Saturday, August 11, 2012

Should We Be Alarmed About Empty Voting?

Author: David Schwartz J.D. CPA David Schwartz J.D. CPA

Should we be alarmed about empty voting? According to a recent article, "A Call to Arms on Empty Voting!" by Andrew MacDougall, Robert M. Yalden and Jeremy Fraiberg, yes, we should indeed.  Using a proxy battle over a proposal by Canadian company, TELUS to eliminate its dual class share structure earlier this year as an example, MacGougall, Yalden, and Fraiberg assert that as "the number of public M&A transactions increases, and if U.S. hedge funds continue to look for opportunities in Canada to engage in strategic gamesmanship, concerns about empty voting will also increase."

The authors admit that in most shareholder voting situations, the subject matter of the vote does not lend itself to an economic arbitrage opportunity, and are therefore unlikely targets of intentional empty voting. The most likely scenario for an economic arbitrage opportunity is an M&A transaction, and clearly only a subset of those M&A transactions can be made to yield profits by empty voting strategies.   Hedge funds or other investors wanting to employ an empty voting strategy must find instances where "the holder of the voting right has an opportunity over the short term to realize economic consequences from the decision that are the reverse of those that would be realized by other shareholders."  The article identifies two particular classes of transactions requiring shareholder approval that may be targets of economic arbitrage via empty voting:

In particular, economic arbitrage opportunities may exist where a target company needs to obtain shareholder approval for a transaction and either (1) the target faces a simultaneous takeover bid from another party (for example, those who support the takeover bid may use empty voting to vote against the other transaction) or (2) the acquirer also requires shareholder approval under stock exchange listing requirements due to the number of shares to be issued by the acquirer in the transaction (for example, by providing an opportunity for shareholders of a target to engage in empty voting of the acquirer’s shares to ensure approval of transaction that is favourable to target shareholders).

Concerns about empty voting have arisen in the past.  In 2006, a team of academic researchers claimed to find evidence of “vote buying” and manipulation of corporate governance in the U.S. equities securities lending markets. Their studies claimed that spikes in equities lending activity on proxy record dates proved unequivocally that abuse by share borrowers was “widespread” and, further, that control of voting rights could be acquired at no cost.”  This led corporate advocacy groups to call on regulators to force the disclosure of “hidden ownership” by activist hedge funds. In turn, the Federal Reserve, Securities and Exchange Commission, Internal Revenue Service and the Finance Committee of the U.S. Senate began to investigate securities lending markets. In addition, investor advocacy groups, including the Council of Institutional Investors and the International Corporate Governance Network, along with leading public pension funds, added their calls for prudent regulatory structures to be rebuilt, along “with heightened international coordination.”

According to a study conducted by the RMA in conjunction with CSFME, however, the data supporting the claims of borrowed proxy abuse was likely incomplete, and failed to account for some key aspects of how the securities lending market and proxy process work (like substitution effects, and proxy allocation controls at the broker level). Lacking proper data, and without considering structural and operational controls currently in place, RMA and CSFME argued that there was no basis on which to conclude from loan volumes around record dates that widespread and abusive empty voting was in fact taking place.  In addition, RMA and CSFME called into question the assertion that votes can be acquired for virtually no cost.

”The research findings from our current study strongly imply that the Christoffersen team had inadequate data resources. Even though two corresponding databases were used to reduce sample bias, their team was unable to observe the substitution of borrowed positions, a dynamic that was taking place after recalls were issued by lenders who, among other motivations, intended to vote.” p.9

“Accordingly, any further research into the relationship of securities loan rates and volume needs to account for these pricing dynamics, as well as for other factors such as rates of return on cash collateral investments. Without such an analysis, firm conclusions about the relationship between pricing and loan volume, or the effects of any particular factor such as the timing of record dates, may well result in invalid conclusions.”

While it is true that events of abusive empty voting like the TELUS proxy mentioned in the article do take place from time to time, it is still unclear two what extent hedge funds or other savvy investors are taking advantage of empty voting strategies for profit.  Without further study using complete and accurate data, should we be alarmed about widespread empty voting based on anecdotal evidence?

It is a fundamental assumption underlying our system of corporate governance that shareholders are entitled to make certain decisions because they have a real economic interest in the outcome.

We can agree that empty voting violates a basic principle on which corporate governance is based.  For this reason, we can also agree that empty voting, both unintentional and intentional, should be curtailed if not eliminated.  There are, however,  less ponderous and drastic ways than globally coordinated regulatory initiatives of controlling empty voting, including CSFME's  "Lender Directed Voting" concept whereby lenders of securities could, by contract, retain their right to vote lent shares without having to recall them. By reserving the right to vote lent shares, institutional lenders can ensure they exercise their corporate governance duties with respect to the shares, while lending them to borrowers like hedge funds whom will be able to use the borrowed shares for permissible purposes, but not for vote buying purposes. Without firm evidence of widespread empty voting for abusive purposes, there just are no grounds for sweeping global reforms, particularly when other more practical solutions may be at hand.