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

Tuesday, May 11, 2021

Live by the Sword. Die by the Sword. Part 1

How the Online Gamestop Crowd Missed the Big Picture

January's GameStop frenzy, where amateur online retail traders took what they hoped would be a rollicking joyride through the world of high finance, has left regulators scratching their heads about what to do next and the retail buccaneers themselves with quite a hangover. The newly minted SEC Chair, Gary Gensler, told the Senate Banking Committee in testimony last week that the Commission is still trying to figure out what the GameStop drama meant and what, if anything, the market regulator should do about it. However, some of the online buccaneers have made their next move clear and filed a class-action lawsuit against seemingly everyone who's anyone in the world of retail and wholesale securities trading. The GameStop episode demonstrates that the online buccaneers failed to appreciate the workings of the markets they opted into, and may even hold some lessons for the more experienced participants, particularly when it comes to the complicated dynamics of leverage.

The heart of the suit is an allegation that the Wall Street Goliaths conspired to protect themselves and shut out the little guy. But were the markets' reactions truly the product of some vast conspiracy between thirty-some-odd brokers, hedge funds, and clearinghouses? Or had the online investors just relied on incomplete models and failed to comprehend a complex and dynamic securities market with checks and balances that are well-understood by the major players?  

 

Retail and wholesale securities markets, though heavily regulated, have developed risk mitigation and management systems through the natural evolution of commerce. These structural and economic guard rails and circuit breakers act as a sort of a market immune system triggered to respond to disruptive or chaotic market conditions. One might say that the habitués of the retail and wholesale securities markets have the complete picture of the markets in which they operate every day. Their understanding of their exposures and models is complete. 

 

On the other hand, the online investors overlooked or were not fully aware of these critical circuit breakers. Margin and collateral requirements and the clearing and settlement processes evolved over decades of retail and wholesale trading activities in good markets and bad. Based on years of accumulated lessons learned, these self-correcting mechanisms kick in during periods of stress, as they did for the GameStop frenzy. 

 

Fair or Foul?

 

Overconfidence may also have played a factor for the online investors. Judging from their class action complaint, the illusion of understanding or superior market foresight may have made them overestimate their market insight and caused them to overlook some critical restrictions on their trading activities.[1]  For example, the online investors did not factor into their trading strategies that institutional investors had access to after-hours trading while the online investors did not.

 

Whether the online investors were treated unfairly vis-à-vis institutional investors, as the class action complaint alleges, is a question of "what duty, if any, did the brokerages owe their online platform clients versus their institutional investor clients?"  Brokers generally owe a duty of best execution (i.e., timely execution at the market price). But does this extend to policing the activity on their own ostensibly free platforms? What do the contracts between brokerages and online investors say? The online investor plaintiffs allege that "RobinHood does not warn users of any situation where it could prevent users from buying stock out of its own volition." [2]  But is this true? It seems unlikely that the terms of service omitted restricting client trading opportunities during volatile market conditions or in response to abusive or disruptive trading. Ultimately, with the help of industry experts, the courts will decide if the treatment of the online investors departed from standard industry practices.

 

The lesson to take away from the GameStop frenzy may be that structures, securities finance markets, and participants reacted to the online investors' disruptive and provocative activity as they should have. Collusion or conspiracy was not necessary to prompt the built-in guardrails and circuit-breakers to engage. They could not have been expected to react otherwise. The online buccaneers have perhaps learned that what you don't know can, indeed, hurt you. And when you live by the sword, you die by the sword. 

 

In part 2, we'll discuss how market forces served to counteract the pressures from the options-leveraged online GameStop investors and eventually shut down the system. 

 


 

 

[1] The illusion of understanding or superior market foresight may have made them overconfident.

    • "Retail Investors correctly deduced that GameStop was undervalued because large financial institutions had taken large short positions" [Class-action Complaint p. 14] 

    • "The Fund Defendants, Clearinghouse Defendants, and unnamed co-conspirators predicted incorrectly." [Class-action Complaint p. 14]

    • "Institutional investors, holding large short positions in GameStop's stock and other Relevant Securities began to push back and attempted to message on media and elsewhere that the Relevant Securities were not as valuables the Retail Investors thought." [Class-action Complaint p. 17]

    • The online investors believed the Fund Defendants' short positions were "highly speculative bets"rather than soundly researched investment decisions made as part of an investment strategy.

      • "Rather than use their financial acumen to compete and invest in good opportunities in the market to recoup the loss in their short positions the growth in the Relevant Securities' prices represented, or paying the price for their highly speculative bad bets, Defendants instead hatched an anti-competitive scheme to limit trading in the Relevant Securities." [Class-action Complaint p. 25]

 

[2] Clapp v. Ally Financial et al. Case 3:21-cv-00896, U.S. District Court for the Northern District of California, Class-action Complaint p. 27

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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