Empty Voting and Social Welfare

Abstract

Recent work (Hu and Black (2005, 2007, 2008); Dekel and Wolinsky (2012)) has detailed the twin issues of empty voting and hidden/morphable ownership. The former arises when an actor has control rights over a corporation but no economic interest in that corporation, such as when an investor borrows shares. The latter arises when a shareholder has an economic or voting interest in a corporation but avoids regulatory disclosure requirements through derivatives transactions. Both off er significant challenges to financial regulatory systems. The lack of a framework for analyzing the problem has hindered attempts to respond to these challenges. Most economic models of financial markets do not incorporate control rights. And, once control rights are introduced, the standard competitive equilibrium concept is unsatisfactory: We show that once control rights are introduced, competitive equilibria may fail to exist and may be inefficient if they do exist. Allowing the transfer of control rights, such as through transactions in corporate stock, only exacerbates the problem. We show that if control rights may be traded independently of economic ownership rights - as modern derivatives markets increasingly allow - competitive equilibria essentially never exist. We propose an alternative equilibrium concept, the Core Outcome. A Core Outcome consists of an allocation of economic ownership, an allocation of control rights, and a set of voting behaviors such that no group of actors can improve the utility of its members by deviating. We show that Core Outcomes have several desirable properties as an equilibrium concept: They always exist, are always efficient, and can be reached through voluntary trading. Our model has strong implications for the regulation of securities markets in general and of derivatives markets in particular. We conclude that there are strong efficiency justifications in favor of an effective mandatory disclosure regime. We also find that, in certain circumstances, empty voting can act as a backstop to public regulation, allowing private actors to block socially inefficient actions that public regulation would permit.