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CHINA LEGAL SCIENCE 2019年第4期 | 我国金融衍生品交易构造下股权利益分离问题研究
日期:20-03-28 来源:CHINA LEGAL SCIENCE 2019年第4期 作者:zzs

RESEARCH ON THE SEPARATION OF SHAREHOLDER INTERESTS IN DERIVATIVES AREA AND ITS REGULATION IN CHINA


Xu Ke


I. INTRODUCTION


The innovation of financial instruments keeps bringing challenges to the market and regulation systems. Derivatives create a variety of economic benefits and obligations which may influence the traditional legal concept in commercial and financial sectors. Although some primordial derivatives originated in the commercial practices, the nature of derivatives has raised intensive discussion in the legal history. The function of the derivatives is so broad that in the modern market there are so many complex categories of assets portfolios embedded with derivatives. What is the purpose of derivative transactions, risk hedging or speculation? People may blame derivatives as a measure of over-speculation that increases the volatility of the financial market. Derivatives could be detrimental to the market because of the high risks associated with speculation activities and the element of gambling may not be entirely eradicated. However, on the other hand, derivatives can also influence corporate governance. 


The principle of ‘one share, one vote’ lies under the fundamental concept of shareholder’s right and constitutes the basic understanding of corporate governance. This notion indicates the equilibrium of economic interest and control right inside a certain corporation. However, assets portfolio embedded with particular derivatives may lead to divergence from this principal line and raise the problem of empty voting and hidden ownership. Hidden ownership which is the economic interest which one is entitled to exceed his governing interest while the empty voting represents the reverse situation. With this disequilibrium, the economic interest is separated from the control right that the assets holders’ incentives deviate from the ordinary shareholders (for the empty voting) or financial investors (for the hidden ownership). These potential conflicts of interests raise problems to corporate governance and financial regulation. This article focuses on issues relating to financial derivatives in theory as well as the practical questions raised to China’s financial regulation system. 


The second part of this article discusses the concept of empty voting and hidden ownership. It introduces a variety of derivatives portfolios which could cause the disequilibrium and separation. The third part begins with typical cases about the practice of empty voting and hidden ownership in market that pose actual threat to the present legal system and potential defect in the regulations. The fourth part uses practices in China as an example to demonstrate the risk of the disequilibrium and separation of interests in an extreme circumstance. 


China’s highly regulated financial market and its special regulation system give rise to some particular issues. In China, those who trade derivatives may have motivations to circumvent some specific regulation regime and manipulate stock speculations. To maintain the whole system stability, the principle of reducing the leverage persists in the market. Currently, the main purpose of Chinese financial regulation is to reduce the debt rate gradually without piercing the underlying bubble. That is to say, there are two conflicting goals of Chinese financial policies: reducing the leverage while keeping the prices of assets. To achieve these goals, the regulatory authorities have imposed rigorous restrictions on providing credit to financial speculation. Using derivatives portfolios to circumvent these regulatory requirements are prevalent in the market. Thus, the interaction between the regulators and derivatives users are much more different from what happened in other scenarios. This research uses observations on China’s practice to illustrate the general issues about derivatives and the particular problems about China’s financial regime. 


The fifth part of this article outlines current regulation system of the empty voting and hidden ownership derivatives across various jurisprudence, which may help to figure out defects of current regulations and shed light on possible reforms of China’s regulative rules and policies.


II. THE FEASIBLE FORMS OF EMPTY VOTING AND HIDDEN OWNERSHIP


A. The ‘One Share, One Vote’ Assumption and the Fundamental Mechanism in a Corporate


In a general corporation, ‘one share, one vote’ is the basic assumption. This assumption contains two principles concerning the corporate governance. Firstly, it implies the equality of capital. Every shareholder gets equal access to the control of the company according to their contribution to share capital. Secondly, it ensures the incentive to shareholders’ decision-making process. Basically, the shareholders have the residual claim right and bear the risk of operation. To enable one who enjoys the economic interests to exercise control over the operation of the company on a pro rata basis is a rational management arrangement. 


Any deviation from this may lead to a conflict of interests in a corporate. If a shareholder has the priority on the shares he holds, he may take advantage and exploit the common shareholders. The majority shareholders have the privilege over the minority of shareholders. Thus, the control right is always worth a premium when being sold. How to reduce the cost of waste and exploitation inside a corporation is the main topic of corporate governance and always the core issue in business practice. Even though it is an everlasting issue in a business organization, the potential unbalances between shareholders should be restrained. Hence, treating the shareholder’s right differently is rather sensitive and usually triggers the most restrictive scrutiny.


B. The Traditional Methods of Separation


As discussed earlier, the imbalance of voting right and economic benefit is not rare. Without derivatives, investors can still adjust their portfolio with other financial instruments in the market.


1. Dual Class Share. — The two-tier share structure is a fundamental amendment to the equal shareholder right. This kind of capital structure is common in innovation corporations and are now accepted by increasing numbers of exchanges like the New York Stock Exchange (NYSE), National Association of Securities Dealers Automated Quotations (NASDAQ), Hong Kong Stock Exchange and the science and technology innovation board at the Shanghai Stock Exchange. There were initially concerns that the shareholder in an advantaged position may exploit the second-tier shareholders through the voting mechanism. In the past, issuing shares with different voting right was treated as a method that financial oligarchies use to exploit common shareholders. Thus, the multiple-tier share structure had not been accepted by the NYSE for decades. However, due to the competition with NASDAQ, the exchange rules of the NYSE have been loosened. Even so, the adoption of the two-tier share structure can only be used in the initial public offering. Once listed, a public corporation is not allowed to change its capital structure or voting right distribution through the amendment by law or constitutional documents.


2. Securities Lending and Short Selling. — Securities lending is another way to get voting right temporarily with low cost. With borrowed securities, the borrowers can exercise the voting right to cast an influence on the resolutions in the shareholder meeting. In the case that the borrowers do not intend to vote, they can sell short such borrowed securities and get unbound with the dividends and stock price of the company. The US Securities and Exchange Commission (SEC) once required the directors of investment institutions, which are the main lenders in the market, to be cautious about the proxy process in connection with loaned securities. If there is a material vote with regard to loaned securities, the directors should recall the shares. Regarding the short selling, there are rules on transparency and disclosure requirements published by the Self-Regulatory Organizations (SROs) and the SEC.


3. Vote Buying. — Vote buying is not illegal per se, but its purpose should be examined, and it should not be used to exploit other shareholders. 


All the methods discussed above indicate that the imbalance between the economic benefit and voting right is of potential hazard. The inside tension of the disequilibrium requires rigid scrutiny. 


C. The Feasible Forms of Empty Voting with Derivatives


First, holding shares while purchasing put options. With put options, the shareholders can lock their economic benefits at a given price, which will separate the benefit from the voting right directly. 


Second, holding shares while trading swap. The shareholders could hedge his long position by trading swaps. It will exchange the fluctuation of the stock price happened in a certain period to the counterparty. In most cases, the counterparty may not bear the risk of holding a long position. They would decentralize the position and hedge the risk exposure with other parties.


Third, combination of purchasing put options and selling call options. The combination of different kinds of options can stimulate the benefit of selling shares. In this portfolio, the put options have the same effect of locking the benefit when the stock price declines. The fee of selling call option can compensate the cost for purchasing put options. If the stock price increases, the call option would suffer a loss but the whole portfolio has the same financial gain or loss just like making a sale of shares in the beginning. 


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D. The Feasible Forms of Hidden Ownership with Derivatives


1. Total Return Swap (TRS). — The TRS is cash settled swap that exchanges the fluctuation of shares price with a fixed interest. When the investors want to get the change of the stock price as well as its dividends and other financial benefits entitled to a shareholder, they may not choose to purchase the shares and hold the long position. Instead, using a TRS can obtain similar financial benefit at the same time with a lower cost. The investor needs to pay part of collateral and margin to the counterparty and make leverage speculation


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2. Combination of Purchasing Call Potions While Selling Put Options. — This portfolio has the same financial benefit as purchasing shares. The call option would gain the surplus as the stock price increases while the put option fee would offset the cost. In addition, if both options are at-the-price, the portfolio would simulate the trade of share in the beginning. If the investor splits the exercise, the price of the options and makes a spread as a collar, he would make speculation with more risk. 


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III. THE PRACTICAL CASES AND THE POTENTIAL HAZARDS


In the market around the world, empty voting and hidden ownership have already raised challenges to the financial regulation system and corporate governance. The cases discussed below would demonstrate the potential hazards.


A. How the Empty Voting Influences the Voting Result ofCorporate Governance


In the US, vote-buying case of Perry Corporation is a typical empty voting. In 2004, Mylan Laboratories announced a stock-for-stock merger with King Pharmaceuticals. Perry Corporation is a hedge fund and it owned about seven million shares of King. However, the market did not hold a positive attitude to this merger and a large Mylan stockholder Carl Icahn opposed this transaction. Therefore, the price of Mylan began to drop. Since the transaction still needed the approval of Mylan’s shareholder meeting, in order to consummate the merger, Perry brought 9.89 percent of Mylan’s shares. What is more, to reduce the cost and the economic loss when the stock price declined, Perry hedged these shares’ economic benefit with Goldman Sachs and Bear Stearns through swaps. Thus, Perry held nearly 10 percent of voting right but did not bear any economic benefit. Finally, the vote did not happen because of the potential accounting problem of Mylan.


The SEC announced a settlement with Perry in 2009. However, in this settlement, the SEC did not deal with the problem about the voting right and the swap. Rather, it focused on the disclosure obligation of Perry’s long position. The SEC alleged that Perry should have disclosed its ownership on a Schedule 13D once it acquired 5 percent of Mylan’s stock within ten days. Perry argued that it acquired the securities ‘in the ordinary course of his business and not with the purpose nor with the effect of changing or influencing the control of the issuer, nor in connection with or as a participant in any transaction having such purpose or effect.’ Thus, it only needed to file a short-form statement on Schedule 13G within 45 days after the end of the calendar year. This explanation was not accepted by the SEC due to Perry’s intention to influence the vote result. 


The SEC noticed that ‘Perry was able to acquire the voting rights to nearly ten percent of Mylan’s stock without economic risk and real economic stake in the company’. In addition, the SEC found that even the long position purchased by Perry was not paid by cash entirely but through margin account. Perry obtained voting right of shares worth approximately 492 million USD with 5.76 million USD. In the settlement, Perry was fined 150,000 USD and admitted no wrongdoing. The SEC did not respond to the question on whether vote buying with derivatives is legal or not.


B. The Hidden Ownership Case and Its Threat to Regulation


The hidden ownership is mainly used in the takeover scenario. The Schaeffler group’s action to acquire Continental AG is a typical hidden ownership through the TRS in Germany. 


Continental AG is one of the largest publicly quoted German companies and Schaeffler group is one of the largest privately-owned industrial companies in Germany. In July 2008, Schaeffler suddenly announced that it had the access to 36 percent ownership of Continental AG without any former disclosure. One day after the disclosure of its equity stake of Continental AG, Schaeffler proposed a cash bid for all Continental AG’s shares. This abrupt takeover action disregarded the disclosure regulation and imposed stress on the target corporation. In fact, the claimed equity stack was not all shares, it includes three parts: first, direct ownership of 2.97 percent; second, physically settled swap transactions of 4.95 percent shares with RBS; third, cash-settled equity swaps of 28 percent shares. The difference between physically settled swap and cash-settled swap is, when the swap is mature, the shares could be delivered from the short leg holders to the long leg under the contract of physically settled swap while the two parties only get the amount via netting cash settlement under the cash-settled swap contract. Thus, the physically settled swap is an indirect access to the shares and there is a certainty to gain the control of settled shares in the future. Under the German regulation regime, the threshold of disclosure for shares holding is 3 percent and 5 percent for the physically settled swap. Therefore, Schaeffler chose the precise number of equity stacks to avoid triggering the disclosure obligation. The major issue of the takeover action is the nature of the cash-settled swap. 


This cash-settled swap is a total return swap between Schaeffler and Merrill Lynch. It allowed Schaeffler to gain the economic stack of the same number of shares. As the short-leg holder, Merrill Lynch had to bear the risk of the fluctuation. The quantity of the equity swap is gigantic, so usually the counterparty would re-hedge its risk exposure. Merrill Lynch could purchase the shares and hold it for a period, but this would be costly. Most importantly, if Merrill Lynch held such number of shares, it would trigger the disclosure obligation which had the same consequence as transmitting information to the market. To avoid the disclosure requirement and reduce the risk, it was said that Merrill Lynch hedged its long-leg with several other investment banks with similar swap transactions. Still, every single investment bank held a position below the disclosure threshold



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This arrangement may not violate the disclosure requirement, the economic benefit alone cannot ensure Schaeffler to exert its own will on the shares. If the terminal investment banks that actually held the shares had a contract with Schaeffler or committed to follow Schaeffler’s guide during the shareholder meeting, there was a possibility that they were treated as persons acting in concert. If the shares are accounted together, the whole arrangement is meaningless. According to BaFin’s investigation, the swap contract between Schaeffler and Merrill Lynch and the followed hedge transactions did not refer to the concerted action or voting commitment. Nor did they set any arrangement that if the swaps were unwound, the terminal investment banks would sell the shares to Schaeffler. Thus, apparently Schaeffler could neither execute the voting right of the shares under swap nor gain access to the shares when the swap was unwound. The separate economic benefit was not seeming to be a threat to the corporate governance of Continental AG.


However, even without an explicit arrangement for the equity stock under the swap, Schaeffler still had an advantage of purchasing the hedged shares from these terminal investment banks. When the swap was unwound, there was no need for the terminal investment banks to hold the shares for hedge anymore and they would sell the shares to the market. When the takeover bid had already become known to the market and the stock price of Continental AG had surged. Since Schaeffler had reaped off the increase in price, it gained the competition over other buyers in the market. Thus, Schaeffler could easily purchase the shares from these investment banks. Taking the whole arrangement into account, even there is no legal binding relationship between participants, the tacit understanding of the purpose of Schaeffler probably lies behind the written agreements. 

IV. THE CASES AND REGULATION IN CHINA


Although the derivatives market is not highly developed in China like some other financial intense market mentioned above and the standard derivative products are facing strict restrictions, Over-the-Counter (OTC) transactions still have enormous influence in the market. With China’s special financial market environment, the financial derivatives practice may bring about many issues beyond the discussion above. The empty voting and hidden ownership practices in China and how the regulatory authorities react to them are examples to indicate the features of China’s financial regulation system and the underlying conflicts relating to portfolios. Both sides of the story reflect the peculiar rationales of the purpose of the regulation administration. Due to the twisted financial environment, the stability of the market could only be achieved through strict restrictions, which further encourages the trader to circumvent the regulation through elaborate financial tools. This mutual stimulus interaction between market and administration continues to be intense and piles up risks for the whole financial system. To cut off the negative self-reinforcement, the Chinese regulators have issued particular rules to regulate the employ of certain derivatives.

The primary issue of market is to restrict the high leverage rate and high-risk speculation which is a severe threat to a solid financial system. Trying to cut down the high leverage while keeping the turmoil moderate remains a tough task for Chinese regulators. Using financial tools including derivatives to build portfolios is a common method to make investments. However, the complexity of financial portfolios, especially those with the OTC derivatives, may set barriers for regulation. It blurs the line between reasonable investment and high-risk speculation or even illegal manipulation which the administration always tries to eliminate uncertainty. Regarding the empty voting and hidden ownership, China’s financial regulation that concerns certain derivatives demonstrates the intense confliction between financial soundness and market innovation. In this scenario, the rules and policies adopted by China’s regulators are based on specific practical conditions in the Chinese financial market. The analysis on these types of transactions reflects the fundamental issues of the market. The far-reaching rationale behind the regulative rules would be helpful to have a comprehensive sight of China’s financial regulation system.   


A. Hidden Ownership Practice and Its Regulation in China


The equity swap and options are all common in the market and serve significant commercial purposes. However, when considering them in a particular situation, the nature of the transaction may be questionable. China’s market is so special that it could exacerbate the problems relating to these transactions. The transactions which are discussed earlier and once employed in China’s market will be facing severe restrictions if not completely prohibited. Firstly, reducing leverage rate is the foremost goal of financial regulation. Since the violent fluctuation of stock market in 2015, the integrity and soundness of the financial market have been challenged severely. This forced the regulative administrations to cope with the mania for speculation in order to avoid a possible crash. The regulative administration elaborately tries to cut down the over-financing in equity and other overrating financial assets. In this circumstance, the TRS transaction would be recognized as credit loan for securities investment which is a hidden method for regulation arbitrage through the OTC market. Thus, the regulation of hidden ownership through financial portfolios in China should be analyzed and comprehended in the circumstance of action on credit over inflation and stock speculation. 

1. Hidden Ownership Cases. — The TRS is commonly used in China’s financial market for two purposes: leveraging the speculations and increasing the shareholding. Here is a model case for increasing shareholding through the TRS. In March 2015, Hengshun Electric, a public corporation listed in the Shenzhen Stock Exchange announced that its board members would buy its shares through a private fund. The first step of the plan is that the board members invest their own 23 million RMB into a private fund managed by Finebutler, a hedge fund management corporation. Then the fund set a TRS with Guosen, an investment bank. The investment bank would raise 46 million RMB itself and purchase the Hengshun Electric’s shares in the public market as well as all the money in the fund. Regarding the voting right, in the announcement, the board members claimed that they would abandon the voting right of shares in the fund. There are a few more cases that have some similar transaction structure as the Hengshun Electric did. Most of the investors are the control persons, the majority shareholders, the directors and the senior managers of the corporations.

Through the TRS, these beneficiaries established a leveraged investment. Their own investment in the fund is treated as the collateral in margin trade under the traditional TRS structure. The reason why investment banks offered them the credit transaction is because of the trust in these investors as the controllers of the corporation. From another perspective, this transaction is treated as a measure to maintain the price of shares and a way of ownership incentive. It enhances the controllers who could already exert the influence on the corporation. Thus, even though they claim the abandonment of voting right of that part of shares, there is no negative effect on their control. Also, if they did not exert voting right directly, according to the purpose of the plan, there is no reason for the investment banks, who hold shares for them, or the fund manager, who is an independent obligation to manage the fund in the law, to have any conflict with the controllers. It is expected that the investment bank and the fund manager would exert the voting right tacitly with the controllers. 

2. TRS Transactions and OTC Financing. — The mechanism of the TRS transaction is not just offering the client an opportunity to attain a magnified appreciation of stock held by the financial institutions. In respect of hidden ownership, it also amplifies the clients’ latent influence in the control over the corporation. Moreover, the structure of the deal would be considered as a credit loan for the client to invest into securities under the swap contract and the fixed fee paid to the institution is more like a loan interest. Depending on the actual amount of securities under the contract, it could create a substantial leveraged investment portfolio. It functions as a margin trading of securities, but it is mostly traded in the OTC market which is not sufficiently supervised by the regulators. After the turmoil of stock marked in 2015, though different on the appearance, various financial tools are named as the OTC financing because they have similarity in function as a credit loan. For this reason, the regulative administration blames it as an OTC financing method connected to high risk securities speculation. To understand the motivation and purpose of TRS transactions and why the regulation rules are formed, we need to look into the development of the OTC financing and analyze its detriment to the integrity of market. 

In China, the formal leverage financing methods, such as margin trading of securities and securities lending tractions, are high regulated. The legal process to make such deal is to register under the China Securities Finance Corporation (CSFC) which is founded by several main exchanges. Also, the object securities of transactions are limited and are enumerated by the CSFC. According to the rules set by exchanges and the CSFC, the margin rate and total amount of the transactions are being controlled. The standard margin trading and securities lending transactions has been referred to as on-floor financing. This policy helps to reduce the access to speculative financial tools and then keep the fluctuation in the market moderate. Although the regulators held a negative attitude to financial product that can provide credit leverage and enlarge the speculation ration, the traders in the market would not abstain from creating their own way of financing initially. Due to the complexity of these financial products, they are often referred to as the OTC financing. 

The OTC financing does not share certain types of transaction or portfolios. On the contrary, it reflects that the basic logic of transferring capital from affluence to scarcity which is the essence of finance. Nonetheless, the financial innovations stimulate the credit inflation that constitutes a threat to the stability and soundness to the market. It may be doubtful why the basic function of financial market should be challenged by the regulators. In 2015, there was a surge in the stock market followed by a sudden decline. The turning-point is the operation against OTC financing. The OTC financing created credit with financial tools and amplified the speculative investment which plays a significant role to push up the securities market. However, the mechanism of financing also revealed the fragility and vulnerability of the financial market. Without specific supervision, the OTC financing undermined the formal regulative system. When our regulators set about handling the OTC financing system in the shadow, it triggered an unexpected chain reaction which pricked the bubble of the stock market. In the next few years, the seesaw battle between the regulators and traders continued to be the main issue of the market and involve the enhanced confine of tools like the TRS.

3. The Special Conditions of China’s Financial Market and How These Influence the Regulation Policy of OTC Financing Like the TRS. — To begin with, the recognition of TRS’s nature and function has been influenced by the policy against OTC financing. The reason why the regulators have held such an extreme attitude towards OTC financing is because of the twisted financial environment. There are four basic issues underlying beneath China’s financial instability: Cutting down the leverage rate, restricting the conduit of investment, breaking up the principle of rigid payment and seeing through the underlying assets and beneficiaries. These issues are related to each other and together reflect the fundamental flaw of China’s financial market in recent years: the surging credit issue and how it accumulated through financial productions.

China’s financial market is highly regulated and different divisions of the financial market are being regulated separately. In the segregated operation framework, assets management is a broad definition that it actually contains any investment a financial institution helps its client to manage as an agency. Most of these assets management products have thresholds for investors and are under specific regulation. In order to circumvent the restrictions and achieve more profits, such products accessible to general public are always used as a conduit to raise funds than re-invest to other products. The re-investment chains are just like the matryoshka dolls, embed the fund in another product one by one and the capital number gets expanded gradually. This strategy brings instability into the financial market. Along the re-investment chain, from the institutions’ perspective, the thresholds cannot help the institutions to recognize the terminal investors and see through who they really are, whether they are sophisticated or how their risk bearing capability is; from the investors’ perspective, they lack information about the underlying assets and the actual risk behind several shells of re-investments. This asymmetry of risk and the interaction of re-investment chains result in the fragility of the financial market. What is worse, the ambiguous nature of the investment aggravates the problem. When the fund suffers loss, it is hard to determine how to share the responsibility and loss between the institutions and investors, especially as the institution does not manage the assets themselves independently but only passes on the fund to others.

To attract the investors and keep this model of financing running, financial institutions implement the rigid payment principle. It is an implicit guarantee for the assets management investment. In practice, if there is the possibility of default, the institutions which issue the products or organize the transaction should use their own source to compensate the investors and remedy the loss. However, this rigid payment principle further exacerbates the issue about  forcasting the risk-bearing. The legal relation underlying the transactions is undefined, with the hidden guarantee, the market would not calculate the risk in a cautiously way because the investor does not have a clear expectation of the benefit and risk. With such guarantee, the different risk-return mechanism between loan and equity is blurred. And every investment seems to be just credit loan. The net worth of the assets portfolios is no longer an indicator of investment value and even the equity investment are treated as financial credit with fixed rate.

Under such circumstance, the financial practice in the market cannot be recognized from their appearance. For example, in some securitization transactions or other structured financial products, different tranches bear different level of risks. With rigid payment, the senior tranches would not bear any loss and the whole structure works as the junior tranche holders borrow loans from senior tranche holders with their investment as collateral. In a notorious merger case that happened in 2016, the insurance corporation group Baoneng planned to acquire a leading real estate developer Vanke. Baoneng established a portfolio of a controlling block of Vanke’s share through nine assets management projects. Baoneng Group held the junior tranches of each projects with conduit funds from other institutions subscribing junior tranches. In respect of the economic nature of these productions, a basic corollary is that the senior tranches fund is just a credit loan offered to Baoneng which would use this fund to acquire shares of target corporations. As the senior tranches’ holder, Baoneng took full control of these projects with the nominal independent institution management keeping cooperating tacitly.

Thus, considering all these special conditions, it was reasonable to regard various assets management as a semi-loan. For the stability of the market, the regulatory authorities are extremely sensitive to the leverage rate because it is the most important signal of risk. Reducing the leverage rate is a major purpose of the regulatory authorities’ prudential regulation. Regarding the TRS transaction, in regulatory authorities’ perspective, the investment bank holds the shares on behalf of the investors is similar to offering a loan to the investors with a high leverage rate. 

4. The Regulation of the TRS and Its Rationale Behind the Policy. — China’s regulation on TRS and derivatives combination is straightforward. Finally, the China Securities Regulatory Commission (CSRC) and Asset Management Association of China prohibited investment banks from trading TRS with clients about listed corporation shares as a precautionary regulation purpose. The fact that the deviation from legitimate commercial purpose in the extreme situation may shed light on the main issues of the regulations. 

Firstly, as to the hidden ownership, the application of TRS definitely has a relationship with the control right. In a TRS, the counterparty would hold shares for the investors, then this long-leg can distribute to the terminal investment banks (or subscribed by other conduit assets management). Every counterparty would hold fewer shares, but they still bear the risk for the investors. Since it is a leveraged transaction, the collateral or margin provided by the investors may not completely cover the terminal counterparties’ risks. The investment banks also realize the risk of offering credit but what they rely on is the relationship between the investors and the corporation because the investors have substantial (or potential) control over the corporation and a consistent interest with the company. Thus, the counterparties rely on the investors’ judgments about the value of the target shares and expect a rise of the price in the takeover process or other situation. The tacit understanding of transaction is not just hedge or speculation but the control majority of the target corporation.

Secondly, the cost and the leverage rate of the transaction structure is a major issue. To conduct hidden ownership, the cost is fewer compared to the share values it intends to influence. This is also found by the SEC in the Perry case. In the meantime, the TRS is a leveraged transaction with a few collaterals. The regulation of derivatives should be in accordance with the specific situation and the real intent of the investor. Derivatives can be used in many proper areas and they are useful financial tools in the market and are a supplement to other financial products. TRS transactions are not illegal per se. China’s prohibition is based on its special financial market practice because the motivation to circumvent the regulations and arbitrage must be restricted. Like Baoneng case, the financial portfoilos are used to manipulate the stock and seize the control rights without clear diclousure. The financal risk of this sort of levergaed acquisation is high and it threatens both the soundness of financial market and the stability of corporate governance. The aggregation of economic and control interests are under rigorous scrutiny. The intent and purpose should be the key issue to be discussed in considering the restrictions on derivatives. Imposing such regulations should take into account the specific situation and business scenario related to the transactions.


B. Empty Voting Practice and Its Regulation in China 


The rigorous entrance standard for public offering is another background of China’s financial market. The process of going public is complex and time consuming. As the supervisors of the stock market, the CSRC and the Stock Exchanges are often criticized for being inefficient. Since the opportunity of equity financing is scant, there is a high premium that exceeds the real value of the public traded shares, which is called the barrier lake effect. This phenomenon generates distorted incentives for shareholders to achieve tremendous gain by dumping out their equity block soon after the Initial Public Offering (IPO). To keep management and control structure stable, a much longer lock-up period of shareholding after IPOs has been set by the CSRC and Stock Exchanges of Shanghai and Shenzhen. In order to realize their profit and keep liquidity, market practitioner would use combined options, securities and pledged loan to sell short of their equity positions in advance. This practice constitutes imbalance of economic interests in the listed corporation and also triggers the discussion of whether these shareholders are still devoted to the best interests of their corporations, which, in another word, is a typical empty voting issue.

1. Empty Voting Practice. — The empty voting practice in China is mainly through OTC options because there are very limited ways to sell short in China’s market. Securities lending is highly regulated and as a result, it can only be used to conduct standard short selling which requires to be registered with the China Securities Depository and Clearing Co., Ltd and China Central Depository and Clearing Co., Ltd. The OTC derivatives create opportunities for some shareholders to reduce their economic benefit secretly. The main reason for a shareholder to conduct the empty voting is the lock-up periods which restrict several specific kinds of shareholders from getting the financial gain from price appreciations. In addition to the Corporate Law and the Securities Law, the CSRC and Stock Exchanges set strict lock-up periods for controlling person, the majority shareholders, director and senior management. For IPOs, a controlling person cannot resell the shares he holds prior to the public issue within 36 months, and in some cases, the lock-up period can be extended to at least 42 months. For the directors and senior managers, they are prohibited from selling any share they hold within one year after the corporation going public. For subsequent offering tailed to the control person and the majority shareholders, the lock-up period is also 36 months.

The sale restriction is so severe that many shareholders have motivation to circumvent it. They use combined options in the counter market to get the financial gain as soon as possible. For example, a shareholder purchases put option of which excise-price is 97.5 percent of the current price, while selling a call option of which excise-price is 102 percent of the current price. Suppose the premium for the put option is 3 percent of the total shares and the call option is 2 percent. After the lock-up period, if the share price is below 97.5 percent of previous price, the shareholder sells the shares at 97.5 percent of previous price. 3 percent of premium cost plus 2  percent of premium income equals the price sold at 96.5 percent of previous price. If the share price is between 97.5 percent and 102 percent of previous price, the shareholder sells the shares at market price. 3 percent of premium cost plus 2  percent of premium income equals the gain got more than 96.5 percent of previous price. If the share price exceeds 102 percent of previous price, the shareholders sell the shares at 102 percent of the previous price. 3 percent of premium cost plus 2  percent of premium income equals the gain got more than 101 percent of previous price.

That is to say, the options combinations stimulate the selling of shares in the beginning and guarantee the financial gain for the shareholders. Thus, some investment banks offer such transaction for the shareholders to circumvent the strict regulation and the cost is not much.

2. The Barrier Lake Effect and Its Influence on Selling Shares through Derivatives Combinations. — The barrier lake effect contributes to the phenomena that public traded shares have a premium in price exceeding their real value.  Due to the high entrance standard for the public offering, any corporation that wants to go to public needs to take a substantial examination by the CSRC and exchange. The examination is strict, and the process is time costly. In practice, the number of companies going public is limited. Thus, the restriction of access is a dam to the stock market. The number of investment objects in the market is limited and the supply side of the shares is low, then the demand side far exceed the supply that pushes up all the prices in the market. The result of this imbalance of market is that if the corporation is listed in both Chinese market and another market like HK or US, there would be a spread premium between prices of shares in different markets. Therefore, as a company goes public, the increase in the market price for those which get the shares before the public offering is huge, and they have strong motivation to resell the stock and get the premium. That is to say, they harvest the profit of a franchise.

Another privilege for the listed corporation is that they can conduct subsequent offerings to the majority shareholders, directors and senior managers. In the subsequent private placement offering, the price is always at a discount, so it is a convenience method for the majority shareholders and inside control persons to enlarge their stock in a substantially lower price and then get the premium at the market price. 

In both the initial public offerings and subsequent offerings, the investors could gain an extra economic advantage because of the unfair franchised market. To restrict them from using the public offerings as a tool to reap off financial benefit once for all, the regulatory authorities set the lock-up periods to bind the corporation performance with interests of these shareholders at least for a period. However, the using of derivatives combination to get economic benefit became a loop-hole for this regulation. The derivatives combination is regulation arbitrage and unbind the economic benefit much earlier, only with options premium as cost which can be compensated by the selling options premium. Generally speaking, derivatives can be used to lock benefit or make speculation with low cost in many situations, which is the advantage of derivative. However, the extreme asymmetry of cost and benefit in the corporate area is that it cannot be recklessly implemented without restriction. Hence, the CSRC and SROs took actions to restrict selling shares through combined options strategy.


V. THE REGULATION OF EMPTY VOTING AND HIDDEN OWNERSHIP IN COMPARISON 


Besides the straightforward prohibition in China, other jurisdictions hold different attitudes to the empty voting and hidden ownership which could help us to comprehend the regulation in a comparative perspective. 


A. Regulations and Legal Practice of Hidden Ownership in the US 


In a leading case CSX Corporation v. The Children’s Investment Fund Management (TCI) LLP, there is a discussion about the main issues of hidden ownership. The background of the case is similar to the Schaeffler case in Germany. TCI is a hedge fund that wants to raise a hostile takeover of CSX and change the management. Before its disclosure of Schedule 13D, it set cash-settled swap to get economic exposure. The district court found TCI has violated the disclosure obligation of beneficial right. The main issue discussed in the case is whether the long position in the swap should be regarded as beneficial ownership and whether TCI should be regarded as a beneficial owner under the Securities Exchange Act of 1934. According to section 13(d) of the Securities Exchange Act of 1934 and the rule of the SEC, after acquiring directly or indirectly the beneficial ownership of more than five percent of equity securities, should file Schedule 13D within ten days after the acquisition. Thus, if the long position of the swap is regarded as the beneficial ownership in the provision, TCI’s action would be a violation of the purpose of the anti-takeover Williams Act. 

According to rule 13d-3 of the SEC, there are two methods to decide the identity of a beneficial owner: First, consider the voting power and the investment power: voting power which includes the power to vote, or to direct the voting of such security; investment power which includes the power to dispose, or to direct the disposition of such security. Second, one who has the beneficial ownership but makes a scheme or plan to evade the reporting requirements.

The district court confirmed both standards had been reached. Firstly, regarding the investment right, it needs to consider ‘have the ability to change or influence control’ and ‘the ability to control or influence the voting or disposition of the securities.’ The court found it was a corollary for the counterparties of the swap to purchase shares to hedges the risk and they would sell the shares to TCI when the swap was terminated. Thus, even though TCI did not explicitly direct the counterparties to physically purchase the shares, it had a significant influence on this action. Secondly, the court considered whether TCI could exert the voting right through the counterparties, since there is no explicit agreement, even the court considered the possibility of a tacit agreement, it did not make a conclusion on this issue.

In addition, the court found TCI violated rule 13d-3(b), and the swap is a scheme to evade its disclosure obligation as a beneficial owner. According to the Amicus Letter of Division of Corporation Finance of the SEC, ‘a person who does nothing more than enter into an equity swap should not be found to have engaged in an evasion’, only the person did so with the intent to create the false appearance, should rule 13d-3(b) be applied. The court was of the view that the purpose of section 13(d) is to alert shareholders of ‘every large, rapid aggregation or accumulation of securities, regardless of technique employed, which might represent a potential shift in corporate control.’ Depending on the specific transaction structure and business scenario, the court found that under the plain language of rule 13d-3(b), TCI created and used the TRSs with the purpose and effect of preventing the vesting of beneficial ownership to evade the reporting requirements.

In an appeal of 2011, the Second Circuit Court avoided to discuss the definition of beneficial interests because the panel was divided.  However, in the concurring, Judge Winter argued that the district court’s analysis is not consistent with the provision of the Dodd-Frank Act that amended the definition of beneficial owner contained in section 13(o). In section 13(o), the standard of beneficial ownership is comparable to direct ownership of the equity security. Thus, it is questionable that whether under the TRS the possibility of tacit understanding to get shares from the counterparties is a direct ownership.

In addition, even if the TRS is regarded as being in violation of the disclosure obligation, the remedy for the target corporation in the takeover process is limited. The district court and the Second Circuit Court both refused to enjoin TCI from exerting voting right of the shares related to the swap. Regarding the share sterilization remedy, an irreparable harm is required by the Second Circuit Court. Since it had been six months between the disclosure of the takeover bid and the shareholder meeting held for voting, the information was already known to the public, the shareholders and the target corporation. Whether timely or not, the stated purpose of disclosure was fulfilled. Thus, there is no irreparable harm in this case.

B. Regulation of Separations in EU


1. The Regulation of Hidden Ownership in the EU. — In 2013, the EU amended its Transparency Directive and added article 13(1)(b) to enforce the disclosure requirement. The former article 13(1)(a) only requires disclosing financial instruments that give the holder access the voting right, the reformed article 13(1)(b) requires to disclose financial instruments with economic effect similar to instruments referred to in article 13(1)(a), whether or not they confer a right to a physical settlement. In addition, the article 13(1b)(g) clearly describes that any other contracts or agreements with similar economic effects which may be settled physically or in cash should be considered as financial instrument in articles 13(1)(a) and 13(1)(b). Thus, there is possibility that the cash-settled swap should be disclosed under this article. 

The UK takes a similar attitude to non-physically settled swap. Section 5.3.1 of the Disclosure and Transparency Rules requires disclosing arrangement with similar economic effect to acquire shares.

2. The Regulation of Empty Voting in the EU. — The EU established a short selling reporting system in 2012. According to the dual class reporting requirement, anyone who holds short position of that equals to 0.2 percent of the issued capital of the company and each 0.1 percent above that should notify the relevant competent authority. In addition, if the short position equals to 0.2 percent of the issued capital and each 0.1 percent above that, it is required to disclose to the public. The time for the disclosure is not later than at half past three in the afternoon on the following trading day. Under this disclosure system, large short position for empty voting would be known to the corporation and the other shareholders. 


VI. CONCLUSION AND PROPOSAL


The separation of interests of shares is a threat to the integrity of the financial market and corporate governance. However, even the derivatives cause the potential deviation from the ‘one vote, one share’ principle, they are still indispensable in the financial market. In the CSX case, the International Swaps and Derivatives Association expressed its concerns about the court’s strict interpretation on beneficial owernship and indicated that the misinterpretation of swap may bring instability to the financial market and restrain the transaction. The regulation should not go extreme and need to focus on the business scenario and real intent. The current regulations on deviations have defects and need reforms. The multiformity of derivatives may make it difficult to understand what has happened within the financial market or inside the corporate organizations. We should also reconsider China’s rigorous restriction because the compelling administrative rules we adopted may harm the market as well. The reasoning of the current policy has specific purposes which may not last all the time. It may stifle the innovation and impede the using of derivatives for legitimate commercial purpose. Yet if the actual conflicts of interests are illustrated, the traditional approaches, like disclosure or excluding shareholders with conflict interest from voting, are still effective in this scenario. 

The main threat of hidden ownership is the challenge to the disclosure system. Based on the principle of anti-takeover, the information of block shareholding should be known to the public and the corporation. The current disclosure rules are established when the market is not equipped with such complex financial instruments. With the new derivatives weapons in the market, the disclosure system should be reformed and introduced standards to recognize beneficial ownership. The EU’s reform in this area is a favorable model. The Transparency Directive also authorizes the European Securities and Markets Authority to take into account technical developments on financial markets and update an indicative list of financial instruments that are subject to notification requirements. Except the disclosure, the remedy to hidden ownership is another issue. In the CSX case, the Second Circuit Court refused the share sterilization because of the lack of irreparable harm. However, the rationale of the Second Circuit Court leaves rooms for further discussion. If the information is not disclosed to the public for enough time before the vote meeting, the protection purpose of the anti-takeover rule is not met. In a takeover scenario, it is arguable that a rigid injunction should be applied if the corporation and other shareholders completely lack the information of hidden ownership before the vote meeting. For China, the amendment of the Securities Law is now considering to add a new rule that prohibits exerting voting right when the disclosure rule has been violated.

For empty voting, current regulation focuses on the disclosure of the short position. Since hedging the risk of long position in equity is a common business judgment, it is complicated to constrain voting by mandatory administrative rules. When the short position is disclosed, one’s net benefit in the corporation can be calculated. The corporation can recognize the identity of the shareholders and their position in the registration day before the vote. This requires the corporation to amend their bylaws and adopted prohibitions on the empty voting shares. 


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