An edited version of this article appeared in the 9/06 edition of ISF Magazine under the title “The Tug of War Continues.”
What is the impact of increased share-voting on exclusive securities lending arrangements? Is the exclusive portfolio attractive in inverse proportion to the likelihood of share recall for voting at AGM/EGMs? And if so… so what?
The tug of war between the corporate governance movement and the securities lending industry seems to have reached a kind of detente recently, despite the considerable number of words still in print on the subject of proxy voting and related matters in the financial press. As both sides learn to live with their gains and losses, this may be just time to pause, take a breath, and look at a previously sidelined issue.
As the EU Directive on Shareholders’ Rights lumbers ponderously toward final form, the recent conspicuous failure of the shareholder attempt (AGM on 25 July 2006) to unseat Vodafone chief Arun Sarin seems to have marked a kind of temporary stand-off. Ranged against Sarin were corporate governance enthusiasts like Morley Fund Management, Hermes Administration Services and Standard Life, voting to replace a chairman whose performance they found unsatisfactory. But in the end, Sarin had 86% of the votes and the shareholder activists could muster less that 10%. So Sarin stayed put.
The graph below illustrates how Vodafone Group Plc reacted within the securities lending arena at certain times over a specific fifteen month period.
The BACKSTORY: Graph and Analysis: ASTEC Consulting Group, Inc.
A = 3 June 2005 Dividend Record Date
B = 26 July 2005 Annual General Meeting
C = 25 November 2005 Dividend Record Date
D = 9 June 2006 Dividend Record Date
E = 25 July 2006 Annual General Meeting
(Data Source: Vodafone.com)
The number of shares of Vodafone Group PLC that were out on loan remained fairly constant throughout the fifteen month time period indicated, with exceptions noted at the three dividend dates (A, C, and D) and prior to the two company AGMs (B and E). This suggests that the stock was more heavily borrowed before some significant events like dividend record dates and Annual General Meetings. There are noticeable increases around the letters A, B, and D which might not be termed as significant, while the increases around letters C and E would be termed significant. What cannot be inferred from the chart is WHY the shares are borrowed more heavily, not only around specific event dates but also during the months of May 2005, August 2005, January 2006, and March 2006. That inference is a matter of speculation. In particular, note the spike in the change of the percentage of outstanding shares on loan (from 0.05% to 0.47%) that took place on or about 17 August 2005, which was neither near a dividend date nor an AGM. Go figure!
Still, corporate governance advocates remain unbowed. Voting in general at AGM/EGMs has increased – slightly – and beneficial owners’ awareness, not only of their rights but also of their duties to vote their shares, has multiplied. A wide variety of other corporate governance issues, in addition to voting shares, are being mooted.
The Institutional Shareholder Services (ISS) 2006 Global Institutional Investor Study of 320 institutional investors in 18 countries says that 63% of investors surveyed “believe [corporate governance issues] will become even more important over the next three years.” The areas they find promising include “building better boards, aligning executive pay with shareholders’ interests, improving the quality of disclosure, and enhancing bottom-line company and CEO performance.” The ISS website lists 1667 current clients, 425 of which were new in 2005. UK-based Pensions and Investments Research Council (PIRC) says that share voting levels have increased 2% every year for the last two years.
However looking at a similar picture Sarah Wilson, Managing Director of Manifest, the UK-based proxy voting agency, suggests that actually, voting has been more or less “static over the last three years.” Wilson suggested several reasons for this “ceiling,” including recent allocation and reallocation of capital. “It may be hedge funds, but nobody knows yet how hedge funds will operate, compared to players who once dominated the market, public pension funds or life insurance companies,” she said. The latter “tended to be more gentlemanly,” she remarked. The problem now, she said, also may be with mutual funds: nobody knows who owns them, so it is difficult to find among them a base constituency from which to increase voting.
The corporate governance movement in the States has had a longer run than its European counterparts. But Brian Lamb, CEO of Equilend points out that as an issue “proxy voting seems more evident in the financial press in Europe than in the United States.” Lamb said cautiously that he had observed no recent change in behaviour with regard to proxy voting activity on Equilend’s platform in the last year. Speaking to the issue of changes in the rate of recalls within portfolios that are under an exclusive arrangement, Lamb said that it is difficult from his perspective to make a generalization about why transactions take place. “I look at statistics every day to tell me which of our functionalities people use. Based on that data, I know what, but I don’t know why” they do transactions.
No matter where on the globe their trading desk is located, from the perspective of industry professionals a bit further along the securities lending food chain, the problem seems clear: if a share on loan can be recalled for voting (and there is no longer any doubt that it can, because the standard documentation for securities lending says it can) the value of loaning that share is thereby reduced. The more shares are recalled for voting, the fewer shares are left out on loan, and so on. To examine their perspective, and their solutions, we need to take a look at this side of the issue. And on this side, significantly, because it suggests which side has the other wrong-footed, if not exactly on the run, sources are privileged. No one wants to come out in front of what they’ve said, but the promise of anonymity has produced enlightening candour. The bottom line is clear: they’ve learned to cope.
•
From the securities lending manager of a large UK pension fund administrator: “I haven’t seen an increase of issues being recalled in the last year. I work under the following guidelines: a) Do Not Lend, b) Recall What’s Out There (i.e. the AGM is voting on a contentious issue), or c) Do Not Lend any More of a Particular Issue.”
•
From the Head of European Sales and Marketing of a large European Master Custodian: “There has been no change in the number of recalls for voting over the past year. Since all clients have large(ish) pools of available securities to lend (ex-hot stock issues), issues are generally replaceable from the pool in order to vote.”
•
From the marketing and product development guru of a custodian/third party agent lender: “I’ve not had to recall any more stock than in the past. I haven’t been instructed by clients to recall in order to vote unless they must be seen to vote on a particular issue at an AGM/EGM.”
•
From the Head of Equity Finance at a London investment management company: “I have seen no difference or change in the number of stocks recalled for voting purposes, recently. As a rule, we don’t recall every share to vote. Our buffer position is good enough to register [us] as having voted.”
•
From the head of an electronic trading platform: “I haven’t seen any change in the number of shares being recalled by my clients to vote at AGMs. Usually stocks are not borrowed prior to an AGM, hence the ability to vote by the owner at the appointed time.”
Obviously, the value of exclusives is especially vulnerable to the impact of recalls. Prior to their award, terms and conditions are agreed, including dividend payments on payment date, custodial liaison details and recall provisions. What does the word “non-recallable” add to the mix?
•
The securities lending manager of large UK pension fund administrator: “Callable stock is by nature cheaper than non-callable stock because trading strategies can be executed if stock is not under the threat of being recalled half-way through the strategy. But [we] operate a list of approved borrowers who understand the recall policy as maintained by [us] – to vote at all AGM/EGM events so that [we] are seen to have voted, and income has not been reduced due to this fact.”
•
The Head of European Sales and Marketing of a large European Master Custodian: “Some clients are not sure if they want to vote or keep the stock out on loan collecting income. However contentious issues at AGM/EGM events will usually bring out the vote. Callable stock is usually cheaper than non-callable and hence easier to obtain whenever it’s needed.”
Some lenders of exclusives use a “material change” clause in their documentation, so that recall for voting becomes a material change event, enabling the borrower to re-negotiate the price of the exclusive if it is recalled.
Allen Postlethwaite, CEO of the UK electronic trading platform SecFinex, outlined the way each of his three programs handles the callable/non-callable issue. Japanese securities offered for loan on the SecFinex price driven Order Market are restricted to non-callable securities only. In the Private Market, traders can set a flag in advance denoting whether or not shares are callable. Participants in the Auction Market can specify in their Terms and Conditions exactly what rights of recall will apply to the securities they are auctioning. The beneficial owner of the shares can make this issue a “Condition of Trade” for the borrowers to see, prior to their bidding for the particular items. If the callable status of a security is clear, then the borrower can decide not only what fee he is prepared to pay but also whether that particular piece is right for his trading strategy.”
Equilend CEO Brian Lamb also noted that “Equilend has always had a callable indicator on the platform.”
The special case of some Japanese stock illustrates “flagged” non-callable stock. Japanese lenders who lend their shares in Japanese companies must recall the stock for dividend and voting purposes. They cannot be seen to have their stock out over AGM/EGM dates. So a beneficial owner’s (or a lending platform’s) “flagged” Japanese stock tells the potential borrower that the stock is from a non-Japanese lender. And this would increase the price of the stock loan accordingly.
This answers one question and raises another. The first question is whether or not increased corporate governance activity has increased the pressure on exclusives recently. The answer from anecdotal information suggests: not a lot.
The second question is whether or not these pressures are exaggerating the differences between callable and non-callable exclusives. The number of recalls of an excusive portfolio will affect the spreads earned by the beneficial owner, as borrowers factor recalls into their final bid price. No one wants to pay to borrow a portfolio of securities only to have hot issues recalled before they can be used in a trading strategy. That should give pause to the engines of the corporate governance movement: non-callable exclusives earn more for beneficial owners, who put exclusives together in the first place to get the stock out the door.
The manager of an international broker dealer who has bid on exclusive portfolios at auction was informative on this point, not least because of what he said about hedge funds. He pointed out that what he pays for exclusive portfolios depends on the use to which he will put the securities. If they are appropriate for dividend trades, they must not be callable. If they are part of what he called his “pass-through” business – on-lending to prime brokerage units for use by their hedge fund client base, or other broker/dealers on the street – then the situation vis-à-vis recalls may be a bit more relaxed.
“Not every thing is usually called with a European portfolio,” he said, and that “is part of the beauty of a European portfolio from European beneficial owners. They hold back about 10% on average, although this “buffer” could be as little as one share. See, they always have a buffer position in addition to the portfolio they’re lending to you, so that they can be seen to vote.”
But if he sees a portfolio that has in the past been “systematically recalled,” he would pass up the opportunity altogether to borrow it. “Our hedge funds depend upon the non-callable nature of the securities they borrow. Some of their strategies would cost a lot to break if the stock [that supports them] is recalled.” Other broker/dealers also agreed that the non-callable factor in a portfolio being offered on an exclusive basis would definitely figure in the final bid total. “This would be a deciding factor,” one said, “as to how high we would go to acquire the basket.”
Exclusives are an essential weapon in a Prime Broker’s armoury, a marketing tool to attract hedge funds to their client list. Non-callable exclusives are preferred by the end users, hedge funds, but the issue of whether or not they suit the best interests of the supplier, the beneficial owner, is another matter.
So Arun Sarin still heads Vodafone – and for that matter Sir John Ritblat still has a great deal to say about what goes on at British Land despite similar shareholder attempts to unseat him several years ago. Nevertheless, the significant progress of the corporate governance movement in the recent past can hardly be denied, not even by the most cynical of the anonymous securities lending traders quoted above. And voting shares at AGM/EGM’s (and the consequent distortion of exclusives portfolios) is just one of the issues the corporate governance movement spearheads, according to the current Manifest Proxy Season Review.
Besides policy issues, and lobbying duties, threshold questions remain, such as whether or not printed material is translated in a timely fashion before meetings, meeting notices and resolutions are published in a timely fashion in any language, and the annual report for the year under review is available, for example. In these areas “significant fundamental changes need to occur,” the Manifest review concludes.
Lending of exclusives isn’t going to go away. It’s just a question of how profitable it will be for all the members of the supply chain, and what they must give up to achieve that profitability. But evidence at least suggests that the trench warfare that surrounded last year’s submissions for the draft of the EU Directive on Shareholders’ Rights appears to have settled down…for the moment.
