Voting rights burn brightly as any issue during all shareholder meeting seasons, and this season they’re brighter than ever. With concerns ranging from empty voting by funds to new NYSE rules proposed as to broker voting, an uncertain season is about to commence.  Along with that uncertainty, though, it is certain that fundamental changes are underway to shareholder voting, offering a promise of improved corporate governance.

There have been several important shifts over the past years to the thinking around voting procedures. These include the Securities and Exchange Commission concerns with the practice of empty voting, the New York Stock Exchange proposals as to voting procedures, and private moves by certain companies moving toward proportional voting.  Together, these bode well for enfranchising shareholders and reducing uncertainty around company votes.

Empty voting, oft-used by hedge funds, can allow covert aggregation of significant voting positions without adequate disclosure.  It is accomplished through a variety of mechanisms, most simply borrowing shares prior to the record date of a shareholder meeting for the single purpose of exercising their right to vote the shares.  These securities loans are well timed to align with companies’ stockholder record dates, which are set by boards of directors for the purpose of determining which shareholders have a right to vote at upcoming meetings. Once the record date has passed, the borrower returns the shares, but he still controls a number of shares which he is entitled to vote at the shareholder meeting.  During the interim, some funds go further by shorting the stock, while negatively impacting the company by impacting the shareholder vote. Regulators are under pressure to tackle the issue, but this made difficult by the lack of disclosure requirements for hedge funds.

The issue has planted itself firmly on the SEC’s radar.  In SEC Comment Letters, the methods underlying empty voting are well described.  These include borrowing shares, purchasing voting rights and purchasing shares while hedging the risk of ownership.  Also known as “vote morphing”, the clever practice has been scrutinized because it effectively separates the voting interest from the underlying economic interest. In a recent Schering Plough Corp. No Action Letter, it is noted that empty voting can lead to “mischief” in shareholder voting.

This practice came under its most glaring lights last summer, when the Children’s Investment Fund and 3G Capital Partners came under fire for initiating a proxy battle at CSX Corporation by backing a dissident slate of directors. A federal judge expressed distaste for the actions of the two hedge funds and ruled that they had violated securities laws by not disclosing their positions and intentions at an earlier date.  However, he also stated that there was nothing he could do to prohibit them from voting their shares. 

A less manipulative, but still significant, voting practice is the target of recent NYSE proposals.  In order to tighten voting procedures, particularly at companies lacking significant institutional shareholders, the NYSE filed a proposed rule change to NYSE Rule 452.  This would eliminate broker discretionary voting for the election of directors.  Broker discretion is called for when the broker has not received instructions on how to vote from their customers, often the case with retail investors. Existing rules on broker discretionary voting allow brokers to vote their customers' shares on certain “routine” matters, like uncontested director elections.  By contrast, on non-routine matters (like contested votes), broker non-votes are counted in helping to establish a quorum, but are not counted on the substance of their vote.

Often, the need for broker discretion arises despite the best efforts at brokers to solicit their clients’ votes. As one example, Enhanced S&P 500 Covered Call Fund Inc., discusses broker dealer firms like Merrill Lynch, Pierce Fenner & Smith Inc.  These firms hold shares of a fund in “street name” for the benefit of their customers, and are required to provide proxy materials and request instructions from their customers on how to vote their shares. If brokers do not receive voting instructions from their customers by a date specified before a company's scheduled meeting, Rule 452 allows brokers to vote on non-substantive matters.  This is what is about to change, in some cases with possible impact on strategic corporate issues.

Regulators aren’t the only one’s seeking changes to voting procedures – certain brokerage firms are making updates as well. For example, brokerage firms like Morgan Stanley, Merrill Lynch and Goldman Sachs have adopted proportional voting rules.  Even on routine matters where they can exercise discretion, these new rules require them to vote shares for which customers have given them no direction according to a general vote breakdown.  This has the effect of allowing investors who provide instructions to have a greater influence on the result of a vote. This puts directors which long relied on a block of votes from brokerage firms to have to work that much harder to get the votes that they need on a particular issue.

With these evolving voting rules, clever investors will have to go back to the drawing board to figure out other creative ways to affect shareholder meetings.  The NYSE proposed rule and proportional voting are both steps in the right direction in eliminating anonymous voting of broker shares. Together with the renewed SEC focus on empty voting, corporate governance seems set to get a much needed boost.

Published: March 17, 2009