Outreach Blog

Saturday, August 11, 2012

Should We Be Alarmed About Empty Voting?

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

Should we be alarmed about empty voting? According to a recent article, "A Call to Arms on Empty Voting!" by Andrew MacDougall, Robert M. Yalden and Jeremy Fraiberg, yes, we should indeed.  Using a proxy battle over a proposal by Canadian company, TELUS to eliminate its dual class share structure earlier this year as an example, MacGougall, Yalden, and Fraiberg assert that as "the number of public M&A transactions increases, and if U.S. hedge funds continue to look for opportunities in Canada to engage in strategic gamesmanship, concerns about empty voting will also increase."

The authors admit that in most shareholder voting situations, the subject matter of the vote does not lend itself to an economic arbitrage opportunity, and are therefore unlikely targets of intentional empty voting. The most likely scenario for an economic arbitrage opportunity is an M&A transaction, and clearly only a subset of those M&A transactions can be made to yield profits by empty voting strategies.   Hedge funds or other investors wanting to employ an empty voting strategy must find instances where "the holder of the voting right has an opportunity over the short term to realize economic consequences from the decision that are the reverse of those that would be realized by other shareholders."  The article identifies two particular classes of transactions requiring shareholder approval that may be targets of economic arbitrage via empty voting:

In particular, economic arbitrage opportunities may exist where a target company needs to obtain shareholder approval for a transaction and either (1) the target faces a simultaneous takeover bid from another party (for example, those who support the takeover bid may use empty voting to vote against the other transaction) or (2) the acquirer also requires shareholder approval under stock exchange listing requirements due to the number of shares to be issued by the acquirer in the transaction (for example, by providing an opportunity for shareholders of a target to engage in empty voting of the acquirer’s shares to ensure approval of transaction that is favourable to target shareholders).

Concerns about empty voting have arisen in the past.  In 2006, a team of academic researchers claimed to find evidence of “vote buying” and manipulation of corporate governance in the U.S. equities securities lending markets. Their studies claimed that spikes in equities lending activity on proxy record dates proved unequivocally that abuse by share borrowers was “widespread” and, further, that control of voting rights could be acquired at no cost.”  This led corporate advocacy groups to call on regulators to force the disclosure of “hidden ownership” by activist hedge funds. In turn, the Federal Reserve, Securities and Exchange Commission, Internal Revenue Service and the Finance Committee of the U.S. Senate began to investigate securities lending markets. In addition, investor advocacy groups, including the Council of Institutional Investors and the International Corporate Governance Network, along with leading public pension funds, added their calls for prudent regulatory structures to be rebuilt, along “with heightened international coordination.”

According to a study conducted by the RMA in conjunction with CSFME, however, the data supporting the claims of borrowed proxy abuse was likely incomplete, and failed to account for some key aspects of how the securities lending market and proxy process work (like substitution effects, and proxy allocation controls at the broker level). Lacking proper data, and without considering structural and operational controls currently in place, RMA and CSFME argued that there was no basis on which to conclude from loan volumes around record dates that widespread and abusive empty voting was in fact taking place.  In addition, RMA and CSFME called into question the assertion that votes can be acquired for virtually no cost.

”The research findings from our current study strongly imply that the Christoffersen team had inadequate data resources. Even though two corresponding databases were used to reduce sample bias, their team was unable to observe the substitution of borrowed positions, a dynamic that was taking place after recalls were issued by lenders who, among other motivations, intended to vote.” p.9

“Accordingly, any further research into the relationship of securities loan rates and volume needs to account for these pricing dynamics, as well as for other factors such as rates of return on cash collateral investments. Without such an analysis, firm conclusions about the relationship between pricing and loan volume, or the effects of any particular factor such as the timing of record dates, may well result in invalid conclusions.”

While it is true that events of abusive empty voting like the TELUS proxy mentioned in the article do take place from time to time, it is still unclear two what extent hedge funds or other savvy investors are taking advantage of empty voting strategies for profit.  Without further study using complete and accurate data, should we be alarmed about widespread empty voting based on anecdotal evidence?

It is a fundamental assumption underlying our system of corporate governance that shareholders are entitled to make certain decisions because they have a real economic interest in the outcome.

We can agree that empty voting violates a basic principle on which corporate governance is based.  For this reason, we can also agree that empty voting, both unintentional and intentional, should be curtailed if not eliminated.  There are, however,  less ponderous and drastic ways than globally coordinated regulatory initiatives of controlling empty voting, including CSFME's  "Lender Directed Voting" concept whereby lenders of securities could, by contract, retain their right to vote lent shares without having to recall them. By reserving the right to vote lent shares, institutional lenders can ensure they exercise their corporate governance duties with respect to the shares, while lending them to borrowers like hedge funds whom will be able to use the borrowed shares for permissible purposes, but not for vote buying purposes. Without firm evidence of widespread empty voting for abusive purposes, there just are no grounds for sweeping global reforms, particularly when other more practical solutions may be at hand.  


The CSFME’s Regulatory Outreach Programs

Regulatory reform has become a collaborative process. Where once market supervisors promulgated rules without regard for input from practitioners, today’s reform process has evolved into a dialogue of mutual respect for the opinions of all stakeholders in the capital markets. The process of regulatory outreach has become embodied in virtually every developed markets in the world.

The CSFME has adopted a role of facilitating this collaborative dialogue at all stages of the professional contribution process. Starting with students’ contributions to published commentary letters, through panel presentation and webinars, right up to trade association initiatives, the CSFME provides assistance through education, data compilation, analysis and commentary for some of the most pressing issues in contemporary markets.

DLT and Preferred Securities Financing

We believe the widespread use of encrypted third-party ledgers, blockchains, and smart contracts (i.e., DLT) is inevitable in securities finance, and that those technologies will permit lending agents to offer new revenue opportunities to their clients. Among these, we believe that certain agents will use DLT to help their lenders expand their loan books by opening their lendable portfolios on a preferential basis to the hedge funds in which they've already invested, as well as to other trusted counterparties, a concept we have dubbed, “Preferred Securities Financing.”  

CSFME is openly soliciting participation in a research initiative to assess the potential benefits to securities lenders from the use of DLT and data sourced from new regulatory disclosures. Specifically, our research will focus on how DLT, blockchain, and smart contracts can facilitate Preferred Securities Financing.  Learn More about our DLT Securities Finance Initiative

Research and Analysis of the Effects of Financial Regulatory Reforms

Given the sweeping changes in financial market regulation following the financial crisis, CSFME has turned its focus to questions relating to to how these changes are affecting the risks and economics of bank activities. The purpose of the Center’s research in this area is to foster sound policymaking and effective regulation with minimal adverse and unintended consequences. CSFME studies supervision and regulation of global financial institutions, the effects of reregulation on the global financial industry, optimal roles and methods of regulation in securities markets, corporate governance at financial institutions, and the most effective metrics and methods of data collection for understanding and measuring the effects of regulations on the global financial landscape. 

Lately, in response to a call from the FDIC for research on financial sector policy and regulation, the Center submitted a paper modeling the indirect costs to markets of bank regulatory reform.  The paper critiques regulators’ models for assessing these costs, and provides empirically-based suggestions for a more complete dynamic model of the long-term effect of bank capital reform.  Mindful of the Basel Committee's ongoing reviews of modeling tools, i.e., May 2012 and March 2016, the Center's critique is intended as a constructive addition to the holistic conceptual base of the regulatory reforms.

The Center also continues to provide input on regulatory proposals.

In March of 2016, CSFME submitted a comment letter to the Bank for International Settlement's (BIS) December 2015 consultative document regarding step in risk.  While supporting generally the goals of the Basel Committee to minimize the potential systemic implications resulting from situations where banks may choose to provide financial support during periods of financial stress to entities beyond or in the absence of any contractual obligations, the Center expressed some concerns and offered some suggestions regarding the approach taken by the Consultation. Drawing on practical experience, the Center offered an example from the trade finance sector supporting its belief that the nature of step-in risk may be one example of an acceptable, non-diversifiable exposure, given the potential positives for the economy at large.

In February 2015, CSFME submitted a comment letter in response to the Financial Stability Board’s November 2014 consultative document, Standards and Processes for Global Securities Financing Data Collection and Aggregation. In its letter, the Center identified additional metrics that may be necessary to assess properly the risk of collateral fire sales associated with securities lending transactions.  In particular, CSFME asserted that FSB and sovereign regulators must expand the data initiative beyond position aggregates, to include risk mitigation resources as well as termination activity.

Students Learn to Evaluate and Contribute to the Reform Process

As the level of intensity surrounding the reform process continued to build in 2013, the CSFME began to bring a fresh perspective to the reform process. By working with finance students and the US regulatory agencies, CSFME hoped to challenge the settled views of stakeholder by introducing the views of those whose careers would be shaped by the outcome of the reforms.

In the spring of 2013, a select group of Fordham University economics students met in Washington with officials at the U.S. Treasury, Office of Management and Budget, Federal Reserve Board, and the Securities and Exchange Commission. The CSFME helped arrange the meetings and funded the logistics. By all accounts, the experience was very positive for students and regulators alike.

Buidling upon the success of the 2013 pilot program, in 2014, both Fordham and the CSFME decided to expand the outreach program and formalized the Regulatory Outreach for Student Education program as the ROSE program. Honor students in finance and economics were selected by the deans of four schools within the university: the Graduate School of Business Administration, Fordham College at Lincoln Center, the Gabelli School of Business, and Fordham College at Rose Hill. The students were organized into four teams representing their schools. The CSFME selected a contemporary issue of career significance, the Financial Stability Board’s Consultative Document on G-SIFI designation of non-bank, non-insurer financial institutions. Each team was charged with studying the issues in debate, then presenting their opinions in the manner of a formal comment letter to the FSB. Over four months, the students reviewed earlier opinion pieces, met with practitioners and regulators, and then submitted their opinions. Without influencing their opinions, the CSFME arranged access to research materials and opinion leaders, then reviewed their letters and, as appropriate, recommended submission on university letterhead. In April, 2014, the four teams’ letters were published by the FSB on its website. In recent memory, no university had ever had one letter, much less four, published on a regulatory website. To finalize the 2014 ROSE program, the CSFME arranged for all four teams to present their opinions to the key regulators at the Federal Reserve Board and the SEC in Washington, D.C. The day of meetings ended with regulators’ praise at the degree to which the students had understood the issues and presented their opinions clearly.

One student team even offered suggestions that regulators had not previously considered and praised for their creativity. “We always know what the trade groups will say, but you brought a fresh perspective.” That team, Fordham College at Lincoln Center, was awarded the 2014 ROSE Award for Analytic Excellence. In retrospect. each student completed the program with a credit that will not only endure on their resumes but also contribute to the evolution of the financial markets through the Twenty First Century.

In 2015 and 2016, Fordham formalized the ROSE Program as a for-credit course in their curriculum. The focus of the 2016 ROSE Program was the Bank for International Settlement's December 2015 consultative document proposing a preliminary framework for identifying, assessing and addressing step-in risk potentially embedded in banks' relationships with shadow banking entities.  Five teams of graduate and undergraduate students in economics, finance, accounting, management, and law researched and drafted comment letters on the consultation and submitted their letters to a panel of distinguished industry judges.  After reviewing each excellent submission, the judges then one winning letter to be presented at a visit to the Federal Reserve Bank on April 27, 2016. The winning team's letter was submitted in full to the BIS, along with a summary of the key ideas from the letters from each of the other four teams, and the submission was published on the organization's website with those of the consultation's other commenters.   All five teams of Fordham Scholars visited Washington, DC on April 27, 2016 and met with officials at the Fed, Treasury Department, and FINRA.  

Institutional Securities Lenders respond to Academic Criticisms

In 2006 the Center was created, initially for the purpose of testing academic criticisms of the securities lending markets. With funding and data support from the Risk Management Association, CSFME found “no strong evidence to conclude that securities lending programs have been used to any great extent to manipulate proxy votes or exercise undue influence on Corporate Governance issues.” Our study also found that “broker borrowbacks” had contributed to spikes in lending activity around record date – the same phenomenon that the academics had misinterpreted as evidence of hedge fund manipulation – due to the efforts of brokers to meet recall notices from securities lenders. In effect, the brokers were scrambling to acquire votes for their customers, not building positions to swing corporate elections. The academics had fatally misinterpreted their findings!

Ed Blount of CSFME testified at the SEC’s Roundtable on the results of the research in September, 2009. Then, the CSFME white paper, published in 2010, was submitted to the SEC as an attachment in response to a consultative document on the “Proxy Plumbing” process. As a result of the Center’s contribution to the collaborative process, the misguided call for reform of securities lending began to subside. Once again, securities borrowers were fairly recognized to be honest brokers in the corporate governance arena.

Securities Lenders consider new means to retain their Voting Rights

In a follow-up to the Empty Voting project (“Borrowed Proxy Abuse” as it came to be known), the CSFME responded in 2011 to requests by the participating securities lenders, by turning its attention to ways in which those lenders might be able to retain their corporate governance rights, while still benefiting from the income attributable to their securities loans. After all, as many studies have found, securities lending contributes significantly to the efficiency of market operations. Why should lenders be forced to choose between their loan fees and fiduciary duties to vote their shares, especially if they are contributing to market efficiency?? With independent funding, the CSFME retained attorneys from two prestigious Washington D.C. law firms, Stradley Ronon and Sidley Austin, to investigate the legal underpinnings to market practices which force pensions, mutual funds, insurers and other institutional securities lenders to give up their voting rights when they lend portfolio securities. In practice, margin customers of brokers also lend their securities, yet they usually retain voting rights -- and most of them aren’t even long-term beneficial owners. Both groups of beneficial owners retain dividend rights, so why, institutional investors asked, shouldn’t institutions also keep their voting rights? With the benefit of exhaustive legal research, CSFME filed a petition with the Securities & Exchange Commission to initiate a pilot program to test new market procedures by which recently-introduced efficiencies in market operations might permit lender to retain votes.  Learn more about Paradoxical Erosion of Corporate Governance

In 2013, the SEC approved that pilot program, largely in response to the encouraging recommendations of the International Corporate Governance Association, as well as the California State Teachers Retirement System and the Florida State Board of Administration.

That pilot was initiated in 2014. Simultaneously, the CSFME began to apply the results to new initiatives in Canada and Switzerland, where the pressure to meet fiduciary voting obligations was intensifying.  More about Full Entitlement Voting