Loan Recalls & the T+1 Countdown: Can Securities Lenders Adapt?

The securities industry is transitioning to a T+1 settlement cycle, where trades settle one business day after the transaction date. While this shift promises benefits like reduced market risk and lower costs, it poses significant challenges for securities lenders.  With new pressures to recall loans for proxy voting coupled with the T+1 environment, the current loan recall process will not be fit for purpose. With the May 24, 2024 T+1 and July 31, 2024 Form N-PX compliance dates fast approaching, immediate action is crucial.   

Pressure to Recall Loans for Proxy Votes 

Under the new Form N-PX requirements, securities lenders will be required to disclose not only the number of shares they voted for but also the number of shares they loaned and did not recall. Disclosing this data spotlights fund and manager voting records and more effectively enables investors to monitor their funds' and managers' involvement in the governance activities of their investments. It also provides information about the magnitude of a fund's voting power. This increased transparency and scrutiny may result in external pressure from investors to be more active and diligent in recalling their loaned shares so they can vote proxies in support of political or social causes, including say on pay for company executives.  

These changes could decrease revenues from securities lending for funds and their shareholders, affecting funds' advisers and affiliates. Additionally, the requirement for lenders to provide additional information on Form N-PX (such as the number of shares loaned and not recalled) could necessitate a reconfiguration of their processes, increasing the cost of compliance for securities lenders and their agents. 

The Existing Loan Recall Process 

In the prevailing T+2 settlement cycle, securities borrowers have two business days after receiving a recall notice to return the borrowed securities. Here's how the process typically works: 

1. The asset manager notifies the lending agent of the recall. 

2. The lending agent then requests the release of the collateral from the cashiering department. 

3. If the securities have a record date (i.e., a date used to determine shareholder eligibility for voting), the share value and voting rights must be considered. 

4. The lending agent must make complicated entries that may need to be corrected quickly. 

5. Finally, the interbank accounts must be reconciled and credited with funds at the central bank. 
   
   All of these steps are interdependent, and delays can cause fails and reconciliation issues. 

Recall Challenges in a T+1 Environment 

The accelerated T+1 settlement cycle significantly compresses the above process, leading to these critical challenges: 

• Timely Recall of Securities: T+1 will affect lenders' timing of decisions to recall lent shares to vote proxies by making the process more time-sensitive and potentially requiring them to make decisions prior to the record date for the shareholder meeting. Currently, lenders have more time to make decisions about recalling lent shares because the settlement cycle is longer. However, under a T+1 settlement cycle, lenders will need to make these decisions more quickly, as they will have less time to receive proxy notices and take the necessary steps to recall the shares. This could lead to lenders making decisions based on incomplete information or without fully considering all of the factors involved. Additionally, T+1 could make it more difficult for lenders to recall shares that are in high demand, as other market participants may be competing to borrow the same shares for short-selling or other purposes. This could lead to increased costs for lenders and potential disruptions to the proxy voting process. 
   

• Increased Buy-In Risk/Risk of Fails: If obtaining the securities proves challenging, borrowers face a higher risk of buy-ins (when a borrower fails to deliver on time, they are forced to purchase the security on the open market). If they are unable to source and deliver the borrowed securities in time, the recall will fail. 
   

• Complex Accounting: Accounting teams will face increased pressure, as title transfer occurs only on the settlement date. 
   

• Operational Strain: T+1 puts strain on existing operational procedures, demanding greater efficiency and coordination between lenders and borrowers. 

The Challenge of Pricing and Recalling Voting Shares: The Disney Trian Proxy Fight 

The Disney-Trian proxy fight exemplifies the challenges involved in valuing and recalling voting shares, particularly in volatile market conditions. Trian Fund Management, a major Disney shareholder, launched a proxy fight in 2019 due to concerns over corporate governance and executive compensation at Disney. 

One major challenge was valuing the stock due to its high volatility during the proxy fight. The stock price fluctuated significantly, making it challenging for Trian and other shareholders to determine its fair value and the premium they were willing to pay for voting rights. 

Another challenge was the need to recall loaned shares to participate in the proxy vote. Many Disney shares were on loan to short sellers, and Trian had to decide whether to recall these shares and risk losing the income from loaning them or vote with the shares they already owned. 

Ultimately, Trian decided to recall only a portion of the loaned shares, as it believed that the potential gains from voting out the incumbent board outweighed the potential loss of income from loaning the shares. However, this decision came at a cost, as Trian had to pay a premium to borrow the shares that it needed to vote. 

Potential Solutions 

Securities lenders can navigate these challenges by implementing a blend of technological advancements and process improvements: 

• Process Automation: Automating critical steps in the recall process can significantly reduce delays. This includes automated notifications, collateral release systems, and streamlined communication channels. 

• Enhanced Communication: Strong communication lines between lenders, agents, and borrowers are crucial. Early notification of sales and potential issues can create time buffers for sourcing securities. 

• Compressing Financing Delays: Lending agents should explore ways to minimize the delays associated with fails to receive. This might involve working with custodians to streamline financing processes. 

• Preemptive Sourcing: Lenders may increasingly use proactive strategies to identify potentially hard-to-borrow securities before a recall occurs, ensuring they have sufficient time to locate them if needed. 

• Industry-wide Collaboration: Securities lenders can work together within industry bodies to advocate for solutions such as standardized communication protocols and more transparent settlement processes that benefit the entire lending industry. 

Conclusion 

The T+1 settlement cycle and new proxy voting disclosure requirements present unprecedented challenges for the securities lending industry. The clock is ticking, and lenders failing to adapt swiftly risk significant operational and financial disruptions. Technology, communication, and collaboration are crucial for successful recall processes in a rapidly evolving landscape.