Stock lending is the lending of securities (including equities, government bonds and corporate debt obligations) to a borrower, with the borrower agreeing to return equivalent securities to the lender at a pre-determined time. The focus of this article is on the lending of securities and, in particular, the potential impact on shareholders’ votes.
Benefits and costs
The International Corporate Governance Network (ICGN) Securities Lending Code of Best Practice (2007) identifies the potential benefits but also the potential corporate governance implications of stock lending. Benefits of stock lending include that it ‘improves market liquidity, reduces the risk of failed trades, and adds significantly to the incremental return of investors.’ However, there are potentially significant adverse effects on corporate governance in terms of shareholders’ voting rights. The ICGN state ‘Misconceptions as to its [stock lending] nature have led to loss of shareholder votes in important situations, as well as to cases of shares being voted by parties who have no equity capital at risk in the issuing company, and thus, no long-term interest in the company’s welfare. Lenders’ corporate governance policies may also be undermined through lack of coordination with lending activity. It is also imperative that there be as little risk as possible that a poll of the shareholders may be compromised through misuse of the borrowing process.’ The issues identified by the ICGN are very real ones which may have heightened importance in situations where investors are voting on contentious issues. Resolutions which otherwise may have failed to be passed, may be passed because of the way in which votes secured through stock lending have been cast, and vice versa.
Pauline Skypala in her article ‘Securities lending – kept from view’ (FTfm, Page 6, 5th September 2011) points out that last year the Pensions Regulator advised pension fund trustees and others managing schemes they should be aware of whether scheme assets could be lent and on what terms. In particular, they should know how much of the income earned was passed on to the scheme.
Ellen Kelleher in her article ‘Inquiries starting into “empty voting”’ (FTfm, Page 3, 26th September 2011) gives the example of an activist hedge fund which might briefly borrow shares in a company purely to vote in favour of its takeover at the next general meeting. This would be legitimate in most markets but can hardly be called best practice.
SCM Private, an actively managed passive investment firm, carried out research which revealed that UK retail fund managers controlling over £241 billion may lend out up to 100% funds but investors would be kept in the dark. Furthermore, levels of disclosure, transparency and protection within current legislation are, SCM find, totally inadequate. http://www.scmprivate.com/content/file/pressreleases/press-release-scm-private-stock-lending-release-01-september-2011.pdf
Meanwhile the Investment Management Association (IMA) has defended stock lending pointing out that they are happy with the level of disclosure required.
ICGN basic tenets of best practice
Lenders and borrowers would do well to take note of the ICGN Securities Lending Code of Best Practice (2007) basic tenets of best practice:
1. All share lending activity should be based upon the realisation that lending inherently entails transfer of title from the lender to the borrower for the duration of the loan.
2. During the period of a stock loan, lenders may protect their rights only with the borrower, since they have no rights with the issuer of the shares which have been lent.
3. Institutional shareholders should have a clear policy with respect to lending, especially insofar as it involves voting.
4. Lending policy should be mandated by the ultimate beneficial owners of an institution’s shares.
5. Where lending activity may alter the risk characteristics of a portfolio, the policy should state the extent to which this is permitted.
6. The returns from lending should be disclosed separately from other investment returns when reporting to clients or beneficiaries. They should not be hidden under management and other costs.
7. It is bad practice to borrow shares for the purpose of voting. Lenders and their agents, therefore, should make best endeavours to discourage such practice.
Stock lending has ramifications in a number of areas including fee income, portfolio risk, and voting rights. Lenders have a responsibility to be aware of the full implications of lending their shares and borrowers should not borrow shares with the intention of using the attached voting rights to circumvent corporate governance best practice.
Chris Mallin 16th October 2011