How Borrowed Shares Swing Company Votes

1. How Borrowed Shares Swing Company Votes Ross Pevitz Current Events 4/17/07

2. Vote Premium • Premium on Stocks with Voting Rights • Theory: Premium = 0 • Entitled to the same CF’s • Actual: Premium = 5.4% in the US • “Benefits of Control” from Voting Powers

3. WSJ Article, “How Borrowed Shares Swing Company Votes” • Hedge Funds and other Investors borrow shares from Institutional Investors • Acquire the Voting Rights • Called “Empty Voting” • Voting Rights divorced from Economic Interests

4. What’s Going On? • Share owners unaware that their Voting Rights have been borrowed or • Brokerages are allowed to lend out stock if held in a margin account • $8B a year in fees (Journal)

5. Strategy • Hide voting power within a company until the last moment • Short Selling Strategy • Goal: Buy stock back at lower Price • Use voting power to hurt the firm • Hire incompetent Board of Directors • Enact poor policies

6. Facts and Effects • Value of borrowed securities $1.6T (1 day) • >10% Growth of borrowed securities • Identified 22 instances worldwide from ‘01 to ’06 • Brokerages keep records of shares lent out and which holders of stocks should get votes • Shares get relent and records cannot keep up • Proxies sent out to both owners and borrowers • Lead to Over-voting!

7. Conflict • Momentum for “Shareholder Democracy” • Increase in Shareholder Power • Risk of votes being from borrowed shares Opposes Movement • Firms pay more attention • Voting process • Who shareholders are

8. Regulation Reaction • SEC Chairman Christopher Cox said… “the practice is almost certainly going to force further regulatory response to ensure that investors’ interests are protected.”

9. Problem Fundamentally • Corporate law is based on the notion that shareholders vote in the best interests of the company in which they own stock. • Did not consider instruments, like Short-Selling, that can separate a vote from economic interest (Hu)

10. Complications and Arguments • Many HF’s actions are mostly legitimate, lawful, and in the best interest of investors • Usually use Short-Selling as a Hedging strategy • How can one differentiate the purpose of strategy? • Institutions make $ from lending shares • Why judge those that make the market? • One should be able to vote shares irrationally • Shareholder voting is controlled by State

11. I- Clicker Question? • If you were the SEC, how would you deal with the problem of borrowed shares swaying votes? • A) Abolish the borrowing of shares • B) Let firms deal with the problem • C) Ask State Governments to figure-out a solution • D) Penalize Institutions with tax/fee for lending shr • E) ↑ regulations - require disclosure of position

12. Proposals • Currently, “empty voting" does not trigger disclosure unless an investor owns more than 5% • Many hedge funds own just shy of 5% • More Transparency • “Integrated Ownership Disclosure Reform” • Require disclosure of voting and economic ownership • Inform for future remedial purposes • Act as some constraint on behavior • Does not eliminate some disclosure delays

13. Recent Example • 2005, Henderson Land Development Co offered to buy the rest Henderson Investment (73%) • Hong Kong law, 10%≥ of shares needed to stop deal • Parent company owned such a large stake and large institutions backed the deal • Acquisition voted down by slim margin • Surge in borrowed shares vs little lending in Henderson shares over the previous seven months • Stock dropped 18% next day • HF’s profit from private knowledge that the buyout would be defeated

14. Questions?