One of the essential tenets of modern corporate governance is that shareholders control corporate managers through shareholder voting. This notion is founded on the premise that shareholders will vote their economic interests, and the weight of their vote will be proportionate to their economic interest. However, research by University of Texas law professors Henry Hu and Bernard Black reveals that as a result of recent capital markets developments, hedge funds and other investors can “decouple” voting rights from economic ownership of shares. For example, a hedge fund borrowing shares from institutional investors can acquire the voting rights of the borrowed shares, even though the shareholder who owns the shares retains the economic interest in the shares.
The professors’ legal research can be found here and here, and is discussed in a January 26, 2007 Wall Street Journal article entitled “How Borrowed Shares Swing Company Votes” (here, text courtesy of the Texas Law School web site).
The hedge funds or other investors who wish to obtain voting power do so by borrowing shares from large institutional investors, often as part of a short selling strategy. Borrowing the shares allows the hedge funds to gamble that the shares will decline, and they can use their vote to try to ensure that they will. The professors call the exercise of voting rights divorced from economic interests “empty voting.” The Journal article cites several examples where shortselling hedge funds used this technique as part of a successful short selling strategy.
The professors emphasize that no one knows how widespread this practice is. Their research examined 22 instances worldwide from 2001 through 2006. The Journal article notes that these kinds of votes have not yet affected outcomes in many general corporate elections. But the practice could become more important given current corporate governance momentum built around increasing “shareholder democracy,” such as the push for majority voting of directos and the right of shareholders to be able to propose board candidates.
The “empty voting” issue has attracted the attention of regulators. SEC Commissioner Paul Atkins, in a speech on January 22, 2007 (here), raised his concerns with the practice, and the Journal article quotes SEC Chairman Christopher Cox as saying that the practice is “almost certainly going to force further regulatory response to ensure that investors’ interests are protected.”
Finding a simple regulatory solution may be complicated by the fact that shareholder voting is largely controlled by state law. In addition, the vested interests in the status quo include not only hedge funds and others who might use the strategy to advance their interests, but also the institutional investors who profit by lending their shares. According to the Journal, brokerages and big banks now make $8 billion a year in fees they earn by lending their shares. CalPERS alone made $129.4 million by lending shares its holds in the year ending March 31, 2006.
The professors proposed solution puts less emphasis on regulation and more on disclosure. They propose an “integrated ownership disclosure reform,” that would require disclosure both of voting and economic ownership. The professors proposed solution would not eliminate some disclosure delays, and even allows the possibility that the disclosure might not take place until after the vote has taken place – but it would still ensure that the disclosure takes place eventually, which would both inform regulators and lawmakers for future remedial purposes, and act as some constraint on behavior.
An interesting perspective on this issue, and a presentation of the brief against further regulation on this issue, can be found on Professor Larry Ribstein’s Ideoblog, here. CFO.com also has an interesting January 26, 2007 article entitle “How to Beat the Hedge Fund Bullies” (here), that examines strategies that companies can use to identify who their shareholders are and analyze how the shareholders’ are voting.
SEC Chairman Cox on Global Competitiveness: As The D & O Diary has noted on numerous recent posts (most recently here), the issue of the competitiveness of the U.S securities markets in the global economy has been the subject of a great deal of comment lately. Regular readers will recall my concern that while the U.S. should look to its competitive interests, it should take care to avoid compromising its regulatory integrity. In a January 24, 2007 speech (here), SEC Chair Christopher Cox added the following perspective on the threats to the competitiveness of the U. S. markets:
The threat comes not from fear of foreign competition, or foreign issuers, or foreign investors. Both competition, and the influx of foreign capital and issuers, promise only good for our markets. Rather, the threat comes from the increasing opportunities for fraud, unethical trading practices, and market manipulation that globalization brings with it. Just as investors and issuers can more easily seek each other out around the world, those with less honorable intentions can also reach across borders, to prey upon distant investors. And when they succeed, they damage confidence in all of our markets.
As the proposals for regulatory reform continue to emerge in the coming months, it will be important for us to remember what kind of investors and what kind of investment activity we do and do not want to attract to U.S. securities markets.
Tellabs Goes to SCOTUS: On January 5, 2007, the U. S. Supreme Court granted certiorari (here) in the Tellabs case on the issue of the standard for pleading scienter under the Private Securities Litigation Reform Act of 1995 in securities fraud suits. An excellent brief summary of the issues involved in the case written by Jonathan Jacobs of the Wiley Rein firm can be found here.
Best in Class: Those readers who, like The D & O Diary, were fans of the late, lamented Securities Litigation Watch blog will be delighted to learn that its author Bruce Carton has launched a new blog, Best in Class, which can be found here. The early posts suggest that the new blog will be as timely and informative as the SLW.
Readers will also be interested to know that Bruce will be hosting a webcast on Tuesday January 30, 2007 at 1:00 p.m. EST on “Emerging Trends in Securities Class Actions.”
Hat tip to the 10b-5 Daily Blog for the information about Best in Class.
Next week: I will be in New York next week for the PLUS D & O Symposium (here). I hope that readers of The D & O Diary will please say hello to me during the Symposium and let me know what they think of the blog. See you all in New York.