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

Monday, June 7, 2021

RESTORING TRUST IN MARKETS: RMA Podcast Series

Creating ESG Models to Change Negative Views of Financial Markets

Good morning, this is Ed Blount and I am speaking to you from the Center for the Study of Financial Market Evolution here in Washington, D.C. I've been asked by my good friends at the Risk Management Association, RMA, just up the road in Philadelphia, to offer some thoughts on "how data-based models can be used to change the negative views of financial markets that are held by some bank customers and regulators, especially in the wake of the pandemic."  So, that is an interesting question.

I'm going to approach the answer in two parts: 

First, I'll talk about the nature of models that are increasing regulatory and litigation risk following the pandemic; and then,
Second, I'll talk about how to deal with those increased regulatory and litigation risks, based on modeling precedents using newer technologies.

As a preamble, and as the reason I've been asked for comment, I have been engaged as a testifying expert [1] over the last 10 years in more than a dozen class-action lawsuits or civil litigation matters; as well as regulatory enforcement actions for the Department of Labor and the Securities and Exchange Commission.  In fact, I've testified before all three branches of the US federal government. So, that's the credentials part. Now, let's talk about models.

 
Deconstructing Negative "Views" to Create Rebuttal Models

Negative views are formed because someone has a belief that is based upon a structured proposition and a set of facts that are assumed to correspond with reality. Philosophers call this the "Correspondence Theory of Truth." There's a very good description available for free on the Stanford University website, in their "Encyclopedia of Philosophy." 

I think it should be no surprise that, in our modern world, we call these theories of truth "models." And, if all financial modeling relies on pattern recognition, as we were reminded in a recent RMA podcast,  then to change a negative view, we have to employ a model that corresponds to a truth that is derived from a positive pattern of propositions.  In the world of financial litigation, we call that a "rebuttal." 

 
POST-COVID REGULATORY AND LITIGATION RISKS

 

So, what is the greatest risk following the pandemic? I would say that it is the relative (a) ambiguity and (b) paucity of information available to defend banks against charges of "Breach of the Public Trust," as implied within the policy sphere that is popularly called ESG (environmental, social, and governmental policies). 

We'll look at two proposed models that, in my opinion, will cause difficulty for banks and their customers over the next several years. 


Negative ESG-derived Views of Securities Finance

I have had to deal with flawed academic papers in my role as a defense expert for banks or asset managers. Often enough, these papers are cited by the plaintiffs' attorneys who are filing charges of malfeasance [4] or, in some cases, market manipulation

  1. 1.    In the case of the negative academic paper [5] we're using as an example, charges were made that (a) banks were aiding index fund managers in neglecting their fiduciary duty to exercise their governance obligations and privileges as portfolio owners of many securities, by (b) lending those securities out in order to gain additional income and improve their tracking errors.  

Now, the typical response to that charge is based on articulated voting policies included either in the documents creating the fund or in the trust that underlies it. Unfortunately, a lot of the available data that's being used for rebuttal is so limited that it lends itself to challenge by plaintiffs' attorneys. 

  1. 2.    The second critical model represents a significant regulatory risk, and is being used by ESMA to energize the European Parliament's call for a review of cross-border securities loans, that are being used (allegedly) to cheat the German and Danish governments out of an estimated 50 billion Euros in otherwise-entitled tax revenues. 


MODELING ESG RISK FOR REGULATION AND LITIGATION 


These are serious charges. Each represents a potential "Betrayal of the Public Trust," which goes to the S within ESG, as well as to the G.   

There are strong challenges that can be brought against the structural propositions that are used in the (a) academic paper, as well as in the (b) basic model for ESMA's support of the intrusion into the investment process that would be represented by audits of cross-border securities loans

Both of these negative models attack the field of Securities Finance, which is essential to the liquidity and price discovery functions of the global fixed income and equity markets, mostly through their support for short sales, as well as hedging by institutions. 

So, how would a bank or an asset manager who's being challenged respond to those charges? Well, actually, we have a precedent to consider. 


Spiking the Negative ESG Views

Several years ago, I was tasked with the response to a series of academic papers that alleged, in great detail and with great quantitative support, that (a) hedge funds were borrowing shares in the securities finance and lending markets in order to (b) gain control of the vote in an Annual General Meeting, determining (c) whether a proposed tender, merger or other corporate action, would be (d) approved by the shareholders. [8]

The argument was made by the academics that, based on the data they had collected from one custodian and one prime broker, that spikes across the proxy record date presented evidence of a theory that the hedge funds were moving before the record date in order to build up their positions. [9]

We at CSFME worked with RMA and the broker-dealer trade group, SIFMA, to collect and analyze more than 800 million loan records, and then to produce a white paper. In turn, the data was anonymized, encrypted and turned over to a team of academics that studied the data and concluded that, in fact, this was not evidence of vote manipulation, but rather it was further evidence that lender-customers of banks were recalling their loans. [10] So, it was a positive outcome from the spike. And that is the way that we responded. [11]

I believe that's the best way to respond to arguments that challenge the compliance of managers or banks with their stated policy goals or investment strategies. 


Building DLT Models to Change Negative Views

Let's deal with the ESMA proposal to establish audits of cross-border loans by the European Union. The rebuttal opportunity there is to use the new technology that's already been developed -- distributed ledger technology -- to respond to charges of complicity in avoiding withholding taxes on cross-border dividend payments. 

Unfortunately, the structure of the increased post-crisis regulatory disclosures that are available for rebuttal in securities finance is such that only positions are really being disclosed. It is true that loan data is being mined for those disclosures, but the objective of that data collection process is to identify excess leverage. 

As a result, it is not easy to reconstruct that loan data into the end-to-end mapping that would be required to demonstrate that the lending spikes are indeed evidence of benign trading activity, not manipulation of the markets. In fact, it would be necessary to recreate what CSFME did before, that is, create a loan-level industry model to demonstrate that lenders, asset managers, agents, and borrowers (as represented by the prime brokers) are, in fact, complying with their disclosed policies about proxy voting. 

That is potentially a big project. But the technology exists to get it done. [12]

In my opinion, that loan level model would not only be available for response to regulatory charges such as those being proposed by ESMA, but would also be available to courts in support of summary dismissal motions for any complaint brought that would be based, even partly, on the arguments embodied within the critical academic paper described above. 


Hoisted on their own Petards (Spikes)

This is a different way to approach a model. It's not a credit or market risk model. It's a litigation or regulatory risk model. There are similarities in that their structures are both based on propositions and data. But the way to approach the rebuttal is not to try forecasting an outcome -- or to absolutely destroy an opponent's argument -- but rather to recast their own evidence in a positive view.  

That's the way you change someone's opinion. You're not going to be able to argue methodology with them. You're not going to argue the facts because they're going to have a different interpretation of those same facts. 

What you have to do is identify the common areas that you agree on and structure the rebuttal to reinterpret that set of facts. 

In the cases that I mentioned before, we all agreed that there were spikes in the activity patterns being recognized by the models. But what we did at the time, and which should be done in the future, was to recast those spikes as evidence of a positive process: compliance with stated policies


Thank you for listening and I hope everyone has a very good outcome from the end (hopefully) of the pandemic.


Originally posted here, as, "The Impact of Data-based Models on Financial Markets," by the Risk Management Association, June 7, 2021.


Notes:

1. Edmon W. Blount, Eric B. Poer, Tiko V. Shah, "Securities Finance Disputes," Chapter 30, The Litigation Services Handbook: The Role of the Financial Expert, 6th Edition, Wiley, 2017, pp 30.1 - 30.20, at https://www.amazon.com/Litigation-Services-Handbook-Financial-Expert/dp/1119166322

2. Stanford University Encyclopedia of Philosophy, https://plato.stanford.edu/entries/truth/#ReaTru

3. RMA Podcasts, “The Impact of Covid-19 on Modeling,” November 19, 2020, https://soundcloud.com/user-524270410/the-impact-of-covid-19-on-modeling.

4. Malfeasance, defined as "Evil-doing; the doing of that which ought not to be done; wrongful conduct, especially official misconduct; violation of a public trust or obligation; specifically, the doing of an act which is positively unlawful or wrongful, in contradistinction to misfeasance, or the doing of a lawful act in a wrongful manner." American Heritage Dictionary, at https://www.wordnik.com/words/malfeasance.

5. Hu, Edwin and Mitts, Joshua and Sylvester, Haley, The Index-Fund Dilemma: An Empirical Study of the Lending-Voting Tradeoff (December 22, 2020). NYU Law and Economics Research Paper No. 20-52 , Columbia Law and Economics Working Paper No. 647, Available at SSRN: https://ssrn.com/abstract=3673531  or http://dx.doi.org/10.2139/ssrn.3673531 

6. ESMA, Final Report on Cum Ex and Other Multiple Withholding Tax Reclaim Schemes, Sept. 23, 2020. https://www.esma.europa.eu/document/final-report-cum-ex-and-other-multiple-withholding-tax-reclaim-schemes   

7. Ibid.

8. Hu, Henry T. C. and Black, Bernard S., The New Vote Buying: Empty Voting and Hidden (Morphable) Ownership. As published in Southern California Law Review, Vol. 79, pp. 811-908, 2006, University of Texas Law, Law and Econ Research Paper No. 53, Available at SSRN: https://ssrn.com/abstract=904004 

9. Christoffersen, Susan E. and Geczy, Christopher Charles and Reed, Adam V. and Musto, David K., Vote Trading and Information Aggregation (January 2007). AFA 2006 Boston Meetings Paper, Sixteenth Annual Utah Winter Finance Conference, ECGI - Finance Working Paper No. 141/2007, Available at SSRN: https://ssrn.com/abstract=686026 or http://dx.doi.org/10.2139/ssrn.686026

10. Moser, Shane and Van Ness, Bonnie F. and Van Ness, Robert A., Securities Lending Around Proxies: Is the Increase in Lending Due to Proxy Abuse, or a Result of Dividends? (December 6, 2011). Available at SSRN: https://ssrn.com/abstract=1969051 or http://dx.doi.org/10.2139/ssrn.1969051

11. CSFME, Borrowed Proxy Abuse: Real or Not, October 2010. https://www.sec.gov/comments/s7-14-10/s71410-202.pdf 

12. CSFME, “Systems Experts Set the Bar for Blockchain in Securities Finance,” Feb. 19, 2019. https://csfme.org/Full_Article/category/all/systems-experts-set-the-bar-for-blockchain-in-securities-finance 

13. See, note 4, supra.

 

Print

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