Proxy Voting Issues

How Shareholder Voting Can Be Influenced and Ownership Hidden

Generally, a share of stock of a publicly traded company has three features.  The first is an economic or financial interest in the company.  Many individual investors purchase a stock and hold it for the long-term.  This is called a "long" transaction and one of the goals of this type of investment is to see an increase in the share price and, in many cases, receive cash dividend payments.

A second feature of a share of stock is the power to sell the stock, also known as the investment power.  This is the power to dispose of the stock (or direct the disposal) at a price to be determined by the marketplace.

The third feature of a share of stock is the power to vote, i.e., the right to vote the stock (or to direct the voting of the stock) on important corporate matters.  Under the American corporate model, one of the most important roles of a shareholder is to elect a board of directors, which is then empowered to manage the affairs of the corporation.  A shareholder is also expected to vote on important corporate decisions, such as a merger plan or a proposed amendment to the company's bylaws.

Lending of Corporate Shares

State law generally grants the right to vote at a shareholder meeting to the investor who has possession or control at the time a public company establishes its record date.  Most of the time, this right rests with the "long" transaction shareholders mentioned earlier.  However, it is possible to "borrow" shares from a long investor and engage in a "short" transaction.

What Is A "Short" Transaction?
The general goal of a short transaction or sale is to profit from a decline in the price of a stock.  A short transaction involves "borrowing" shares from a long investor and then selling these shares.  The funds received from this sale are deposited in the account of the short seller. The short investor agrees to replace these borrowed shares to the original owner, and he or she hopes to be able to buy the shares back later at a lower price.  If the share price has declined during this period, the short investor makes a profit on the difference between the sale price when the shares were borrowed and the lower price at which the shares were returned.  If the price of the shares increases during this period, the borrowed shares need to be replaced at a higher cost than the sale price when they were borrowed, and the short investor realizes a loss on the transaction.

If shares have been loaned out in a short transaction on the record date, it is often the borrower (or the third party who purchased the shares from the borrower) who is entitled to vote the shares at the shareholder meeting.  These types of transactions are executed through written agreements, although many individual investors with margin accounts do not realize that their margin account agreements permit the broker to loan out their securities without notice.  These margin agreements may permit this to occur even if an investor has fully paid for the shares in cash and does not use leverage to purchase the shares.

Click here to review a New York Stock Exchange (NYSE) summary of the rights of investors with margin accounts.

Click here to review PDF files of sample margin account agreements used by major brokerage firms.

The "Over-Voting" Problem

Share lending practices and other related transactions can cause a broker to cast more votes than it is entitled to cast in a corporate election.  This is called "over-voting."

Brokers should, but are not required to, address this problem by adopting a method to reconcile their long and short securities positions with their share count at DTC.  A significant number of brokerage firms send out voting instructions to both long and short investors of the same securities, without reconciling these positions before mailing out voting instruction forms.  Only a handful of brokers reconcile their positions before voting instruction forms are mailed to beneficial owners.

In 2006, the New York Stock Exchange investigated and sanctioned four broker-dealers for failing to reconcile their beneficial ownership positions to avoid over-voting.  The Exchange determined that a lack of timely reconciliation caused customers who were ineligible to vote to receive voting instruction forms.

Click here to review the NYSE administrative decision involving Deutsche Bank Securities, Inc. (2/2/2006)

Click here to review the NYSE administrative decision involving UBS Securities, LLC (4/18/2006)

Click here to review the NYSE administrative decision involving Credit Suisse Securities (USA) LLC (4/18/2006)

Click here to review the NYSE administrative decision involving Goldman Sachs Execution & Clearing, LP (5/4/2006)

The securities industry is working on solutions to this problem.  Click here to review the guidelines suggested by the Securities Industry and Financial Markets Association (SIFMA) on proxy processing.  Click here to review an October 2007 speech by SEC Division Director Erik Sirri, presenting Commission staff views on this issue.

The "Empty Voting" Problem

Another problem that is caused by share lending practices is called "empty voting."  Empty voting occurs when any investor acquires voting rights but not an economic interest in common stock. One example of "empty voting" is when an investor borrows shares just before a record date and then returns these shares to the long investor shortly after the record date.  This is called "record date recapture."  Under current rules, the short seller is in possession of the shares on the record date and, therefore, is entitled to vote the shares at the shareholder meeting, even though he or she has no economic interest in the company.

The "Hidden Ownership" Problem

A third area that is causing problems in the share voting process involves hidden ownership or control.  The SEC requires public disclosure when an investor becomes the beneficial owner of more than 5% of a company's shares.  Since the SEC's disclosure rules require the physical possession of the shares, investors using complex derivative products have been able to avoid these SEC disclosure requirements through the use of cash-settled equity swaps.

Under an equity swap of this type, two parties enter into an agreement that seeks to replicate the positions of a long and a short investor in a particular stock.  The long investor receives all of the benefits of an increase in the stock price, along with cash flows that replicate any dividends paid.  The short investor receives the benefits of any decline in the stock's price.  Any differences are settled in cash, although the counterparty to the short side of the transaction often holds the underlying securities as a hedge against its position.

Both "empty voting" and "hidden ownership" problems are discussed in the following academic articles written by Henry Hu and Bernard Black of the University of Texas.

Click here to read the article by Hu and Black published in May 2006 edition of The Business Lawyer.

Click here to read the companion article by Hu and Black, which is directed to an academic/legal audience.

Click here to read the companion article by Hu and Black, which is directed to a finance audience.

Click here to review the latest article by Hu and Black on this subject, published in January 2008.

Actions By Regulators in the United Kingdom

The Financial Services Authority (FSA), the securities market regulator in the United Kingdom, announced in July 2008 that it will require the disclosure of certain derivative contracts, including cash-settled equity swaps, which reach a 3% level, when aggregated with ownership of common stock.

Click here to review the FSA's policy statement, issued on July 2, 2008.

Click here to review the FSA's consultation paper, issued in November 2007.

A Case Study: CSX Corporation vs. TCI Investment Fund

The issue of hidden ownership arose in a 2008 proxy contest between the CSX Corporation (CSX), a U.S. railroad company, and The Children's Investment Fund (TCI), a British hedge fund.  TCI and its hedge fund allies purchased cash-settled equity swaps and are attempting to elect five new members to the CSX board of directors.  CSX filed a lawsuit in March 2008, alleging that TCI and others were not complying with SEC disclosure rules.  CSX argued that the TCI swap agreements should trigger an SEC disclosure filing because the swap counterparties holding CSX shares are likely to vote these shares at TCI's direction.  The U.S. District Court for the Southern District of New York ruled on June 11, 2008, that these equity swaps were subject to SEC disclosure rules, although the hedge funds were not prohibited from voting their shares at a shareholder meeting.

Click here to review CSX's complaint in this lawsuit.

Click here to review a friend of the court brief in this case filed by the International Swaps and Derivatives Association and the Securities Industry and Financial Markets Association.  This brief explains how cash-settled equity swaps work.

Click here to review the brief filed by the SEC in this case.

Click here to review the U.S. District Court's decision of June 11, 2008.

The Need for More Transparency

All of these attempts to influence the shareholder voting process suffer from a lack of transparency or disclosure.  These problems can cause disadvantages to other shareholders and to the public companies they own.  The SEC needs to examine these issues as it conducts a thorough evaluation of the shareholder voting and communications processes.