It’s hard to see why something as beneficial to market liquidity as stock lending is generating such bad headlines. In the UK, a government-backed report by Paul Myners, a former fund manager and chairman of retailer Marks & Spencer, warned recently that stock lending threatens to offset improvements made to share-voting practices through the adoption of electronic voting.
‘Part of the problem is that it’s hard to tell how many shares end up on loan and how many get voted,’ points out Ted White, deputy director of the Council of Institutional Investors (CII), based in Washington, DC.
The reality is that stock lending has soared alongside hedge fund asset growth in recent years and there is concern it is obscuring voting practices and investor transparency. At FTSE 100 companies the average portion of shares on loan climbed to 5 percent this year, compared with 3.5 percent in 2003, according to capital markets advisory firm Makinson Cowell. Some £400 bn ($729.2 bn) – roughly one third of the entire UK equity market – is now available for loan.
‘The problem is that securities lending has grown under the radar,’ says Dr Andrew Clearfield, president of Investor Initiatives and chairman of the International Corporate Governance Network’s (ICGN) committee on securities lending. ‘Originally stock lending was being done as a way to siphon off a little revenue to offset the costs of custodian registration, but what nobody was paying attention to was the process.’
Investors are paying attention now. The ICGN securities lending committee is using the input of major global institutions to hammer out a new code of ethics for stock lending that will encourage investors to take greater responsibility for governance and transparency.
Lending votes
For long-term institutional investors, stock lending is a low-risk way of increasing revenue by using ‘idle’ stock holdings, while for borrowers it is an easy, secretive and cheap way of moving in and out of stock they don’t hold. Hedge funds borrow on the expectation that share prices will be lower when they return the loan.
Because voting rights are transferred, for a fee, from lender to borrower each time a stock is lent out, fund managers basically exchange their right to vote for a lending fee. On paper, institutions reserve the right to recall loans whenever contentious issues arise to vote on, but in practice they seldom do. Often, shares on loan aren’t voted or, worse, are voted by a short-term borrower.
Clearfield says investment companies need to issue clear public guidelines stating the conditions under which shares on loan will be recalled. Ultimately, he points out, this information will allow investment companies’ clients to decide whether or not they want their shares voted in a dutiful way and governance matters attended to.
‘It’s amazing the number of senior portfolio managers and trustees who, even though the shares have been lent out, feel they somehow retain some interest in them – but of course they don’t,’ Clearfield explains. ‘They should be recalling the shares in order to vote them on important issues, assuming that is their policy.’
Ulterior motives
Fewer votes also mean IROs find it harder to form an accurate view of what shareholders are thinking. Companies are even more concerned, though, that borrowers can use voting rights to push short-term agendas.
In 2002, one week before British Land’s annual shareholder meeting, hedge fund management company Laxey Partners topped up its 1 percent share ownership with an extra 8 percent on loan for the sole purpose of challenging senior management through the ballot. And in late 2004 Carl Icahn suggested New-York based hedge fund Perry Corp bought up votes to influence the merger vote on Mylan Laboratories’ acquisition of King Pharmaceuticals, which was never completed.
According to Lindsay Tomlinson, the outgoing chairman of the UK’s Investment Management Association (IMA) and vice chairman of Barclays Global Investors Europe, which engages in stock lending, such cases are thankfully rare because the investment industry has created a consensus that stocks should not be borrowed or lent solely for the purpose of exercising voting rights.
‘In most jurisdictions this practice is severely frowned upon,’ Tomlinson points out. ‘The expectation is that the stock is being borrowed for an economic reason, not to push some voting decision.’ Even so, he warns that lenders cannot be held responsible for how borrowers act.
‘You can have some sort of understanding with your borrower that stock is not being taken for abusive purposes, but you don’t actually have any control over this,’ Tomlinson says. ‘The lender is obliged to keep an eye on what’s going on and, if it believes something inappropriate is going to happen, it should recall the stock, but one can never really know whether or not the other party is borrowing the stock to vote.’
Top dollar
The reality is that there are no repercussions when funds don’t recall shares to vote. The actions of large pension funds are generally viewed through the lens of their fiduciary responsibility. As such, lending out shares for hefty fees is often seen as in the economic interest of pension holders, with proxy voting coming second. And with so much money to be made in stock lending – $40,000-$100,000 a day, according to a recent Wall Street Journal article – it’s easy to understand why the buy side does it.
But pension funds aren’t ignorant of the value of controlling the vote. ‘Many times they require that they can unwind or undo the transaction [if they wish to vote the proxy],’ notes Linda Rappaport, a partner at law firm Shearman & Sterling in New York. She says institutions need to be aware that in a securities lending situation, funds have a responsibility to keep track of the vote. It’s certainly possible to set up safeguards that allow these funds to maintain control of the proxy while still making money from lending.
Many big funds have built-in safety valves to maintain control of their votes. ‘At Calpers, we developed a program where we could do lending at the beginning of each year but had a very large number of shares that would be back for the record date,’ explains CII’s White, former head of governance at Calpers. ‘We did it because a lot of votes tend to be routine in nature but some would rise to the level where you absolutely want to vote that share and you need to have it back.’
New York-based pension heavyweight TIAA-Cref has been lending shares for 25 years and looks at each transaction on a case-by-case basis. ‘We have always been attuned to the issue of governance versus lending,’ says Todd Bazarnik, who heads TIAA-Cref’s securities lending program. ‘We have a fiduciary responsibility [to lend out shares] for our policy holders and, at the same time, we take our governance responsibility very seriously.’
While the fund won’t specify how often or why, over the last 25 years it has recalled shares in instances where it wants to engage actively on a particular proxy issue.
Maintaining control
Calpers and TIAA-Cref have a history of taking governance seriously so their outlook on lending is not indicative of the general approach institutional investors are taking. The question is: how can investors be forced to take their responsibility for voting seriously even when their shares are on loan? According to Clearfield, an agreement signed between lender and borrower clarifying how the share and its voting rights may be used and recalled is the most obvious solution. ‘The whole process could be cleaned up with contractual procedures,’ he observes.
In any case, he adds, clearer guidelines for stock lending benefit everyone because lending institutions also suffer when the borrower creates too much downward pressure on the share price and damages the institution’s core holding. There’s a lot less to be gained from stock lending when capital value suffers as a result of the borrower’s actions.
For IROs, the most visible side of stock lending is the involvement of intermediaries that link the underlying owners with eventual borrowers. Because ownership is hidden under so many layers of custodians, IROs find it impossible to identify borrowers in any detail through a normal shareholder register analysis. What makes it even harder is that registers do not distinguish between stock-lending movements and those resulting from actual trading.
‘One of our largest shareholders owns about 40 mn shares and it has held them for the best part of two years,’ explains Peregrine Riviere, IR director at UK-based Carphone Warehouse. ‘However, I get a monthly register analysis from our brokers that never shows that particular shareholder in a position of more than 25 mn. Then, every three months or so I’ll check its core position and find it’s still 40 mn-plus – it’s just that the difference has been loaned out.’
The lack of transparency surrounding securities lending is disruptive to shareholder targeting efforts, too, says David Ladipo, co-founder of London-based governance consultants Lintstock, which recently conducted a study into the changing relationship between companies and hedge funds. ‘We had a client who had an excellent meeting with one of his key underweights,’ Lapido recalls. ‘But two hours later it emerged that this supposed underweight wasn’t underweight at all, and that much of the stock had been lent out by a different arm of the institution.’
Secrecy through intermediaries is good for large investment institutions because it means they don’t expose themselves to borrowers. Hedge funds borrowing in a strategic way don’t want that information made available, either. ‘The fact is that, especially when dealing with non-liquid stocks, you don’t want the world to know about it,’ says Christopher Fawcett, chairman of the Alternative Investment Management Association (Aima), which represents the global hedge fund industry. ‘The unexpressed part of concerns over transparency is that companies don’t know whether investors are going to short them or not.’
In the UK, share registers become even more opaque when stock lending is accompanied by high levels of contracts for difference (CFDs), financial instruments whereby the borrower receives the economic benefits of the underlying equity without physically owning the stock. Some service providers can help companies better identify lenders and borrowers but most IROs still rely on free – and possibly conflicted – anecdotal information from the sell side.
Big disconnect
Regulatory bodies aren’t likely to issue any broad-ranging rule or voluntary guidelines requiring investors to disclose their actual economic interest in a share on loan. However, investment companies could be encouraged to improve the internal flow of stock-lending information, as more IROs are finding portfolio managers operating blindly, entering into a negotiation with companies based on the assumption they control more shares than they actually do. ‘At times, the left arm of the institution doesn’t know what the right arm is doing,’ says Riviere.
‘There needs to be some sort of policy in place to deal with it,’ agrees Clearfield. ‘Everybody involved in the voting and management decisions within an organization – the whole chain of ownership and custody – should know whether shares are on loan, whether they were recalled or whether they should not be loaned out because of some portfolio management decision.’
But will investment companies be able to live with these guidelines? Absolutely, says Tomlinson. ‘It is something most investment management companies would be receptive to,’ he states. ‘For most, this would be advantageous. It’s perfectly reasonable to say that those who do the investing should know what they have on loan.’
What companies can do
The International Corporate Governance Network’s (ICGN) code of ethics for stock lending ends its first consultation period this month but won’t have any teeth until it’s endorsed by most of the major global investment associations and their members. In the meantime, there are some things companies can do to minimize voting risks that go beyond issuing instructions in anticipation of contentious votes and recommending that shareholders not lend out stock during that period.
Stock lending increases in the run-up to annual shareholder meetings because borrowers are entitled to dividends and other economic benefits that come with the share, so companies may find it useful to ensure no dividend dates coincide with or come close to voting dates. ‘This is especially true in Europe where most of the dividend comes once a year and the interim dividend is only a small amount,’ explains Dr Andrew Clearfield, president of ICGN. ‘This is a smaller problem in the US because of regular quarterly dates, but even then, one of them coincides with the meeting.’
Another suggestion is that companies allow investors more time to prepare their votes. ‘Companies should ensure the agenda is as full as it can be when it is made available to investors, which should be at least a week before the record date,’ Clearfield says. ‘That way investors have enough time to react to the information and recall their shares. Currently, particularly in the US, they are informed afterwards, even if a fund has promised to recall shares for important votes when in fact there may be no way it can actually do that.’
