The New Financial Assets: Separating Ownership from Control

• Publication year: 2010
• Citation: Vol. 33 No. 04

SEATTLE UNIVERSITY LAW REVIEWVolume 33, No. 4SUMMER 2010

The New Financial Assets: Separating Ownership from Control

Tamar Frankel(fn*)

Introduction

In The Modern Corporation and Private Property, Adolf A. Berle and Gardiner Means wrote about the separation of ownership from control in corporations. They noted that the interests of the controlling directors and managers can diverge from those of the shareholder owners of the firm.(fn1)

They wrote:It has been assumed that, if the individual is protected in the right both to use his own property as he sees fit and to receive the full fruits of its use, his desire for personal gain, for profits, can be relied upon as an effective incentive to his efficient use of any industrial property he may possess. In the quasi-public corporation, such an assumption no longer holds. As we have seen, it is no longer the individual himself who uses his wealth. Those in control of that wealth, and therefore in a position to secure industrial efficiency and produce profits, are no longer, as owners, entitled to the bulk of such profits. Those who control the destinies of the typical modern corporation own so insignificant a fraction of the company's stock that the returns from running the corporation profitably accrue to them in only a very minor degree. The stockholders, on the other hand, to whom the profits of the corporation go, cannot be motivated by those profits to a more efficient use of the property, since they have surrendered all disposition of it to those in control of the enterprise. The explosion of the atom of property destroys the basis of the old assumption that the quest for profits will spur the owner of industrial property to its effective use.(fn2)

Berle and Means concluded that the separation of ownership from control would lead to the inefficient use of property because the motivation for the most efficient use of the property would no longer lie with those who profit from the enterprise.(fn3) Harold Laski expressed a similar concern, focusing on those who control the corporations. He suggested that the modern corporation may have to face control by dishonest managers in addition to inefficiency.Under the modern company laws, any body of men may secure capital from its owners, with no sufficient guarantee either of a genuine service to be rendered or of a possible return on the investment. The company may be dishonest in its operation, or inefficient, without the public being able at any point to have knowledge. Its proceedings are wrapped in secrecy . . . .(fn4)

Today's scholars have similarly identified this separation of components of ownership, naming the separation "decoupling." These scholars note the decoupling of the "bundle of rights" represented by a traditional financial asset, such as a share of stock. Professors Hu and Black noted, for example, that "[l]ongstanding legal and economic theories of the public corporation assume that the elements of this package of rights and obligations are generally bundled together-and in particular that voting rights are linked to an economic interest in the corporation, and usually held in proportion to that economic interest."(fn5) They then note that decoupling changes this package of rights.

There are those who consider such a decoupling beneficial. Others express the same concern that Berle and Means have expressed. And depending on what one focuses on in viewing the pluses and minuses of these separations, one could reach different conclusions. I reach a number of conclusions. First, the separation of ownership from control creates the problems that Berle, Means, and Laski noted, regardless of how sophisticated, complex, or enticing the separation is. That is, those who control but do not own may control corporations inefficiently and sometimes dishonestly. Second, there is a need to maximize the benefits from decoupling while minimizing the potential losses by those who do not have their "skin" in the losses. Above all, the aspects of decoupling that pose a threat to the financial system must be controlled by private and public regulation.(fn6) The time has come to raise the scholarly and public awareness about these issues.

This Article is organized in three parts. Part One examines the nature of financial assets and their transition by market transactions from contracts to property. The discussion highlights the gray areas which financial assets occupy in decoupling, falling within both contract and property law.

Part Two describes four types of decoupled financial assets. The first type separates into two financial assets: ownership benefits and ownership risks. The presumed reduction of owners' risks prompted some academics to justify reducing the owners' protection. I suggest that attempts to protect owners from ownership risk have failed. Therefore, the suggestion was ill-conceived. The second type of decoupling separates into two financial assets: voting control and the ownership of financial assets. It creates "empty votes." This innovation can be abused in many different ways, as has been shown. The third type of decoupling is, in fact, coupling. It is called "reverse exchange securities." The fourth form of decoupling is process-based securitization. In fact, it may have been the first to appear publicly in the 1970s. It offers advantages, but excesses have created great disadvantages. Part Two concludes by noting that during the past thirty years, fundamental financial concepts and designs have been warped or eliminated. Therefore, we must reanalyze the new financial assets to discover whether the decoupling of these assets produces the results Berle and Means were concerned with.

Part Three poses a number of questions. First, does decoupling undermine the traditional property-type protections? Second, does decoupling warrant more regulation? Third, where is decoupling headed?(fn7) Fourth, what regulation can we expect for current decouplings? And finally in this part, I argue that a radical regulatory view may be worth examining based on the principle that those who create benefits and risks for sale may not collect just part of the benefits. They should have "skin in the game" and bear a significant part of the risk as well; then, many of the problems that we reviewed might be ameliorated.

I. The Nature of Financial Assets and the Application of Contract and Property Laws

A. What Are Financial Assets?

I define financial assets to mean promises by one person or institution to another person or institution to pay money or deliver another financial asset upon certain conditions, in exchange for money or another financial asset to be provided immediately or at a later date. Financial assets differ from real assets and from money because they consist of promises; in other words, they are contractual promises.(fn8)

Like real assets, some financial assets are tradable-for example, shares of stock-and some are not tradable-for example, loans. This distinction is crucial because non-tradable financial assets are treated in law as contracts. Tradable financial assets are treated in law as contracts as well, but the trading of these contracts is treated as the trading of property and is subject to conditions different from contract law.

Contract law is designed to encourage interaction among fewer and more specific parties.(fn9) Therefore, the parties may agree on any legal terms, impose limitations on the transfer of the contract rights to others and, with some exceptions, keep the terms of their relationships secret; contract law allows the parties to "personalize" their relationship. In contrast, property law is designed to encourage the creation and development of markets.(fn10) Therefore, to reduce information costs, property law limits the deviations of terms classifying ownership property to approximately thirteen types.(fn11) In addition, property law declines to enforce a total prohibition on the transfer of property; such a prohibition is deemed contrary to public policy.(fn12) Further, property law imposes different degrees of publicity regarding transfers of property.(fn13)

B. Financial Assets Offer Promises and Combine Contract and Property Law

One feature of financial assets is that they combine contract and property. To be sure, property rights include the right to contract with others on various terms. Financial assets, however, consist of the parties' agreements. The law rarely imposes conditions on the structure and terms of these agreements; they are, after all, contracts. However, agreements subject to market trading must be suitable for trading, and market rules apply to tradable financial assets, including publicity of relevant information. If, however, the number of parties is small, and the parties are wealthy and sophisticated, then more of the contract view will be taken, and the availability of legal intervention will be weakened.

As noted, like property rights in real assets, trading in financial assets is limited to a fairly small number of forms of alienation (e.g., sale, lease). However, the content of financial assets, being contracts, remains unlimited.(fn14) It is assumed that, regardless of their complexity, disclosure of the terms of these assets will suffice to protect the buyers and the traders from misunderstanding the benefits and risks that they are taking. One could argue that some real assets are highly complex as well...