Activist hedge funds ‘borrowing’ votes?

Hedge funds, and perhaps some activist pension funds, could be borrowing stock solely to vote the proxies, according to researchers who have studied securities lending patterns.

But corporate governance officials and others disagree, at least about pension fund involvement. They note that, by law, some pension funds are not allowed to borrow stock. They also say most, if not all, pension funds are in the securities lending business to make money, which they do by lending, not borrowing.

Hedge funds, on the other hand, are among the biggest players in the securities lending market and are likely the ones borrowing stock to sway proxy votes.

Such use of the securities lending market illustrates how far some investors will go to exert their will on the companies in which they invest. In the case of hedge funds, swaying a vote can mean profits.

A study by four finance professors found the percentage of shares out on loan increased to 0.26% on the record date — the date an investor must be on record as owning the stock in order to vote the proxy — from 0.21% in the days before and after the record date.

While the increase is slight, the professors said it was statistically significant.

"The connection between voting and lending is clear and strong," they said in the study. "Loans that convey votes are in much greater quantity than loans in general…"

The researchers said they would have expected lending to decrease over the record date as beneficial owners of the securities recall them to vote their shares.

They also found that shares on loan are typically tendered in favor of shareholder proposals and against management proposals.

"My feeling is this is being used as a mechanism by large institutions to put pressure on management, potentially," said Susan Christoffersen, assistant professor of finance at McGill University, Montreal, and one of the study's authors.

The other authors are: Adam V. Reed, assistant professor of finance at the University of North Carolina at Chapel Hill's Kenan-Flagler Business School; and Christopher C. Geczy and David K. Musto, both assistant professors of finance at the University of Pennsylvania, Philadelphia.

"If they really wanted to push something through, this would be a mechanism for them to get more voting power," Ms. Christoffersen said. She cautioned, however, that the study did not prove this conclusion because the data she and her colleagues analyzed were anonymous.

Ms. Christoffersen had suggested that pension funds were among those borrowing stock solely to vote proxies. But Cynthia Richson, corporate governance officer at the $64.5 billion Ohio Public Employees Retirement System, Columbus, said no.

"What she's completely missing is that funds like mine and CalPERS (the California Public Employees' Retirement System, Sacramento) and others are doing it (securities lending) for the incremental revenue," Ms. Richson said. "Our incremental revenue from securities lending was $19 million" in 2004.

"In this low-return environment, securities lending is another investment strategy," she said.

Patrick McGurn, executive vice president and director-corporate programs at Rockville, Md.-based Institutional Shareholder Services Inc., agreed with Ms. Richson. Institutions — even activist ones — are more interested in securities lending as a source of return than as a way to influence the companies they own, he said.

"Share lending has become a major source of portfolio alpha for a lot of firms and funds out there. It's literally free money," he said.

Kathy H. Rulong, senior vice president and executive director of Mellon Global Securities Lending, Pittsburgh, said she has never seen a public pension fund — the pension funds most likely to be activist investors — borrowing securities. She also noted that public funds are not allowed to short stock, which is one of the main reasons firms borrow stock.

"I don't know why they would be borrowing," she said, adding that "quite a long time ago," Mellon had some corporate pension fund clients interested in shorting securities. In that case, she said the firm told the clients they had to handle borrowing through a broker/dealer, the traditional means of borrowing securities.

She added that the proxy record date is often the same record date for dividend payments, and that increased lending over that date could be part of a dividend capture strategy.

But in some cases, she said, hedge funds "may want to take some control and influence the vote."

Mellon only lends to broker/dealers, but Ms. Rulong said in conversations with broker/dealer clients "there is consistent talk about hedge funds and the growth in hedge funds and their (borrowing) needs." She said it was clear hedge funds were increasing demand for securities to borrow.

Mr. Reed, one of the authors, said the research showed vote trading is higher for poor-performing companies, which suggests at least some shareholders look to the lending market to drive change.

"Poor performers would be where you start looking for management doing a bad job," he said. "That's when these voting issues become more important."

Mr. McGurn said while borrowing stock to capture the proxy voting right is not illegal, the practice can be abused, and institutions seeking to use the proxy for the good of shareholders and the company itself "would lose the moral high ground" by borrowing shares to influence the vote.

"They could do that. But are they? To the best of my knowledge, no," Mr. McGurn said.

The researchers used two proprietary databases. One, from a custodian bank acting as a lending agent, included about 250,000 loans of U.S.-listed equities. The other, from a prime broker, contained rebate rates for loans but not quantities of securities lent.

"One of the problems with the data is that we don't know who is on either side," Ms. Christoffersen said. "The problem is that the data doesn't have who it was lent to nor who was the lender. We only know which shares transacted" and how they were voted — for or against shareholder or management resolutions.

"Securities lending is shrouded in secrecy, and hedge funds in even more secrecy," said Ms. Richson at Ohio PERS. "But hedge funds are allowed to short stocks and arbitrage, so we believe hedge funds are driving a lot of the lending."

Mr. McGurn pointed to hedge fund manager Richard Perry, who used hedging techniques last year to increase his stake in Mylan Laboratories Inc., Pittsburgh, without increasing his risk. Whether he used securities lending specifically as part of his strategy was not clear. (Mr. Perry did not return phone calls seeking comment.)

But by the end of November, Mr. Perry had expanded his position in Mylan to become the largest shareholder, in an effort to drive through the company's planned acquisition of Bristol, Tenn.-based King Pharmaceuticals Inc. His stake narrowly topped that of financier Carl Icahn, who opposed the deal.

The ploy failed, however, as Mylan and King terminated the agreement on Feb. 27.

"The question is how often are people really attempting to buy voting rights by hedging and other strategies a la Perry at Mylan," Mr. McGurn said. "This is a pretty limited phenomenon, but clearly, given the increasing role in the market by hedge funds and other arbitrageurs, it's going to grow over time."

Michael Dubin is a partner at hedge fund-of-funds manager Powers & Dubin Asset Allocation and Management Co., Jersey City, N.J. He said hedge funds' use of securities lending "wouldn't be the thing we'd be asking about" as part of his due diligence when researching hedge fund managers. Still, he thinks activist hedge funds remain a small group in the hedge fund industry.

"There are a few that have been popping up in the merger/arb area that are taking a more activist role, but it's very limited," Mr. Dubin said. "The big guys are not interested in getting their shareholding to the level where they have to report, much less maneuver." (Investors who acquire more than a 5% stake in a company are required to disclose that fact with the Securities and Exchange Commission.)

Peter Economou, senior vice president and head of global trading and risk management at State Street Corp., Boston, said hedge funds dominate the securities borrowing community, but most borrow stock as part of a long/short or risk arbitrage strategy. As for increased borrowing over the proxy record date, that could be investors seeking to capture the dividend payment, Mr. Economou said.

On the other side of the securities lending equation, some lending agent contracts prevent borrowers from borrowing to vote the proxy — or they're supposed to prevent it.

Ms. Rulong at Mellon said her firm includes such wording in its contracts with borrowers. She said she thought such wording was standard, but acknowledged: "You don't know what happens. You can't really police that."

Ms. Richson at Ohio PERS said there is potential for abuse, but the evidence is lacking. Still, "anytime you disassociate long-term economic interest with voting activity, risk emerges," she said.