Corporate Governance:
Shaking the business to its core
ISF MAGAZINE
March 2005
Stoked by the corporate governance movement, the idea of formalising the duty to vote shares is gathering steam. But if securities lending is deemed to be a sale and not a loan for these purposes, the very foundations of the business could be threatened. John Piccitto reports.
Having won many famous victories, the corporate governance movement is being pushed to even greater achievements by well-meaning enthusiasts. There seems to be general agreement that shareholders should know how much corporate executives make, whether or not the policies of a company are ethical, who is the company auditor and what accountancy policies are followed.
But the issue of how to implement the right of shareholders to vote stocks out on loan is going through a difficult patch. This is further complicated by the mirror image issue - whether or not borrowed shares should be used to vote in AGMs and EGMs.
Stoked by the corporate governance movement, the idea of formalising the duty to vote shares has been mooted. But hastily rewritten regulations could affect market liquidity by diminishing the amount of shares coming on to the market - whether through plain vanilla stock loans or by more exotic routes. And more importantly, some of the more drastic of these suggestions – the formal recognition that a securities loan is a sale and not a loan – could imperil the legal basis of the securities lending business, taking it back to its pre-1980 status in the UK.
To accommodate the growing feeling that shares ought to be voted, and the legitimate desire to facilitate share voting by all shareholders who wish to vote, a light regulatory hand is necessary, as well as a sure knowledge of what constitutes current best market practice. At the same time, the problem of borrowers who wish to vote borrowed shares must be addressed. Here are two worst case scenarios.
1) Obligatory share voting, or automatic recall of votable stock can cramp the securities lending business in all affected jurisdictions. Shares withdrawn from the market when AGMs or EGMs take place can create short-term market illiquidity. In France, under the AFTI agreement, shares are not loaned over record date when AGMs are held. While French law permits companies to use other international agreements to avoid this stricture, few have done so.
2) In response to concerns about identifying the owner of shares (in order to prevent borrowers voting shares in which they have a less than vital economic interest), recent proposals have suggested that a securities loan should be seen as a sale, not as a loan. This would return the securities lending business to where we started, more than 20 years ago.
In the early 1980s, stock lending in the UK was nearly impossible, because the UK Inland Revenue refused to see the loan of securities as a loan, and insisted that it was a sale because the shares returned were not necessarily the same as the shares loaned out (ie not the same certificate numbers). So capital gains tax was due from the "lender" of the shares, and stamp duty as well. And after a return, the cost basis of the position would have to be recalculated, too.
At a meeting, five rumbustious broker/dealers tried to explain to dubious representatives of the Inland Revenue and the Bank of England. "Borrow my car," one urged, waving car keys in the air. "If you drive it around, use up the petrol, bash a wing and wear some rubber off the tyres, and then return it, it's still my car!" Another explained, to avoid doubt: "Even though the car is different, it's the same car. It's a loan, not a sale." By the mid 1980s the Inland Revenue finally recognised that securities lending did not involve a sale, but this status quo is now under threat.
Pressure from regulators has been ramping up for some time. The Enron and WorldCom debacles led to the US's Sarbanes-Oxley Act; the Ahold and Parmalat scandals have inspired parallel European efforts. Revised OECD Principles of Corporate Governance (January, 2004) emphasise that "the costs of voting can and should be reduced" and that "impediments to cross-border voting should be eliminated".
A May, 2004 study of the share voting behaviour of its members by the International Corporate Governance Network (ICGN) revealed that "70% of respondents rarely, if ever, recall shares for the sole purpose of voting them". The same report warned that "there is a strong implication that lenders of shares over the period of a record date or AGM are effectively selling their voting rights whether they realise this or not". ICGN has promised a draft Code of Best Practice by midsummer 2005, to be offered for discussion to the industry.
The fund manager's dilemma
The fund manager is at the sharp end of this, of course. Their plight is to decide whether to loan, recall and vote (thus being a good corporate citizen) or to loan, not recall and not vote (thus maintaining loan income for shareholders). This dilemma is exacerbated by what is widely recognised as traditional practice: you don't recall shares on loan, except to make delivery to cover fails. That's how the business has always worked. The Risk Management Association (RMA) Committee on Securities Lending Statement of Best Practices: Guidelines for Loan Termination (2001) backs into the issue when discussing buy-in risk, commenting: "Since recalls are typically initiated to settle a client sale, the exposure for the buy-in from the failing counterparty may become a day-to-day concern of risk and exposure."
And the current GMSLA agreement on voting rights states: "Where any voting rights fall to be exercised in relation to any Loaned Securities or Collateral, neither Borrower, in the case of Equivalent Securities, nor Lender, in the case of Equivalent Collateral, shall have any obligation to arrange for voting rights of that kind to be exercised in accordance with the instructions of the other Party in relation to the Securities borrowed by it or transferred to it by way of Collateral, as the case may be, unless otherwise agreed between the Parties." This is not very encouraging to anyone who wishes to compel the voice of the shareholder to be heard.
The corporate governance movement seems to be heading toward producing something "otherwise agreed between the Parties," to compel revision of standard documents and codes of practice. But this is a minefield, involving changes to long-settled arrangements. It seems to many in the industry that the relationship between lender and borrower is difficult enough as it is, without adding more reasons to argue about recalling stock.
The desire to keep business moving forward sometimes enables counterparties with divergent interests to negotiate a settlement. In a recent case, a fund manager instructed his securities lending office to withdraw shares (the shares had become hot) from a portfolio on exclusive loan after having been auctioned. The borrower countered that he had paid to have the exclusive right to use those shares, except when they were required by the lender to cover fails. Standard market practice, he said. The securities lending manager responded that he couldn't control his fund manager's activities. "So why did I pay to borrow the shares?" the borrower wanted to know. The securities lending manager, wishing to keep the broader deal alive, did some fast calculation and rebated the percentage of the auction price represented by the disputed shares.
There is a reputation issue here, as well. The aggrieved borrower in this example could have refused to do any future business with the lender, and word would have gotten around. However, since a compromise was reached, apparently satisfactory to both lender and borrower, they may well have continued to do business because of their willingness to recognise problems and make restitution.
Rising recalls
In a similar spirit, it may not be necessary to make changes to current legal arrangements and codes of standard market practice to accommodate the very real need for increased shareholder activism. Recalling shares to vote is already becoming, informally, standard practice. The manager of a Europe-wide securities lending operation says: "We tell beneficial owners two things. First, we tell them they're giving away their voting rights [when you loan out securities]. Second, we tell them, but you can recall stocks to vote."
But European customs do differ. According to Tim Smith, head of inventory management at Axa Investment Managers, French securities are not loaned out over record date to prevent misunderstandings about voting rights. AGMs are set to take place near record date, and that is when dividends can be paid to beneficial owners. So shareholders can vote their own shares. Since 2003, a decree has allowed French shareholders to lend shares under other securities lending standard agreements, GMSLA and OSLA among them, thus keeping securities out on loan over record dates. But so far, very few French lenders have signed up for this practice.
By contrast, SPF Beheer in the Netherlands has set up a comprehensive system to decide whether or not to vote beneficial owners' shares when it becomes desirable to do so, without unnecessarily disturbing shares out on loan, earning profits. SPF Beheer makes use of Institutional Shareholder Services (ISS), feeding it data about shares held, and shares out on loan. In return, ISS provides full research services, on the basis of which SPF Beheer, in concert with investors, decides whether or not to vote the shares held but not on loan, or to recall shares out on loan for voting purposes. Hans Van Roekel, SPF's head of securities lending, notes that loaned shares are only claimed back in very extraordinary circumstances, giving the example of Ahold and Telecom Italia. Information about share voting is posted on the SPF Beheer website, so that all investors can see that their interests, including voting rights, are being taken care of. SPF Beheer, incidentally, uses a version of the GMSLA standard document.
The matter gathered pace in 2004 with responses to an EC consultation paper on Fostering an Appropriate Regime for Shareholders' Rights. Soon after the ICGN warning that lenders had effectively given up their right to vote, ISLA tried to smoothe things over. "We believe that the [Securities Lending and Repo Committee] Code, backed up by the provisions of the standard agreements which are already used by all participants, provides a firm foundation for the practice of Securities Lending," Mark Hutchings, ISLA chairman, wrote. "It is important that the market participants provide the solutions and that this should not be an area that needs centrally imposed regulations."
Cautiously, an ICGN sub-committee moved toward agreement in a draft proposal insisting that while maximising profits is important for portfolio managers, "there should also be an obligation to act in ...shareholders' longer-term interests by behaving as responsible owners and stewards of those same assets". It continued: "Since income maximisation and voting are mutually exclusive over the period of a share loan, the only way to mediate the conflict is by dramatically increasing the transparency of both leading and voting..."
The Dutch may have solved this problem, introducing transparency by enabling shareholders with shares on loan (having appropriately forewarned clued-up fund managers) to vote their shares, but only if they want to, not automatically, and most importantly, under existing contracts and codes of practice. The response of the ICGN to the EU consultation document cut through the problem of sale vs loan: "We recommend that the share loan should be considered a transaction that merits disclosure to all parties responsible for voting the relevant shares," the ICGN wrote.
But this resolves only the first part of the problem. It allows securities to be loaned with the proviso that they might be recalled should an occasion to vote them arise, without making that compulsory, and without changes to existing documentation or laws. What about the second part of the problem? If voting rights are "lost" by the lender of shares when title to the shares is transferred to a borrower, are those rights thereby "gained" by the borrower? Should borrowers be able to vote borrowed shares?
Enter the corporate raider
What if the beneficial owners, duly notified of an impending AGM, decide not to vote the shares and leave them out on loan with a corporate raider who decides to vote them? The Myners Report states the case against succinctly: "Borrowing...shares for the purpose of voting is not appropriate, as it gives a proportion of the vote to an agent which has no relation to the agent's economic stake in the company." There seems to be general agreement on the point among other industry sources.
However, policing this is difficult. Lending shares to facilitate corporate takeovers has been a nice little earner from time to time for securities lending/prime broker operations around the world. The effort by Laxey Partners to borrow shares in order to oust the chairman of British Land in 2002 was followed in 2004 by a similar effort through the mechanism of CFDs. Requests to UK authorities to stop the practice met with protracted deliberation, but no action, suggesting that while voting borrowed shares may be a bad idea, it's not bad enough to actually do anything about it.
There has been a protracted discussion of notification times, getting lists of borrowers and changes of ownership back to issuers, and discussions of what happens in the case of CFDs. But events took a new twist on December 10, 2004 when Carl Icahn filed a suit against Perry Corp of New York alleging that his attempt to take over several companies (the Hewlett Packard/Compaq situation) had been inhibited by such practices. Whether or not the Icahn suit is won or lost, the ideas involved in it have been mooted, and they are unlikely to go away.
Press reports suggest that Icahn's argument revolves around the idea that as in the case of soliciting proxy votes, buying or selling CFDs should be registered with the SEC (if the value exceeds a designated level) when the purpose of the sale is to acquire control of the business of the issuer. Could applying such ideas to borrowing shares be a next step? This could get very interesting, because failure to register your percentage interest under conventional rules can result in forfeiture of proxy votes accumulated. And just as other corporate governance ideas have crept into the laws of various countries, enabling legislation along the lines foreshadowed by the Icahn suit might too, if regulators really feel that they should put a stop to voting borrowed shares. In due course, there could be some very good reasons indeed for not voting borrowed shares.
Little impact
However, speaking at the February, 2005 securities lending conference in Phoenix, Arizona, Charles Stopford Sackville, managing partner of Securities Finance International, considered several recent cases in which shares have been borrowed in greater volumes around AGMs, particularly those of British Land, P&O Princess, BSkyB, Marks & Spencer, and Olivetti/Telecom Italia. While abuse is theoretically possible, he said, there is no evidence that borrows/loans made around those times had any impact on AGM outcomes.
He is considering supervising the work of a student writing an MBA thesis on the issue to look more closely at other examples, but in those he reviewed, "in not one case was the borrowing/lending of shares found to have had any significant influence". "Indeed, in two of the cases, shares were actually borrowed by the companies themselves probably as, ultimately unnecessarily, protection." Speaking at the same conference, Adam Reed, assistant Professor of Finance at the University of North Carolina at Chapel Hill, pointed out that borrowed shares are usually voted with shareholders, even if the shareholder position is against that of management, as in the British Land example.
Thus the issue may not require tinkering with standard agreements and settled laws. Perhaps there is breathing time in which to think through the implications of the problem, and to decide whether or not anything needs to be changed at all, or whether the natural evolution of market practices might accommodate new views of the rights and obligations of a good corporate citizen.
