The search for causes of the financial crisis of 2007 and 2008 has given rise to a long list of likely corporate suspects: financial institutions that originated loans without regard to creditworthiness of applicants, credit-rating agencies that issued AAA ratings on packages of these disastrous mortgages and investment banks that accumulated vast hoards of asset backed securities with little regard for the risk they carried. Far less attention has been paid to why shareholders in these publicly held companies apparently went along for the ride. However, a new concept paper issued by the U.S. Securities Exchange and Commission (SEC) suggests that the answer to this riddle may lie at least in part in the creaky machinery of proxy voting.
Proxy voting has long played a key role not only in corporate governance, but in political institutions in Europe and the United States. The concept is simple: A person with the right to vote, the principal, delegates the power to vote to another person, the proxy.
The benefits of this device for corporate governance became obvious with the rapid expansion of investment in the 19th century. Although shareholders had the right to attend shareholder meetings to vote their shares in electing directors and approving or rejecting major corporate transactions, geographic dispersion and slow transportation made attending these meetings impossible. By appointing a proxy to vote their shares at corporate meetings, shareholders could ensure that distance would be no bar to their participation in key company events.
Over time, national exchanges came to require that listed companies solicit proxies for all shareholder meetings. In an effort to assure the enfranchisement of widely dispersed individual investors, Congress enacted measures in the Securities Exchange Act of 1934 granting the SEC the power to regulate proxy solicitations.
The postwar decades of the 20th century saw the beginning of fundamental changes in the structure of the equities markets that were to have far-reaching consequences for the proxy voting system. Share ownership in U.S. publicly held companies became increasingly concentrated in fewer investors with larger holdings and, at least theoretically, proportionately greater power to influence corporate affairs. Damon A. Silvers and Michael A. Garland, "The Origins and Goals of the Fight for Proxy Access," Shareholder Access to the Corporate Ballot (Lucian Bebchuk ed., Harvard University Press 2004).
Despite this concentration in ownership, however, actual shareholder influence in corporate affairs has not increased at the same pace. This is at least in part because the vast majority of large shareholders in the United States are only beneficial owners of their investments - that is, they hold their shares through intermediaries such as a bank or broker-dealer, which are the registered owners listed on corporate records. Because state laws generally vest the right to vote shares with these registered owners, beneficial owners can vest their governance rights only though the registered owners.
As a result of this indirect ownership relationship, the power and effectiveness of proxy voting in the United States is inextricably intertwined with the ability of beneficial owners to meaningfully direct the voting of shares held by their intermediaries. When this system breaks down, the oversight and stewardship functions that are essential for shareholder oversight of management can be badly compromised - a phenomenon that may have given fuel to some of the excesses of risk and executive compensation of the past 10 years.
THE SEC'S REPORT
In a July 14 report titled "Concept Release on the U.S. Proxy System," the SEC signaled that it has serious questions about whether the current proxy voting system is in need of some structural overhaul. The commission explained that it was concerned with three principal issues: whether the proxy voting process needed to be strengthened, whether current rules should be revised to encourage greater participation from shareholders and, finally, the extent to which voting power is aligned with economic interest. Concept Release on the U.S. Proxy System, at 9.
One key issue confronting the SEC with respect to the integrity of the proxy voting system relates to the practice of securities lending. Institutional investors frequently permit their shares to be loaned out by brokers to other customers. However, because loan agreements generally transfer the right to vote borrowed securities, institutional investors lose the right to vote on key governance issues during the period of the loan. Under current practice, broker-dealers are not required to notify their customers when securities have been loaned - leaving investors unclear about whether they have any shares to vote. When key governance questions are at issue, this ambiguity may stymie participation in the voting process. Accordingly, the SEC seeks comment on the question of whether broker dealers should be forced to disclose when share-lending programs deprive investors of the opportunity to vote. Id. at 28-29.
Another thorny question relates to beneficial shareholders' ability to determine whether registered owners have voted shares as directed. Institutional investors exercise their contractual voting rights through securities intermediaries, who in turn employ third-party proxy service providers to collect and send votes to tabulators. However, these investors have little ability to determine whether shares have been voted in accordance with their wishes, because there is no legal or regulatory requirement that proxy service agents, vote providers and other third parties participating in this process cooperate to confirm that votes were accurately cast. To remedy this problem, the SEC suggests that issuers be granted the power to track votes, such that shareholder representatives can confirm that shares were correctly voted. Id. at 38-43.
The catch with this proposed solution is that some beneficial holders have no desire to disclose their identities to stock issuers. The SEC urges that this problem could be resolved by assigning each beneficial owner a unique identifying code that could be used to create an audit trail for voting.
Another provision in the concept paper appears to stem from an ongoing international examination of the key role played by institutional investors in corporate governance. Although management investment companies in the United States are already required to report to investors how proxy votes are cast by filing Form N-PX, there is now no requirement that funds disclose how many shares were voted. Because securities lending can dramatically alter a fund's voting power in a shareholder election, the SEC seeks comment on whether to disclose this additional information to fund investors. A key consideration for this proposal will be the cost and difficulty associated with the collection of this information. Id. at 96-104.
Perhaps the most troubling problem the SEC attempts to grapple with in the concept paper is the "decoupling" of voting rights and economic interests. Id. at 137-50. At the heart of the proxy voting system is the understanding that shareholders vote to protect their economic interests in the companies they own. An important example of decoupling exists when investors hold shares but simultaneously hedge against that interest.
This concern is hardly theoretical. In the concept paper, the SEC identifies a recent enforcement action involving an investment adviser who, through hedging techniques, was able to vote nearly 10% of a company's stock in a merger without having any underlying economic interest in the company. Such behavior strikes at the core principal of shareholder suffrage - that a voting shareholder's economic interests are aligned with the corporation issuing the shares.
The dangers implicit in the decoupling of interests are a persistent theme in the analysis of the origins of the financial crisis. Commentators suggest that the subprime debacle had its roots in the fact that banks issuing loans no longer had any economic interest in the mortgages they underwrote, because the loans were immediately sold and distributed. Cristie Ford and Carol Liao, "Power Without Property, Still: Unger Berle and the Derivatives Revolution," 33 Seattle Univ. L. Rev. 889, 904-905 (2010). Executives awarded rich bonuses for short-term performance had little interest in promoting less risky strategies that favor long-term benefits for shareholders. Id.
The SEC offers a number of possible regulatory responses to such "empty" voting. Its most potent solution is a measure that would permit only persons who possess pure long positions in the underlying shares to vote by proxy - or to allow proxy voting only commensurate with their net long positions. Alternatively, the SEC suggests imposing disclosure requirements and a cooling-off period for those who have no or negative economic interests before voting.
Although the "plumbing" of proxy voting lacks the glamour of popular debate over executive compensation, dysfunctional credit rating agencies and other touchstones in the current debate over financial reform, there can be no doubt that the SEC's new focus on the machinery of corporate governance will play a key role in promoting the recovery of the financial markets during the next decade.