Proxy Voting and Economic Ownership: Getting the Big Things Right

Paul Atkins, a commissioner at the SEC, is in a snit over the potential influence of hedge funds in the wake of proxy voting reform. This was chronicled in an article in today's Financial Times:

Short-termist activist hedge funds could gain undue influence on companies' boards as a result of expected new rules allowing shareholders to vote on company directors, Paul Atkins, a commissioner at the Securities and Exchange Commission has warned.

In a speech to company directors and corporate governance experts on Monday night, Mr Atkins said giving investors greater say on the composition of boards could have the unintended consequence of increasing the power of hedge funds.

He said hedge funds' ability to borrow and short-stock before crucial corporate meetings and use financial derivatives to own shares without having an economic interest in the company could lead to the appointment of "special interest directors".

"What if a shareholder who participates by voting at a meeting holds no economic interest or possibly a negative interest in the corporation?" Mr Atkins said at the Corporate Directors' Forum in San Diego, California.

"Who is making the nominations and what are the interests and the conflicts involved?"

********************

The SEC is expected to revisit the issue in coming weeks, four years after an earlier attempt to allow such access failed. The subject is part of growing calls by investors for greater influence on corporate governance matters after the scandals of the past few years.

********************

Opponents of such access, chiefly the Business Roundtable and US Chamber of Commerce, have long argued that opening up the proxy for voting purposes could allow companies to be "hijacked" by special interests - usually a reference to unions and environmental activists.

But Mr Atkins said the increasing role of hedge funds and other activist investors in pushing for change to underperforming companies, or influencing the outcome of takeovers, means any debate should now also include the role of such interests.

********************

"As the financial markets are moving towards instruments where you can artificially boost your shareholding it is important to have disclosure, and a system that shouldn't be able to be gamed by people who have marginal economic interest," Mr Atkins told the Financial Times.

Quite frankly, Mr. Atkins, I agree with you. It is great that the SEC has finally reached the level of sophistication where an issue this subtle - voting power vs. economic ownership - is in the minds of its commissioners (though, to be fair, this issue was first flagged in Europe. Those European derivative shops were ahead of the game, let me tell you). The concept of the bifurcation of vote and value has long been a bedrock in the fields of taxation and partnership structuring, not to mention in the dual class shareholding structures so prevalent in the media business. But let's not confuse the issue of proxy voting reform with the particular issue you raised. They should be dealt with separately and in a focused manner.

There is no question that proxy voting needs a face-lift and that entrenched Managements and Boards of Directors need the bejeezus scared out of them (if not appropriate checks-and-balances) to do what they are, in fact, hired to do. If I read of one more example of a stupid, irresponsible Board or of a self-serving, self-aggrandizing, shareholder-unfriendly CEO I seriously might barf. The necessity of reform is simply a fact, regardless of the cronies populating the Business Roundtable and US Chamber of Commerce who are against such changes. All I have to say to them is - grow up and lose that sense of entitlement. Hijacking by special interests? You've got to be kidding me. This isn't a movie, guys. This is life. Get on the clue bus, ok? It's leaving the terminal as we speak.

Now the issue raised by Mr. Atkins is legitimate, to be sure. Anyone who has been hanging around M&A, derivatives or prime brokerage knows of the ability to split off voting power from economic value, which can be used to great effect during hotly contested corporate fisticuffs.  And I've got to say it does seem somewhat unethical (if not illegal) to wield voting power in the absence of economic interest or, more precisely, to use disproportionate voting power to impact a substantially smaller economic interest. It doesn't cost that much to buy votes, and if it can be used to sharply increase the odds of maximizing value on a position without risking a like amount of capital that is pretty cool. But is it fair, and does it go against the very principles or one share/one vote, when the shares and votes cease to be inextricably linked? I am neither an ethicist nor a moralist, but I can certainly appreciate the objections to this type of financial engineering.

In sum, two thumbs-up for proxy reform as well as a review of the voting power vs. economic ownership issue. These are the kinds of substantive, non-trivial discussions I like to see being had by the SEC. Let's hope they can stay on track and get the big things right. Because it is easy to get tangled up in the details.

ADDENDUM: Today's Wall Street Journal has a big article on this very issue. It raises a lot of the same points noted in my post, as well as providing some examples of when these tactics were used to sway outcomes.

Comments

[Yaser Anwar]

In the majority of instances where hedge funds, irrespective of long/short investment horizons, have taken a majority stake has been for the good.

Most recently SAC took a 5% stake in PD, a month or so before their take over was announced. Now they are going to use their proxy to reject the FCX merger bid.

Similarly, HFs have taken a sizable stake in LSE which has resulted in rejection of NDAQ's bid.

I can think of various instances where 3-5% stakes were taken which resulted in the good for shareholders as a whole. Sure every now and then we will have the outcome of their stake turnout to be negative, but I just don't think there are any major problems with proxy voting. Why? Because at the end of the day investors, retail and inst. can make money riding HFs/PEs coattails.

[RichL]

If memory serves, during the HP-Compaq merger, a prominent risk arbitrageur borrowed large blocks of Hewlett to be a record holder for the merger vote, and proceeded to vote in favor of the merger. Many long-term holders felt the Compaq deal would be a disaster, but their negative votes were diluted by a technical move that frustrated the dissident voices. Incumbent management didn't complain, but the vote wasn't a fair reflection of the voice of the true owners of Hewlett stock.

[Roger]

Byrne, is this a real threat? Yes. I think you are rushing to the far end of a continuum without considering the intermediate possibilities. If a hedge fund can get their hands on an incremental 3-4% of voting rights, this is often very significant in a contested shareholder vote.

We're not talking about them accumulating 20%+ of the voting rights in an indirect manner, and even if they could, they generally have shareholder value as their core motivator. I think this issue is more what do shareholders, in aggregate, want, and isn't the fairest way for those with economic interest to be able to have that opinion expressed in a proportionate manner? That is my point.

[Byrne Hobart]

Is that a serious threat? I can't imagine the voting-rights market being elastic enough for someone to buy a serious voting stake and be short the stock. The institutional investors of a company have to be 1) sophisticated enough to sell voting rights while retaining economic interest, and 2) naïve enough to sell a huge bundle of those voting rights at a low price.

Also, isn't this kind of thing already covered by normal fiduciary responsibilities? If I buy 50% of a company and then fire everyone and replace them with my family members, and sell company assets to my own privately-controlled entity at low prices, I'm probably going to get sued. Doesn't the same law apply to anyone irresponsibly destroying value, regardless of their motives?