Earlier this year, a front-page article from The Wall Street Journal drew attention to what some believe may be an increasingly-used practice in corporate governance. This practice, which has been dubbed "empty voting," occurs when individuals acquire voting rights that substantially exceed their economic interest in a publicly-held company. This practice is sometimes referred to as "vote borrowing."

Empty voting occurs when a person acquires, often at relatively little cost, the right to vote significant blocks of shares in a publicly-traded company either without acquiring any corresponding economic interest in the company or while simultaneously acquiring a short or "hedging" position in the company, which offsets the person's economic interest. By separating voting power from economic interest, empty voting undermines a fundamental principle of corporate governance, which is that shareholders will vote their shares in a manner that maximizes the value of their ownership interest in the company.

The growth in the modern derivatives market has made it fairly easy to separate a stock's voting rights from its economic ownership. While the details of most of these methods, such as equity swaps and OTC equity derivatives, are beyond the scope of this bulletin, one fairly straightforward method of empty voting is to borrow shares in the market prior to the company's announced record date and return the shares after the record date. Banks, institutional investors and brokerage firms who hold shares for their clients in street name frequently lend shares for a fee (typically, less than 1 percent per year). Stocks are borrowed in this manner to facilitate the practice of short-selling; however, this same process may allow a borrower to obtain a substantial voting block of shares for a minimal cost. When a stock is borrowed, the borrower acquires the voting rights but has no economic interest in the stock.

Some research indicates that empty voting can actually have a positive impact on corporate governance. According to a January 2007 study, empty voting is generally exercised in support of shareholder proposals and in opposition to management proposals. It is more likely to occur when a company is performing poorly in relation to its industry. As a result, empty voting serve as a check on poorly-performing management by transferring votes to more informed voters.

Conversely, there are examples that suggest that a company's shares were borrowed and voted in ways that directly benefited the borrower of the shares at the expense of the company. One such example occurred in 2006 when Henderson Land was seeking to buy a 25 percent interest in Henderson Investments, a publicly-held affiliate. Henderson Investments' stock price increased substantially on news of the potential buyout. Under Hong Kong law, which governed the transaction, 10 percent of the "free-floating" shares could block the buyout. Despite the general opinion of observers that the buyout was a good deal for Henderson Investments' shareholders, when the shareholders' votes were counted, the buyout was defeated. The price of Henderson Investments stock fell 17 percent when this was announced. Apparently, prior to the announced record date for voting on the buyout, one or more hedge funds borrowed enough shares of Henderson Investments stock to defeat the buyout. These hedge funds then voted against the buyout and, knowing that the buyout would ultimately be blocked by the shareholder vote, sold the borrowed Henderson Investments shares short before the outcome of the vote was determined, thereby profiting when the stock price fell. While this transaction was governed by Hong Kong law, a similar result could be attained under U.S. securities laws.

This example illustrates the primary problem caused by empty voting, which is that a portion, perhaps even a determinative share, of the voters in a shareholder vote could actually benefit from voting to cause the company to take an action that may not be in the company's best interest. Further, under current securities laws, such voters often have no obligation to disclose their ownership of derivatives or other hedging arrangements the disclosure of which would make it clear that their economic interests are directly opposed to the economic interests of the company.

The Wall Street Journal quoted SEC Chairman Christopher Cox as saying that the practice of empty voting "is almost certainly going to force further regulatory response to ensure that investors' interests are protected. This is already a serious issue and it is showing all signs of growing." Empty voting was one of several topics discussed at an SEC Roundtable Discussion regarding proxy voting mechanics on May 24, 2007. At the conclusion of that discussion, Chairman Cox indicated that the SEC intends to propose rules on proxy voting mechanics this year. It is not clear, however, whether such proposals would address the practice of empty voting. Given the importance of stock borrowing in the securities market and the potential beneficial uses of empty voting, the SEC may wish to move slowly. University of Texas law professors Henry T.C. Hu and Bernard Black brought the practice of empty voting to light in their research. As a first step, they propose revising the reporting requirements under Section 13(d) and Section 16 of the Securities and Exchange Act of 1934 to require disclosure of arrangements that facilitate empty voting, such as when a holder of a significant portion of a company's voting rights also holds an offsetting position that eliminates some or all of that person's economic interest in the company.

Regardless of any action taken by the SEC, it is important for shareholders and management of publicly-traded companies to be aware of the practice of empty voting and to understand its implications, both positive and negative.

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