Governance and the Decoupling of Debt and Equity: The SEC Moves

Henry T. C. Hu is the Allan Shivers Chair in the Law of Banking and Finance at the University of Texas Law School.  This post is based on his recent paper, forthcoming in Capital Markets Law Journal, and is part of the Delaware law series; links to other posts in the series are available here.

“Decoupling”—the unbundling of the rights and obligations of equity and debt through derivatives and other means—has posed unique challenges for corporate and debt governance. Corporate governance mechanisms, such as shareholder voting and blockholder disclosure, have faced “empty voting with negative economic ownership” and “hidden (morphable) ownership” issues. Debtor-creditor contract-based interactions have faced “empty crediting with negative economic interest,” “hidden interest,” and “hidden non-interest” issues. In 2006, the initial version of an analytical framework for decoupling was introduced. In that decade, foreign regulators, Delaware and other substantive law authorities, and private ordering started responding.

In 2021 and 2022, the Securities and Exchange Commission (SEC) voted out proposals directed at decoupling, as well as other proposals that may affect decoupling. My article, Governance and the Decoupling of Debt and Equity: The SEC Moves (forthcoming in Capital Markets Law Journal, 2022), is the first work to: (1) analyze the SEC proposals as a whole, propose significant changes, and offer ideas for enhancing the proffered cost-benefit analysis (CBA); and (2) situate the prospective SEC role with the roles that substantive law authorities and private ordering are already playing.

The SEC Proposals and the CBA

The Article urges changes to the SEC proposals, some of which are described in this post. It also offers two new avenues for enhancing the robustness of the SEC’s CBA against possible challenges in the D.C. Circuit.

The “hidden (morphable) ownership” strategy refers to the use of holdings of cash-settled synthetic equity to avoid large blockholder disclosure requirements of the Exchange Act Section 13(d) variety. Section 766 of the Dodd-Frank Act effectively prevents the SEC from requiring that holdings of cash-settled equity swaps—the key synthetic equity historically used in the strategy—be counted toward the Schedule 13D 5% filing threshold. As a result, the SEC proposed a complex, bifurcated regulatory architecture consisting of two discordant disclosure regimes for synthetic equity holdings. One regime is for cash-settled synthetic equity other than cash-settled equity swaps (per a revised Schedule 13D proposed in SEC Release 33-11030). This regime is designed to address this decoupling strategy, with a filing date requirement set at five days intended to strike the right balance between promoting market efficiency/transparency and incentivizing shareholder activism. Technically, proposed Schedule 13D continues to use the 5% filing threshold; however, the proposed, highly expansive definition of “group” affects matters considerably. The regime for holdings of cash-settled equity swaps (per a new Schedule 10B proposed in SEC Release 34-93784) is not designed to address this decoupling strategy or corporate governance generally. Instead, largely animated by the Archegos debacle, the Schedule 10B regime’s mindset centered on financial stability and fraud and manipulation. Based on this mindset, Schedule 10B has a one-day filing requirement. Filing would be triggered by, e.g., a cash-settled equity swap position in a notional amount of $300,000,000.

The proposed SEC approach to synthetic equity disclosure has two core weaknesses. First, the “situs” of cash-settled equity swaps within the architecture and the “silo” mindset that resulted in the associated one-day filing requirement would upset the vital balance between enhancing market transparency/efficiency and incentivizing shareholder activism. Second, unjustified asymmetries in regulatory treatment as to thresholds and filing dates would arise across categories of synthetic equity holdings and between synthetic equity holdings and direct equity holdings. Direct and certain synthetic equity holdings face a Schedule 13D 5% threshold. Cash-settled equity swap holdings of $300,000,000—a mere 1% of a company at the median capitalization of the S&P 500—would trigger Schedule 10B.

The Article offers a partial solution that, despite Dodd-Frank Section 766, would better incentivize activism and reduce the asymmetries. The solution is, for cash-settled equity swaps, that the filing date and threshold requirements for the proposed Schedule 10B should incorporate by reference the filing date and threshold requirements of the proposed Schedule 13D.

Another set of changes the Article proposes relates to the SEC’s primary effort to address “empty creditors with negative economic interest” (aka “net short” creditors). In this connection, the SEC alluded to a media story on Windstream/Aurelius. However, the Article shows that the proposed disclosure requirements could be triggered when empty crediting is impossible even in theory. Merely holding credit default swaps (CDSs) in the requisite amount could trigger filing, without any concurrent debt or equity holdings. This aspect of the requirements ignores the necessary conjunction of troublesome incentives from certain CDS holdings with the power flowing from the control rights associated with debt or equity holdings. The Article proposes changes.

The SEC’s proposals are susceptible to CBA-based challenges. For example, broadly speaking, some have questioned the existence of the hidden (morphable) ownership phenomenon. The Article shows how judicial findings in certain litigation involving U.S. persons or U.S. courts can help address this claim. Similarly, the SEC should consider why and how so many foreign jurisdictions—indeed, all the ones examined (Australia, Canada, France, Germany, Hong Kong, Ireland, Italy, Netherlands, Switzerland, and the United Kingdom)—have addressed hidden (morphable) ownership.

The Roles of Substantive Law Authorities, Private Ordering, and the SEC

Substantive-law-centered authorities, such as the Delaware legislature and courts, are addressing empty voting issues. Delaware courts have been receptive to the analytical framework for decoupling, as evident in the 2010 Delaware Supreme Court Crown Emak case (992 A.2d 377 (Del. 2010)) evaluating a third-party vote buying agreement based on the alignment of economic interest and voting interests. More recent cases include this year’s Vice Chancellor Laster opinion in Hawkins v. Daniels, 273 A.3d 792 (Del. Ch. 2022), on whether an irrevocable proxy arrangement ran with the sale of a corporation’s majority shares. The most dramatic example of judicial intervention to curb the voting rights of an empty voter with negative economic ownership occurred in British Columbia, in the proxy fight between TELUS Communications and hedge fund Mason Capital Management. TELUS Corporation (re), 2012 BCSC 1919 (2012).

Private ordering has responded to equity and debt decoupling. The rise of “second generation” advance notice bylaws and poison pills has been directly attributed to concerns about equity decoupling. As for debt decoupling, the use of “net short” provisions in debt agreements increased following Windstream/Aurelius.

Because of externalities and other reasons, private ordering alone is insufficient to address empty crediting. The SEC has a vital role. As for empty voting, the SEC can help courts and private ordering in identifying the presence and extent of empty voting.

Conclusion

Properly addressing decoupling is a difficult task. The issues are complex: corporate governance, investor protection, market transparency, financial stability, and other considerations can run in different directions. The techniques used for decoupling are constantly evolving, and often in ways opaque to outside observers. The SEC is moving toward the role it must play. I am confident that the SEC is up to the task.

The complete article is available here.

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