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, December 20, 2020

Compliance with the DOL's New Proxy Rules May Stump ERISA Fiduciaries

A counter-revolution in ESG Investing?

On Friday, December 11, the Department of Labor (DOL) issued its final rules on proxy voting by ERISA fiduciaries. As proposed last August 30, the draft rules drew hundreds of responses by the ESG-directed investing community, many of which criticized the proposal as unworkable. The final version of the rules eliminates the proposal's rigid requirements for plan sponsors to weigh the economic vs. non-economic effects before casting their proxy votes. Yet that softer, principles-based approach may itself create compliance problems for ERISA fiduciaries -- and may not even survive the first hundred days of the Biden administration.

Commenters seem to have persuaded policy-makers at DOL that compliance with the original draft rules would have been too costly and complex to implement. Rather, the Labor Department focused the final rule on "whether a fiduciary has a prudent process for proxy voting and other exercises of shareholder rights" as a more workable framework for achieving the DOL's objectives. 

 

What is the Purpose of the Rules?

What were the DOL's stated objectives with its new proxy guidelines? The DOL sought to rectify a "persistent misunderstanding" that ERISA fiduciaries must vote all proxies. According to Jeanne Klinefelter Wilson, acting assistant Secretary of Labor for the Employee Benefits Security Administration, these new proxy restrictions are meant to ensure that ERISA fiduciaries are only expending resources researching and voting proxies that have a financial effect on the plan:

 

"The plan fiduciary must never subordinate the interests of participants and beneficiaries in their retirement income to unrelated objectives, including promoting non-pecuniary goals or benefits."

 

What do the Rules Require?

The final proxy voting rule makes clear that fiduciaries are not required to vote every proxy. It outlines six points a fiduciary must undertake when making decisions on exercising shareholder rights, like proxy voting:

  1. Act solely in accordance with the economic interest of the plan and its participants and beneficiaries.
  2. Consider any costs involved.
  3. Not subordinate the interests of the participants and beneficiaries to any non-pecuniary objective.
  4. Evaluate material facts that form the basis for any particular proxy vote.
  5. Maintain records on proxy voting activities and other exercises of shareholder rights.
  6. Exercise prudence and diligence in the selection and monitoring of proxy advisory firms.[1]

 

The DOL's new rules have two safe harbor provisions. ERISA fiduciaries adopting at least one of these policies will be considered to have satisfied their responsibilities when deciding whether to vote proxies.  

  1. Adopting a policy that proxy voting resources will focus "only on particular types of proposals that the fiduciary has prudently determined are substantially related to the corporation's business activities or are expected to have a material effect on the value of the plan's investment."
     
  2. Refraining from voting on proposals when the size of the plan's holdings in the stock subject to the vote are below quantitative thresholds that the fiduciary prudently determines.[2]


Fall-out Effects on Fiduciaries

Securities Lending.  Even with the change to a more principles-based regime from the rules as proposed, these new requirements can be a hardship on ERISA fiduciaries and costly to the plans they manage. Outside of the safe harbors, the complex calculus an ERISA fiduciary must now engage in for each and every proxy voting decision just became more time-consuming and expensive. Plus, ERISA plans with securities lending programs may find their previous discretion regarding whether to recall loaned securities to vote their proxies has been all but eliminated. As SIFMA pointed out in their comment letter on the proposal: 

 

"Moreover, there may be logistical challenges with determining the economic benefits of some proposals. For example, when an institution lends shares under a securities lending program, it cannot generally vote those shares at an upcoming shareholder meeting if the shares are on loan on the record date to identify voting rights. Because the institution may not know what will be on the meeting agenda until after the record date, it would not be able to perform a rigorous "economic analysis" to determine whether the benefits of recalling or objective costs associated with a recall or restriction, the likely outcome is that these shares would not be voted." [3]

Voting ESG Proxy Matters.  Despite numerous mentions in the rule's preamble, the term "ESG" is not mentioned anywhere in the rule text. According to the DOL, The lack of a precise or generally accepted definition of 'ESG,' either collectively or separately as 'E, S, and G,' made ESG terminology not appropriate as a regulatory standard. . . The focus on the final rule is on whether a factor is pecuniary, not whether it's an ESG factor." [4]   Nonetheless, ERISA fiduciaries are going to find it difficult to justify voting proxies for a whole host of issues that are not so clearly tied to a pecuniary benefit to the fund. The DOL counters, however, that voting on ESG-related proxies is still an option. Jeanne Klinefelter Wilson, acting assistant Secretary of Labor for the Employee Benefits Security Administration said of the rules:

 

"Now, this does not mean that fiduciaries are prohibited from considering such issues as environmental impact and workplace practices when they are relevant to the financial analysis. Because these issues are pecuniary in that instance, and therefore appropriate considerations under the rule."

 

On the other hand, it is fairly well known that these rules arise out of the perceived skepticism of ESG by the current administration. George Michael Gerstein, co-chairman of the fiduciary governance group at Stradley Ronon Stevens & Young recently said of the rules:

 

"I think many view as being the impetus for the financial factors rule and this rule and that it was designed to target ESG in some way," Mr. Gerstein said, referencing a Labor Department rule that was finalized in October and requires ERISA plan fiduciaries to select investments based on pecuniary factors. "I think the DOL has at least attempted to allay those concerns but the devil is ultimately going to be in the details, which is whether the rule has enough clarity that it's not going to chill activity that was otherwise commonplace."[5]

 

During the comment period, ERISA fiduciaries like TIAA urged the DOL to soften its apparent stand against ESG investing. In their comments, TIAA argued that ESG factors do not always have an immediately discernable pecuniary effect, but rather can enhance a company's shareholder value in less tangible ways like risk reduction and reputational value. They also noted that the rules as proposed (and ultimately adopted) make these kinds of considerations more, not less, difficult for ERISA fiduciaries. 

 

"while not every ESG issue subject to a proxy vote has economic implications, ESG factors are often in direct alignment with a company’s pecuniary considerations – and thus it is often the case that voting proxies on ESG-related issues is in the economic interest of investors."  

"Given the direct link that can exist between a company’s financial performance and its handling of  ESG  factors,  we believe plan fiduciaries are well justified in expending resources to make careful informed proxy voting decisions on  ESG-related items on behalf of plans and plan participants. The Proposed Rule would make it even more expensive and difficult for plan fiduciaries to make these voting decisions."[6]

 

Will the Rule Survive? 

Successive administrations have fought over how often ERISA fiduciaries must undertake this cost-benefit analysis concerning proxy voting and other shareholder rights, making new rules and moving the goalposts with each new Secretary of Labor. Presumably, President Biden's administration will swing policy back to a more favorable posture to ESG investing and proxy voting by ERISA fiduciaries. Given the outcry against this rulemaking, it would not be at all surprising if the new DOL leadership amends or repeals these burdensome proxy rules. 

 


 

[1] DOL Fact Sheet, https://www.dol.gov/sites/dolgov/files/ebsa/about-ebsa/our-activities/resource-center/fact-sheets/fiduciary-duties-regarding-proxy-voting-and-shareholder-rights-final-rule.pdf

[2] Ibid.

[3] SIFMA Comment Letter https://www.dol.gov/sites/dolgov/files/EBSA/laws-and-regulations/rules-and-regulations/public-comments/1210-AB91/00261.pdf

[4] DOL Fact Sheet, see note [1] above.

[5] https://www.pionline.com/regulation/dol-finalizes-rule-proxy-voting

[6] TIAA Comment Letter https://www.dol.gov/sites/dolgov/files/EBSA/laws-and-regulations/rules-and-regulations/public-comments/1210-AB91/00266.pdf 

 

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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 2014FL 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, 2012ICGN sends LDV letter of support to the SEC, signed by Chairman of the ICGN Board of Governors.

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

July 18, 2011Florida 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