The new scandal: vote buying

Today's WSJ has got hold of a new scandal, and of course it involves hedge funds: they're swinging corporate elections with borrowed shares, sometimes from brokerage accounts without owners' knowledge.

And, according to the article, this is a problem: "It's as if in the U.S. electoral system, someone could borrow your voting rights and use them to vote in your place without your knowing it." "If elections can be too easily gamed, critics fear, a basic foundation of public companies -- that shareholders vote in the company's best interest -- will be undermined." Henry Hu, the more vocal author of Hu & Black's study of so-called "empty voting," says "You have this whole superstructure built on this notion that there is this coupling of economic interest and voting power. With these financial innovations, you're screwing around with the foundation."

SEC Chair Cox says there's "almost certainly" going to be a regulatory response. After all, we wouldn't want to undermine the whole basis of "shareholder democracy" moves to give the owners greater rights. I can almost hear Gretchen screaming in the background.

Note that Delaware law allows voting borrowed shares, and shareholders' agreements with those who hold their shares don't bar it. Why is that? One reason could be that big shareholders actually make a lot of money from lending their shares. The article notes that CalPers made $129.4 million.

Another reason could be that shareholder rights really aren't like the right to vote in a political democracy – and that the whole move to make it so is a scam. But now that all these shareholder voting proposals are on the table – director nomination, majority voting for directors – we have to make the reality match the scam by restoring the rights of the corporate "citizens." Ironically, according to the article, the "empty voting" problem "could delay the SEC from moving forward in resolving whether shareholders are permitted to nominate their own directors on corporate ballots."

The article points out that "regulators. . . . don't want to disrupt the stock-lending market, and also have to be careful that any fix doesn't have the reverse effect that they intend. For instance, weighing votes by how long the stock has been held could curtail empty voting but disenfranchise individual investors, too." Hu and Black don't actually call for substantive limits on the practice, as Hu's quote might imply, but more sensibly stop at asking for more disclosure.

However, even simply disclosure regulation may end up imposing significant costs. So before we do anything we should ask if there really is some fundamental problem here. One might ask, what good can possibly come of separating ownership from voting rights?

I noted two years ago in response to Martin & Partnoy's broad criticism of "encumbered share" practices:

There may be all kinds of reasons why legal and economic encumbrances do not cause the perverse effects the authors claim. For example, arbitrage opportunities might overcome inefficiencies that would otherwise result from one share one vote. Or current rules strongly empowering managers to adopt takeover defenses might already address this problem. If encumbered shares do create problems, why are firms not fixing them?

Bruce Kobayashi & I recently examined these practices in more depth in our article, Outsider Trading as an Incentive Device. There we begin with the notorious case in which hedge fund operator Richard Perry owned stakes in two drug companies, Mylan and King, when Mylan was trying to buy its competitor. Because the price was perceived as too high, the takeover would cause King to increase and Mylan to decline, but probably result in an overall gain for the two companies. Carl Icahn owned Mylan and opposed the transaction. Perry hedged his position in Mylan by arranging to transfer his shares at his purchase price while arranging with the buyer to keep the vote.

This was not a case of an unwary buyer who didn't know his vote had been sold. Why did the buyer agree? The likely answer, as we explain, is that

The vote “seller” (i.e., the party who agreed to buy Perry’s stock without the right to vote it on the transaction) may have been willing to speculate on a positive outcome of the Mylan/King combination by supporting the person in the best position to make it happen.

The problem is that a holder of a block of shares that is big enough to swing an election is also likely to be undiversified. A diversified shareholder who owned shares in both companies would favor a transaction that increased the joint value of the firms. But an undiversified holder like Icahn, and perhaps like the Perry's buyer, would oppose the transaction if his company will lose. So, as we say,

By hedging the purchase, the hedge fund can increase the probability that the transaction is approved . . . . without having to become an undiversified shareholder. . . Moreover, the hedge fund votes the shares consistent with the interest of the diversified shareholder who sold the voting rights. * * *

Viewed from this perspective, the Perry gambit was not pernicious, but rather a way to maximize the joint capital of the participating firms without interference from self-interested managers or non-diversified shareholders. The gambit is necessary because federal takeover regulation and strong takeover defenses at the state level have reduced the leverage of outside investors like Perry in control transactions. New techniques are necessary to make speculating in control pay off, just as Milken had to perfect the use of junk bonds for a similar purpose twenty years ago. In other words, Perry can be viewed as the new Milken (or Icahn, for that matter). Vote selling and buying can be viewed as a way for the vote seller to share in the benefits from Perry’s information gathering, and for the control rights associated with the votes to flow to the person with the most reliable information and, therefore, the ability to use the rights most profitably.

In other words, instead of acting perversely, contrary to the interests of most shareholders, Perry actually had at heart the interests of the diversified shareholders, whose voting power is also, in effect, separated from their ownership by virtue of their diversified portfolios. Yet through vote buying Perry was able to, in effect, permit those shareholders to overcome the large undiversified shareholders who sought to defeat their interests.

The reasoning works even outside a Mylan/King type control contest. A big problem with "shareholder democracy" is that it empowers unions and other activists that, like the undiversified shareholder Icahn, aren't really interested in the same things most shareholders are. In effect, hedge fund vote buying evens the scales by promoting the interests of the typical diversified shareholder who is just interested in maximizing the value of his shares. And it may be that this is just what those who favor regulating the practice are concerned about.

In short, vote buying may be a way to arbitrage regulatory constraints on shareholder power. Federal laws changing those rights will lead to different types of arbitrage. At the same time, messing with the equilibrium may make formerly efficient practices perverse. Instead of worrying about how the market is adjusting, we should be worrying about what the regulators are doing to mess things up. Even if regulation is called for, federal regulation (with the possible exception of disclosure) clearly is not, at least at this point.

But, in the end, we might nevertheless get regulation. Because, after all, this may not be about vote buying at all, but about getting those nasty hedge funds

Comments

[sa]

awesome post.too good. i am forwarding this to my friends.