A little too much democracy
Conventional shareholder democracy dictates, as most stock owners would believe, that one share does equal one vote (with the exception of dual share classes). But largely unknown to some of their clients, securities brokerages can loan out stock, often to short sellers like hedge funds, meaning both stock owners – or even more if the stock is repeatedly lent – may vote their proxies. And at a time when corporate shareholder activism is on the rise and some votes are particularly hard-fought, such double or triple voting creates misrepresentative results and often damages shareholder rights.
‘A lot of institutions lend shares, too, because it can be a lucrative thing to do,’ says Paul Schulman, executive managing director of the Altman Group, a proxy solicitation firm. ‘But some are very diligent about proxy voting and will look to pull back shares right around voting record dates. Not enough institutions do this, but some do.’
Don’t bite the hand that feeds you
Why has such a peculiar Wall Street practice remained not just in rude health but tucked away from the limelight for so long – particularly when bad-news stories about corporate governance and shareholder transparency are leaking into the business press almost daily?
Rick Grubaugh, senior vice president at proxy solicitor DF King, says stock loan activity has always been a concern in contested elections and merger votes, but brokerage firms do not seem to want to focus on a situation earning them a steady commission, not to mention a potentially lucrative income for investors loaning their shares.
‘Most of the problems start with the active stock loan market where, for example, retail investors aren’t always aware that their shares have been loaned out and their voting rights depleted,’ Grubaugh says. ‘Institutional investors, the main driver of the stock loan activity, loan shares out for income, but there has to be a balance between receiving extra income from stock loans and the right to vote your entire position at every meeting. If investors were truly concerned about their voting rights, they would likely not loan out their shares. But some institutional investors are addicted to the extra income – it can make an impact on their overall return.’
Bruce Goldfarb, senior managing director at proxy solicitor Georgeson, agrees that the current voting process leaves a great deal to be desired. ‘This process is being more publicly attended to,’ he says. ‘Institutional investors and corporations charged with auditing elections do take seriously the role of making sure that the appropriate amount of shares get voted, and we are seeing much more attention paid to the audit process.’
However, even when brokers attempt to make contact with shareholders, there’s often a fair measure of voter apathy when the relevant proxy material is sent out. Many shareholders don’t bother to reply, and if the brokerage firm is affiliated with an investment bank that wants business with the issuing corporation, it’s not hard to guess how the broker will vote. Despite Enron and the tech washout at the beginning of this century, retail investors remain largely a passive investor group.
What’s more, the usual custodial arrangements don’t help companies get to know their stockholders any better. Most shareholders own stock via street name registration under a broker’s name, meaning companies are at the mercy of brokers when sending accurate information to the tabulator. Business Roundtable, a Washington, DC-based organization representing company chiefs, has already asked the SEC to consider giving companies access to the contact details of all their shareholders, allowing them to contact investors directly – a potential boon in tightly fought shareholder votes. No SEC decision has been reached so far.
What has sparked much more debate on the issue is a new study called ‘Vote trading and information aggregation,’ by professors from McGill University, the University of Pennsylvania and the University of North Carolina. It demonstrates that stock lending and over-voting could potentially encourage those with a motive to influence the outcome of corporate voting. ‘Shareholders,’ the report states, ‘do not know how to vote their interests, and are taking their chances that the votes transfer to investors who do know how and who share their preferences.’
The research does not point to any systematic undermining by, for instance, short investors attempting to ‘rig’ the outcome of votes, but the potential for abuse remains, as many have known for some time. But how likely is vote rigging?
Thomas Joo, a professor at the University of California’s Davis School of Law, thinks it’s unlikely. ‘According to this paper, brokers can lend out their customers’ shares, and so the number of customer voting instructions may, theoretically, exceed the number of shares that the broker possesses on the record date. This is unlikely because many, if not most, customers will not submit voting instructions. Even if a broker did over-vote, it would not likely be discovered because the total number of votes cast in the election will certainly be far less than the total number of outstanding voting shares.’
Joo also questions why it’s even an issue when shares are cast by someone who isn’t the original owner. ‘What exactly is the problem? If we accept that shares can be lent, we accept that the borrower, for a certain period of time, enjoys the rights that attach to the shares,’ he says. ‘If you lend me your car, we accept that I may drive it. So if you lend me your shares, why can’t I vote them? What is so special about shareholder voting that’s so troubling?’
Similarly, one could argue that direct shareholder voting is not about the control of public firms by investors acting en masse as a democratic institution; shares are simply a commodity bought and sold while the company remains controlled by directors and executives, and in some cases by controlling shareholders. In other words, the analogy between shareholder democracy and ordinary political voting simply does not carry.
David Musto, co-author of ‘Vote trading and information aggregation,’ says it’s simply a matter of definition that although shareholder votes may not yield much useful control, their votes still count. He adds that his and his co-authors’ research clearly shows shareholder votes being transferred on the record date – a specific day set by companies to encourage shareholders to vote – and that a spike in lending was clearly visible during the days leading up to a vote. This indicates that bona fide stock owners are seemingly comfortable – or perhaps just unaware – that their own votes were being lent to others.
‘We thought we would see the price of borrowing shares go higher on record dates, showing how the public would value the date,’ says Musto. ‘But we were surprised the price did not spike up at all. What could be going on if there is zero price for the vote?’
In the quest to find out how vote trading affected outcomes, Musto and his colleagues went on to look at a cross section of a bunch of votes. They saw that there was more borrowing of stock when there was generally less support for company management and more support for shareholders. ‘It’s not the kind of mischief that people worry about,’ he says. ‘Sure, you would have concerns about vote borrowing, and it is natural to be concerned about the entrenchment of management in such a situation, but that’s not what we’re seeing here.’
A broken process
Whatever the outcome of such practices so far, the fundamental issue of over-voting and its potential to skew the democratic polling process remains. Anne Faulk, CEO of Swingvote LLC, which manages an internet-based proxy delivery system for public companies, points the finger of blame squarely at the brokerages for failing to come clean with their clients.
‘One of the issues is a clear lack of discipline from the custodians,’ she says, ‘particularly the brokerage firms where they prepare two proxy ballots with the same number of shares for two shareholders, knowing full well that only one of those ballots has any right to be distributed, and knowing that if both shareholders vote, there’s going to be over-voting.’
Faulk’s point touches on a cornerstone of basic shareholder democracy: the right to be heard. If both proxies are voted, whoever votes last – even if they’re the legitimate holder of the shares – is likely to have his or her vote thrown out. The fact that both proxies are sent out seems to indicate a measure of brokerage unease about the process, rather than admitting frankly to their client that their vote has been given away.
So what’s the solution? ‘It’s absolutely simple,’ says Faulk. ‘You get the share positions checked on the record date and ensure that they reconcile so the legitimate holders get the ballots. That’s it. It’s the easiest thing to do to demand from the brokerage that they reconcile their positions on the record day and that they do not send a ballot to someone who they know good and well doesn’t have the right to vote.’
Not only is over-voting hardly fair for shareholders, it’s also potentially damaging to directors and management – especially if some of the votes are being played by hedge funds with little interest in long-term shareholder value. ‘This practice is completely inappropriate on a lot of levels,’ says Charles Elson, director at the University of Delaware’s John L Weinberg Center for Corporate Governance. ‘Institutions certainly have an obligation to vote in a company’s best interest, but if you [lend your shares], then you’re disengaging from that process and from management.’
The SEC is said to be concerned about over-voting, though it has not yet put forward a formal proposal addressing the issue. The NYSE is well aware of the issue and acting against it. In February it fined Deutsche Bank Securities $1 million for proxy over-voting between 1998 and 2003, after the company submitted more proxies for more shares than it was entitled to and ran the risk that customer proxy votes would not be ultimately accepted.
‘From March 1998 to November 2003,’ according to the NYSE, ‘Deutsche Bank failed to timely reconcile stock records on beneficial ownership in connection with proxy voting, issued duplicate requests for proxy voting instructions for securities held in certain omnibus accounts, which resulted in duplicate votes in some instances, failed to transmit accurate information to its proxy service provider on numerous occasions, voted more shares than it was entitled to vote in proxy matters in numerous instances and did not adequately retain proxy solicitation records.’ It added that Deutsche Bank’s failure to reconcile the stock record in connection with proxy voting instructions was a ‘central failure.’ A Wall Street insider close to the over-voting debate claims the NYSE is preparing to slap down more brokerages on the issue.
But until state law and the US securities industry takes the issue seriously, the opportunity for proxy votes to be corrupted by over-voting remains wide open. Big bucks can ride on such elections, and as votes get tighter and short-term investors get increasingly skilled in the art of proxy fights, the bigger an issue over-voting will become.