The Securities and Exchange Commission recently announced it is seeking public comment on a wide number of what many people called “proxy plumbing” issues. Mostly mundane changes to the proxy voting infrastructure.
However, buried on the list is a practice favored by some activist hedge funds to boost their voting power in a company without putting up much money. It is called “empty voting.” The regulator wants to determine whether this practice is being used to inappropriately influence corporate voting results.
The regulator notes that “empty voting” occurs, for example, if a holder of shares buys a put option to sell those shares, the holder retains voting rights on all of those shares, even though it has hedged away at least some of its economic interest. Empty voting can also occur if a shareholder sells its shares after the record date of a shareholder meeting, but before the meeting. In that instance, the shareholder retains the right to vote those shares, even though it no longer has an economic interest in those shares.
“This decoupling -- which we call ‘the new vote buying’ -- is often hidden from public view and is largely untouched by current regulation,” asserted a paper published several years ago by Henry Hu, at the time Allan Shivers Chair in the Law of Banking and Finance, University of Texas Law School, and Professor Bernard Black, Hayden W. Head Regents Chair for Faculty Excellence, University of Texas Law School, and Professor of Finance, University of Texas, McCombs School of Business. “Hedge funds have been especially creative in decoupling voting rights from economic ownership.”
It is no coincidence that last September, Hu was named the Director of the SEC’s newly-established Division of Risk, Strategy, and Financial Innovation, with the mandate to cover three broad areas: risk and economic analysis; strategic research; and financial innovation.
The most high profile use of “empty voting” took place several years ago when Mylan Laboratories agreed to buy rival King Pharmaceuticals for a huge premium. Richard Perry’s hedge fund Perry Corp. owned seven million shares of King. In a typical merger arbitrage deal, Perry also shorted the stock of Mylan.
However, after Mylan’s shares slumped on the takeover news, Perry bought 9.9 percent of Mylan’s stock, becoming its largest shareholder. However, he fully hedged the market risk of his Mylan stake, enabling him to have 9.9 percent voting ownership of Mylan but absolutely no economic ownership.
At the time, Carl Icahn acquired 6.8 percent of Mylan’s stock and opposed the merger. He subsequently sued Perry for using complex hedging techniques to obtain shareholder voting rights without holding an economic interest in the shares.
Alas, in July 2009, Perry agreed to pay $150,000 to settle an Administrative Proceeding with the SEC. However, it was not for engaging in “empty voting” per se, for rather for failing to file a 13(D)—required after obtaining a 5 percent ownership in a stock--in a timely matter.
The SEC explained at the time that Perry had entered into a series of swap transactions designed to hedge fully its financial exposure from owning Mylan shares. The swap transactions provided that the swap counterparty would reimburse Perry for any decrease in the market price of Mylan shares between the time of Perry’s purchase and the time Perry’s position was unwound, which had the effect of insulating Perry from movements in the Mylan share price. As a result, Perry acquired the voting rights to nearly 10 percent of Mylan’s outstanding shares without any economic risk of share ownership. “Perry’s ability to acquire the voting rights to Mylan shares without disclosure enhanced its ability to profit potentially from its merger arbitrage position, in which he was long King and short Mylan,” the SEC noted.
In their paper, Hu and Black illustrated another potential way of using empty voting, involving outside shareholders to magnify an existing long position. For example, an activist hedge fund can borrow shares just before the record date for a shareholder vote, then reverse the transaction afterwards.
They said the first publicly reported instance of this “record date capture” strategy occurred in the U.K. in 2002. Hedge fund Laxey Partners held about one percent of the shares of British Land, a major U.K. property company. At the annual meeting, Laxey had voting power over 9 percent of British Land’s shares, in order to support a proposal to dismember British Land. Just before the record date, Laxey had borrowed 42 million shares.
“Hedge funds may see this record date capture as a tool for responding to incompetent or self-serving management,” the authors wrote. “Company managers will have a different view.”
Soon we’ll hear the SEC’s view.
