Derivatives Trading and Negative Voting — The Harvard Law School Forum on Corporate Governance

Small business need-to-know, of-interest and heads up.

Excerpt:  Securities regulators, practitioners, and legal commentators worry that derivatives may provide shareholders and creditors incentives to destroy value in their corporation (references here). The basic concern is that if shareholders or creditors own a sufficient amount of off-setting derivatives such as put options or credit default swaps (CDS), any losses on their shares or debt will be more than off-set by the corresponding gains on their derivatives (“over-hedging”). In this case, shareholders and creditors benefit by using the control rights inherent in their shares or debt to reduce the corporation’s value (“negative voting”).

An important question that is generally not considered, however, is whether it would ever be profitable for shareholders or creditors to acquire so many derivatives in the first place. After all, any gains to shareholders and creditors come at the expense of their counterparties on their derivative contracts. These counterparties would therefore prefer not to sell the derivatives, or only at a price that compensates them for the future payouts, thus depriving shareholders and creditors of any profit in the overall scheme. This is an important difference from the related problem of vote-buying, which forces (dispersed) counterparties into a collective action problem approaching a prisoners’ dilemma. By contrast, derivative counterparties have the option simply to abstain from the transaction.

Read full article via Derivatives Trading and Negative Voting — The Harvard Law School Forum on Corporate Governance and Financial Regulation.

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