How To Process Corporate Ballots - Tomorrow
Many large investors appeal for representation to the CEOs and directors of their corporate holdings. Through the ESG process, these investors meet with corporate officials to influence the company's policies in the environmental, social and governmental aspects of its business. Considerable time and effort is invested by all parties. Yet, when the votes are counted at the annual meeting, all parties are surprised to learn that very few votes are actually cast by these large investors. For example, an institution with 5 million shares may cast votes representing only 5 thousand shares. What happened?
The shares were lent out to brokers by the institutional investor's custodian.
That situation recurs time and again in today's market, where low yields force pensions, insurers and other institutional investors to seek as much income as possible from their portfolio investments. Securities lending income cannot be ignored by these fiduciaries, even to the detriment of their' corporate governance obligations. Yet there is a better way. A clearing system for fungible proxies, restricted to the actual entitlements of beneficial owners, would enable institutional securities lenders (and brokers' margin customers) to instruct proxies and achieve their full entitlement of voting (FEV) rights.
Under an FEV framework, lenders of securities would retain votes without forcing their agents to recall borrowed securities. In addition, the adoption of fungible proxies would permit every proxy to be assigned and instructed, thereby assuring investors, issuers and regulators that votes could be confirmed from instruction to tabulation, i.e., “end-to-end”. Fairness in governance is a central goal of every capital market system. And, by rebalancing away from proxy-surplus brokers, FEV could minimize the use of brokers’ discretionary votes. That’s also a goal.
The FEV infrastructure would help brokers to rebalance their voting allocations at the depositories before record date. For example, if shares borrowed and loaned prior to record date were known, then brokers could take steps to equilibrate those loans so as to balance their supply and demand for proxy votes.
Rebalancing positions before record date could buy time until the industry could convert voter instruction forms (VIFs) into fungible proxy records, thereby resolving a technological challenge. There would still be a lot of work to do, but a jump-start can be made by building on the Lender Directed Voting model.
“…[W]e note that Broadridge’s service operates only to identify vote totals that are in excess of intermediaries’ CDS positions, and the evidence from retail investors suggests that they often do not vote their shares. As a result, routine over-voting may be occurring without ever engaging the Over Reporting Prevention Service. Moreover, we note that while Broadridge’s service contributes to identifying and correcting over-reporting issues before materials are sent to eligible votes, the fact that there is a continued need for this service suggests that the problem is systemic.”
Brown, Michael, “Hansell LLP to Canadian Securities Administrators,” Letter, November 13, 2013, p3, at http://hanselladvisory.com/includes/CSA_Commentary.pdf
Lender Directed Voting
Lender Directed Voting (LDV) is an initiative that would re-enfranchise long-term investors who have temporarily loaned their portfolio securities to brokers in return for additional portfolio yield, but as a result have lost their proxy rights.
As described in a November 28, 2012 letter to the SEC, the CSFME stated its belief that LDV would:
- Increase investment earnings, reduce operational risks and improve corporate governance -- without impairing existing rights or responsibilities
- Comply with current federal and state laws and regulations, and
- Reinforce existing market practices and the stated intent of Congress and the SEC to minimize the influence of broker votes.
Sources from which Proxies can be Reallocated
To start, assigned proxies will likely come from brokers’ proprietary shares. Brokers, as owners, have complete discretion over voting these shares. Indeed, any owner may assign proxy voting rights to lenders. During the pilot stage, proprietary share assignments will allow the market to work out LDV operations. However, the ultimate goal is to mobilize the equity proxies that are un-voted each year, fully 110 billion in the U.S. during 2012! Most abandoned proxies are assigned to retail investors.
CSFME’s review of the legal and regulatory issues revealed no impediments to brokers assigning proxy rights for these shares to lenders. In particular, Delaware law provides precedents for considering securities lenders to continue as beneficial owners even when the shares are on loan. Nevertheless, some observers believe that the reassignment of broker-held proxies to their institutional lenders raises public policy issues. For example, certain investors may intentionally withhold their votes (i.e., conscionable objectors). It would be inappropriate to assign their proxies to other investors. However, most of proxies surely go un-instructed because their holders are truly indifferent. Assignment of such proxies to lenders would not impair any current holder, but would improve corporate governance and enable institutional lender to continue to earn lending revenue. That said, the potential for misdirection of shareholder intentions suggests that mechanisms should be included in LDV to prevent inappropriate outcomes.
Full Entitlement Voting
A special proxy clearing system may be created to redistribute fungible proxies to brokers whose depository positions are not sufficient to satisfy their customers’ full proxy entitlements. Supplemental assignments for beneficial owners can be made possible using an assignment process based partly on shares borrowed and loaned; partly on level of beneficial ownership; and partly on operational factors. The supplemental assignments would be limited so that no more than the trade date position of any beneficial owner could be voted.
In concept, FEV can be designed as a multilateral netting process for proxies, similar to the transaction clearing services of central securities depositories. If implemented, brokers would cast fewer discretionary votes, while beneficial owners would be able to exercise their full allotment of proxies. This would be true even if their shares have not yet been received by the brokers or are being loaned out for financing / settlement purposes. The inherent fairness of the process should gain support from large investors and issuers alike, as well as from their trade groups and regulators. Shares are fungible and so are income payments. Proxies should be fungible, too.
With Full Entitlement Voting, brokers also benefit because their retail margin customers would no longer risk having their votes discarded as a result of insufficient proxy allocations. Shortfalls of proxies at the broker level generally result from permissible rehypothecations (loans) that are made out of customer margin accounts prior to record date. For that reason, in an FEV-enabled market, all retail and institutional beneficial owners could receive full voting entitlements — so long as proxy-deficient brokers receive extra proxies (or borrow the related positions) from those brokers who hold a surplus of proxies.
Brokers are legal owners of dematerialized shares, technically — or
perhaps the depository, depending on one’s perspective — and not
the customers. Both the margin customers and securities lenders
are beneficial owners, ultimately, but even the borrowed shares are
the brokers’ legal positions at DTC, since they accept credits for
dematerialized shares through the depository as member/principals
from principal/institutional lenders by way of the custodial
member/agent banks. Fungibility of the shares in the brokers’ box
and at DTCC makes it all work.
Institutional securities lenders can be viewed as the functional equivalent of margin-financed customers. Both groups of beneficial owners are (a) unable to vote their entire positions as a result of (b) their* shares being borrowed by brokers and delivered out to cover fails or meet financing requirements. LDV is a subset of FEV, since there will always be some group of brokers who wish to set up direct relationships with institutions, to deal with them as lenders, investors or whatever, away from and apart from a central netting or clearing system of any kind.
The FEV clearing network would benefit the market system by transferring abandoned proxies into the accounts of well informed and motivated beneficial owners. In effect, it would improve on the fungible reconciliation process that takes place within certain brokers, but at an industry level.