Hedge funds get active in empty voting on borrowed shares
What if an investor borrowed shares or engaged in an equity swap, acquired voting rights on your company’s record date, and then attempted to alter the outcome of a pivotal election?
Been there, done that, some hedge funds could boast. Known as ‘empty voting’, this practice has rocked a handful of companies with highly contentious shareholder contests underway. Although the practice is not exactly an everyday occurrence, the issue recently moved from academic journals to the nightly news.
In the US, the poster child for empty voting is Perry, a hedge fund that held a position in King Pharmaceuticals and wanted to make sure Mylan Laboratories was successful in its proposed acquisition of King. Through a negotiated derivative transaction, Perry acquired voting rights to 9.9 percent of Mylan without actually owning the shares.
According to Richard Grubaugh, senior VP at DF King, ‘The Perry/Mylan situation showed the world how empty voting is done, and how somebody with an economic contrary position could basically dictate the outcome of a transaction.’ He continues: ‘I believe many regulators’ jaws must have dropped when they read in full the Perry/Mylan 13D.’
In May 2006, Henry Hu and Bernard Black, two University of Texas law professors, published the definitive paper on empty voting. They studied 22 worldwide instances of private investors either borrowing stock or using hedging strategies to alter the outcome of shareholder elections. Hu points out that empty voting is most pernicious when an investor has interests that run counter to that of the company. ‘The more Mylan (over)paid for King, the more Perry would profit,’ wrote Hu and Black. Or, as Hu says, ‘If you want Inspector Clouseau to be running the company, it’s worrisome.’
Difficult to detect
Empty voting is difficult to track because it comes in many guises. The simplest scenarios revolve around stock lending, explains Paul Schulman, executive managing director of the Altman Group: an investor owns stock but borrows more shares immediately before the record date, increasing his or her voting power; as soon as the record date passes, the investor returns the shares.
More complicated are cases of negotiated agreements in which a brokerage firm hands over shares to an activist investor with the agreement that the shares be returned at some predetermined date after the vote is completed, explains Chris Schelling, director of strategic research at Thomson Financial. Over-the-counter (OTC) asset swaps can be structured many different ways, but they have one thing in common: they’re very difficult to detect.
Although empty voting is not necessarily common, its implications are profound. It’s no exaggeration to suggest that empty voting erodes the underpinnings of corporate democracy: the one-share-one-vote concept.
‘Normally, you think if shareholders really want something, management should care. But what if the shareholder has zero economic interest?’ Hu asks, quickly adding, ‘This raises an important issue from an investor relations standpoint: how do you interpret the result of votes?’
Inside track
Given the potential for empty voting – and the difficulty of knowing if and when empty voting has occurred – what’s a company to do? Schelling advises issuers to familiarize themselves with the various hedge funds, learning their names, their personalities and also their tactics. ‘Know Perry has done it before,’ he says. ‘If you see Perry didn’t own any stock but suddenly has a 20 million share stake, well, that’s pretty suspicious.’
Amanda Jones, head of investor relations at British Land, has firsthand experience in this realm. In 2002 Laxey Partners borrowed eight percent of British Land’s shares prior to the annual meeting in order to garner support for its proposal to break up the company. Jones says that even though Laxey wasn’t ‘proposing any viable changes that shareholders would have wanted to approve,’ the company still took the situation seriously. British Land published a circular explaining why the proposals weren’t in shareholders’ best interests.
‘The only way it was good for us is that we had an opportunity to communicate clearly with shareholders,’ says Jones. ‘Perhaps shareholders came away understanding our approach and strategy even better.’
Fuller disclosure
Both the SEC and the UK Financial Services Authority (FSA) are said to be engaged in studying empty voting. Rather than fiddling with proxy voting, regulators might demand fuller disclosures that would make empty voting schemes harder to enact. ‘There are ways to see trading shifts that look suspicious,’ says Grubaugh, ‘but there is no way to uncover the actual agreements they’ve entered into with the brokerage firms unless we see a disclosure requirement.’
Hu is also convinced that ‘disclosure of economic ownership and not just voting ownership’ is the answer. In practice, this might mean revisiting 13F disclosures. Hu points out that under the current system, institutional investors ‘aren’t required to make any disclosure whatsoever with respect to OTC derivative holdings, such as equity swaps.’
Disclosure, in and of itself, has the power to effect change, maintains Hu. ‘Some hedge funds would be reluctant to do in the sunlight what they’re willing to do in the dark,’ he says.
Without greater disclosure, ‘the bottom line is that we really don’t how extensive this problem is,’ says Hu, who likens empty voting to bird flu: There are over 20 known cases worldwide, but while other deaths may also have resulted from bird flu but this is mere speculation. ‘Part of the reason we’re pushing for better disclosure,’ says Hu, ‘is to get a better sense of how serious these problems are.’
