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

Friday, September 2, 2011

BOE’s Paul Fisher Examines Tail Risks and Contract Design


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

In a September 1, 2011 speech at Clare College in Cambridge, Paul Fisher, Executive Director for Markets of the Bank of England, outlined his thoughts on ways risk taking is executed and how contracts between parties assuming these risks can have “a profound impact on systematic stability beyond the normal consideration of formal regulations.” 

We focus on one aspect of market structure: contracts where, because of a failure to take into account how the financial system as a whole operates, the true value of the contract is different from what it was intended to be – by at least one of the counterparties who struck the contract. This can arise either because in states of the world in which a particular contract is designed to have value there is high correlation with other events or where, in that state of the world, full adherence to the legal structure would cause large unintended consequences in terms of signaling or reputational damage.

Applying lessons learned from the financial crisis, Fisher recommends that parties should structure their transactions with a critical evaluation of contingent exposures, and take into account stress correlations with an eye on capturing tail events properly.  In addition, Fisher also advises that implications of a contract should be clear and the structures should be as transparent as possible. 

To illustrate his recommendations, Fisher looks at two areas where the value of contracts did not match market realities.

“Wrong Way Risk”

Fisher begins with an examination of “wrong way” risk in tail events, where contracts entered into for the purpose of providing insurance ended up adversely correlated with the credit quality of the counterparty providing the “insurance.”  Mr. Fischer addresses a fundamental question of why the correlation problems of these transactions were not apparent before default events occurred. 

If such an insurance contract is worth having, one must be able to envision the tail event happening and what the circumstances might be. Why was it so hard to anticipate what would happen if there were losses on large numbers of bonds insured by monoline insurers which had relatively small amounts of capital?

The primary reason seems to be that the parties involved measured the risk of default events using antiquated, or inappropriately local metrics like VAR and other correlations based on historical averages rather than actual stress tests for different sets of potential market conditions. 

A lot of the surprise seemed to come from the fact that virtually all risk management had been done within a “local” framework, rather than genuinely extreme stress tests. If regulators, rating agencies or, for that matter, bond and equity investors had demanded analysis based on extreme stress tests, many of the repercussions in the system could have been identified. The main point is that a stress test has to be internally consistent.

Secondarily, large numbers of these transactions were entered into, not as genuine hedging transactions, but as portfolio management or “window dressing” measures.  Having the insurance in place made exposure numbers reported to regulators and stakeholders more palatable, and obscured the true magnitude of the risks undertaken.  These window dressing transactions worked together with true hedging contracts to increase systematic risk by creating a highly interconnected web of contingent exposures across leveraged institutions. 

Many of these investor groups are, however, subject to an extensive regulatory framework, making them unable to hold such risks in their portfolios, in many cases even as a very small fraction of total assets. There is a potentially difficult tradeoff here between public policy objectives of appropriate investor protection and systemic stability considerations. That probably deserves to be debated more fully. It is clear, however, that highly leveraged institutions such as banks and hedge funds are not really suited to be the ultimate repositories of extreme tail risk

Reputational Risks in Tail Events

In certain circumstances, “a market participant may voluntarily choose not to enforce a contract that is “in the money” if the reputational repercussions are perceived to  cause more damage than whatever could be gained financially by enforcement.”  According to Fisher, this course may seem irrational on the surface, but is driven by classic time inconsistency, and may make perfect sense in practice. 

Fisher uses the structured investment vehicle (SIV) crisis to illustrate.  In 2007, when the asset backed commercial paper markets closed suddenly, SIVs were starved for funding.  Banks sponsoring the SIVs had only very limited legal obligations to the SIVs, but seeing the reputational damage sinking SIVs would have, most stepped up, collapsed the SIVs, and moved them back to their balance sheets or directly funded them. 

At this juncture, one would think that the optimal economic behaviour for the banks with outstanding SIVs, would be to let the SIVs unwind according to the legal construct in place, rather than accept responsibility. In fact, all the banks except one decided to collapse the structures and repurchase the securities. 

The case of SIVs demonstrates some short-term and long-term thinking on the part of the banks.  In the short term, the bank would absorb the troubled assets of the SIV into its already over-extended balance sheet, but in the long term would signal that the bank was sufficiently strong to do so.

From an investor protection standpoint, one may have drawn a sigh of relief, as any potential issues about misrepresented risk profile disappeared, but from a financial stability perspective, it was obviously disturbing. In a short space of time, billions of assets showed up on already over-extended bank balance sheets.

One may think it somewhat surprising that (almost) all the banks decided to absorb their SIVs, especially since it must have seemed likely that the SIV structure would not come back any time quickly as a viable funding structure. We believe that the main reason for doing this was that not doing so would have sent a distress signal to the market. In other words, if a bank chose not to absorb this problem, the perception would be that they simply could not afford to do it, thus telling the market that they were in even worse shape than previously feared. There may also have been an element of “repeat game”. If one lets one’s investors take the pain, then they may not return for future transactions.

Designing Contracts With Contingent Exposures in Mind

In order to match up the value of a transaction with market realities, participants should perform a rigorous and critical evaluation of contingent exposures and stress correlations.  Capturing tail events properly depends almost entirely on proper design of stress tests. 

A crucial component of this analysis is the proper design of stress tests. Obviously, scenarios have to be rather draconian in order to serve the purpose of challenging the “unthinkable”, but at the same time there are difficult decisions to be made, for example, in deciding how much bank capital (contingent or not) banks should hold – and what the probability is of it being wiped out. We believe that it is better to have a collection of ex ante determined stress scenarios that illustrate banks’ potential weaknesses publicly, even if the actual regulatory capital is not sufficient in all those scenarios. In other words, stress tests should not always be a check list “pass” or “fail” (after all, to make a bank fail or pass a stress test is just a question of scaling the test). Comparable, tail event stress tests could be an important piece in the information set that investors and regulators analyse to determine the relative value and risk profile of the institution.

Fisher advises that contract design features which are exclusively relevant to the extreme tails should be avoided, because these features are never taken seriously.  Fisher also finds fault with market participants for expressing surprise at banks’ exercising the option to absorb SIVs.

Market participants need to make sure that an exercise of an option is seen as just that, a normal exercise of an option. No more and no less. Sophisticated market participants should not be genuinely surprised (or feign surprise) by another market participant trying to optimise its behaviour consistent with a contract. The implications of a contract should be clear and the structures should be as transparent as possible.

Lessons Learned

As the debate about the higher levels of capital banks must hold rages on, it is important also look at how these new levels of capital will be achieved.   Despite the financial crisis, contingent capital instruments remain attractive, and should be evaluated on how they would perform in a crisis.   Whatever is decided in terms of capital requirements, the numbers should be calculated with tail event analysis in mind.

Fisher applies two lessons from the preceding examples to contingent capital instruments.

First it has been suggested to us by market contacts that the trigger point in existing contingent instruments is such that many investors have bought them on the assumption that these contingent capital securities never will be called (or worse, that there will be official support before that point). If that were to be the foundation for this market, we believe that the very purpose of contingent capital may be subverted, creating a risk to financial stability in a crisis situation. The whole point of contingent capital securities should be that the recapitalisation is triggered without any grand repercussions, making it easier than raising fresh capital in the market. If triggering the conversion were to cause the sort of damage reported in our examples above, then the market could be severely disrupted just when it was most needed. The contract design must therefore reflect a need for the trigger to be as smooth as possible.

Second, it is obviously crucial from a financial stability standpoint that contingent capital securities do not end up largely in the hands of other highly leveraged financial institutions, where losses could cause further spill-overs and thus generate financial instability. We believe that regulators could play a constructive role in allowing a broad range of “real money” investors to own sensible amounts of this systemic risk.

The balance between public policy objectives of appropriate investor protection and systemic stability entails some difficult considerations. Over all, however, it is readily apparent that highly leveraged institutions such as banks and hedge funds are ultimately not well suited to be the final repositories of extreme tail risk. 

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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.