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«“Empty Voting” and Other Fault Lines Undermining Shareholder Democracy: The New Hunting Ground for Hedge Funds Highlights Empty voting is a ...»

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“Empty Voting” and Other Fault Lines Undermining Shareholder

Democracy: The New Hunting Ground for Hedge Funds

Highlights

Empty voting is a generic term embracing a variety of factual circumstances that result in a

partial and often total separation of the right to vote at a shareholders' meeting from beneficial

ownership of the shares on the meeting date. Empty voting occurs principally as the result of

several different circumstances.

• Shares are bought and sold between the record date and the meeting date, and it is impossible to trace beneficial ownership back to beneficial owners on the record date who are accorded the right to vote by practice and law. The more shares that trade in the interval, the larger the number of shares subject to empty voting at a shareholders' meeting.

• There is a large market in borrowing and lending shares for a variety of purposes, including for short sales and for hedging transactions. Under the standard documentation, the borrowed shares are entitled to the vote. Most beneficial owners have no idea whether their shares have been lent to third parties by their custodians and as a result believe, wrongly, that they have the right to vote the lent shares held in their accounts. The borrowers likewise believe they have acquired the right to vote the borrowed shares. This often leads to "over voting", in which more votes are cast with respect to a block of shares held by a custodian than the number of shares held.

• Moreover, borrowing shares immediately prior to a record date and repaying the shares immediately after the record date can readily be used by hedge funds or other activist investors to assemble a large voting position at a very small cost with virtually no market exposure.

• Finally, modern hedging techniques readily permit investors to separate ownership of the economic risks of stock from ownership of the right and ability to vote those shares. As a result, activist investors sometimes create large hedge positions solely to gain the vote, while avoiding economic exposure to the market. These empty voting positions are used solely to affect the outcome a shareholder vote.

Introduction The last 20 years have ushered in a new age of corporate governance that is grounded in the very powerful concept of shareholder democracy. Activist institutional investors, hedge funds and other event driven investors and academics have united to promote a model of corporate governance that rests squarely on the fundamental right of shareholders to use their voting franchise to shape the governance of the modern corporation and to insist on heightened accountability by management and the board of directors to the company’s shareholders.

Structural impediments to the unfettered utilization of the shareholder voting franchise have come under attack over this period of time. Witness the increasingly successful investor

campaigns against:

• Shareholder rights plans

• Staggered boards

• Plurality rather than majority voting

• Supermajority voting requirements

• Impediments to shareholders’ ability to call special meetings By the same token, shareholders have also begun promoting greater affirmative rights to

exercise their voting power, including most recently:

• Direct shareholder access to company proxy materials for director nominations

• Expansion of shareholders’ ability to utilize SEC Rule 14a-8 to promote corporate governance and shareholder democracy positions The SEC and the SROs have also participated in this movement toward enhanced shareholder

voting rights by actions such as:

• Discouraging high and low vote common stocks

• Reforming the Proxy Rules to permit internet dissemination of proxy materials by managements and shareholders

• Eliminating broker discretionary voting for directors While a number of these initiatives are in progress or as yet largely untested, there is no doubt that structural impediments to shareholder exercise of the voting franchise are being eliminated at an increasingly rapid pace. Moreover, few would doubt that investors will continue to prevail in their quest for increased power through an expanded utility of their voting power and increased accountability of managements and boards to shareholders.

There are, however, a number of theoretical and practical problems with this rosy model of shareholder democracy that are becoming increasingly evident as hedge funds and other like minded, event driven investors become more active in voting contests.

Background Our existing corporate governance model is imbedded in the relatively simple but fundamental concept that the “owners” of the residual economic value in the corporate enterprise—the equity—are best suited collectively to govern the enterprise because they bear the full brunt of the entrepreneurial risk inherent in the corporate entity. The drafters of our corporate laws translated this simple principle into a series of statutory provisions that focus on shareholders’ meeting, annual or special, and set default principles for the holding of a shareholders’ meeting intended to give the equity owners their fundamental governance rights through voting on the basis of “economic,” not “political” equality. That is to say, recognizing that the modern corporation is an economic (not a political) entity, votes are distributed by number of shares owned, not by the number of owners. Instead of our political model of democracy embodied in the precept of “one person, one vote,” our corporate statutes uniformly have adopted an economic model of democracy embodied in the precept of “one share, one vote.” At the formative stages of our corporate law, share ownership and trading were very different from today. While somewhat of an over-simplification, our corporate statutes and





accompanying judicial decisions are premised on a paradigm of:

• relatively low volatility in share ownership,

• the purchase and sale of shares in face-to-face (or near face-to-face) transactions,

• physical embodiment of shares in the form of share certificates,

• transfer of shares through the manual assignment of negotiable share certificates and their reissuance to new owners through physical delivery to and by transfer agents and registrars,

• a coincidence of record and beneficial ownership, or at most a relatively simple (one tier) system of “street name” holdings, and

• perhaps most fundamentally, the ability to link beneficial ownership to specific share certificates.

In a world of low ownership volatility and physical share certificates, the statutory construct of setting a record date well in advance of a meeting to determine rights to vote at a shareholders’ meeting was not only meaningful, but necessary to allow for identification of, and written communications with, owners entitled to vote at a meeting. An implicit assumption of the advance record date structure for shareholder meetings was that relatively few shares would change ownership between the record date and the meeting date, and that purchasers of shares after a record date would have the practical means to obtain a proxy from the seller if they wanted to exercise their franchise at the meeting. This paradigm, moreover, implicitly underpinned the SEC’s proxy rules, particularly the requirements for physical distribution of proxy statements and accompanying proxy cards to shareholders.

For better or worse, today’s reality of share ownership and trading is vastly different from the relatively simplistic physically certificated paradigm underlying our corporate statutes and the SEC’s proxy rules.

• Trading on modern stock exchanges, because of their auction or inter-dealer structures and net clearing and settlement policies, makes it impossible in all but a few rare cases for a buyer to identify its seller.

• The anonymity of the modern trading markets has been increased by the necessary development of central share depositaries (such as DTC) and more frequent use of nominee holders, frequently on several levels, as an improvised but effective system for book entry transfers and net clearing trade settlement procedures.

• Trading volumes have expanded exponentially over the last 50 years. Beneficial ownership can no longer be viewed as a relatively static, long-term phenomenon for vast portions of the equity markets. This trend has been exacerbated in the last few years by the growth of hedge funds whose direct and indirect (through the purchase and sale of related derivative products) trading today dominates the equity markets in terms of volume and volatility.

• The growth in exchange and over-the-counter derivatives has further complicated the picture, both in terms of classic concepts of beneficial ownership and in terms of “virtual” ownership.

While all of these trends have long been evident, their importance to the corporate governance model of our statutory and judicial law could be (and by and large were) ignored until the advent of event driven hedge funds and similar activist investors. These market players have increasingly recognized the disconnects between the theoretical model of shareholder democracy and the actuality of our equity trading markets. They have used the resulting fault lines to advance their economic interests, often at the cost of the goals and theory of shareholder democracy.

Fault Lines Between the Theory of Shareholder Democracy and Reality Record Date vs. Meeting Date. By edict of our corporate statutes and Wall Street custom, the right to vote at a shareholders’ meeting is determined by ownership on the record date.

Whatever may have been the case in the simpler world of the early 20th Century, in today’s world of central depositaries and nominee holdings, it is beyond dispute that there is a vast gulf between record ownership and beneficial ownership. Accordingly, law and practice accept the principle that it is the beneficial holder on the record date which is entitled to vote, either by direction to the record holder or by obtaining an effective proxy from the record holder.

The task of bridging the gulf between record holders and beneficial holders is simpler in theory than in practice because of the layers of ownership between the ultimate beneficial owner and the top-tier depositary, most frequently the DTC. In practice, the process is mediated through a combination of NYSE and NASD member firm rules and custom and is implemented by the various depositories which delegate voting authority through “master proxies” to underlying depositories and nominees, as well as by private providers, principally ADP, which deliver proxy materials and voting instruction forms to ultimate beneficial holders and receive, tally and report voting instructions by ultimate beneficial holders to holders of “master proxies.” Barring mistake and mischief, the process, while cumbersome, usually will produce a reasonably accurate tally of proxy votes attributable to the beneficial owners on the record date. If no beneficial owner sold shares between the record date and the meeting date, the practical inability to match beneficial ownership of specific shares that have been transferred would not matter.

Of course, in the real world many beneficial owners do sell their shares between the record date and the meeting date, making their exercise of the franchise suspect since they lack the financial stake in the company that underpins the very concept of shareholder democracy. This is the classic instance of what two current academic observers have labeled “empty voting”— the exercise of the voting franchise divorced from the ownership of the residual equity interest in the company. On the other side of the coin are the buyers of the residual equity interest between the record date and the meeting date who in practice lack the voting rights normally associated with beneficial ownership.

There is a body of case law dealing with this divorce of the vote from the other attributes of beneficial ownership; it provides the succeeding beneficial owner with the right to require its predecessor beneficial owner to provide a proxy with the shares being sold. In practice, however, it is impossible in ordinary market trading to match sellers and buyers. As a result, the theoretical legal rights of succeeding beneficial owners to obtain proxies from preceding beneficial owners are of no practical consequence. The only exception is for true face-to-face trades in which the buyer is in contractual privity with its seller and can bargain for and obtain an effective proxy, assuming of course that the seller held the shares beneficially on the record date and itself has a proxy vote that would be recognized by the current corporate voting system.

Where there is no controversy about the outcome of a shareholders’ meeting, the failure of our current system to match votes and beneficial ownership as of the meeting date is of little practical significance. For many years that has been the case with the result that, with the exception of an occasional proxy contest, the conceptual and practical weaknesses of the time gap between the record date and the voting date did not matter and went largely unnoticed.

The advent of event-driven equity investing and the growing assertiveness of activist investors in opposing the election of certain directors or proposing by-law amendments and other binding actions has changed the world of shareholder meetings by multiplying the number of at which there is a significant controversy. The controversy may take the form of opposing a target company’s plan to merge or be acquired (as in the proposed WorldCom acquisition by Verizon on the grounds WorldCom was selling too cheap), or opposing an acquirer’s plan to buy a company (as in Mylan’s proposed acquisition of King Pharmaceuticals on the grounds Mylan was buying too dear), or opposing the election of certain directors (as in a proxy contest or withhold or against vote campaigns) or acting on any other shareholder proposal, particularly of a binding nature. Whatever the nature of the controversy, it seems clear that allowing former beneficial owners to vote shares where the vote may be outcome determinative is a real-life problem.



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