, Rev. of Fin., 52, 2008, where ample reference can be found to the specific literature. 25 See for example F. Partnoy, Encumbered shares, cited, for example at 778: “Shareholders are neither necessarily nor commonly in the residual claimant position that the literature has heretofore assumed.” (referring to the use of financial derivatives). 26 M. Burkart, S. Lee, The one share – one vote debate: a theoretical perspective, cited, at 17 “the optimal security-voting structure depends on a variety of factors, notably the extent of competition and the (assumed) correlation between the parties’ private benefits and security benefits.” 27 M. Burkart, S. Lee, The one share – one vote debate: a theoretical perspective, cited, at 17. Similarly, A. Khachaturyan, The one share – one vote controversy in the EU, ECMI Paper N. 1/2006, at 1, “The conditions for 1share1vote being the optimal choice are highly contestable, and depending on the circumstances and the nature of corporate actions, 1share1vote may be value-decreasing”.
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optimal; conversely, one share - one vote makes majority ownership of a corporation costly to obtain, and thus discourages it.28 A recent survey commissioned by European Commission found that corporations around the world use numerous instruments to deviate from the one share - one vote principle.29 The report found that 44% of the companies in the sample have at least one control enhancing mechanism. The most frequent control enhancing mechanisms are pyramid structures among corporate groups and dualclass shares. The determinants of control enhancing mechanisms remain unclear, although “there is some robust evidence that the protection of private benefits and the desire to keep control in the family are reasons [for example] for choosing a dual-class structure”.30 Using different methodologies, two seminal articles examine private benefits of control on a cross - country basis.31 Both studies have found private benefits to be very low in the United States, around 2%. This would seem to suggest that control enhancing mechanisms are uncommon. Indeed numerous pyramid structures among corporate groups were expunged by the harsh trust-busting policies of the past, as well as the Public Utilities Holding Act.32 With regard to law specifically endorsing the one share - one vote principle, there is however some debate.33 Partnoy has written that the one share - one vote requirement stemmed from “a populist uprising and the worries of the New York Stock Exchange about possible federal regulation (and related damage to its reputation)”.34 Indeed after the Nineteen Twenties the New York Stock Exchange generally refused to list companies with non-voting shares, with only minor exceptions. One of these exceptions was the Ford Motor Company, which was allowed to list in 1956.35 The stance of the New York Stock Exchange changed in the Nineteen Eighties, as voting practices became more important due to the continuous threats of
M. Burkart, S. Lee, The one share – one vote debate: a theoretical perspective, cited, at 28. Institutional Shareholder Services, Shearman & Sterling, ECGI Proportionality between ownership and control in EU listed companies: external study commissioned by the European commission, Report on the proportionality principle in the European Union, 2007, at 24. Recently on the subject M. Bennedsen, K. Nielsen, The principle of proportional ownership, investor protection and firm value in Western Europe, ECGI, Finance Working Paper N. 134-2006; A. Pajuste Determinants and consequences of the unification of dual-class shares. European Central Bank, Working Paper 4652005. 30 R. Adams, D. Ferreira, “One share – one vote: the empirical evidence”, cited, at 62. 31 T. Nenova, The Value of Corporate Voting Rights and Control: A Cross-country Analysis, J. Fin. Econ., 68(3): 325–51, 2003; A. Dyck e L. Zingales Private Benefits of Control: An International Comparison, J. Fin, 59(2): 537–600, 2004. 32 W. E. Kovacic, C. Shapiro Antitrust Policy: A century of economic and legal thinking, J. Econ. Persp. 14, 2000; R. Morck How to eliminate pyramidal business groups – the double taxation of intercorporate dividends and other incisive uses of tax policy, NBER WP, 2004. 33 See Easterbrook and Fischel, Voting in corporate law, cited. 34 F. Partnoy, Encumbered shares, cited, at 784. See J. Seligman, Equal protection in shareholder voting rights: the one common share – one vote controversy, 54 Geo. W. L. Rev. 687, 712-713, 1986, stating “the primary motivation for the NYSE’s initial decision on nonvoting common stock was concern about public opinion”. 35 See F. Partnoy, Encumbered shares, cited, at 784.
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hostile takeovers, as well as increased competition between Stock Exchanges. The New York Stock Exchange thus liberalized its approach. In 1988 the Securities and Exchange Commission promulgated Rule 19c-4, requiring Stock Exchanges to bar the listing of corporations that reduced voting rights of any class of shareholders. Rule 19c-4 was applied for only two years, as the Court of Appeals of the D.C. circuit held that it was beyond the Securities and Exchange Commission’s authority, and improperly intruded on state corporate law.36 The Securities and Exchange Commission has nonetheless sought to pressure Stock Exchanges to limit the issuance of non-voting shares or shares with limited voting rights. Stock Exchange rules now allow listed companies to issue non-voting or limited voting shares only under certain conditions.37 2.2.1 Intrinsic Separation and Financial Derivatives Academia has concentrated almost exclusively on traditional control enhancing mechanisms that deviate from the one share - one vote principle. Financial derivatives can also create an intrinsic separation of ownership and control by allowing individual shareholders to separate economic ownership and voting (control) rights. In a different perspective, this too is a deviation from the one share one vote principle. Moreover though, this intrinsic separation can occur at the individual level of each shareholder, it is not structural, and often remains undetected. A first type of intrinsic separation may occur when a shareholder hedges its equity position through equity swaps or other derivatives. Insiders can, for example, hedge their economic exposure, as is commonly done through zero-cost collars.38 The press reported in 2008 that Goldman Sachs had shorted securities related to the subprime industry, which it was underwriting. A spokesman at Goldman Sachs said that the company routinely shorts the securities it underwrites and said that this had been disclosed.39 A shareholder may even come to hold voting rights though it carries a negative economic interest. By way of example, let us imagine that a hedge fund holds shares in a company X. X is being sold to another company, Y, in a stock-forstock merger at a premium, but its share price drops sharply when the deal is
Bus. Roundtable v. S.E.C., 905 F.2d 406, 416 (D.C. Cir. 1990). See F. Partnoy, Encumbered shares, cited, at 786, specifically note 58. A different query, beyond the scope of this paper, concerns the ways to render corporate voting more incisive. Academia has engaged in a long debate. The authoritative Delaware courts have recognized that “(t)he shareholder franchise is the ideological underpinning upon which the legitimacy of the directorial power rests” (Blasius Industries, Inc. v. Atlas Corp., 564 A.2d 651 Del. Ch. 1988). In the cited case, former Chancellor Allen opines that shareholders have two general protections against perceived inadequate business performance: they can sell their stock (vote with their feet) or they can vote to replace the board. 38 This common strategy involves buying a put option to limit losses, while simultaneously selling a call option, thus reducing potential gain. This preserves voting rights and reduces economic ownership. 39 B. Stein, The Long and Short of it at Goldman Sachs, http://www.nytimes.com/2007/12/02/business/02every.html?pagewanted=1&ei=5088&en=cb27663f7 71ef3d3&ex=1354251600&partner=rssnyt&emc=rss
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announced. To help Y obtain shareholder approval, the hedge fund buys 9.9% of Y, becoming its largest shareholder. The hedge fund fully hedges the risk associated with the shares in Y and thus controls 9.9% voting rights with no economic ownership. Considering its position in X, the hedge fund has an overall negative economic interest in Y, as the more Y pays for X, the more the hedge fund stands to profit.40 Decoupling strategies are often used by corporations themselves. Corporations may use decoupling techniques to protect against changes in control, by allowing insiders or friendly third parties to vote shares with partial or no economic risk. A typical example can be seen when a corporation acquires economic ownership of its shares through an equity swap, but no formal voting rights. The dealer will have usually hedged its position by holding matched shares on which it can vote, usually as directed by the corporation.41 A second type of intrinsic separation may occur through the use of the share lending market. In general, shareholders who hold shares at the close of business on the record date have the right to vote at the shareholder meeting. It is thus possible to borrow shares only for short periods, around the record date: voting rights are transferred to the borrower although economic ownership is left with the lender.42 A third type of intrinsic separation may occur when derivatives are used to circumvent legal obligations and hide ownership and/or voting power. For example, the press reported in 2008 that the Jana and Sandell funds purchased derivatives that effectively gave them a noticeable interest in CNet, although they did not purchase its stock and thus no disclosure under Securities Exchange Act Section 13D was required.43 Similarly, in 2005 the Agnelli family entered into an equity swap for Fiat shares with Merrill Lynch, without any disclosure. Fiat had a forthcoming debt-forequity swap with major Italian banks that would have diluted the stake of the Agnelli family. The Agnelli family thus wanted to retain control of the company without launching a mandatory bid or disclosing acquisitions that would have influenced share price. After the debt-for-equity swap was completed, the Agnelli family immediately unwound its equity swaps, obtaining the dealer’s matched Fiat shares, and keeping a controlling stake of Fiat without launching a mandatory bid.44

This is the substance of the Perry-MyLan Laboratories case cited by H. T. C. HU, B. Black, The new vote buying: empty voting and hidden (morphable) ownership, cited, at 828. 41 See H. T. C. HU, B. Black, Equity and debt decoupling and empty voting II: importance and extensions, cited, at 643, where “soft parking” strategies are discussed. The authors point out that this strategy appears not to be used in the U.S. yet, although it has been used quite extensively in Europe. 42 See H. T. C. HU, B. Black, The new vote buying: empty voting and hidden (morphable) ownership, cited, at 833, and specifically note 50, where reference is made to literature describing share lending agreements. 43 A. R. Sorkin, A Loophole Lets a Foot in the Door, http://www.nytimes.com/2008/01/15/business/15sorkin.html 44 See H. T. C. HU, B. Black, The new vote buying: empty voting and hidden (morphable) ownership, cited, at 840. In an equity swap, the dealer will usually hedge its exposure by holding “matched shares”, to offset gains or losses on the equity swap.

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To date few academic articles have focused extensively on this new phenomenon.45 Nonetheless, the sophistication and growth in equity swaps and other derivatives, as well as the development of the share lending market, now allow corporate insiders and outsiders to decouple voting and share ownership with unprecedented ease. 3. The Regulation of Financial Derivatives in the United States Financial derivatives that can be used to achieve an intrinsic separation of ownership and control include a number of standard contracts, the most common being options46 and swaps47, as well as new, esoteric hybrid financial instruments.48 Financial sophistication has reached considerable peaks in the United States, where two main competing federal statutes - and corresponding federal agencies - are involved49: the Securities Acts50 and the Commodity Exchange Act. After the 1929 Wall Street crash, the Securities Acts introduced a disclosure regime aimed at protecting all investors “unable to fend for themselves” in their financial transactions and overall activities.51 The Securities and Exchange Commission was committed to regulate the securities industry and enforce the Securities Acts. The fulcrum of the Securities Acts is of course the definition of a “security”.52 Throughout the years, the statutory definition has been developed by the case law,
Most recently: H. T. C. HU, B. Black, The new vote buying: empty voting and hidden (morphable) ownership, cited; H. T. C. HU, B. Black, Equity and debt decoupling and empty voting II: importance and extensions, 156 U. Penn. L. R. 625 (2008); M. Burkart, S. Lee, The one share – one vote debate: a theoretical perspective, cited; A. Khachaturyan, The one share – one vote controversy in the EU, cited; F. Partnoy, Encumbered shares, cited; F. Partnoy, Financial innovation and corporate law, 31 J. Corp. L. 799, 2006. 46 The right to purchase (a ‘call option’) or to sell (a ‘put option’) a certain number of securities at an agreed price. 47 In an equity swap a set of future cash flows (‘legs’) is exchanged between two parties: one stream of cash flows will usually be based on a reference interest rate, while the other will depend on the performance of a certain stock. It can be used to hedge risks such as interest rate risk, or to speculate on changes in the underlying prices. 48 See F. Partnoy, D. A. Skeel Jr., The promise and perils of credit derivatives, U. Cin. L. Rev. 1019, 2006, where the authors examine two growing markets of credit derivatives: the credit default swap market and the collateralized debt obligation market. 49 This is true only in broad terms. Not all derivatives disputes with federal statutory claims involve either the Commodities or the Securities Statutes. Other legal bases have been argued, including violations of the Racketeer Influenced and Corrupt Organizations Act, and the Employee Retirement Income Security Act. Other federal regulatory agencies such as the Federal Reserve Board also play a role in the regulation of derivatives. See for example F. Partnoy, “The shifting contours of global derivatives regulation”, cited, at 430, notes 24 and 25. 50 In particular the Securities Act of 1933, and the Security Exchange Act of 1934. 51 S.E.C. v. Ralston Purina Co., 346 U.S. 119, 73 S.Ct. 981, 97 L.Ed. 1494 (1953). 52 Section 2(a)1 of the 1933 Securities Act states that unless the context otherwise requires, “The term "security" means any note, stock, treasury stock, security future, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, pre-organization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or
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although some uncertainty still exists. This uncertainty has recently been exacerbated when ascertaining the exact extent of applicability to financial derivatives. Nonetheless, some bright line rules do exist: options are expressly included, pursuant to Section 2(a)-1 of the 1933 Securities Act, while Section 2A of the same Act expressly excludes swap agreements. The main competing federal statute is the Commodity Exchange Act, pursuant to which the Commodity Futures Trading Commission assures that futures markets operate correctly and encourages their competitiveness and efficiency. The main role of the Commodity Futures Trading Commission is to protect market participants against fraud, manipulation, and abusive trading practices, while ensuring the financial integrity of the clearing process. All derivatives not expressly regulated by one of the two main competing federal statutes - usually hybrid financial instruments - are hard to categorize and thus to regulate. Indeed financial derivatives may even be economically equivalent, serving the same economic purpose, and yet fit under different statutory regimes.53 If the financial instrument is not a security or a commodity, and no other federal regulatory regime applies, the claims become state law claims. Noticeable uncertainty regarding regulation of derivatives is also present at state-level. Indeed state judges have decided derivatives cases by applying either state statutes - such as those prohibiting gambling -, or common law. Plaintiff lawyers have often argued violations such as breach of fiduciary duty, common law fraud and negligent misrepresentation, lack of authority, and contract-based claims.54 3.1 Financial Derivatives as “Securities” In theory, financial derivatives could fit in the definition of a “security” pursuant to the 1933 Securities Act. In practice though, this may only occur if, pursuant to Article 2(a)-1 of the 1933 Securities Act, such financial derivatives can be included in the definition of an “investment contract” or be considered a “note”. Section 2(a)-1 of the 1933 Securities Act, after enumerating a list of investment contracts that are per se securities, establishes a broad, catch-all, “investment contract” notion. The case law has developed a four-part test to determine when a contract is an “investment contract” pursuant to the Act.
other mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a "security", or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing”. 53 F. Partnoy, “The shifting contours of global derivatives regulation”, cited, at 432. 54 See F. Partnoy, “The shifting contours of global derivatives regulation”, cited, at 444, 447. The author analyzes some cases and finds that “The drawbacks of common law in this area are enormous. It is extraordinarily expensive to resolve these disputes, and there are few published decisions to guide future parties, Facts are difficult to ascertain. Complaints often do not describe the underlying transaction accurately and neither do the paltry number of judicial opinions… The result is an expensive, inefficient, unfair, and uncertain process”, at 449.

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SEC v. W.J. Howey Co.55 involved the offering of units of a citrus grove development, along with a service contract for cultivating, marketing and distributing proceeds to the investors. The court found that the contract was an “investment contract” pursuant to the 1933 Securities Act - and thus a ‘security’ - as the proponents were offering more than simple interests in the land. Indeed the offer was made to investors residing far away, with no technical expertise, and attracted solely by the prospects of a return on their investment. De facto, the investors were being offered the participation in a large citrus fruit management enterprise. The four-part Howey test to establish when a contract is an “investment contract” requires that: (i) a person invests value - future legal consideration may suffice, for example a future service -; (ii) there is a common enterprise - pooling of money, proceeds and opportunities as well as sharing of profits between investors56 -; (iii) there is an expectation of profits or change in economic status - i.e., a motive to invest and not to consume57 -; and (iv) this occurs solely (or predominantly) through the managerial efforts of others.58 Section 2(a)-1 of the 1933 Securities Act, also considers a “note” as a “security”. The leading case in the definition of a “note”, Reves v. Ernst & Young, involved demand notes issued by a farmers’ cooperative.59 The Supreme Court applied a family resemblance test and concluded that such notes were securities. As stated in Reves v. Ernst & Young, the analysis to determine whether a contract is a “note” pursuant to the 1933 Securities Act must begin with the rebuttable presumption that all notes with a term of more than 9 months are “securities”. The presumption does not apply if the note is or bears a family

328 U.S. 293 (1946). Commonality can be horizontal: pooling of funds, sharing of losses and profits related to the common pool. Intent to pool may be enough, even if no one else participates. Profits should be based on the collective pool of investments. There should usually be nothing anyone above the participants has to do. At times courts have also found commonality to exist when it is vertical: investor (a) and investee (b) have their fortunes tied as each one’s profits depends on the relationship (i.e. profit sharing). Strict vertical commonality is less likely to be found by courts. It exists between two persons, directly tied. See SEC v. Koscot Interplanetary Inc., 497 F.2d 473 (1974), involving a pyramid scheme. 57 See SEC v. Life Partners 87 F.3d 536 (1996): the difference between buying a note secured by a car and a car. No distinction should be made between promises of a fixed return and promises of variable returns for the purposes of the Howey test. See SEC v. Charles Edwards 157 L.Ed.2d 813 (2004): an investment scheme promising a fixed rate of return can be an “investment contract”. 58 Steinhardt v. Citigroup 126 F.3D 144 (1997): the need to rely substantially on others. Limited Partnerships are usually an investment contract, as the limited partner is a passive investor. In this case though, the limited partner had substantial involvement and control.; SEC v. Life Partners 87 F.3d 536 (1996): dependence on others’ managerial efforts - and not ministerial services - must be after investing; pre-investment managerial efforts are not enough for the “relying on efforts of others” test, if after investing only ministerial acts are carried out; Great Lakes Chem Corp v. Monsanto Comp 96 F.Supp.2d 376 (2000): members of an LLC have limited liability and are usually less ‘participant’ than in a partnership. Great lakes could remove the managers without just cause: no security was involved because Great Lakes had control over management (i.e. not exclusively from the efforts of others). 59 494 U.S. 56 (1990).
56

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resemblance to a category of instruments such as notes of consumer finance.60 If the notes do not bear any family resemblance with such instruments, then the courts must apply a four-part test to determine whether the financial instrument is not a security. The Reves four-part test looks at whether: (i) the purpose of the buyer/seller is to raise money for a business enterprise or rather to finance the purchase of an item/improvements, (ii) there is a plan of distribution or common trading/speculation versus a face – to - face transaction, (iii) the investing public reasonably expects the note to be considered a security, and (iv) there are other factors or alternative regulatory regimes that reduce risks for investors.61 Procter & Gamble Co. v. Bankers’ Trust62 clearly exemplifies the uncertainty regarding the rules applicable to most financial derivatives. Procter & Gamble filed a complaint alleging both state and federal causes of action, in connection with two interest rate swap transactions it had entered into with Bankers Trust Company. The claims included fraud, misrepresentation, breach of fiduciary duty, negligent misrepresentation, violations of the Federal Securities Acts and the Commodity Exchange Act, the Ohio Blue Sky Laws, and the Ohio Deceptive Trade Practices Act. The litigation involved two different swaps. One swap was a leveraged derivatives transaction whose value was based on the yield of five-year treasury notes and the price of thirty-year treasury bonds. The other swap was also a leveraged derivative based on the four-year German deutschemark rate. The Court concluded that - like most other derivatives - these swaps fell under general common law. The analysis through which the Court arrives at this conclusion is interesting. The Court first applied the Howey test to verify whether the swaps were investment contracts and thus a “security” pursuant to the 1933 Federal Securities Act. In finding that they were not, the Court stated: “While the swaps may meet certain elements of the Howey test… what is missing is the element of a "common enterprise." P&G did not pool its money with that of any other company or person in a single business venture. How BT hedged its swaps is not what is at issue -- the issue is whether a number of investors joined together in a common venture. Certainly, any counterparties with whom BT contracted cannot be lumped together as a "common enterprise." Furthermore, BT was not managing P&G's money; BT was counter-party to the swaps, and the value of the

60

The same resemblance test applies for: notes used in consumer lending; notes secured by a mortgage on a home; short-term notes secured by an assignment of accounts receivable; consumer financing; commercial bank loans for current operations; short-term open-account debts incurred in the ordinary course of business. 61 Marine Bank v. Weaver 455 U.S. 551 (1982): certificates of deposit should be securities but since there are other federal regulatory regimes to reduce risks, they are not considered securities; Bass v. Janney Montgomery Scott 210 F.3d 577 (2000): if the note is not collateralized and not subject to securities regulations it is most likely a security; if the note is secured or otherwise regulated by another regime it is most likely not a security. 62 925 F.Supp. 1270 (1996).

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swaps depended on market forces, not BT's entrepreneurial efforts. The swaps are not investment contracts.”63 The Court then applied the Reves test to determine whether the swaps could be considered “notes” pursuant to the 1933 Federal Securities Act. Bankers Trust Company aimed at making a profit by generating a fee and commission, while Procter & Gamble wanted, most of all, to reduce its funding costs. The Court believed these motives leaned more toward a commercial rather than an investment purpose, and yet it considered the first prong of the Reves test not to be determinative on its own. Applying the second prong of the test, the Court found that the swaps were not widely distributed, as they were customized for Procter & Gamble and could not be sold or traded to another counterparty without the agreement of Bankers trust Company. Balancing all remaining factors of the Reves test, the Court concluded that the swaps were not “notes” for purposes of the 1933 Securities Act.64 4. Regulating Intrinsic Separation of Ownership and Control in the United States Scholarship and financial regulators have begun to focus only recently on the increasing ease with which intrinsic separation of ownership and control can be achieved through financial derivatives. Numerous different regulatory responses have been proposed: a per se prohibition, the extension of the vote-buying doctrine, a more aggressive disclosure regime, and the application of fiduciary duties. In general, while the most effective regulatory response seems to be to adopt a corporate governance disclosure regime that includes all hypotheses of intrinsic separation, in the long run, this response may not yield the stabilizing outcome sought. The recent crisis has indeed shown that market mechanisms - as stimulated by disclosure obligations - may prove ineffective, especially when related to sophisticated financial instruments. The future legislative framework will thus have to posit an express recognition of the intrinsic separation of ownership and control. Furthermore, in the medium term it might well be necessary to distinguish and specify ex ante prohibitions in all those cases in which intrinsic separation may become undetectable and thus lead to hidden conflicts of interest. In this Section we examine only some of the different regulatory responses proposed in the United States vis-à-vis the increasing ease and diffusion of the intrinsic separation of ownership and control. Specifically, we will look at the possible extension of the vote buying doctrine, the corporate governance disclosure regime, as well as make some brief reference to the fiduciary relation paradigm.
63 64

Id. at 17-18. Further arguments regarding Federal Statutes and state law were also presented by the plaintiff. The Court concluded that the swaps were exempt from the Commodity Exchange Act and that Bankers’ Trust owed no fiduciary duty to Procter & Gamble Co. Moreover, Procter & Gamble Co.'s claims of negligent misrepresentation and negligence were considered redundant.

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4.1 The (New) Vote Buying Doctrine Hu and Black have concentrated extensively on the use of financial derivatives and its effects on corporate governance. They have called this phenomenon “new vote buying” because of its ability to decouple votes and economic ownership.65 The authors find over 80 cases of vote buying in over 20 countries, and distinguish two sub-categories. “Empty voting” occurs when votes are emptied of their economic stake, as a shareholder has the power to cast more votes then her actual ownership of the corporation. “Hidden (morphable) ownership” occurs when an investor appears to have fewer votes than those she can actually exercise, usually informally, through an intermediary. Considering the intrinsic separation of ownership and control as new votebuying and thus attempting to frame this new phenomenon within the traditional vote-buying doctrine may prove helpful if the abuse and fraud potentially perpetrated through certain forms of intrinsic separation can be prevented. Nonetheless, it is generally agreed that current State law on vote-buying does not apply to intrinsic separation. The leading modern case on vote buying remains Schreiber v. Carney, decided by the Delaware Court of Chancery in 1982.66 Before this case, the standard applicable to vote buying was uncertain. In general two principles could have applied: vote buying could have been considered illegal per se, if its object or purpose was to defraud or disenfranchise the other stockholders, or vote buying could have been considered illegal per se as a matter of public policy, as each shareholder should be entitled to rely upon the independent judgment of her fellow stockholders. The Schreiber case involved a loan by the corporation to a shareholder detaining virtual veto power on a merger, in order to render the operation economically viable for her. Chancellor Hartnett found that this constituted vote buying, although the agreement was not per se void because its object and purpose was to further the interest of all stockholders. The agreement was thus voidable, subject to a test for intrinsic fairness. Ultimately though, the ratification of the transaction by a majority of independent shareholders - after full disclosure precluded any further judicial inquiry. Vote buying has been defined as “a voting agreement supported by consideration personal to the stockholder, whereby the stockholder divorces his
65

See most recently H. T. C. HU, B. Black, The new vote buying: empty voting and hidden (morphable) ownership, cited, and H. T. C. HU, B. Black, Equity and debt decoupling and empty voting II: importance and extensions, cited. On the same subject, although apparently limited to options and their effects on corporate governance, S. Martin, F. Partnoy, Encumbered shares, cited, who define as ‘economically encumbered’ those shares held by stockholders who lack the otherwise homogenous incentives generated by pure share ownership (e.g. own shares plus short positions) and as ‘legally encumbered’ those shares held by stockholders who have a legal impediment to voting such shares (e.g. loaned out shares). 66 447 A.2d 17 (1982).

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discretionary voting power and votes, as directed by the offeror”.67 This definition focuses specifically on a vote-seller and a vote-buyer. Furthermore, a voting agreement is necessary, the shareholder must be given personal consideration, and she must vote as directed by the offeror. Intrinsic separation usually does not seem to contain the elements envisaged by the traditional vote-buying doctrine. Indeed it does not involve either a sale or a purchase of votes and there is usually no ex ante voting agreement.68 Due to the absence of a purchaser and a seller, no buyer can direct the voting of any seller. Vote lending, for example, by definition does not entail a purchase or a sale, but a loan. Common hedging transactions fall outside the scope of the definition for much the same reasons. The traditional vote-buying doctrine thus does not appear to provide a sufficient regulatory response to intrinsic separation of ownership and control. Nonetheless, one of the positive aspects of common law systems is that they react quickly to changes in the social and economic context.69 The specific nature of the Courts of Equity provides even greater flexibility to the legislative framework. Regulatory competition between federal and state legislators could also encourage an expansive interpretation of vote buying by State Courts.70 Future State law may thus adapt the traditional vote buying doctrine to prohibit or limit pernicious manifestations of the intrinsic separation of ownership and control, for example when a shareholder de facto carries a negative economic interest in an operation vis-à-vis her corporation. This expansive interpretation would require a shift from a formal approach to vote-buying, to a more substantial approach and does not seem unlikely.71 4.2 The Disclosure Regimes

Schreiber v. Carney, 447 A.2d 17, 23 (Del.Ch. 1982). Similarly, H. T. C. HU, B. Black, The new vote buying: empty voting and hidden (morphable) ownership, cited, at 862. 69 See the analysis provided by the ‘dynamic law and finance view’, T. Beck, A. Demirguc-Kunt, R. Levine, Law, Politics, and Finance, World Bank Policy Research Working Paper No. 2585, (April 12, 2001), available at SSRN: http://ssrn.com/abstract=269118. 70 See for example M. Roe, Delaware’s Competition, 117 Harv. L. Rev. 588, 2003; L. E. Strine, The new federalism of the American corporate governance system: preliminary reflections of two residents of one small state, 152 U. Pa. L. Rev. 953, 2003; R. S. Karmel, Realizing the dream of William O. Douglas – the Securities and Exchange Commission takes charge of corporate governance 30 Del. J. Corp. L. 79, 2005; M. W. Ott, Delaware strikes back: Newcastle partners and the fight for state corporate autonomy, 82 Ind. L. J. 159, 2007. 71 Justice Jack Jacobs has for example stated that “(s)hould an egregious case of empty voting abuse arise, that in turn may lead to legislation and to court decisions that would result in a new paradigm for share voting”, J. Jacobs, “Paradigm shifts in American Corporate Governance law: a quarter century of experience”, Corp. Governance Advisor, Sept.-Oct. 2007, at 1,4, quoted in H. T. C. HU, B. Black, Equity and debt decoupling and empty voting II: importance and extensions, cited.
68

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The United States disclosure regimes pursuant to the Federal Securities Acts are complex, contain at least four discrete ownership disclosure systems, and do not effectively address intrinsic separation of ownership and control.72 Hu and Black have found that “the current disclosure rules are highly complex, treat substantively identical positions inconsistently both across and within disclosure regimes, do not effectively address either empty voting or hidden (morphable) ownership, and for the most part do not cover share lending and borrowing.”73 By way of example, institutional money managers must disclose their holdings at the end of each quarter through Form 13F, to be filed with the Securities and Exchange Commission. Form 13F requires the disclosure of holdings of more than $100 million of securities appearing on a list prepared by the Securities and Exchange Commission. No disclosure is required for securities that are not publicly traded, short positions are not reported, and share lending is irrelevant. Positions acquired through the use of OTC derivatives also escape disclosure requirements. The academia that has focused on intrinsic separation of ownership and control has concentrated mainly on the disclosure regime.74 The main problem regulators must confront themselves with - in the immediate future - is believed to be transparency. Indeed capital markets will only operate efficiently if they are adequately informed. Moreover, greater transparency would allow regulators to ascertain the exact extent to which these new decoupling techniques are being used in the market place.75 Table 1 which follows, reproduces Table 3 prepared by Hu and Black in their discussion of current disclosure requirements with regard to decoupling using derivatives76.

This brief discussion is meant only to frame the background to the fundamental problem of transparency which is posed by the new intrinsic separation of ownership and control. We have often relied on the specific analysis provided in H. T. C. HU, B. Black, The new vote buying: empty voting and hidden (morphable) ownership, cited. 73 H. T. C. HU, B. Black, The new vote buying: empty voting and hidden (morphable) ownership, cited, at 876. 74 H. T. C. HU, B. Black, The new vote buying: empty voting and hidden (morphable) ownership, cited. 75 H. T. C. HU, B. Black, Equity and debt decoupling and empty voting II: importance and extensions, cited, at 654, have found that the public visibility of decoupling strategies - and maybe its use - has for the moment been far less in the United States than in Europe, although it is not clear why. 76 H. T. C. HU, B. Black, The new vote buying: empty voting and hidden (morphable) ownership, cited, ‘Table 3’, at 866.

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Table 1. Current Ownership Disclosure Requirements Relating to Intrinsic Separation

Source: Table 3, T. Hu, B. Black, “The new vote buying: empty voting and hidden (morphable) ownership”, 79 Cal. L. Rev. 811, 866, 2006.

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4.2.1 The Corporate Governance Disclosure Regime Section 13(d) of the Exchange Act sets forth the fundamental corporate governance disclosure regime. It provides that any person who is, directly or indirectly, beneficial owner of more than five percent of a class of securities must, within ten days after such acquisition, file a report with the issuer, the exchange where the security is traded, and the Securities and Exchange Commission. Furthermore, when two or more persons act as a partnership, limited partnership, syndicate, or other group for the purpose of acquiring, holding or disposing of securities of an issuer, such syndicate or group shall be deemed a ‘person’ pursuant to Section 13(d). The Securities and Exchange Commission has defined the notion of ‘beneficial owner’, pursuant to the Exchange Act. Indeed under Rule 13d-3 a beneficial owner of a security includes any person who, directly or indirectly, through any contract, arrangement, understanding, relationship, or otherwise has or shares: (1) voting power, which includes the power to vote or to direct the voting of such security, and/or (ii) investment power which includes the power to dispose or to direct the disposition of such security. Furthermore, Section 13(d) applies to any person who, directly or indirectly, creates or uses a trust, proxy, power of attorney, pooling arrangement or any other contract, arrangement or device with the purpose or effect of divesting such person of beneficial ownership or preventing the vesting of such beneficial ownership as part of a plan or scheme to evade the reporting requirements of section 13(d) or (g) of the Act. “Beneficial ownership” also includes the right to acquire beneficial ownership within sixty days, including through the exercise of an option or warrant. Moreover, Item 6 of Schedule 13D requires disclosure of any contract or arrangement relating to any securities of the issuer. This regime does not cover some cases of intrinsic separation through the use of financial derivatives. Short positions do not trigger disclosure requirements, while share lending might require disclosure.77 Equity swaps alone would not trigger disclosure requirements: it is generally believed that disclosure of cash-settled equity swap positions is not necessary.78 If an investor holds a stake in both an acquirer and a target, affecting its economic interest in the acquirer, this does not need to be disclosed as Item 6 of Schedule 13D requires
H. T. C. HU, B. Black, The new vote buying: empty voting and hidden (morphable) ownership, cited, at 868 argue that borrowing shares brings voting power and thus would probably trigger disclosure. 78 H. T. C. HU, B. Black, The new vote buying: empty voting and hidden (morphable) ownership, cited, at 868.
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disclosure of arrangements or contracts with respect to securities of the issuer, not of other companies. The recent CSX case tested the notion of beneficial ownership under Section 13 (d) of the Exchange Act, in the perspective of intrinsic separation of ownership and control, with specific reference to an equity swap context. The parties involved were CSX Corp., a publicly traded railway and transportation company on one side, and the Children’s Investment Fund and 3G Capital Partners, two hedge funds, on the other. At the time of the suit, each hedge fund owned about four percent of CSX Corp., as well as certain equity swap positions giving them a greater economic interest in CSX Corp. At the June 25, 2008 CSX Corp. annual meeting, the Children’s Investment Fund and 3G Capital Partners planned to elect their own nominees to the board and amend CSX Corp.’s by-laws. On March 17, 2008, CSX brought an action against the two hedge funds alleging violations of their reporting requirements under Section 13(d) of the Exchange Act, and thus seeking to enjoin their vote at the annual meeting. The case went to trial (Judge Kaplan) on May 21 and 22, 2008, and was decided on June 11, 2008. CSX Corp.’s position was that the power of influence the hedge funds had vis-à-vis the equity swap counterparties gave rise to beneficial ownership under Rule 13d-3(a). This Rule refers to the power to influence the disposition or the voting of securities. Indeed, CSX Corp. argued that the Children’s Investment Fund and 3G Capital Partners controlled the investment power relating to the securities underlying the equity swaps, as their counterparties in the equity swap would buy and sell the underlying securities - to hedge their positions - in accordance with the entering into and termination of the equity swap. Moreover, the swap counterparties had strong economic incentives to vote their shares in accordance with the hedge funds’ interests, in order to maintain and reinforce their client relationships. The Court found that the Children’s Investment Fund and 3G Capital Partners should have been deemed beneficial owners under Rule 13d-3(b) as they had engaged in some concerted action vis-à-vis CSX Corp. Moreover, Judge Kaplan seemed to recognize, albeit only incidenter tantum, the relevance of equity swaps under Rule 13d-3(a). An express change in the regulatory framework may nonetheless be necessary for such equity swaps transactions to be caught by the corporate governance disclosure regime. 4.2.2 Briefly on the Implementation in Italy European Transparency Directive and its

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The European Community recently adopted a Transparency Directive79, with a view to stimulating economic growth and development through more efficient and transparent capital markets80 and, inter alia, achieving a greater harmonization in the disclosure obligations regarding holdings in listed issuers.81 The Transparency Directive contains disclosure rules directly applicable to the intrinsic separation of ownership and control. Under Article 10, disclosure obligations apply to any natural person or legal entity entitled to acquire, dispose of, or exercise, voting rights in a number of different situations expressly set forth.82 Furthermore, pursuant to Article 13, disclosure obligations also apply to any natural person or legal entity holding, directly or indirectly, financial instruments that result in an entitlement to acquire, on such holder’s own initiative, under a formal agreement, shares to which voting rights are attached, already issued, of an issuer whose shares are admitted to trading on a regulated market. The Level 2 Directive enacted by the European Commission has further specified, under Article 11, that the holder of the financial instrument must enjoy, on maturity, either the unconditional right to acquire the underlying shares or the discretion as to his right to acquire such shares or not. Furthermore, a formal agreement means an agreement that is binding under the applicable law. The regime set forth in the Directive provides investors with conspicuous information regarding the ownership, quasi-ownership, and control structure of
Directive 2004/109/EC of the European Parliament and the European Council. Pursuant to the Lamfalussy method, the European Commission also adopted a level 2 Directive 2007/14/EC, and the Committee of European Securities Regulators (CESR) has performed some level 3 work. 80 Considerando 1. 81 Consideranda 5 and 18. 82 Specifically, “(a) voting rights held by a third party with whom that person or entity has concluded an agreement, which obliges them to adopt, by concerted exercise of the voting rights they hold, a lasting common policy towards the management of the issuer in question; (b) voting rights held by a third party under an agreement concluded with that person or entity providing for the temporary transfer for consideration of the voting rights in question; (c) voting rights attaching to shares which are lodged as collateral with that person or entity, provided the person or entity controls the voting rights and declares its intention of exercising them; (d) voting rights attaching to shares in which that person or entity has the life interest; (e) voting rights which are held, or may be exercised within the meaning of points (a) to (d), by an undertaking controlled by that person or entity; (f) voting rights attaching to shares deposited with that person or entity which the person or entity can exercise at its discretion in the absence of specific instructions from the shareholders; (g) voting rights held by a third party in its own name on behalf of that person or entity; (h) voting rights which that person or entity may exercise as a proxy where the person or entity can exercise the voting rights at its discretion in the absence of specific instructions from the shareholders.”
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listed companies. It is nonetheless debatable whether, for example, cash settled equity swaps such as the one enacted in the CSX case would be included in the disclosure regime under the Directive. Furthermore, disclosure obligations related to financial instruments only include those instruments resulting in the right to buy voting shares and not those resulting in the right to sell voting shares: investors are thus provided only a partial view. Italian disclosure obligations for material holdings in the voting share capital of listed companies are among the most rigorous in the European Community, as they require extensive and detailed disclosure of the ownership structure of individual companies and corporate groups. The disclosure obligations are set forth in Legislative Decree no. 58 of 1998 and CONSOB Regulation no. 11971. CONSOB has recently published a draft of new rules regarding disclosure obligations for material holdings in listed companies, with a view to implementing the Transparency Directive.83 Adoption of these new rules is not expected before the end of the first semester of 2009. As a result of these proposed rules, Italy appears to have adopted a more restrictive - and thus transparent - stance vis-à-vis the Directive, with specific regard to intrinsic separation of ownership and control. Specifically, the proposed rules consider, separately, both financial instruments that confer the right to buy and to sell shares of a company. Furthermore, in the proposed regime, financial instruments - expressly considered ‘potential holdings’ - will be counted separately from ‘effective holdings’, when ascertaining whether a shareholder’s interest has reached, exceeded, or reduced below relevant thresholds. The proposed Italian rules, even though more restrictive than the Directive, focus - inter alia - on financial instruments that result in the entitlement to buy or sell shares with voting rights. In its comment to the proposed implementing rules, CONSOB has stated that cash settled equity swaps may not fit within the current disclosure regime, but it will evaluate whether to extend disclosure requirements to these derivatives transactions when reconsidering rules regarding tender offers.84 4.3 The Fiduciary Duty of Loyalty
83

CONSOB proposed new rules implementing the Transparency Directive on July 7, 2008 and comments were due by September 20, 2008. 84 CONSOB’s Comment to its proposed new rules, available (in Italian) at http://www.consob.it/main/documenti/Regolamentazione/lavori_preparatori/consultazione_emitte nti_20080707.htm?hkeywords=&docid=5&page=0&hits=91, p. 129.

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The fiduciary duty of loyalty has traditionally been one of the fundamental pillars of corporate law and governance. What has been called ‘fiduciary rhetoric’ has often reminded academics and practitioners that: “[m]any forms of conduct permissible in a workaday world for those acting at arm's length, are forbidden to those bound by fiduciary ties. A trustee is held to something stricter than the morals of the market place. Not honesty alone, but the punctilio of an honor the most sensitive, is then the standard of behavior”.85 The importance and role of the fiduciary duty of loyalty in the corporate context has come under attack in recent years.86 Academia has acknowledged the importance for directors to pursue the interests of corporate constituencies other than the shareholders, in a stakeholder perspective.87 The intrinsic separation of ownership and control presents a fundamental problem of fiduciary duty of loyalty within the corporation, which goes beyond the traditional agency problem. Ultimately, intrinsic separation questions to whom the fiduciary duty of loyalty should be owed: by way of example, to the lender or to the borrower of shares; to the shareholder that has hedged her risk in the company or to the counterparty to the derivatives transaction. Furthermore, there may be cases where imposing directors’ fiduciary duties towards shareholders that have intrinsically separated ownership and control, is inefficient. Conversely, there may be cases where it is efficient to impose fiduciary duties on corporate directors vis-à-vis non-shareholders in the perspective of an intrinsic separation of ownership and control. In a sense, financial innovation may have eroded the fiduciary duty concept from within: the increased sophistication and possibility of large scale use of financial instruments may have indeed made the term ‘shareholder’ less meaningful, especially when thought of in connection with the idea of a residual claim.

85

This is of course the well-known citation by Benjamin Cardozo in Meinhard v. Salmon, 249 N.Y. 458 (1928), at 464. Most recently regarding this case, R. B. Thompson, The Story of Meinhard v. Salmon and Fiduciary Duty's Punctilio, Vanderbilt Public Law Research Paper No. 08-44, Available at SSRN: http://ssrn.com/abstract=1285705, October 2008. 86 See, inter alia, H. Marsh, Jr., Are Directors Trustees? Conflict of Interest and Corporate Morality, 22 Bus. Law. 35, 1966; A. Bulbulia & A. R. Pinto, Statutory Responses to Interested Directors' Transactions: A Watering Down of Fiduciary Standards?, 53 Notre Dame L. Rev. 201, 1977; F. H. Easterbrook, D. R. Fischel, Contract and Fiduciary Duty, 36 J.L. & Econ. 425, 1993. 87 In an economics perspective, L. Sacconi, A Social Contract Account for CSR as Extended Model of Corporate Governance (I): Rational Bargaining and Justification, Journal of Business Ethics, Special Issue on Social Contract Theories in Business Ethics, 259-281, 2006.

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Accordingly, some scholars have recently proposed to change one of the traditional terms of reference of fiduciary duties.88 In this view, directors of the corporation should no longer pursue the best interests of the shareholders, or the shareholders as a whole. Instead, directors should maximize “the value of the firm as a whole”.89 Similarly, the fiduciary duty of loyalty could give way in favor of a duty of good faith of corporate directors, with a view to imposing the obligation to balance the interests of the different constituencies. As one of the fundamental pillars of traditional corporate law and governance analysis, the fiduciary duty of loyalty and, as a consequence, the principal-agent paradigm, need to be reconsidered in light of the intrinsic separation of ownership and control. 5. Concluding Remarks The increasing ease with which financial instruments can be used to decouple voting rights and economic ownership, achieving an intrinsic separation of ownership and control at the individual level of each shareholder, disrupts traditional corporate governance analysis. By way of example, if a shareholder hedges its position, it may de facto no longer be a residual claimant of the corporation and yet still exercise the corresponding voting rights. Some authors have suggested, for example, to limit the voting rights of shareholders who hold more votes than economic ownership. 90 Nonetheless, it is generally agreed that “[o]ne possible explanation for the persistence of the one share/one vote rule, regardless of economic encumbrance, is that the process of deciding which shareholders should be entitled to receive a vote would be too costly under most circumstances”.91 Academia has also proposed per se prohibitions, the extension of the vote-buying doctrine, and the need to reconsider the fiduciary duty of loyalty. To date, disclosure has been the most acclaimed regulatory response to the intrinsic
S. Martin, F. Partnoy, “Encumbered shares”, cited; F. Partnoy, Financial innovation and corporate law, cited, at 811; F. Partnoy, Adding derivatives to the corporate law mix, cited, at 603, “The put option and call option perspectives demonstrate that the legal rule could be the opposite: corporate law could assign control to debt and force equity to bargain for contractual protection”. 89 D. G. Baird, M. T. Henderson, Other People’s Money, 60 Stan. L. Rev. 1309, 2007, at 1311 and 1313. 90 S. Martin, F. Partnoy, “Encumbered shares”, cited, at 793 “At a minimum, shareholders with substantial short positions should not be entitled to vote…”. In general the authors argue that shareholders are not necessarily residual claimants, and thus under certain conditions it may be more efficient if votes are given to actual economic owners. 91 S. Martin, F. Partnoy, “Encumbered shares”, cited, at 793.
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separation of ownership and control92: the fundamental principle seems to remain that “[s]unlight is said to be the best of disinfectants; electric light the most efficient policeman”.93 Traditional theory asserts that an opaque system of corporate governance facilitates the extraction of private benefits of control. Accordingly, investor protection through disclosure obligations pursues the general aim of stimulating capital market development and thus, in turn, economic growth.94 The law and finance literature has indeed shown a correlation between investor protection and capital market development.95 The regulatory focus on disclosure - and generally on financial market information - facilitates the operation of financial market mechanisms.96 Moreover, an effective disclosure regime stimulates greater competition between the banking system and the stock market.97 Greater transparency would allow market mechanisms and monitoring to operate effectively, reducing the risk of fraudulent activity through derivatives. Indeed share prices would discount any abnormal or fraudulent manifestations of the intrinsic separation of ownership and control. Reputation sanctions and the

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This has for example been the Swiss response: prior to 2007 disclosure rules were similar to current U.S. rules. The Swiss federal Banking Commission then amended its rules, on July 1 2007, to require disclosure of cash-settled call options. New legislation was also adopted on December 1 2007, to reduce the disclosure threshold to 3% and require disclosure of holdings of any financial product that would enable the holder to acquire voting rights with respect to a potential public takeover. Regulators have acted similarly in the United Kingdom and in Hong Kong. For specific reference see H. T. C. HU, B. Black, The new vote buying: empty voting and hidden (morphable) ownership, cited; H. T. C. HU, B. Black, Equity and debt decoupling and empty voting II: importance and extensions, cited, at 684. 93 L. D. Brandeis, Other People’s Money and How The Bankers Use It, 1914, reprint 2003, at 92. 94 A. Demirguç-Kunt, R. Levine, Financial Structure and Economic Growth, MIT, 2001. 95 For example R. La Porta, F. Lopez-de-Silanes, A. Shleifer, R. W. Vishny Law and Finance, cited. 96 The theory is of course well-known. See E. F. Fama Efficient Capital Markets: A Review of Theory and Empirical Work in 25 J. Fin. 2, Papers and Proceedings of the Twenty-Eighth Annual Meeting of the American Finance Association New York, N.Y. December, 28-30, 1969, at 383417. 97 I am referring to the ongoing debate on the convergence of different economic and legal models as well as corporate governance systems. The literature on the topic has become extremely vast. See for example A. R. Pinto, G. Visentini, The Legal Basis of Corporate Governance in Publicly Held Corporations, A Comparative Approach, cited; G. Visentini, Compatibility and Competition Between European and American Corporate Governance: Which Model of Capitalism?, cited; R.A.G. Monks, N. Minow, Corporate Governance, Wiley, 2003; T. Clarke, Theories of corporate governance. The philosophical foundations of corporate governance, cited; R. Kraakman, P. Davies, H. Hansmann, G. Hertig, K. Hopt, H. Kanda, E. Rock The Anatomy of Corporate law: A Comparative and Functional Approach, cited.

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media would also have a role in policing the efficient functioning of corporate governance.98 Furthermore, increased compliance costs would probably be offset by the advantages of a transparent stock market with high investor confidence and trust.99 This new disclosure policy could increase the bonding effect from cross listing in the United States, and may actually attract foreign company listings.100 Nonetheless, the underlying assumption of this proposed disclosuredriven regulatory stance is that the market - i.e., the qualified investors on it will be able to absorb, evaluate and process the information provided. Indeed this regulatory response moves within the same regulatory paradigm as current regulation; in essence the same paradigm that demonstrated its shortfalls in the recent financial crisis. In light of these considerations, a targeted corporate governance disclosure regime may well be the best regulatory response to intrinsic separation in the short term. However, in a medium term perspective, it will also be necessary to re-think corporate governance from some of its fundamental principles. New corporate governance analysis will have to consider explicitly the intrinsic separation of ownership and control. It will have to focus on how the
See for example M. M. Blair, L. A. Stout, Trust, Trustworthiness, and the Behavioral Foundations of Corporate Law, http://papers.ssrn.com/paper.taf?abstract_id=241403, 2000; J. C. Coffee, Jr., Do Norms Matter?: A Cross-Country Examination of the Private Benefits of Control, http://papers.ssrn.com/paper.taf?abstract_id=257613, 2001; A. Dyck, L. Zingales The Corporate Governance Role of the Media, CRSP Working Paper No. 543, 2002; A. Dyck e L. Zingales Private Benefits of Control: An International Comparison, 59 J. Fin., 2, 2004; R. H: McAdams, E. B. Rasmusen, Norms in law and economics, papers.ssrn.com/sol3/papers.cfm?abstract_id=580843, 2004; T. Frankel, Court of Law and Court of Public Opinion: Symbiotic Regulation of the Corporate Management Duty of Care, Boston Univ. School of Law Working Paper No. 07-03, 2007; H. Hong, M. Kacperczyk, The price of sin: the effects of social norms on markets, papers.ssrn.com/sol3/papers.cfm?abstract_id=766465, 2007. 99 There has been a lively debate on the effects of the increased compliance costs imposed by the Sarbanes Oxley Act, on the listing of foreign corporations. Most recently, C. Doidge, G. A. Karolyi, R. M. Stulz, Has New York become less competitive in global markets? Evaluating foreign listing choices over time, 2007. L. Zingales Is the U.S. Capital Market Losing its Competitive Edge?, ECGI - Finance Working Paper No. 192/2007, available at SSRN: http://ssrn.com/abstract=1028701, 2007. 100 A. Karolyi, Why Do Companies List Shares Abroad? A Survey of the Evidence and its Managerial Implications, Financial Markets, Institutions & Instruments 7, New York University Salomon Center, 1998; M. Pagano, A. A. Röell, J. Zechner, The Geography of Equity Listing: Why Do Companies List Abroad?, 57 J. Fin., 6, 2002; C. G. Doidge, A. Karolyi, K. V. Lins, D. P. Miller, R. M. Stulz, Private Benefits of Control, Ownership, and the Cross-listing Decision, available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=668424, 2006.
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move away from, or combination of, the functional and intrinsic separation of ownership and control within the corporation, affect theory, incentives, policy considerations and thus, most importantly, regulatory approach.

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