Elizabeth Judd looks at what regulators are doing to prevent hedge fund overvoting.
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 under way. 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.
‘The Perry/Mylan situation showed the world how empty voting is done, and how somebody with a contrary economic position could basically dictate the outcome of a transaction,’ says Richard Grubaugh, senior vice president at DF King. ‘I believe many regulators’ jaws must have dropped when they read the Perry/Mylan 13D.’
In May 2006 University of Texas law professors Henry Hu and Bernard Black 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 and Black point out that empty voting is most pernicious when an investor has interests that run counter to those of the company. ‘The more Mylan (over)paid for King, the more Perry would profit,’ they wrote.
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 in many different ways, but they all have one thing in common: they’re very difficult to detect.
Empty voting is not necessarily common, but its implications are profound. It’s no exaggeration to suggest that it erodes the underpinnings of corporate democracy – the ‘one share, one vote’ concept. ‘What if the shareholder has zero economic interest?’ Hu asks. ‘This raises an important issue for Iros: how do you interpret the result of votes?’
Given the potential for empty voting and the difficulty of knowing if and when it has occurred, what’s an IRO to do? Schelling advises Iros to familiarize themselves with the various hedge funds, learning their names, personalities and tactics.
Amanda Jones, head of IR at British Land, has experience in this area. In 2002 Laxey Partners borrowed 8 percent of British Land’s shares prior to the AGM to garner support for its proposal to break up the firm. Jones says even though Laxey wasn’t ‘proposing any viable changes shareholders would have wanted to approve,’ British Land still took the situation seriously. It 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 in the US and the UK’s Financial Services Authority are said to be 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 spot trading shifts that look suspicious,’ says Grubaugh, ‘but there is no way to uncover the actual agreements 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. He 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 daylight what they’re willing to do in the dark,’ he points out.
Without more disclosure, ‘the bottom line is that we really don’t how extensive this problem is,’ says Hu. He likens this to bird flu, from which just over 20 people are known to have died worldwide. Many other deaths may also have been caused by bird flu, but this is mere speculation. ‘Part of the reason we’re pushing for better disclosure is to get a better sense of how serious these problems are,’ Hu concludes.