Voting Loaned Securities Today - The Rebalancing Process

Prior to proxy record date, U.S. securities lending agents endeavor to return loaned and recalled shares to those of their institutional customers who wish to vote. The agents first try to rebalance their loaned positions (see box) and, if that’s not possible, the agents then pass the recall notice along to borrowers. In both cases, the banks try to improve the chances that their accounts at the appropriate central securities depository (CSD) will have sufficient shares on proxy record date to satisfy their customers' needs. Similar procedures exist to support the voting interests of securities lenders at securities custodians in Australia, Europe, Canada and elsewhere. The loans are recalled from brokers before the record date for an upcoming election.

If, after receiving a recall notice, the brokers don’t have the shares available to return, the firm can either a) borrow the necessary shares from a bank custodian or broker/dealer with an oversupply of lendable shares in the CSD; or, less often, b) buy the shares in the market and redeliver to the custodian’s account.

The recall of loans from the broker can be avoided right at the outset if the lending agent knows that another of its customers doesn’t intend to vote the shares. In that case, the agent can “substitute” the loan on its books from one customer to the other, without changing the identity of the borrowing broker.

If the lending agent is a "third-party” (TPA) specialist to the loan transaction, the TPA may send orders through the CSD moving the position from one custodian to another. The voting customer will have the necessary position at its custodian on record date. As a result, the lending agent will keep the loan active and neither the broker nor its hedge fund will ever know that it was almost subject to a recall notice from the original lender and its agent

The recall of loans from the broker can be avoided right at the outset if the lending agent knows that another of its customers doesn’t intend to vote the shares. In that case, the agent can “substitute” the loan on its books from one customer to the other, without changing the identity of the borrowing broker. If the lending agent is a "third-party” (TPA) specialist to the loan transaction, the TPA may send orders through the CSD moving the position from one custodian to another. The voting customer will have the necessary position at its custodian on record date. As a result, the lending agent will keep the loan active and neither the broker nor its hedge fund will ever know that it was almost subject to a recall notice from the original lender and its agent.

Presumably, oversupplied CSD members either have trading or hedging positions in which the firm has no voting interest; or they may have a number of customers that the firm assumes, based on experience, won’t cast votes. The retail shares can easily be lent out, since brokers have the right to lend shares associated with their margin account customers.

Brokers will do almost anything to avoid forcing a customer to terminate a short sale and break the trade before its time. (For this, as well as balance sheet reasons, brokers prefer to borrow the deficient position, not buy the shares outright.) On rare occasions, the brokers may not be able to find a new lender nor buy the shares outright in the market. In those cases, the lending agents have standing instructions from their lending customers to "buy in” the equivalent shares, deliver them to the custodian and declare the broker in default under terms of the industry-standard master securities lending agreement (MSLA).

Of course, neither the bank nor the broker wishes a default, so banks may sometimes accept an executed voter instruction form (VIF) in lieu of the recalled shares. Again, that VIF might be associated with a proprietary position or uninstructed retail proxies. The firm is willing to give up the vote to avoid an MSLA default and allow the loan (and trade) to continue unbroken.

It is clear that the approaching record date for an issue can impose on the market’s participants a disruptive rebalancing process, all intended to allow voters to exercise their fiduciary duties while enabling hedge funds to maintain their trades. (That disruption is part of the dynamic rebalancing that misled academic researchers ten years ago into thinking that hedge funds were manipulating the vote through the securities lending markets.)

There’s got to be a better way, right?


1 CSA Roundtable in January 2014