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Running on Empty

by Michael W. Stocker and Christine S. Azar
The Deal |
The idea that shareholders voting in corporate elections have their company's best economic interests at heart is the cornerstone of U.S. corporate governance.

Imagine you could buy the right to vote in elections, as often as you liked, without anyone knowing, and without facing any economic downside if you make bad decisions. Sound dangerous?

It is. And this phenomenon, known as "empty voting," is already happening-at least in the corporate elections of U.S. companies. The solution to this problem might seem simple: Forbid investors who bet against companies from participating in corporate elections. As a recent release from the Securities and Exchange Commission illustrates, however, getting there will not be easy.

The idea that shareholders voting in corporate elections have their company's best economic interests at heart is the cornerstone of U.S. corporate governance. So long as participants in elections profit by the success of the company holding the vote, this assumption makes sense.

In recent years, however, academics have become aware of a phenomenon called "decoupling"- that is, the ability to separate a share's voting rights from any economic stake in the company itself. In 2006, Henry Hu and Bernard Black of the University of Texas issued a provocative paper identifying various methods by which hedge funds were separating the voting and economic attributes of stock through swap transactions and other equity derivatives such as options. These practices make empty voting possible.

The potential for abuse is obvious. When voting rights are decoupled from any economic stake in a company, shareholders' interests are no longer aligned with those of the corporation. Indeed, holders of voting rights can actually bet against a company's success and then ensure their profits by casting votes for actions that would likely lead to declining share prices.

By 2009 it had become clear that such concerns were not just academic. On July 21, 2009, the SEC announced a settlement agreement with Perry Corp. arising from allegations that the hedge fund failed to disclose its accumulation of nearly 10% of an issuer's voting shares, with the intent of influencing a merger vote in Mylan Laboratories Inc.'s attempted acquisition of King Pharmaceuticals Inc. Perry's shares were hedged through swap transactions in order to eliminate Perry's economic exposure if the share price declined.

According to the SEC lawsuit, Perry had a significant ownership stake in King and stood to benefit from the merger if it was approved by Mylan's stockholders. When the proposed merger was vocally opposed by a large Mylan stockholder, Perry began accumulating Mylan's outstanding voting stock in a manner that avoided public reporting requirements, with the intent to vote it in favor of the merger.

At the same time, Perry entered into swap transactions that hedged the risk from any potential drop in Mylan's share price. According to the SEC, Perry was "essentially buying votes" "without having any economic risk and no real economic stake" in Mylan-and unbeknownst to anyone.

While the King-Mylan merger was never consummated, the SEC brought an enforcement action alleging that Perry should have disclosed its ownership once it acquired 5% of Mylan's stock. Perry argued that the purchases were made in the "ordinary course of business" and therefore could be disclosed after the end of the calendar year. The SEC disagreed, taking the position that the acquisition of ownership of securities by institutional investors for the purpose of voting those shares in a contemplated merger is not considered to be a transaction made in the "ordinary course" of business.

The fear of the potential abuse of empty voting has grown strong enough that the SEC raised the issue in its Concept Release on the U.S. proxy system issued in July of last year. The commission warned that significant decoupling of voting rights from economic interests could potentially undermine investor confidence in the already-fragile public capital markets, and called for comments and proposals to deal with the problem.

To address these concerns, the SEC has recently proposed several measures aimed at improving disclosure of information about shareholders' economic positions and intentions.

In the end, however, transparency alone will not be enough. So long as shareholders with no economic stake in a corporation's success are permitted to vote in company elections, there will be the potential for mischief that can further undermine investor confidence in the public equities markets.