Financial Innovation and Governance Mechanisms

Financial innovation has fundamental implications for the key substantive and information-based mechanisms of corporate governance. My new article, Financial Innovation and Governance Mechanisms: The Evolution of Decoupling and Transparency (forthcoming in Business Lawyer, Spring 2015) focuses on two phenomena: “decoupling” (e.g., “empty voting,” “empty crediting,” and “hidden [morphable] ownership”) and the structural transparency challenges posed by financial innovation (and by the primary governmental response to such challenges). In decoupling, much has happened since the 2006-2008 series of sole- and co-authored articles (generally with Bernard Black and one with Jay Westbrook) developed and refined the pertinent analytical framework. In transparency, the analytical framework for “information,” developed and refined in 2012-2014, can contribute not only to the comprehensive new SEC “disclosure effectiveness” initiative but also to resolving complications arising from the creation of a new parallel public disclosure system—the first new system since the creation of the SEC.

“Decoupling” undermines classic understandings of the allocation of voting rights among shareholders (e.g., “empty voters”), of the control rights of debtholders (e.g., “empty creditors” and “hidden interests”/”hidden non-interests”), and of takeover practices (e.g., “hidden (morphable) ownership” to avoid Section 13(d) 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 insufficient to capture highly complex objective realities, including 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 creation of the SEC—also creates difficulties. This new parallel public disclosure system developed by bank regulators and applicable to major financial institutions is not directed primarily at the familiar transparency ends of investor protection and market efficiency.

As starting points, the 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 opinion in the Supreme Court of British Columbia, involving perhaps the most complicated public example of decoupling to date. The analytical framework’s “empty voting 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 court—and the pressing need for more action by the SEC. At the time the debt decoupling research was introduced, available evidence was limited as to the significance of empty creditors and of hidden interests/hidden non-interests in bankruptcy proceedings and otherwise. This Article helps address the 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 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 parallel regulator universes with divergent ends and means—is unsustainable in the long run and implicates 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.

The full article is available for download here.