My Examiner column:
One vote per share of stock long has been the dominant rule in American corporations. This link between economic and governance interests generally works well. It ensures that as a shareholder’s voting power increases, so does the shareholder’s proportionate share of the corporation’s earnings. Accordingly, a shareholder with a substantial voting position has a strong interest in ensuring that the corporation performs well.
Increasingly, however, hedge funds and private equity funds are decoupling voting and economic interests. To take a simple example, a hedge fund might borrow shares in Ajax Corporation from another institutional investor. Under standard corporate law rules, the hedge fund is entitled to vote the shares, while the lending investor retains the economic interest. More complicated arrangements using various forms of derivative securities, such as options or futures, are also being used increasingly often.
As Texas law professors Henry Hu and Bernard Black have demonstrated, thisso-called "empty voting" phenomenon is potentially subject to serious abuses. Because the hedge fund has "more votes than economic ownership," Hu and Black explain, the fund could end up with "a negative economic interest and, thus, an incentive to vote in ways that reduce the company’s share price." Suppose, for example, that the hedge fund is selling Ajax stock short. It now has an incentive to drive down Ajax’s stock price and, accordingly, an incentive to cast its "empty votes" in value-reducing ways.
A related problem is the risk of over voting. In some cases, both the lender and borrower of the securities receive proxy materials and attempt to vote the shares. Because tracking of stock lending is often incomplete, companies routinely end up counting both votes. Nobody knows for sure how common over voting has become, but there’s general agreement that it is a growing problem.
The U.S. Securities and Exchange Commission and its global counterparts in other major markets, such as the UK’s Financial Services Authority and Hong Kong’s Securities and Futures Commission, are well aware of the potentials for abuse and are now considering regulatory responses. The problem is that the simplest regulatory solutions all are fraught with the risk of serious unintended consequences.
For example, the simplest solution to empty voting would be to ban the lending of securities. On the one hand, however, it’s not clear that even a complete ban on lending securities would solve the problem. As already noted, hedge funds are using increasingly sophisticated financial derivatives, which likely would provide ways to end run any such ban.
On the other hand, there are lots of legitimate reasons for lending securities. It facilitates short selling, for example, which helps promote market efficiency. Indeed, there’s an emerging consensus among financial economists that short sellers often have identified price-relevant information of which the market as a whole is unaware. By selling short, these sellers help move stock prices in the correct direction and thus make the stock market more efficient.
Instead of attempting substantive regulation, with its potential for unintended consequences for the capital markets and its conflict between federal and state law, regulators ought to go back to Louis Brandeis’ famous aphorism: "Publicity is justly commended as a remedy for social and industrial diseases. Sunlight is said to be the best of disinfectants; electric light the most efficient policeman."
Under current law, Securities Exchange Act Section 13(d) requires that anyone who controls more than 5 percent of a class of voting securities must file a written disclosure statement with the SEC within 10 days after crossing the 5 percent threshold.
This provision was adopted back in the 1960s and has long since been rendered obsolete by technological developments. The 10-day filing window, for example, makes little sense for an era in which computer monitoring of stock positions and the availability of electronic filing makes real time disclosure practicable.
As a first step towards dealing with the issue of empty voting, Congress should authorize the SEC to amend its rules under Section 13(d) to make clear that anyone with the right to vote more than 5 percent of a class of a company’s voting securities must file a disclosure statement with the SEC, regardless of whether the holder has an economic interest in the shares, and that the holder of the economic interest in more than 5 percent of a class of a company’s voting securities also must file a disclosure statement, regardless of whether the holder holds the voting right with respect to those shares.
In addition, the 10-day filing window should be shortened to no more than 48 hours. The person filing such a disclosure statement should be obliged to electronically submit a copy of the disclosure statementto the issuer, which should be obliged to immediately post the statement on its investor relations Web site.
