Derivatives Trading and Negative Voting

Holger Spamann is an assistant professor at Harvard Law School.

Securities regulators, practitioners, and legal commentators worry that derivatives may provide shareholders and creditors incentives to destroy value in their corporation (references here). The basic concern is that if shareholders or creditors own a sufficient amount of off-setting derivatives such as put options or credit default swaps (CDS), any losses on their shares or debt will be more than off-set by the corresponding gains on their derivatives (“over-hedging”). In this case, shareholders and creditors benefit by using the control rights inherent in their shares or debt to reduce the corporation’s value (“negative voting”).

An important question that is generally not considered, however, is whether it would ever be profitable for shareholders or creditors to acquire so many derivatives in the first place. After all, any gains to shareholders and creditors come at the expense of their counterparties on their derivative contracts. These counterparties would therefore prefer not to sell the derivatives, or only at a price that compensates them for the future payouts, thus depriving shareholders and creditors of any profit in the overall scheme. This is an important difference from the related problem of vote-buying, which forces (dispersed) counterparties into a collective action problem approaching a prisoners’ dilemma. By contrast, derivative counterparties have the option simply to abstain from the transaction.

In my recently posted paper on Derivatives Trading and Negative Voting, I argue that over-hedging and negative voting with derivatives can nevertheless be profitable with a minimal and realistic degree of investor heterogeneity and asymmetric information. The paper presents a model of parallel trading of corporate securities (shares, bonds) and derivatives in which a large, strategic trader interacts with liquidity traders and competitive market makers. The key assumptions are that market makers cannot observe the large trader’s orders directly, and cannot infer them from aggregate order flow because of fluctuating liquidity trades. In this case, market makers cannot predict how control rights will be exercised if the large trader only over-hedges some of the time. Prices will reflect some probability of negative voting, allowing the large trader to benefit from its private information about its own trades and expected vote. In effect, the large trader is exploiting private information about payoff uncertainty that the large trader itself creates. The large trader benefits at the expense of liquidity traders, whose trades provide camouflage to the large trader.

The assumption that counterparties cannot observe the large trader’s positions and hence its incentives for exercising control rights seems to capture many situations in real world derivative markets. This is obvious to the extent derivatives are traded on an exchange and centrally cleared. Such anonymous trading has long been the standard for equity options and is now generally mandated by the Dodd-Frank Act. But even when trading occurs over-the-counter (OTC), traders’ positions and strategies are confidential and remain largely hidden from their counterparties. To be sure, any market participant in an OTC market knows the identity of it direct counterparty, at least post-trade. But since dealers routinely enter into chains of hedging transactions, the ultimate buyer of protection will usually be unaware of the identity of the ultimate seller, and vice versa. In addition, investors can conceal their overall position even from their direct counterparties by splitting trades among many of them.

Economic and legal constraints curtail over-hedging and negative voting. In particular, it seems implausible that anyone could acquire and over-hedge a voting majority (51%) of a corporation’s shares or publicly traded debt. Such quantities of shares/debt and derivatives may not even be available on the market, and if they were, could hardly be acquired in secret and without strongly affecting prices. For shares, acquiring such quantities would also trigger disclosure and other obligations under corporate and securities laws and, in most U.S. corporations, the “poison pill.”

Many relevant decisions, however, can be affected by much smaller percentages of shares or debt. One possibility is that an over-hedged shareholder or creditor joins forces with some other constituency pursuing interests other than maximizing share or debt value, such as a corporate insider. More importantly, some corporate decisions, notably out-of-bankruptcy restructurings and freeze-out mergers, provide blocking power to relatively small minorities.

Ultimately, the relevance of the problem identified here is an empirical question. Empirical work on negative voting has been severely limited, however, by the lack of investor-level position and voting data. Papers that have looked at correlations between the availability of CDS and corporate bankruptcy have found mixed results, depending on the time period studied and the construction of the sample. [1] In the future, regulators may gain access to the requisite data for more probative empirical studies. In the meantime, gaining a firm theoretical understanding of the question remains of pressing importance.

The full paper is available for download here.


[1] See, e.g., Stavros Peristiani & Vanessa Savino, Are Credit Default Swaps Associated with Higher Corporate Defaults?, Federal Reserve Bank of New York Staff Report no. 494 (May 2011); Mascia Bedendo, Lara Cathcart, & Lina El-Jahel, In- and Out-of-Court Debt Restructuring in the Presence of Credit Default Swaps, working paper (March 2012), Bocconi University and Imperial College, available at
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