Regulatory resistance to the use of stock borrowing in proxy battles is likely to harden , according to a report in the Wall Street Journal (WSJ) this week.
The newspaper says that the effects of fund managers who borrow stock (and therefore voting rights) to influence the outcome of votes – a practice dubbed “empty voting” in a study by two University of Texas professors, and worth an alleged $8 billion a year to brokerages and fund managers – is exacerbated by the failure of registrars to prevent stock being voted more than once, by borrowers and owners of the same shares.
The New York Stock Exchange, which says tracking of votes has become inadequate, found over-voting in almost all the shareholder votes it tested in 2002 and 2003: 23 of 27 instances.
Problems such as this can not only result in outcomes inimical to the interests of long term shareholders, but undermines efforts by public authorities to improve corporate governance by encouraging greater exercise of proxy votes by institutional investors.
In 2002, British hedge fund Laxey Partners, which owned a 1% stake in real estate company BritishLand, sought to break up the company and oust its chairman John Ritblat. With a key proxy vote approaching, Laxey boosted its voting stake in BritishLand to 9% by borrowing more than 40 million shares days before the record date. By being shareholders of record on the record date, Laxey was entitled to vote at the next meeting. Laxey’s proposals were eventually defeated, but Ritblat criticized Laxey for borrowing the shares, and three institutional invesrors that lent out shares – Hermes, Barclays Global Investors and Scottish Widows – apologized to BritishLand. Hermes says it did not lend shares to Laxey but apologized to BritishLand for not recalling its shares and voting its full strength in support of management.
The WSJ cites Securities and Exchange Commission Chairman Christopher Cox promising a “regulatory response” to the practice in a recent interview., but says the SEC has no firm plans yet. The London regulator, the Financial Services Authority, is studying the issue. Fund manager Hermes, now run by former CalPERS luminary Mark Anson, has called for regulators to outlaw voting by stock borrowers. The Hong Kong Securities and Futures Commission is also studying “issues relating to borrowed shares and voting,” says the WSJ.
The WSJ says that Paul Atkins, a Republican SEC commissioner, expressed concern in a speech this week that empty-voting and other techniques should be considered as the SEC looks to tackle other shareholder proposals.
The average value of securities borrowed has reached $1.6 trillion, according to New York-based research house, Astec Marketing Research Group Inc.,
The WSJ notes that securities lending experts point out that shareholders can recall stock if they wish to vote, but says this is not always easy to accomplish.
The WSJ says law professors Henry Hu and Bernard Black at the University of Texas at Austin studied 22 instances world-wide from 2001 through 2006 in which either borrowed stock or hedging strategies, or both, were used, and had a material effect on the outcome of the vote. The study identified twelve instances in which it appeared that hedge funds or other large shareholders voted to try to swing public-company contests in their favour without a substantial stake. In ten others, they said investors just hid their stake in the company until a vote was held.
“You have this whole superstructure built on this notion that there is this coupling of economic interest and voting power,” the WSJ quotes Hu as saying. “With these financial innovations, you’re screwing around with the foundation.”
Hedge funds argue that voting borrowed stock is a legitimate activity, and often in the interests of shareholders, and not that institutional investors profit from the practice. CalPERS reported in October that it made $129.4 million in net income from lending securities for the year ending 31 March 2006.
On the other hand, the WSJ says mutual fund manager Lord Abbett has reduced its lending of securities because of recall difficulties. CalPERS says it prohibits lending its 30 largest equity investments to make sure they are available for voting, and on a second list monitors 300 of its largest so that if it wants to vote the shares, it can try to get them back.
One idea is to tie voting rights to length of time stock is held, says the WSJ. However, the WSJ adds that any response by regulators will be designed to avoid disrupting the stock lending market, and any unintended or perverse consequences, such as disenfranchising retail investors.