Director elections are no longer a sure thing for management
As the proxy season pendulum swings in favor of majority voting, shareholder activism and access, memories of landslide director elections are fading fast. The possible loss, under the NYSE’s proposed rule changes, of the broker discretionary vote is creating further boardroom angst. Corporate secretaries are also worrying about achieving quorum and getting their directors elected.
Growing concerns about traditional voting practices and new anxieties about potential shareholder ‘over-voting,’ and ‘empty voting’ are causing sleepless nights. Couple that with visions of nefarious, undisclosed investors ‘morphing’ into corporate equities just to gain voting rights, as some describe it, and you may have a proxy nightmare on your hands. While some are questioning proxy voting traditions, others are pointing to share borrowing and derivative trading as potential sources of voting problems.
Overall, a groundswell is building for greater investor disclosure rules as public companies and others are raising such questions as: Who is voting? Are some shares being voted more than once? In case of ‘over-voting,’ what standards determine which votes to accept and which votes to discard? Are some activist investors ‘buying’ votes through complex combinations of short-selling, share borrowing and equity swaps (or the trading of other derivatives) in the lead up to the record date with the intention of gaining extra leverage in the proxy vote? Is ‘empty voting’ occurring because hedge funds and other investors with little or no economic interest are gaining a significant number of votes?
Like a bad dream, multiple votes per share can, on occasion, recur. ‘Over-voting has been a problem area for a long time but no one has really focused on it,’ says one brokerage industry executive who wishes to remain unidentified. ‘I don’t think there’s a good sense from anybody on how often there’s been a breakdown. People are worried now because corporate elections are becoming more important.’
Getting an accurate count
Indeed, as shareholder activists flex their muscles and proxy seasons become more contentious, more eyes are focusing on corporate elections – and the voting process. The objectives are to ensure that only eligible shareholders vote, that votes are counted fairly (with no over-votes) and that no one manipulates the votes.
Obtaining and counting the vote involves a host of players – nominees, processors, tabulators, transfer agents, inspectors and proxy solicitors. Each player observes voting from a very unique perspective, which means that communication between the various groups is not always efficient.
‘An over-vote occurs when a specific bank or broker votes more shares than was allotted to them on the DTC [Depository Trust Company] omnibus,’ says Bill Marsh, president of IVS Associates, a provider of independent inspectors of election for corporations throughout the US.
As Marsh explains, DTC, which holds the shares of its broker and bank participants, develops the official count of each participant’s positions. ‘DTC issues an omnibus proxy on the record date that gives each bank and broker a share entitlement to vote,’ he says. Although no participant may submit more votes than their DTC entitlement, problems can arise before the final tally.
Banks and brokers generate their own record-date tapes of their beneficial holders and send them to a processor who distributes proxy materials and voting cards to shareholders. If more votes come back than a participant’s official DTC position, some would say an ‘over-vote’ has occurred.
Who’s vote is it anyway?
Chuck Callan, senior vice president of regulatory affairs at Broadridge (an ADP spin-off and currently the major proxy processor) says that his firm prefers to use the term ‘over-reporting,’ in describing the situation when a nominee’s voting report exceeds the nominee’s votable position before the meeting. ‘Since a nominee can’t submit more votes than their DTC position, the votes have to be reduced in some way by a tabulator before they can be entered into the official count,’ he says. To help eliminate over-votes, over 300 nominees have enrolled in Broadridge’s ‘over-reporting service’ that permits Broadridge to compare the respective nominee’s DTC position report to the voting instructions that come in before the meeting. ‘If an instruction exceeds a nominee’s position, we communicate that back to the broker and it is the broker’s responsibility to reconcile and provide an accurate home for that vote,’ Callan adds.
The problem with this system, according to a number of corporate secretaries, is that when the reports are sent back to the broker, little is done. The brokers and other players have very little incentive to perform extra work (often at their own expense) to rectify their errors and get an accurate count. The over-votes are just arbitrarily removed, and often they are removed from the legitimate owner of the vote.
Tabulators may also get involved in instances of over-votes. How tabulators and nominees make decisions to reduce instances of over-voting or over-reporting can be a point of contention. According to Richard Grubaugh, senior vice president at proxy solicitor DF King, the practices of tabulators vary. Many tabulators simply ‘carve out’ and ‘scale back’ the vote in order to get to the DTC number. In describing a typical process, Grubaugh says, ‘When they carve it back, they carve back just the favorable [discretionary broker] votes for management.’ Grubaugh refers to the traditional practice of brokers casting discretionary votes – usually in favor of management – on behalf of beneficial owners who don’t return their proxies. (A proposed change of the NYSE’s Rule 452, still pending SEC approval, would make director elections a non-routine item, thereby eliminating the discretionary broker vote.)
There are various theories of how over-votes occur. Some place blame on street practices. Thomas Montrone, president and CEO of Registrar and Transfer Company, a non-bank transfer company, refers to the over-voting conundrum as ‘street over-distribution of voting rights’ and says it’s done in a ‘neglectful’ process. ‘The brokerage community, I believe, takes a less serious approach in accounting for reduced voting authority,’ says Montrone. ‘Therefore [they] will distribute excessive voting rights, diluting the voting authority of each shareholder in a neglectful process. They just don’t bother to reconcile it.’
Some blame share borrowing. ‘Essentially over-voting occurs when proxy materials are sent to the borrower and the lender of the same stock,’ says Domenick DeRobertis, managing director of the The Altman Group, a proxy solicitor. ‘What happens is that votes are collected for double the amount of shares that are eligible to vote.’
A share purchase that is executed through one broker at or on the record date, and the corresponding sale executed through another broker, could increase the likelihood that both buyer and seller will receive voting cards for the same security. Throw share borrowing into the mix and you add another layer of complexity. Patrick Quick, partner at the law firm of Foley & Lardner, says that when share loans are made brokers don’t necessarily ‘allocate’ the loaned shares to particular accounts. ‘So you don’t know who can and can’t vote,’ Quick says. ‘In the absence of a specific allocation, everyone gets proxy materials and then the vote needs to be pared back somehow. Then the question is: How do they pare it back when they haven’t specifically allocated the borrowed shares?’ he continues.
At Pershing, a subsidiary of the Bank of New York Mellon, managing director Irving Klubeck says that ‘failures to receive and failures to deliver contribute to the need for votes to be reconciled in the middle of the voting process so that they agree with the DTC file.’ Klubeck continues; ‘In every securities loan, the rights to vote go with the shares. The buyer anticipates being able to vote. If everyone assumes that every failure to receive and failure to deliver was actually settled properly, we would never have any over-voting, and the votes would be put into the hands of the people absolutely entitled to vote.’
A web of confusion
One educator takes issue with those who would also blame the usual suspects – derivatives – for voting woes. ‘Most derivatives that you would think of involving equities have nothing to do with voting,’ comments Stephen Figlewski, a finance professor at NYU’s Stern School of Business. (See ‘Derivatives defined’ sidebar.)
‘An option contract gives you the right to buy the stock but you don’t get any voting rights until you actually do buy the stock,’ continues Figlewski, who also serves as editor of The Journal of Derivatives, a quarterly peer-reviewed research journal oriented towards practitioners in the field of derivatives. ‘Once you have bought the stock, you’re a stockholder and you have all the voting rights that a stockholder has. But that has nothing to do with the fact that you acquired the stock by exercising an option.’
Randall Dodd, director of Financial Policy Forum, a non-profit research group that studies the financial markets, says that kind of logic is definitely misleading. ‘It’s like saying, Guns don’t kill people, people kill people,’ he explains. ‘Technically, derivatives themselves do not give you voting rights in a firm. But, if it is your objective to go out there and try to manipulate voting rights – and to profit from it – you are using derivatives every time.’
‘Use of equity swaps and other derivatives make it easy for investors to hold more votes than economic interest, a practice we call empty voting,’ says Henry Hu, Allan Shivers Chair in the Law of Banking and Finance at The University of Texas Law School.
Hu and his colleague from the University of Texas Law School, Bernard Black, first discussed the findings of their research in the May 2006 article, ‘The New Vote Buying: Empty Voting and Hidden (Morphable) Ownership.’ The professors coined the terms ‘empty voting’ and ‘hidden (morphable) ownership.’ Empty voting describes situations in which hedge funds or other investors have voting rights in companies greater than their economic interests in those companies. Hidden, morphable ownership describes situations in which they may have large, ownership-like stakes that are not disclosed under existing SEC rules.
‘Instead of one share, one vote, an investor with 100,000 shares’ worth of economic interest may instead have the voting power of one million shares,’ Hu says. ‘Corporate secretaries should be concerned that someone who has a lot of votes could try to cause the company to take actions that would be contrary to [the interests or desires of] most shareholders.’
‘Everyone’s always pointing a finger at derivatives,’ continues Figlewski. ‘But the real culprit is the short sale. Derivatives are kind of innocent bystanders.’ Although the ‘innocence’ of derivatives would spark fierce debate, Figlewski’s comment about short sales may be worth pondering, for share borrowing, often associated with short sales as well as derivatives keeps recurring in discussions about both over-voting and empty voting.
The impetus for change is here, and motivation is building. In a recent comment letter to the SEC, the Society of Corporate Secretaries and Governance Professionals questioned the logic behind share-lending agreements that assign voting rights to the borrower stating, ‘Is the investor who borrowed shares to cover short sales the appropriate person to make decisions regarding the long-term direction of the company?’
Newer investment vehicles like equity swaps and over-the-counter derivatives post-date existing disclosure regulations. Hedge funds and derivatives investors are finding ways to avoid disclosure.
Professor Hu believes that the SEC should change disclosure regulations. ‘If the disclosure proposal set out in the May 2006 article is adopted, corporate secretaries would have a better sense as to the ownership of their company’s stock,’ says Hu. ‘This greater transparency would be useful to everyone. Also, if hedge funds realize their actions would be out in the open, they may change their behavior.’
‘With these disclosure reforms, there would be more information as to the extent and nature of empty voting and hidden, morphable ownership, information that would help regulators and companies determine if additional responses might make sense,’ says Hu.
For its part, the Society is calling upon the SEC to undertake a comprehensive review of the proxy voting system. In a comment letter before a recent SEC roundtable to discuss voting integrity, the Society made the following statement, ‘Because stockholder votes have a direct impact on our companies’ operations (including the election of directors, ratification of auditors, approval of equity plans and approval of mergers and acquisitions, to name a few), it is critical that the voting system be accurate and fairly represent the interests of our stockholders.’
Perhaps there’s hope that proxy voting won’t be such a nightmare after all.
