Introduction by CNBC co-anchor Becky Quick
“When you look at what’s been happening over the last couple of years in Washington and on Wall Street, there’s been a huge turn and there’s been a shift at the Securities and Exchange Commission as well. [SEC Chairman] Mary Schapiro came in and really decided that the SEC needs to get ahead of Wall Street, and one of the key ways that she did that was to create a new division devoted to risk and financial innovation. It was the first new division created in almost 40 years. And Schapiro was incredibly intelligent in who she reached out to in this respect, because she found someone who is one of the leading scholars in the country in both law and the financial markets. She also identified someone who first started warning us about derivatives and the danger that they pose back in 1993—pointing out that these things can kill. It’s a message we all wish we had listened to sooner. Henry Hu is an incredible scholar who has built up this new division. He joins us tonight to talk about what that process and the goals are. The key thing he’s changing is the way the SEC looks at things. It’s not just a division of lawyers— it’s also economists and others who think about things differently.”
Henry Hu
First, the standard disclaimer: the views that I express tonight are merely my own, not necessarily those of the SEC, individual commissioners, or my colleagues at the Division of Risk, Strategy, and Financial Innovation or elsewhere at the SEC. This disclaimer takes on particular resonance, as my focus will be “Financial Innovation and Corporate Governance” and virtually everything that I say tonight is based on my pre-SEC academic research.
Directors are fully aware of the heightened expectations that shareholders, the Delaware courts, and others now have for the corporate board. Directors may be less aware of the challenges that I believe modern financial innovation poses to effective governance.
In an article published in the Yale Law Journal in 1993, I suggested that a new process of financial innovation had emerged, and that the particular characteristics of this process can cause even the most “sophisticated” financial institutions to make mistakes as to derivatives and other complex financial products. That article, “Misunderstood Derivatives” focused on a number of structural factors, including cognitive biases (such as the tendency to ignore low probability/catastrophic events) and the peculiarities of financial “science.” Models in financial science differ from those in physics in ways highly pertinent to market participants and to regulators. The 1993 article also emphasized such factors as the incentive structure sometimes found in the derivatives industry. The incentive structure can be highly asymmetric: True success—or the perception by superiors of success—could mean lifetime wealth. Failure or perceived failure may normally result, at most, in job and reputational losses. This “lottery ticket” may lead to excessive risk-taking, especially if senior management or the board do not really understand the products or if the really big risk exposures occur years after entering into the transaction. These “negatives” may surface long after the rocket scientist is gone.
But tonight, I’d like to focus instead on one particular type of financial innovation process. Although perhaps less well-known, the issue that I want to focus on tonight is one that I think poses challenges to corporate governance and what can be dubbed “debt governance.”: It’s the phenomenon I’ve termed “decoupling.” In my view, decoupling affects some of the core mechanisms of our economic and financial system.
The foundational architecture of the corporation used to be pretty clear. Ownership of equity conveyed a package of economic rights and voting rights, as well as many other kinds of rights; then you had certain obligations.
Similarly, ownership of debt conveyed a package of rights and obligations, including economic rights like the right to principal and interest, control rights given in a loan agreement or a bond indenture and other legal rights such as those flowing from bankruptcy, corporate and securities law, as well as obligations.
That is, classic understandings of “equity” and “debt” contemplated bundled packages of rights and obligations. Today, however, because of the derivatives revolution, the rise of hedge funds and other factors, you can, as a practical matter, often break up these packages quickly, on a massive scale and possibly sometimes in secret.
Consider, first, the equity side, which is a little bit simpler than the debt side. Although there are many varieties, let me just focus on one particular type of “equity decoupling”—the separation of the voting rights associated with equity from the usual economic interest.
In almost all corporations, there is a proportional relationship between the number of shares held and shareholder voting rights. That is, one share, one vote. And existing theories of corporate governance are generally based on this coupling of economic interest and voting power.
From an instrumental standpoint, this generally makes sense. The more shares you have, the more incentive you have to monitor management. And from a legitimacy standpoint, the more shares you have-—the greater your ownership stake-—the more control you should arguably have over what is, in essence, your property.
Today, however, the voting rights you have no longer need to depend on the economic stake. There are lots of ways to do this. Say a hedge fund happens to own a million shares of your company, and thus, has a million votes. But, at the same time, the fund holds the million shares, the fund holds the short side of equity derivatives to eliminate all or most of the economic exposure to that company. So that hedge fund, which might have the highest number of votes in your company, could have little or no economic interest in your company.
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