Why stock borrowers should make disclosures

It started as a simple convenience of “borrowing” stock by those who had lost their certificates, to settle trades. Now stock lending is a huge business. However, as it has grown, it has developed – some would say unwanted – side effects.

As I have argued elsewhere in this blog, good IR starts with knowing who your shareholders are. Without that, how can you analyse where you are strong and weak, how can you reach out to new share holders: and very importantly how can you manage the process where a major issue is up for voting?

Whether it is board changes, a contested takeover, corporate responsibility issues – or more and more in connection with executive compensation, investors will seek to express their views. And IRO’s and their advisors will seek to predict outcomes.

However, to do so companies need to know who owns their stock – AND to know who can vote it.

Enter the rise and rise of so called empty voting. This phenomenon, the subject of recent research by two professors at the University of Texas, has highlighted the practice whereby speculators may gamble that a company's stock will drop, and then vote for decisions that will ensure that it does -- without their ever having to own any stock themselves. Some outside interests have used the strategy to hide their voting power within a company until the last moment. Others of course deny that this practice exists – or at least is commonplace.

The practice can cause challenges for IRO’s.

First, some investors are not aware that their stock is being lent, meaning that they may have problems voting their intentions. IR’s seeking to build relationships, and with a significant vote coming up, can be misled.

Second, stock being lent in volume is sometimes an indicator that a company’s equity is being shorted, perhaps by a hedge fund.

The third issue is whether there may be some element of double counting of votes. For voting effected through Crest, this should not be a problem, as Crest ensures accurate counting. However where the vote is exercised through a proxy form, companies need – especially in a tight vote - to ensure that votes are being exercised properly.

The FSA is promising to consult on the wider issue of disclosures of “non material” positions, including stock lending. And one of the largest pension-fund managers, Hermes, is said to have called for regulators to outlaw voting altogether by borrowers of shares.

And in the EU, shareholder democracy is being reviewed (watch this space for comment on that).

Meantime, the challenges in identifying and managing voting intentions by investors who have lent their shares, continue. And companies that do not fully understand the impact of lent stock on their register, may find themselves on the wrong side of a vote. Regulators should act soon to mandate the disclosure of borrowed stock positions.