What is LDV ?

Who benefits from LDV?

LDV benefits all participants in the securities finance industry.  Lenders are better able to exercise their corporate governance responsibilities and, since lenders recall fewer loans, overall securities lending volume and revenue increase.  Loan, borrow, and collateral portfolios are more stable, allowing agents and brokers to more effectively manage investment, counterparty, and operational risks.  Corporate issuers receive more proxy votes from long-term investors, allowing them to reach quorum more quickly and at lower cost, and counterbalance votes of short-term activists.  Higher loan volumes also improve financial market liquidity and price discovery.

 

What is Lender-Directed Voting, or LDV?

LDV is a new process that matches securities lenders' loaned shares to broker securities that would otherwise go unvoted, enabling lenders to direct proxies without recalling loans.  It substantially improves existing market practices, which require lenders to recall loan in order to vote proxies.  Recalls are inefficient in that they reduce overall lending and borrowing revenue, and create instability in loan, borrow, and collateral portfolios. 

Why haven't lenders voted on loaned shares in the past?

Historically, institutional securities lenders had to forgo voting rights on loaned shares because there was no mechanism to vote without recalls.  Recent technology and transparency improvements in securities finance markets, however, enable loaned shares to be matched with broker shares that would otherwise go unvoted.  In particular, the Agent Lender Disclosure Initiative made apparent the direct counterparty relationship between lenders and broker-borrowers and provided brokers with detailed loan data necessary to include lenders in their proxy allocation routines.

Are there enough unvoted shares to cover lender voting interest?

Approximately 60 billion U.S. equities go unvoted each year[1], while roughly 15 billion shares are on loan[2], suggesting that sufficient votes could be available to meet lender vote demand.  However, it is unlikely that lender voting interest will be fully covered for all issues, such as those with particularly contentious proxy events or that are hard-to-borrow in securities lending markets. 

[1] www.broadridge.com/investor–communications /us/Broadridge_Proxy_Stats_2010.pdf
[2] Data from RMA securities lending composite, assuming $20 average stock price

Does the broker have the lender’s shares on the proxy record date?

1.  U.S. Federal Reserve Regulation T (“Reg T”) defines the permitted purposes for the extension of credit in the borrowing and lending of securities. In general, all of these purposes involve settling trades through re-delivery of the borrowed securities. Most often, the broker’s need to borrow has arisen after failing to receive securities required for an impending trade settlement, either as the result of an operational breakdown or after a short sale.

2.  Given the broker-borrower’s mandatory compliance with Reg T, it can be argued that borrowed shares, which are re-delivered in the settlement of a trade, are not available on the broker’s books (as a technical matter, the position would be held at DTCC) in order to earn voting rights on the proxy record date. However, this argument would only be true per se if the settlement took place on the proxy record date, because an analysis of the ongoing process reveals that the proxy votes, not just the entitled shares, are properly treated as fully fungible on the broker-borrower’s books.

3.  Reg T does not require that the borrowed shares be returned to the original lender when a subsequent receipt of securities is used to offset the original failure-to-receive. At that point, the borrower can certainly return the securities to the original lender. Yet, an active borrower can also compliantly decide to close a loan of the same securities with a different institutional lender whose terms may have become less attractive or from another broker-dealer lender who may be viewed as more likely to recall shares at an inconvenient time in the future, especially if the shares were borrowed for an ongoing short position. Still another reason may exist to hold the securities if the broker considers the return on its cash collateral, received through a rebate from the lender, to be very attractive compared with other investment options. In all those cases, as well as for actively traded issues where there may be a high risk of ongoing settlement failures, the broker can simply keep the newly-received shares in its inventory, balanced against its obligation to the lender.

4. As a result of efficient management of its settlement obligations, a broker – perhaps all brokers – may well have borrowed positions on their books on proxy record dates. The brokers would have gained the right to assign proxies or even to vote at the next corporate meeting as a direct result of the original loans from institutional lenders. In effect, the proxies are fungible on the brokers’ books, along with the borrowed shares themselves subject, of course, to an equitable assignment of proxy rights in compliance with stock exchange rules. Yet, brokers are not expressly permitted to assign proxies to their institutional lenders. At this point, the Lender Directed Voting (“LDV”) argument gains relevance and substance.

5. As noted, in addition to holding the shares cum voting rights, the broker also retains an obligation to its original lender. Indeed, one could argue that an institutional lender's ownership rights are stronger than those of other “beneficial owners” to whom the broker owes shares in the same securities. That is partly due to the distinction that can be drawn between the institutional lenders, who do not receive proxy assignments, and the broker’s own margin customers and hedge fund clients, who do receive proxy assignments. The distinction resides in the timeline of their property rights: the former owned the shares fully prior to lending them to the broker, while the latter required broker-financing in order to acquire their positions. Although we have seen that the institution’s shares may now be on the broker’s books, it is very likely that the financing customers’ shares are out on loan, i.e., hypothecated as collateral to source the broker’s own funding needs. And, in such cases, those positions are truly not in the brokers’ DTC account, although the brokers may well be assigning proxy rights to their accountholders. One can ably argue that those proxies would more equitably be assigned to the institutional lenders.

How can lenders instruct broker shares?

Brokers administer proxy allocation routines to distribute proxies to their customers.  Since broker shares are held in fungible bulk and lenders have beneficial ownership to loaned shares, brokers can include lenders in their allocation routines.  After brokers allocate proxies to lenders, standard proxy processes are followed to garner and submit voting instructions and submit them to corporate issuers.  For example, proxies are assigned to Broadridge accounts designated for the lenders, then are instructed by lenders or ISS on the lenders' behalf.

Could lenders also instruct custodians' unvoted shares?

Regulatory and operational considerations may pose challenges to matching custodians' unvoted shares with lenders’ loan positions.  In particular, custodian shares are not held in fungible bulk, as are broker shares, which presents difficulties when considering custodial allocation of proxies across lender accounts. Furthermore, custodians are not counterparties on loans, so the lenders are not beneficial owners to any of the custodians’ unvoted shares.

Does LDV contribute to “over-reporting,” since lenders’ shares were delivered to new buyers who now have the associated voting rights?

Existing proxy reconciliation processes are sufficient to address any potential "over-reporting" issues.  For example, brokers already use post-reconciliation processes to mitigate the risk of over-reporting that may arise from assigning proxies to margin customers whose shares may have been loaned or rehypothecated.

How do brokers decide which lender(s) are assigned proxies?

Beneficial owners and regulators have expressed concerns about voting opportunities being directed to preferred lenders or leveraged for beneficial loan terms.  In the same way that agent lending queues are designed so that lenders get equitable access to borrower demand, brokers need pre-defined and algorithmic “proxy queues” to ensure equitable assignment of voting opportunities.  Furthermore, on-going auditing and validation of proxy assignments may be needed to ensure against development of a “market for votes.” 

What if proxies are not available from a lender's borrower, but are from another broker?

Reallocation of the loans to brokers with available proxies would increase overall lender voting opportunities.  However, numerous other loan factors would need to be taken into account, such as counterparty risk assessments and credit limits, loan prices, and collateral types and quantity.  Considering these factors, loan reallocations may not be in the overall best interest of lenders and borrowers, and will have to be considered on a case-by-case basis.

How can lenders know, before record date, how many proxies they will be assigned?

To the extent that lenders receive proxies through LDV, they will not have to recall loans to regain voting rights.  However, broker holdings change daily and varying numbers of investors vote, so the number of proxies that can be assigned to lenders cannot be known with certainty until just before the meeting date, which is typically two months after lenders must make record date recall decisions.   The number of available proxies must therefore be forecasted, taking into account factors such as each broker's customer base, the scarcity of shares in the securities lending market, and the expected materiality of proxy ballot items.

Corporate Governance Blog

Sunday, February 26, 2017

The Overlooked Merits of Bank Disclosure


Author: David Schwartz J.D. CPA

  • What if banks were to get a capital benefit from investing in superior risk management technology – and if that benefit was disclosed to the market?
  • Should not the costs of risk management investments by FDIC-insured banks be partly repaid by taxpayers in the form of capital relief?
  • Why don’t capital rules allow a reduction in risk-weighted requirements, to help offset the lost revenue and encourage conservative risk management?
  • Dynamic metrics are far more relevant for understanding the levels of stability in securities finance than are static sizing and demographics alone.

 

European bankers are caught up in a debate over whether to disclose their full supervisory capital demands to market participants. That’s an issue because bank supervisors, under Pillar 2 of the Basel III accord, can set a bank’s regulatory capital “guidance” at a level higher than its Pillar 1 “requirements.” Bank analysts and investors can discount the securities of banks with relatively high guidance, assuming that supervisors have learned something negative in their confidential reviews. That’s the essence of Pillar 3: Market Discipline.
 
Financial reporters and investors are in favor of full disclosure for both capital requirements, as well as Pillar 2 guidelines. “Markets operate best with greater transparency,” asserted an editor in the January 31, 2017 issue of Global Capital. “There is simply no need for banks to let the size of their capital buffers become a subject for speculation when they have the option to publish all of their supervisory capital demands.”[1]
 
At least some legislators also support the release of more information underlying the regulatory capital metrics.  For example, Conservative Party MP Andrew Tyrie has urged the Bank of England to disclose more about the internal risk models of large UK banks.
 
“The market mechanism for imposing good behaviour on banks might work better, possibly much better. Its manifest shortcomings were brutally exposed in the crash,” argues Mr. Tyrie, whose views were cited in the Financial Times of June 7, 2016. [2] “The case for greater disclosure is now strengthened, not weakened, by the greatly increased intrusiveness and complexity of the supervisory process and of financial regulation.”
 
Regulators and supervisors have resisted calls for more disclosure of specifics. Bankers are uncertain, at least based on the disclosure evidence cited by the FT. That may be a function of the fact that Pillar 2 can only be capital accretive, not reductive.[3] Yet, bankers should be firm supporters of universal disclosure – for the reasons that we explain below.  
 

  • What if banks were to get a capital benefit from investing in superior risk management technology – and if that benefit was disclosed to the market?

 
There is no explicit credit in the regulatory capital accord for banks which offer superior risk-management services. Presumably, supervisors invoking Pillar 2 of the Basel Accord can take that into consideration, although at present they cannot adjust capital buffers below the minimum requirements. That’s not fair to banks that have invested heavily in systems to control their risk exposures.
 
Case Study: Securities Finance
Banks lend securities while offering indemnification against borrower default to their institutional and corporate customers. Currently, the weight of new capital regulations is forcing banks to price the indemnification beyond customers’ ability to pay.[4]  As a result, the availability of securities to lend is expected to drop by as much as 50% in the next five years, potentially leading to impaired pricing efficiency in markets and higher risks for investors.
 
If supervisors were willing to accept the relative strength of an agent bank’s risk management systems and if Pillar 2 could be used to reduce a superior risk manager’s capital requirements, then it could be argued that lender indemnification for some agent lending programs should be exempted from the capital regulations or fractionalized in some way. (Similar arguments with different metrics could help borrowers with their own regulations, especially the net stable funding ratio.) That would be a huge incentive for banks to invest in the best possible risk management technology.
 
There is a solid logical basis to argue for regulatory capital relief resulting from superior risk management technology. There is also strong evidence to believe that banks would seek that relief, rather than repeal of Dodd-Frank regulations, based on the enormous post-crisis investment that banks have made in risk management and compliance systems.
 
According to one senior banker, “Agent lenders have made great strides in mitigating the perceived risks in securities lending especially in terms of cash reinvestment where most of the problems occurred during the financial crisis.  We focus on liquidity, concentration risks, diversity, as well as appropriateness of haircuts, collateral type, the mix of collateral – it goes on and on.”
 
That level of risk management is a big investment for any bank. But it’s not being considered as an offset against such capital impositions as the counterparty concentration limit, the leverage ratio, or other metrics that force capital to be reserved against off-balance sheet risks. 
 

  • Should not the merits of risk management investments be disclosed and their costs partly repaid by taxpayers in the form of capital relief?

 
Supervisors should have the ability to reduce the capital requirements for banks with above-average risk management systems in their business lines.  What does that mean in specific terms? Let’s look at one example:
 


Discussion: In securities finance, agent banks currently hold collateral against the securities that are loaned out for their customers. The agents’ risk management systems mark the collateral to market prices each day, but the details of the process can differ among banks. Sometimes the differences are subtle, visible only when comparing contractual commitments among agent banks. Perhaps a benchmark should be devised to show those differences – not to rate the contracts of individual customers, certainly, but to reveal an average for the bank itself, which may be kept confidential by supervisors, and, for all banks, as an information release to the public market.[5] 


 
Initial haircuts on collateral in securities lending may be standard, depending on the form, but the point can vary at which additional margin is demanded of the borrowers. Conceivably, any bank which allows collateral margins to fall below 100%, all else equal, would be taking more risk to offer its default indemnity. However, that bank might be in an excellent position to judge the exposure to its counterparty, more so than a universal statistic. Conversely, banks might be seen to take less risk when maintaining margins above the average. That adds protection against a taxpayer bailout, ultimately, but such a policy is also likely to make loans of easy-to-borrow securities less attractive to borrowers.
 
(These examples are merely illustrative to help consider options “outside the box” for regulatory capital reform. It may be far too difficult to collect the required metrics, compute the benchmarks and then analyze the results to be practical. Yet there must be a better system than the one that currently has resulted in so many unintended consequences. )
                                                                                                  

  • Why don’t capital rules allow for a reduction in risk-weighted capital requirements, to help offset the lost revenue and encourage more conservative collateral management?

 
Customer income and bank fees will fall if borrowers consistently avoid banks which enforce tough collateral margins. Still, that income drop is a normal risk-return outcome, well understood by customers and their bank relationship managers.


Discussion: In another example from securities finance, the trading desks of agent lenders generally hold a loan buffer that prevents the distribution of the total inventory of available positions in a securities issue. That’s useful in the case of a loan recall, when the customer has sold its position and needs the borrowed securities back to make delivery.  The buffer allows the agent bank to substitute another lender’s position, thereby obviating the need to close out the loan and return the borrower’s collateral. Buffers are clearly risk mitigants, since excessive recalls by lenders during a crisis would force the return of cash collateral and possibly lead to fire sales of longer-dated instruments. The buffers protect the taxpayer, but there’s an obvious opportunity cost to the customer and the bank that holds a substantial buffer. Fear of cascading fire sales is at the heart of the securities finance regulation, but none of these dynamics are currently being considered either in the details of the capital regulations or in the data collection process itself.
 


At present, the data aggregation process of global supervisors is focused on levels and loans. There’s very little data on collateral management, buffer maintenance or other dynamic metrics. But now may be the time to change that, along with a revision of the capital regulations. Banks that disclose the efficiency of their investments in risk-mitigating technology should be granted not only a market premium on their securities, but also consideration in relation to their capital requirements (and guidelines).
 

  • Dynamic metrics are far more relevant for understanding the levels of stability in securities finance than are static sizing and demographics alone.

 
There’s no question that the time is right for an enlightened construct to revise/replace the current macroprudential framework. In a January 31, 2017 letter to Federal Reserve Board Chair Janet Yellen, the House Republicans announced “a comprehensive review of past agreements that unfairly penalized the American financial systems in areas as varied as bank capital, insurance, derivatives, systemic risk, and asset management.”

There's more than one way to approach systemic risk mitigation so why not try capital relief and disclosure?

 
 
[3] Although the limits of Pillar 2 are not entirely clear, the Prudential Regulation Authority of the Bank of England’s Statement of Policy, dated July 2015 and updated 2016, makes no mention of any methodology used to lower the capital requirements set in Pillar 1 computations.
[4] Advocates for the new capital charges contend that the market has not priced the risk properly to date. Opponents show a long history without losses and reply, ‘Yes, it has.’
[5] However, the bank could elect on its own to release the comparative results in responding to customer requests for proposals or in other forums, should it so desire.

 

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Corporate Outreach Milestones

MILESTONES FOR LENDER DIRECTED VOTING

May 8, 2014: Council of Institutional Investors; - CII Elects New Board, Names Jay Chaudhuri Board Chair. http://www.bloomberg.com/news/2014-01-31/north-carolina-treasurer-may-cede-pension-control-5-questions.html )

February 2014:  Swiss Minder Initiative implies the value of LDV. http://www.ipe.com/switzerlands-minder-initiative-will-cripple-securities-lending-experts-warn/10000947.article.

January 2014 – FL SBA begins their SecLending Auction Program with eSecLending.

November 27, 2013 – CSFME staff call with Glass Lewis Chief Operating Officer. He gave his commitment for cooperation and support for LDV, and most importantly, he suggested that perhaps we should discuss with a Broadridge/State Street/Citi the scenario that permits Citi to forward an “Omnibus Ballot” of proxies to State Street, which State Street would then take and assign the proxies to their pension lenders/LDV participants, which would then be incorporated into a single ballot and sent to Broadridge. This eliminates the secondary ballot issue. While this description is oversimplified, Glass Lewis was fairly certain the parties involved could operationally create such a combined ballot. Responding to the question on cost, the Glass Lewis executive stated that the cost depends on the number of voting policies a fund has. Most funds have one policy; therefore, depending on the client, the cost would be $.75 – $2.00 per ballot.

October 21, 2013 – CSFME staff call with ISS Chief Operations Officer. He committed his cooperation and support to advance LDV’s implementation into the markets. He responded to the question about cost: “It depends on the client and the services they use. $6-7 per ballot on average.”

June 25-28, 2013 – CSFME staff attended ICGN Annual Conference in NY, NY. Spoke with executives of CalSTRS; ICGN Chair and Blackrock about LDV.  We received favorable comments and encouragement from each.

June 6, 2013: CSFME meets with Chief Investment Officer for NYC Pension Funds. While very much in favor of the LDV concept, the comments that the NYC Pension Fund Boards are for the most part followers in new initiatives and would prefer a roll-out by other funds first.

April 5, 2013: ‘SEC gives CSFME limited approval for LDV going forward’ providing brokers assign proxies only from their proprietary shares.

March 26, 2013 – CSFME and its legal team presented the case for LDV to SEC Commissioner Dan Gallagher. Present by phone and speaking on behalf of LDV were representatives of FL SBA who spoke about the difficulty of timely recall of shares on loan following release of record date and issues on agenda; and a representative from CalSTRS who spoke about their recall policy affecting income.

March 13, 2013 – CSFME meet staff of Senator Rob Portman and Congressman Steve Stivers of Ohio. These meetings were for the purpose of lining up political support, should the SEC resist the LDV concept. We also met and spoke with CII Deputy Director Amy Borrus for one hour and 15 minutes for a scheduled 30 minute meeting.  She expressed great interest in the value of LDV to long-term beneficial owners.

January 17, 2013 – CSFME conference call with CoPERA Director of Investments.  Among CoPERA’s concerns were: (1) How are agents/brokers notified re: LDV? (2) Who moves or approaches first lender to agent or agent to lender? CSFME responds  that a side letter is needed between lender, agent and broker.

November 8, 2012 – CSFME conference call with Council of Institutional Investors (CII) detailing LDV. Some in attendance were opposed to securities lending because of their desire to vote 100% of recall. This position would be irrelevant giving CalSTRS’ change to policy on proxy recall.

October 24, 2012, 2PM – CSFME presents LDV to Broadridge Institutional Investor Group. At this meeting, a representative of CalSTRS states: “We would view brokers willing to provide proxies more favorably than those who would not.” We were also informed by CalSTRS that they were looking to change their 100% recall policy. A representative of SWIB led a discussion on International Voting Issues, and apparently was chairing 3 meetings to determine the following: 1. who is voting internationally? 2. What are the issues in the international markets? 3. How do we increase and improve international processes?

October 24, 2012, 11AM – EWB/KT conference call with ICGN.  Executives stated that the argument for LDV may not be as strong in a non-record date market, and asked what would be the cost for LDV.  They further stated that they would like to see the U.S. go with LDV first and would need more information and operational detail.

October 13, 2012 email note from Elizabeth Danese Mozely to Broadridge’s Institutional Investor Working Group: “TerriJo Saarela, State of Wisconsin Investment Board, will provide commentary on their fund’s interest in international voting and an update on her participation in the Council of Institutional Investors’ working group on international voting.  Our discussion will include the differences in process for voting abroad, share blocking, attendance at the meeting via proxy or Power of Attorney (POA), best practices available through the various laws and regulations, etc.”

September 18, 2012: CSFME contacts Blackrock/ICGN Chair for a brief on LDV.

August 13, 2012 – CSFME conference call with OTPP.  Discussion of LDV was not timely in that their SecLending Program stopped lending securities through agents in mid-2006. State Street is their custodian and they were using a tri-party repo through Chase to Lehman, until the Lehman collapse. All the assets sat at Chase. It was not clear who had voting rights. At the time of this discussion in August 2012, OTPP was thinking formulating an SLA because they do not have the capacity to lend securities on their own. We have had no discussion with them since.

August 2, 2012 – CSFME contacts Ontario Teachers’ Pension Plan (OTPP) regarding LDV.

March 19, 2012 – CSFME conference call with executive in charge of securities lending for Franklin Templeton

February 22, 2012 – ICGN sends LDV letter of support to the SEC, signed by Chairman of the ICGN Board of Governors.

September 30, 2011 – CalSTRS sends LDV letter of support to the SEC, signed by Director of Corporate Governance Anne Sheehan.

July 18, 2011 – Florida SBA sends LDV letter of support to the SEC, signed by Executive Director and Chief Investment Officer.

November 2011 – CSFME introduces Council of Institutional Investors editor to LDV.

July 5, 2011 – CSFME sends a Comment Letter to the Securities and Exchange Commission regarding LDV.

October 2010 – CSFME releases report: Borrowed Proxy Abuse: Real or Not? This report and the SEC’s Securities Lending and Short Selling Roundtable prompted the question from beneficial owners and regulators regarding the need to recall shares on loan to vote proxies, why can’t lenders receive proxies for shares on loan when we get the dividends? From this question, the idea for Lender Directed Voting was born.

January 2010 – SEC issues rules that brokers no longer have the discretion to vote their customers’ shares held in companies without receiving voting instructions from those customers about how to vote them in an election of directors. http://www.sec.gov/investor/alerts/votingrules2010.htm. The rule, periodically, contributed to the difficulty of corporate meetings attaining a quorum.

Fall 2009/2010 – Four public pension funds join CSFME in Empty Voting studies/LDV initiative; FL SBA, CalSTRS, SWIB and CoPERA.

September 29-30, 2009 - SEC Announces Panelists for Securities Lending and Short Sale Roundtable; http://www.sec.gov/news/press/2009/2009-207.htm.