Hedge Funds Use Borrowed Shares to Influence Company Votes

A recent Wall Street Journal article entitled “How Borrowed Shares Swing Company Votes” looked at the practice by hedge funds and other private investment firms of borrowing shares of publicly traded companies specifically for the purpose of influencing the outcome of proxy votes.  The article cited situations where public company shares were borrowed (and voted) by persons whose interests may have been in conflict with those of the company.  

In several circumstances, it was noted that this strategy potentially allowed speculators to profit from rapid changes in the stock’s price after the outcome of a particular vote is released to the public.  It was also noted that third parties seeking to influence the outcome of such votes have often used this strategy to hide their voting power until the last moment.  Typically, the individual shareholder doesn’t even realize their stocks, and their voting rights, have been borrowed from their brokerage accounts until it is too late.

This practice (termed “empty voting”) while legal, has piqued the interest of the SEC and has rekindled a long debate over stock lending practices.  Below is a simplified example of how the practice works:

1. A hedge fund borrows the voting stock of a publicly traded company before the announced “record date” to be eligible to vote the stock at the next stockholder’s meeting; 
2. The fund typically will put up collateral for the borrowed stock and pay a fee to the lending broker once the shares are transferred to its account(s);
3. The borrowed shares are then “voted” at the stockholder meeting;
4. The borrowed shares are then returned to the lender after the record date.

NYSE IM 07-08 recently reminded members that when customers with margin accounts have a debit balance, member organizations pursuant to their margin agreements with such customers, have the right to hypothecate or lend the shares subject to certain limitations.  When the shares are lent under the standard stock loan agreement, the right to vote the shares goes with them.  If a corporate vote takes place while the shares are on loan, the margin customer may be unable to vote them.  Thus, member organizations need to provide effective disclosure to customers regarding the possibility of their losing proxy voting rights for securities held in margin accounts.  Most member organizations have chosen to address this disclosure within the customer margin agreement.

In response to this trend, some pension funds have recently become reluctant to loan out their shares to short sellers due to their concerns that those shares may be voted in a manner that is inconsistent with the goals and objectives of the fund.

Currently, the SEC has no firm plans as to how they may address the issue, although some foreign regulators have begun studies to look into the problem.  SEC Chairman Christopher Cox is quoted as saying that this practice “is almost certainly going to force further regulatory response to ensure that investor interests are protected”.