Empty Voting and the Efficiency of Corporate Governance

In our paper Empty Voting and the Efficiency of Corporate Governance, which is forthcoming in the Journal of Financial Economics, we model corporate voting outcomes when an informed trader, such as a hedge fund, can establish separate positions in a firm’s shares and votes. Recent research has shown that some hedge funds may use “empty voting”—a practice whereby they accumulate voting power in excess of their economic share ownership—to manipulate shareholder vote outcomes and generate trading gains. This practice is possible even when one share, one vote is the explicit rule. It can be accomplished, for example, by borrowing shares of stock on the record date, or by hedging economic exposure in the derivatives markets. This can lead to perverse voting incentives, and may decrease the efficiency of the corporate governance process. However, there may be an offsetting benefit if empty voting enables parties with superior information to have a greater impact on voting outcomes. Our theoretical model explores this trade-off.

We derive the optimal share and vote position of a strategic trader that has the ability to acquire unique information about the value of a management proposal, and the ability to acquire votes separately from shares. We show that while the trader may sometimes reduce efficiency by ultimately selling to a net short position and then “voting the wrong way” (from a firm value perspective), the cost of these possible manipulations can be offset in equilibrium by a greater probability that the trader will “do the right thing” and vote to maximize firm value. In other words, we find that both the presence of the strategic trader and the ability to separate votes from economic ownership can increase expected efficiency by making the “right” outcome more likely, though a positive overall impact is by no means guaranteed.

Intuitively, if a shareholder has relevant private information about the value effect of a proposal, and he can be expected to vote the right way, then any mechanism such as empty voting that allows him to have a greater impact on the outcome will be beneficial. However, we find that making empty voting easier also increases the trader’s incentive to “game” the system by trading to a net short position prior to the actual vote, and then voting to decrease firm value. In some situations, the former positive effect outweighs the latter negative effect, so that allowing empty voting improves efficiency overall. Furthermore, we show that the situations where this positive outcome is most likely are those where other shareholders have poor information about how they should vote, and where empty voting is initially quite expensive.

Our analysis has important implications concerning how private information is incorporated into corporate voting outcomes, as well as agents’ incentives to gather such information in the first place. In our model, the strategic trader’s incentive to gather information is directly connected to the expected profits from his trading and voting strategy. These profits will be greater the easier it is to generate an empty voting stake, and the greater is market liquidity. Thus, we argue that any proposal to regulate empty voting should, at a minimum, consider the possibility that eliminating empty voting or making it more expensive could both (a) decrease effective voting power for well informed voters, and (b) reduce efficient information gathering by strategic empty voters. This could have the perverse effect of decreasing the efficiency of voting outcomes, and particularly for proposals with a large expected value impact, and proposals about which other voting shareholders may not have very precise information.

The full paper is available for download here.