Henry T.C. Hu uses the term "morphable ownership" to describe the new proxy-vote buying and hidden ownership employed by some activist hedge funds to boost their voting power for control of boards or other corporate battles beyond their economic ownership.
Activist hedge funds, in some instances, have had a decisive influence on shareholder votes in corporate takeovers by obtaining more votes than reflected in their economic stake, often harming — although sometimes furthering — interests of other investors, according to Mr. Hu, professor of the law of banking and finance, University of Texas School of Law, Austin, and a pioneer in studying the issue.
It is a phenomenon that has come to light in recent years in a few corporate battles in the U.S. and some other developed markets, he said. It takes places largely hidden from the public and untouched by regulation, he said.
Morphable ownership, or vote buying, disrupts the traditional corporate governance structure based on the proportional relationship between voting rights and economic ownership, Mr. Hu said at a conference of the Council of Institutional Investors in Washington in September.
Through the use of derivatives, swaps and other innovative financial vehicles, Mr. Hu said, hedge funds or other investors undermine the one-share, one-vote principle. They can evade 13F, 13D and other stock ownership disclosure regulations. Such manipulation — what he calls "decoupling" of ownership and voting rights — misleads other investors, relying on disclosures for an indication of the position of a hedge fund in a corporate battle, by failing to present the hedge fund's real economic stake and voting interest. "Hedge funds can game disclosure rules," he said.
Decoupling isn't always detrimental to other shareholders, he said. Hedge funds can use it to acquire voting rights of apathetic shareholders, thus moving voting rights to better informed investors "to wake up sleepy management" and improve corporate value.
In a 98-page paper in the Southern California Law Review in May, Mr. Hu and Bernard Black, professor at both the School of Law and the McCombs School of Business of the University of Texas, wrote, "The coupling of votes and shares makes possible the market for corporate control. The power of economic owners to elect directors is also a core basis for the legitimacy of managerial authority."
"Hedge funds have been especially creative in decoupling voting rights from economic ownership," they noted. Since 2002, they found some 20 known or rumored examples, including several involving "empty voting by investors with negative economic interests, who would profit if the companies' share prices go down." Thus in some cases these hedge funds have "an incentive to vote in ways that reduce the company's share price," they wrote.
Their paper, one of several recent ones Mr. Hu has co-authored on the subject, includes discussion of the involvement of pension funds in the activity, such as short-selling, securities lending, and their forgone proxy votes.
They warn "any regulatory response to decoupling must also consider its impact on derivatives and short-selling," both of which have valuable roles for markets and investors. Pension funds, for sure, have long been big users of both, to the profit of their portfolios.
"The right regulatory response to the new vote buying is not obvious," Messrs. Hu and Black wrote. "The first step is to better understand" it, they wrote. The near-term answer is disclosure, they added, "to require more consistent, symmetric disclosure of both voting and economic ownership."
Institutional investors and corporations need to get behind disclosure.