Equity Swaps and Schedule 13D

Abstract:     
In a series of articles with Henry Hu (Hu and Black, 2006, 2007, 2008a, 2008b), I explore the emerging practice of equity decoupling, including both "empty voting" (voting while holding greater voting power than economic ownership) and "hidden (morphable) ownership" (economic ownership which remains undisclosed under current disclosure rules, but can often quickly morph to include voting ownership as well). These forms of decoupling pose risks to the one-share-one-vote paradigm that underlies conventional U.S. models of corporate governance and shareholder voting. We argue that an initial U.S. regulatory response to equity decoupling should be to expand the principal shareholder ownership disclosure rules (Schedule 13D, Schedule 13G, and Form 13F) to cover both economic and voting ownership.

I argue here that rulemaking is the right way to go. An effort by the courts or the SEC to stretch the concept of beneficial ownership under the current 13D rules, to cover equity swaps would be a mistake. Equity swaps alone clearly do not convey beneficial ownership over shares. The case for thinking that equity swaps might convey beneficial ownership relies instead on a complex set of market practices which surround the equity swaps business.. However, these market practices are evolving, and will surely shift in response to whatever the courts or the SEC do. They offer an unstable basis for finding beneficial ownership. Moreover, while the distinction between economic and voting ownership is increasingly unsatisfactory as a basis for regulation, it is an intelligible basis, reflected in a number of SEC rules. Twisting 13(d) to capture equity swaps will produce an unintelligible, inconsistent line, which will soon be evaded.

This paper takes an unusual form. I first introduce, and then present, a letter I wrote to the SEC in connection with ongoing litigation between CSX, which finds itself the target of activist hedge funds, and the hedge funds, which initially acquired equity swaps and today hold a combination of shares and equity swaps.

Conflict disclosure: I was compensated by The Children's Investment Fund and 3G Capital Partners for preparing the letter to the SEC.

Keywords: equity decoupling, equity swaps, hidden ownership, Schedule 13D

JEL Classifications: G18, G32, G34, K22

Working Paper Series