The Econophysics Blog

This blog is dedicated to exploring the application of quantiative tools from mathematics, physics, and other natural sciences to issues in finance, economics, and the social sciences. The focus of this blog will be on tools, methodology, and logic. This blog will also occasionally delve into philosophical issues surrounding quantitative finance and quantitative social science.

Monday, April 17, 2006

Vote Buying & Financial Engineering: The Other Reason to Borrow Shares

Usually, financial speculators borrow shares to 'short sell' -- bet that that the stock's price will drop before the borrowed shares have to be returned, thereby resulting in a profit for the short seller (i.e., borrower/speculator). However, according to financial econometric research conducted by a group of finance professors, there is an entirely different and novel reason why some market participants borrow shares: to buy votes.

For those of you not familiar with corporate governance issues, here is a little bit of remedial Corporate Law 101:

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(1) Traditionally, holding shares of stock in a corporation conferred the right to the shareholder to vote on certain corporate governance matters. Today, only certain classes of shares -- common stock and preferred stock with voting rights -- confer this right.

(2) Traditionally, the law has generally frowned upon vote trading under the 'one share-one vote' rule (it should be noted that, under corporate law, some classes of shares may confer more or less than one vote per share). The better explanation for this attitude is that it has seemed unseemly to trade (sell and/or purchase) votes even in a profit-driven atmosphere of a corporation (as opposed to the buying and selling of votes in a political context).

(3) Normally, holding shares with voting rights in a U.S. corporation at a particular point in time called the 'record date' (used as a time marker to identify 'the registered owner(s)' of the stock in question) confers on that shareholder the right to vote on various corporate governance matters at the annual shareholder meeting or via proxy voting.

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Notice the bolded parts of section (3); it turns out that there is a 'loophole' (if you're inclined to think in that way) in U.S. corporate & securities laws (corporate laws are usually administered by the individual states, with most publicly traded U.S. corporations incorporated under Delaware law; securities law, although states do have limited jurisdiction over it, is mostly administered by the federal government via the Securities & Exchange Commission and the Justice Department) that essentially means that one does not have to actually hold or own the shares beyond the record date to cast a vote so long as the borrower of the shares is, technically, 'the registered owner' (even if the borrower is not the real owner). (Note: Like the U.S., most 'common law' jurisdictions -- notably England where U.S. 'companies law' originated from -- will allow certain classes of shareholders to vote on corporate governance matters. However, I don't know if they have similar 'loopholes.' The research paper, does make the point that -- since England does not have the type of restrictions against short selling, the typical reason to borrow shares, that the U.S. has -- there is probably an active market in vote trading via the securities lending market.)

Mark Hulbert, in his New York Times piece (April 16, 2006), One Borrowed Share, but One Very Real Vote, summarized the implications of the research with the following paragraph:
As the study points out, the right to vote on a corporate resolution comes from possession, not ownership, of shares. That means a trader can borrow shares and thus be temporarily eligible to vote on corporate resolutions. The number of votes he can acquire is limited only by his ability to put up collateral -- which is required to be 102 percent of the value of shares borrowed -- and the number of shares available on the securities lending market. This market primarily serves those who wish to borrow shares in order to sell them short, but there is nothing to prevent its use by those whose motive is to influence the outcome of corporate votes.
In my opinion, Mark Hulbert -- in an otherwise fine descriptive article of the research paper -- didn't adequately understand the legal principle that the research paper is concerned with. It is the timing of the holding of the shares (i.e., holding it on the record date) and not the distinction between ownership and possession that is at issue here. In fact, it is hypothetically possible under the law that, where shares are being lent/borrowed, someone who does not even possess the shares can still have the voting rights so long as that person is, technically, 'the registered owner.'

The researchers -- finance professors from McGill University, Wharton (Penn), and University of North Carolina -- utilized econometric techniques to examine data from the securities lending market on and around over 6,000 'record dates' for a one year period from November 1998 to October 1999. The researchers found that there was a substantial spike in the number of borrowed shares on the record date. Furthermore, the level of borrowing in shares declined dramatically the day after the record date -- returning to nearly the same level as the days preceding the record date. Based on the econometric evidence, as well as qualitative reasoning, the researchers concluded that the most plausible reason for this type of pattern in the data is that speculators borrowed shares -- not to short sell (which, again, is the typical reason to borrow shares) -- but to buy votes.

The researchers also found that, in most cases, the cost of buying votes was extremely low; so low, in fact, to be almost negligible. According to one of the co-authors (Prof. Reed of UNC), presuming that the borrower of shares had sufficient collateral, the cost to borrow $1 million of stock for one day (in this case, the record date) "could be less than $6."

Who would buy votes by borrowing shares? At least in the one year period studied, this tactic was employed by anti-management factions of shareholders. The researchers concluded that there appeared to be no reason why corporate management couldn't use the same tactic to influence votes in their favor.

My non-legally binding opinion on this last point is that shareholders completely outside of the sphere of influence of management is more likely to be able to use this tactic than corporate management itself. Why? There is a principle that generally applies in U.S. corporate law (i.e., most states' corporate law) called 'self-dealing transactions' that might cause this type of 'acquiring shares to influence voting' scheme to come under greater scrutiny by the courts and the SEC.

Having said that, this study has some very interesting implications for the in vogue field of corporate governance. This type of tactic could throw a monkey wrench into corporate governance reforms, especially if unscrupulous corporate managers (e.g., Enron's supposedly 'smartest guys in the room') adopted this tactic and managed to either dodge detection or find legal loopholes to shield their attempts to artificially manipulate votes away from the best interests of non-management shareholders.

At any rate, whatever one thinks of the implications for corporate governance, one thing that everyone should be able to agree on is that this is yet another example of 'financial engineering' at work: Creating a virtual, covert market for vote trading via the securities lending market where a more overt market does not exist for institutional and/or legal reasons.

[You can download a copy of the research paper, Vote Trading and Information Aggregation, at http://papers.ssrn.com/sol3/papers.cfm?abstract-id=686026 ]

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