Three separate incidents CSX Corp.'s lawsuit against two hedge funds, a Conference Board report on hedge fund activism and recommendations from the European Hedge Fund Working Group should serve as catalysts for action to prevent subversion of the proxy-voting process.
So-called proxy-vote buying and hidden ownership have been used by hedge funds and other activist shareholders to boost voting power beyond the level of their economic ownership. Such moves have become a decisive influence in determining the outcome of contests for control of corporate boards, or in takeovers.
By borrowing stock and using swaps and other innovative financial vehicles, an activist hedge fund can accumulate many more votes than are reflected in the number of shares it actually owns. This can often harm the interests of other investors, whose voting power is based solely on the shares they hold. This acquisition of additional votes undermines the principle of one-share, one-vote.
It also disrupts traditional corporate governance based on the relationship between voting rights and economic ownership.
Some of these vote accumulation techniques also can evade 13(f), 13(d) and other stock ownership disclosure regulations. As the Conference Board report says, positions do not trigger disclosure.
Through these techniques, an activist hedge fund could have an incentive to vote in a way that promotes the interests of its other holdings, to the detriment of both the target's share price and the company's other shareholders.
CSX contends in its lawsuit filed in U.S. District Court in New York against The Children's Investment Fund and 3G Capital Partners that TCI employed swap agreements to evade 13(d) disclosure and failed to disclose that swap counterparties intend to vote CSX shares in accordance with TCI's wishes.
As the Conference Board report notes, Despite their increasing institutionalization, the operations of many hedge funds remain relatively opaque and exempt from some registration and disclosure requirements. Information may be inaccessible not only to target companies, but also to the institutions allocating assets to hedge funds.
The SEC should modify 13(f) and 13(d) disclosure to incorporate techniques to prevent activist investors from evading disclosure, but should do so without undermining the benefits to the market and economy of swaps, short selling and other such investing innovations.
Such required disclosure also should not harm the efforts of activist hedge funds or shareholders to improve corporate performance. The New York Times Co. recently gave two board seats to representatives of two activist investment funds.
Proxy-vote buying isn't always detrimental to other shareholders and could help improve corporate management and corporate performance, and it's hard to see how transparency about such activities would hurt such efforts. If other shareholders see they would benefit, they presumably would support the move.
Activist shareholders should welcome disclosure because it might end the suspicion of other shareholders that the activists have ulterior motives.
Indeed, among its recommendations, the Conference Board report says corporate boards should not assume that requests for change made by activist hedge funds always reflect a hostile orientation or short-term investment goals. The Hedge Fund Working Group recommends that all investors disclose their interests in companies held through derivatives and not vote where they have no underlying economic interest in a company.
As for pension funds and other investors that lend securities, they should set written policies regarding stock-lending activities and when to call back stock to vote proxies. Pension funds, such as the $184 billion Florida State Board of Administration, already do so.
Corporations concerned about hedge funds subverting proxy voting should also call for the SEC to ban broker voting of uninstructed shares in elections for corporate directors. The SEC has not acted on a New York Stock Exchange proposal to ban such voting. With some form of majority voting at 66% of S&P 500 companies, such votes cast by brokerage firms in favor of management undermine the votes of shareholders seeking corporate governance changes, and tip the balance to the incumbent boards.
Undermining the proxy-voting process, whether it favors activist shareholders or entrenched corporate management, should be stopped.