1.3.2.1 Adverse Effects on Market Efficiency

Ownership disclosure can inform share prices, and thereby improve market efficiency, by creating transparency of the voting structure and of capital movements. As we will see below, hidden ownership reduces transparency of both the voting structure and capital movements.

By creating transparency of the voting structure, section 1.2 demonstrated ownership disclosure enables investors to anticipate agency costs and to assess the implications for the value of a firm's share. Hidden ownership reduces transparency of the voting structure in several ways. This point is eloquently made by the court in CSX, which describes how accumulating shares to hedge equity derivatives may alter the "corporate electorate": (1) it may eliminate the shares from the "universe of available votes" because the baraks have a policy of not voting hedge shares, (2) it may subject "the voting of the shares to the control or influence of a long party that does not own the shares," or (3) it may result in the shares being voted by an institution "that has no economie interest in the fortunes of the issuer" but "is aware that future swap business from a particular client may depend upon voting in the 'right' way."1

Hidden ownership also reduces transparency of changes in the voting structure. Consider the use of cash settled equity derivatives to facilitate a creeping take-over. Although a change in control is imminent, the stakebuilding is not disclosed and investors are unable to assess the implications for the value of the share.2 This affects not only market efficiency, but also the operation of rules that rely on efficient markets. The Takeover Directive requires that a mandatory bid be made against an "equitable price," defined as the highest price paid (on or off the market) for the target shares by the acquirer during a certain period, e.g. 12 months, prior to the bid.3 Similarly, the laws of some Member States require that if no target securities have been acquired during that period, the equitable price be defined as the average market price during such period.4 In each case, one could argue, it is implicitly assumed that the share price reflects the increased probability of a control contest. This assumption is no longer valid if the market is unable to anticipatea control contest because the acquirer silently built his stake through derivatives. Thus, derivatives enable acquirers to effectively reduce the price to be paid in the mandatory bid.5

Ownership disclosure also informs share prices by creating transparency of trading interest, of the size of the free float and of economic interests of shareholders. Again, hidden ownership reduces this transparency. First, the heightened interest in the share remains undisclosed. If the bank, acting as counterparty, discloses its purchase of reference shares, the market may attach less significance to this than it would if the purchase was made by a hedge fund known for identifying undervalued targets. If the bank acting as counterparty does not need to disclose its purchase of reference shares because the fund transacted with a number of banks and kept the volume of each transaction below the initial threshold for disclosure, the market does not even learn of the increased interest in the share at all, other than through a possible shift in supply and demand. As a result, the fundamental information that may drive the fund's transactions is impounded in the share price at a slower rate than if its transactions were fully disclosed.6

Second, hidden ownership may distort the market's perception of the size of the free float. In the example of a long party transacting with a number of banks, none of which have to disclose their purchase of reference shares, the free float may be significantly reduced because the reference shares are effectively taken out of the market. Yet, in contrast to the situation where one party amasses a stake and makes appropriate disclosure, the market remains unaware of this. Consider the case of carmaker Porsche, which in late 2008 disclosed that it had increased its economic stake in Volkswagen from 35% to 74.1% through cash settled options.7 As a result, the free float had effectively been reduced to a mere 5.8%, assuming Porsche's counterparties had hedged their positions by acquiring the reference shares. Until Porsche made its disclosure, this reduction in free float had remained invisible because Porsche had not been required to disclose its stakebuilding, and liquidity was supplied by hedge funds that were massively betting on a decline in Volkswagen's share price by borrowing shares and selling them short. As reported by the Financial Times, Volkswagen's shares more than doubled after Porsche's disclosure, as hedge funds, "rushing to cover short positions, were forced to buy stock from a shrinking pool of shares in free float."8 A leading corporate governance expert observed that the incident "should get the politicians and supervisory authorities to think again about allowing this untransparent situation."9

Finally, the long party's true interest remains undisclosed. Because its economic ownership exceeds its formal voting rights, though, there is no increased incentive to extract private benefits. On the contrary, the long party will often have an increased incentive to encourage maximization of cash flow through dividends. To the extent the long party can influence corporate decisionmaking, it may therefore be risk-averse to a different degree than ordinary shareholders. This, it would seem, is less of a concern than some of the other issues associated with hidden ownership.