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E-MailThe following post comes to us from Alon Brav, Professor of Finance at Duke University, and Richmond Mathews, Associate Professor of Finance at Duke University.
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.
One Comment
Any Reduction of ‘Empty Voting’ to Hedge Fund Trading Falls Short
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Read your paper, thank you. Event-driven hedge fund strategies may indeed lead indirectly to trading gains if a given target corporation adopts the value proposition articulated by an activist investor, whether by stating a convincing case directly to senior management or the board or by casting votes at an AGM. It could be any measure in a given range of possible corporate actions that would eventually translate into a short-term windfall trading profit.
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It is the rare activist shareholder that actually attempts to engender a change-of-control (CSX, Perry, JC Penney). I am not saying that it never happens. Yet empty voting, to my mind and in my experience, plays meanwhile a much broader role in long-term strategic planning of corporate officers and boards contemplating an acquisition of a publicly traded target than in the hedge fund trading context. In fact, empty voting has travelled since a couple of years into the corporate mainstream directly into the core repertoire of senior management of potential strategic bidders or family offices attempting to effect an anchor investment or outright control purchase by shaving off control premiums. When a venerable Fortune 500, Footsie 100 or DAX 30 client walks into any of our offices and wishes to discuss strategy whereby control premium is reduced or avoided altogether, empty voting may be just a step on the way to effectuate such control play with as little/low a premium as possible (in Germany Porsche, AWD, Schaeffler, Skion (Quandt family) – SGL Carbon, in France LVMH). This is not only the case if and when a private equity or hedge fund without a buy-and-build strategy attempts to initiate a going private transaction that from the get-go does not entail much synergetic promise; or if the target happens to be reputationally challenged. It has become the norm rather than some outlandish exception that prudent corporate officers discuss with their boards, financial and legal advisors how best to avoid overpayment and value destruction. If the past financial crisis has taught us any lesson, then that wasteful spending best be avoided and resources allocated towards better corporate ends of value creation and governance integrity. Takeover bids and acquisition finance are not exempt from this renewed commitment to frugality and corporate humility.
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If I am correct that senior executives and boards of strategic bidders all across the U.S. and the world over – that are currently canvassing prospects with renewed commitment to build value – ask from us as their legal advisors to devise approaches where value extraction via control premiums be best minimized if not avoided altogether, what are we going to tell them? That surreptitious stake-building with the aid of stock lending and derivative transactions is illegal and no, thank you, we cannot advise you on such a matter? Such an answer would seem counterintuitive to say the least.
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In such guise, empty voting tactics have become innovative, if mainstay, approaches to stake-building where the prudence of legislative intervention is far from clear. The interconnectedness between empty voting and change-of-control quests designed to mitigate value destruction by overpayment had not been maturely and responsibly addressed in the European discussions leading to the respective curtailments of financial innovation. But it is true that the U.K. adopted such restrictions, as did Switzerland and in Germany, legislation is currently being debated in the Bundesrat.