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Hedge funds fill up on ’empty voting’

Amy Scott Oct 18, 2007

Hedge funds fill up on ’empty voting’

Amy Scott Oct 18, 2007


KAI RYSSDAL: Democracies come with some founding principles. Life, liberty and the pursuit of happiness in the Declaration of Independence. In corporate constitutions, it’s supposed to be one share, one vote. For every share you own of a company’s stock, you get one vote in company elections. It stands to reason the more shares you own, the more interest you have in the company’s financial success. And so the more likely you are to use those shares — or those votes, if you like — to improve its fortunes. Theoretically, yeah, sure. In the real world, maybe not. Marketplace’s Amy Scott explains.

Amy Scott: Last year the Hong Kong company Henderson Land wanted to buy out a subsidiary called Henderson Investment, which it already partly owned. The parent company offered Henderson Investment’s shareholders a premium, and the deal looked like a shoo-in. Henry Hu teaches securities law at the University of Texas. He says when it came time for those shareholders to vote on the buyout, they turned it down.

Henry HU: And what it turned out probably happened is that one or more hedge funds had apparently borrowed just about the right number of shares needed to kill the deal, and at the same time sold the shares short.

Uh-oh. Time to get out the dictionary.

OK, short-selling is a way to make money when a stock goes down. Hu says by voting against the buyout, the hedge fund made sure the stock would fall. And then it cashed in.

HU: The day the vote was announced the shares fell about 20 percent. That’s a pretty nice profit for one day’s work.

Hu calls this “empty voting.” It’s a way to influence company decisions without actually holding an economic stake in the company. The Henderson investors did it by borrowing shares. Another tactic is to own shares but hedge the economic risk. Hmm. Let’s get that dictionary back.

Here we are. Hedge: To reduce the risk of a loss by counterbalancing an investment. So you might own stock in a company but make another investment that would cancel out any losses in that stock — a futures contract, for example. All this is perfectly legal. But it kind of goes against that whole assumption that shareholders will vote in the best interests of the company. The Securities and Exchange Commission is looking into the practice of empty voting, and the stock lending business in general. Henry Hu says investors should have to report any borrowed shares or hedges that give them voting rights without an economic stake.

HU: If you have more disclosure, some hedge funds may be reluctant to do in the sunlight what they might be willing to do in the dark.

But hedge funds like the dark. Attorney Ron Geffner represents hedge-fund managers for the law firm Sadis and Goldberg. He says too much exposure could take away their edge.

RON GEFFNER: They’re looking for something that somebody else hasn’t found. Trying to find new, uncharted ideas. So if you find a great idea, the last thing you want to do is notify other people so they take the profit out of it.

Of course, it’s almost impossible to keep a really good idea secret for long. Jill Fisch teaches securities law at Fordham University. She says hedge-fund tactics are used by investors of all kinds these days.

JILL FISCH: Your average individual investor who owns stock might own an option or a straddle position or something to hedge them in case there’s a stock market crash. They don’t expect that that hedge would cause them to lose voting rights.

Fisch also questions how widespread empty voting really is. U.T. professor Henry Hu uncovered more than 20 cases over five years in which an investor borrowed stock or hedged to influence a company vote. The more digging he does, the more cases he finds.

But Fisch says empty voting only works in those rare situations when shareholder votes are binding, such as in corporate mergers or board elections. In most cases, she says, shareholder votes are nonbinding — management can ignore them. And why would any self-respecting hedge fund run the risk of being ignored?

In New York, I’m Amy Scott for Marketplace.

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