The Paradoxical Erosion of Corporate Governance as Market Efficiency Rises

Financial market efficiency and risk management techniques, notwithstanding a crisis or two, have improved substantially in the last three decades. Investors today can create more diversified portfolios, largely due to the ongoing integration of global capital markets, and at lower cost, owing to the introduction of innovative products such as derivatives and Exchange Traded Funds (ETFs). Yet, market innovations can also contribute to a decline in the efficiency of corporate governance systems. A shortfall in informed voting has grown over time for several reasons.

First, today's investors purchase many more foreign shares, but typically vote only in their home countries. Even when local custodians cast discretionary votes, their positions would not be informed by the foreign investors’ instructions;
Second, issuers of ETFs, derivatives, and other financial innovations often accumulate actual, underlying shares only to hedge their issuances. Those intermediaries are often indifferent to their associated voting rights and cast default votes with management;
Third, many arbitrageurs and index managers are passive, cost-sensitive investors who are unaffected by the performance of the corporate issuer. Those investors are not motivated to bear the research costs to vote knowledgeably on the enormous long positions they accumulate;
Fourth, regulators have curtailed broker discretionary votes to reduce distortions in the perceived support given to directors and initiatives.
Fifth, the growth of securities finance has reduced the record-date holdings of margin customers and institutional securities lenders, which reduces the number of shares they can vote at the annual meeting.

Today’s market is a marvelous lattice. Within the market system’s own scaffolding, the “dematerialization of securities” (elimination of certificates) has enabled brokers and other intermediaries to settle billions of shares traded each day at very low cost. Regulators have encouraged investors to accept their securities, not as finely engraved certificates, but as book-entries in computerized ledgers stored within a vast network of virtual vaults called “securities depositories.” Brokers borrow securities from banks, pension funds and even from their own customers in order to make good on deliveries in depositories with ever-decreasing settlement deadlines. Yet all this efficiency has come with trade-offs, especially in the critically important practice of corporate governance.

Pension funds and other institutions that lend their shares to brokers (an institutional market activity which has grown during the last two decades to represent trillions of dollars in daily activity) keep their rights to dividends and price changes. However, these funds are forced by industry practice to give up their other entitlement: the right to vote. As fiduciaries, fund managers are required to vote if they can do so without sacrificing portfolio yield.
Income can be passed back to securities lenders because the collateral margin adjusts as the stock price changes in the market. That is called “cum dividend.”
Because loaned shares sold on the open market must encompass all rights of ownership, no one has ever been able to invent a system for securities lenders to retain their proxy votes. Moreover, many of these shares are acquired by the passive voters referenced above and therefore go unvoted. Lenders can only recover their votes by recalling loaned shares. Loans can be recalled but the operational ripples can disrupt market systems and strategies, undermining the very efficiency of ETFs, derivatives, global arbitrage, and other market improvements.

Lender directed voting (LDV) solves this problem by creating a new mechanism to bolster the efficiency of corporate governance systems. Through a novel system, LDV collects the voting preferences of securities lenders and applies them to shares that would otherwise go unvoted. In other words, LDV will maintain securities loans that support capital market efficiency while helping to reverse declining governance trends in Europe and elsewhere. Unvoted share pools operating under LDV systems will now be voted by well-informed, long-term holders. It is important to note that LDV is not an evolutionary inevitability in the securities lending markets. (Quite the opposite, since, as noted above, growth in lending has contributed to a decline in voting.) LDV is also a genuine systematic invention: no extant market, participant, or system collects voting preferences from securities lenders for loaned shares, nor matches those preferences to shares that otherwise go unvoted.

By offering to assign proxies to lenders, i.e., what we call Lender Directed Voting (LDV), brokers can gain preferential access to lendable inventory as well as enhanced standing in the agent bank queues. This is because, once the LDV process is well underway, lenders will direct their agents to allocate loans before record date to those borrowers most likely to assign proxies (but always on a 'best efforts' basis).

With enough of these preferential financing relationships, brokers can select counterparties whose credit ratings, trading characteristics or other attributes allow fine-tuning of capital charges under the Basel III regime. We believe some lenders will also be willing to offer more attractive rebates to those LDV-compliant brokers with whom they have these preferred relationships, as an incentive to position their loans most efficiently before the proxy record date.