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

Abstract

“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, including those related to shareholder voting and blockholder disclosure in control contests, have faced “empty voting with negative economic ownership” and “hidden (morphable) ownership” issues. Classic contract-based interactions of debtors and creditors have faced “empty crediting with negative economic interest,” “hidden interest,” and “hidden non-interest” issues. In 2006, an analytical framework for decoupling was introduced. Overseas disclosure regulators, Delaware and other substantive law authorities, and private ordering started responding years ago.

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. Using the analytical framework, this Article is the first to: (1) analyze the SEC proposals as a whole; and (2) consider how the possible SEC role relates to the roles already played by substantive law authorities and private ordering.

As for (1), the Article proposes a variety of fundamental changes to the proposals and shows how such changes as well as judicial findings and actions of foreign jurisdictions can enhance the robustness of the SEC’s cost-benefit analysis to potential court challenges.

One set of changes the Article proposes is regarding two SEC proposals relating to the hidden (morphable) ownership strategy for avoiding blockholder disclosure rules under Section 13(d) of the Securities Exchange Act of 1934. Because of Dodd-Frank Act Section 766 “security-based swap” constraints, the SEC proposed a bifurcated disclosure architecture, one for holdings of cash-settled equity swaps (aka total return equity swaps) (per a new Schedule 10B) and one for holdings of other cash-settled synthetic equity (per a revised Schedule 13D). The proposed architecture has two core weaknesses. First, the “situs” of cash-settled equity swaps within the architecture and the architecture’s “silo” mindset would upset the vital balance between enhancing market transparency and efficiency and incentivizing shareholder activism important to corporate governance. Second, startling, unjustified asymmetries in regulatory treatment would arise across categories of synthetic equity and between synthetic equity and direct equity. The Article offers a solution that, despite Dodd-Frank Section 766, would better incentivize activism and reduce the asymmetries.

Another set of changes the Article proposes is regarding an SEC proposal directed at empty creditors with negative economic interest. The Article shows, for example, that the proposed disclosure requirements could be triggered when empty crediting is impossible even in theory. This is because merely holding credit default swaps in the requisite amount could require disclosure even absent any holdings of the debt or equity that carry with them the control rights essential to undermining the company’s viability. The Article proposes changes.

The SEC’s proposals are susceptible to litigation on cost-benefit grounds. For example, broadly speaking, some market participants question the existence of the hidden (morphable) ownership phenomenon. The Article shows how judicial findings in related litigation involving U.S. persons or U.S. courts can help address this claim. Similarly, it shows that all foreign jurisdictions examined (Australia, Canada, France, Germany, Hong Kong, Ireland, Italy, Netherlands, Switzerland, and the United Kingdom) have adopted measures to address hidden (morphable) ownership.

As for (2), the Article begins by showing that Delaware and other state substantive law authorities have used the analytical framework and exhibited aversion to empty voting. It also shows how private ordering is addressing both debt decoupling (via, e.g., “net short” provisions in debt agreements) and equity decoupling (via, e.g., “morphable ownership” provisions in poison pills). Certain SEC proposals are potentially helpful to such Delaware and private ordering efforts.

Keywords: Archegos, banks, corporate governance, credit default swaps, decoupling, Delaware, derivatives, disclosure, equity swaps, empty voting, empty creditors, hedge funds, hidden ownership, net short creditors, Schedule 10B, Schedule 13D, SEC, securities regulation, shareholder activism, total return swap

JEL Classification: G01, G14, G15, G18, G21, G23, G24, G28, G32, G33, G34, G38, K20, K22, K23