Theseus’s Paradox – Form and Substance in Evolving Capital Markets
posted by Charles Whitehead
Living in Beijing underscores the importance of change and adaptation. There is a noticeable drop in the amount of processed sugar in foods, reflecting local (and healthier) tastes. Virtually every restaurant delivers, including McDonald’s (which raises the question, if you’re going to order delivery, why McDonald’s?). And, most particularly, I recently joined the thousands of Chinese students and pensioners who weave in-and-around traffic on electric battery-powered mopeds. It is a great way to get around the city (even if some of the pensioners have a tendency to cut you off).
The same focus on change arises in the capital markets. A person who owns or sells a security is presumed to own or sell the financial risk of that security. By selling shares, for example, the costs and benefits of those shares—the rise or fall in share price—are understood to run with the instruments being sold. Changes in the capital markets, however, have begun to call that presumption into question. Increasingly, market participants can use new trading methods to sell instruments to one person, but transfer their financial risk to someone else. The result is greater complexity and new challenges to regulation and the regulators.
To what extent should the securities laws adjust to reflect those changes? The answer largely turns on the question of “identity.” Moving from modern-day Chinato to ancient Greece, the Greek historian Plutarch identified the question in his story of Theseus, the mythical king of Athens. For many, Theseus is known for slaying the Minotaur, a half-man, half-bull monster that devoured children sent to Cretein tribute to King Minos. According to Plutarch, after Theseus returned to Greece, his boat remained in Athensharbor for centuries as a memorial to his bravery.
To keep the boat seaworthy, caretakers replaced old planks, sails, and ropes with new ones as the originals rotted or wore away. Little by little, new materials were substituted for old. Over the years, it became unclear how many of the boat’s original items remained, prompting Plutarch to pose the question, was the boat in the harbor still Theseus’s boat? Writing centuries later, the philosopher Thomas Hobbes added a further wrinkle to the question. He asked what would happen if the original materials were stored as they were replaced and then, years later, used to build a second boat. In that case, which boat—the first or the second—would be Theseus’s?
The story helps frame the growing tension in the federal securities laws caused by change in the capital markets. Tying regulation to tangible instruments—their “form,” like the boat inAthensharbor—has the benefit of clarity. Different parties to the transaction, who may buy, sell, or hold the particular instruments, can have a clear idea of what requirements apply to each step.
Nevertheless, an approach that focuses only on form risks missing the economic “substance” of what is occurring. Differences in the regulatory treatment of transactions that are substantively the same—the “new” boat comprised of “old” planks—can result in arbitrage opportunities that distort regulation’s effects.
Let me offer an example, drawn from a series of relatively recent U.S. district court cases, including SEC v. Berlacher, No. 07 Civ. 3800, 2010 WL 3566790 (E.D. Pa. Jan. 23, 2008), SEC v. Lyon,529 F. Supp. 2d 444 (S.D.N.Y. 2008), and SEC v. Mangan,598 F. Supp.2d 731 (W.D.N.C. 2008), where the court granted the defendants’ motion to dismiss SEC claims they violated section 5 of the 1933 Act.
In those cases, a public company (A) whose shares trade on the stock exchange (Exchange), sold shares privately to a hedge fund (B), agreeing to later file a resale registration statement so that B could resell the restricted shares publicly. Due to the shares’ limited liquidity, B’s purchase price was at a discount to the price of the freely-traded A shares.
Shortly after B’s purchase from A (A -> B), B sold freely-tradable A shares short on the Exchange ( B-> Exchange) in order to lock in the spread between the Exchange price and the restricted share price. B borrowed freely-tradable A shares from a Custodian Bank (C), which held those shares for third-party clients, to settle its sale of A shares on the Exchange. A filed a resale registration statement with the SEC and, two to three months later, the SEC declared the registration statement effective. B claimed it was now able to use the A shares to return what it had borrowed from C and terminate the lending relationship.
The SEC argued for a focus on the “substance” of the transaction. Strictly speaking, the SEC’s position was that the sale of restricted A shares took place when B entered into contracts of sale with public investors as part of B-> Exchange. That sale was traced to the restricted A shares later used to settle the sale (or, in this case, to close-out B’s borrowing of shares). A’s sale to B was no longer “private” but rather was the first step in a public distribution, causing B to be engaged in an underwriting that required an effective registration statement at the time of B-> Exchange.
Within the context of Theseus’s boat, A -> B and B -> Exchange were integral to the total transaction. Combining the two changed the “identity” of the shares B purchased, from illiquid to liquid investments, with B-> Exchange transferring B’s economic risk—the “planks” of the restricted A stock—to the general public.
Notwithstanding the SEC’s position, the courts opted for an analysis that focused on form—the difference in “boats” rather than the transfer of “planks.” The instruments sold in A -> B differed from B-> Exchange and, the courts reasoned, that difference should be reflected in their regulatory treatment. How B chose to cover its short sale did not alter the nature of the short sale itself. Characterizing A -> B and B-> Exchange as two separate transactions also gave market participants a clearer idea of what requirements applied to each step.
That analysis differed from the D.C. Circuit’s opinion in Zacharias v. SEC,569 F.3d 458 (D.C. Cir. 2009) (per curiam), which affirmed an SEC order that found two officers and directors of a public company, and a group of unaffiliated third parties, to be engaged in a scheme to sell unregistered shares in violation of the 1933 Act. In the original administrative proceeding, the SEC concluded that two transactions should be collapsed into one, causing the entirety to be considered a distribution of restricted shares in violation of the 1933 Act. The court agreed, praising the SEC’s decision as “a triumph of substance over form.”
This is not the first time the securities laws have confronted questions of form and substance. Two areas, in particular, are relevant. The first is case law (in particular, United Housing Foundation, Inc. v. Forman, 421 U.S. 837 (1975); Landreth Timber Co. v. Landreth, 471 U.S. 681 (1985); and Reves v. Ernst & Young, 494 U.S. 56 (1990)) concerning the definitions of “stock” and “note.” The second is SEC efforts (among others, the standard five-factor test) to define when two separate transactions, each of which on its own would be exempt from SEC registration (or one of which is registered), should be collapsed into one transaction for purposes of determining which (if any) exemption applies.
Both areas incorporate factors that relate to the form or substance of the instrument or transaction under review. Economic substance is important, as Forman indicates, but Landreth also underscores the importance of certainty in transactions involving “traditional” stock. Reves begins with the presumption that form matters, but provides guidance on the substantive features of a note that take it from under the securities laws.
Lastly, the five integration factors address features to be considered when determining whether separate transactions should, in substance, be treated as one. Neither the cases, Forman, Landreth, or Reves, nor the integration factors relate directly to the tension between form and substance that is arising today. Each of them, however, provides useful guidance on characteristics to consider when assessing the form of a transaction and the substantive features that determine when two transactions should be treated as one.
Perhaps we are at a stage when it would begin to be useful—from the perspective of certainty and consistency—to consider a basic test to assist in adapting existing regulation to changes in the capital markets. Continued change in the capital markets is likely to place further pressure on securities regulation.
At this early stage, the SEC and the courts have had difficulty defining the basis on which existing regulation should apply to new products and strategies. The resulting ambiguity can slow innovation, as well as raise the possibility—like in the hedge fund short-sale cases—that new decisions will disrupt settled SEC positions and marketplace expectations.