Empty Voting - Activist Funds

Things are not always as they seem to be. It used to be that a vote in a company meant the person entitled to the vote had a certain quanta (pro rata to his vote) economic interest in the company. However, activist funds (and others) may use "empty voting" to acquire voting interest in a target company without having any actual economic ownership or with very limited economic ownership far less than their voting position.

There are a  number  of  ways  to  unlink votes  from economic ownership. One method relies on the share lending market, which lets one  investor  “borrow” shares   from  another.  Under  standard lending arrangements, the borrower has voting rights but no economic ownership, while the lender has economic ownership without voting rights. Think short sale without the sale - just with the borrowing. A second approach employs an equity swap, in which the person with the long equity side (the “equity leg”) of the swap acquires economic ownership of shares (but not voting rights) from the short side  (the “interest leg”). The short side often hedges its economic risk by holding shares, thus ending up with votes but no net economic ownership.

Empty voting can also be used to multiply the  voting power of  an existing long ownership position. For example, a shareholder can borrow shares just before the record date for a shareholder vote, and then reverse the  transaction afterward. Other tactics used are so-called zero cost collars and variable pre-paid forwards.

The zero cost collar essentially involves holding an underlying security long, shorting (selling) a call with a strike above the market value of the underlying security for $x premium and being long (buying) a put with a strike below the market value of the underlying security for $x premium. It essentially reduces the economic risk of holding the position to the range between the two strike prices.  For example, assume the a person's basis in the stock is 10 and the stock has a current fair market value of 100. The person could buy a put at 90 (which limits his/her downside risk to 10) and sell a call at 110 (which limits his/her upside to 10).

Under a variable forward arrangement, a person with a substantially appreciated equity position, enters into a contract (typically with a bank) that economically resembles the collar, i.e. a combination of a sold call and purchased put. The difference is that the settlement is permitted to be made in shares. Specifically, using the example above, if the share price at maturity was below 90, the person would deliver one share, between 90 and 110, the client would deliver shares with a value of 100 and if the share price was greater than 100,the client would deliver a number of shares to the bank that allowed the client to recognize the value of 10% appreciation. Often, the bank writing these contracts will then make an upfront payment on the contract (usually no greater than 85 on the numbers used in the example). When there is an upfront payment, the transaction is known as a “variable prepaid forward contract.”

The essence of these collar and variable forward transactions is that those employing them, typically managers and controlling shareholders, retain formal ownership of shares while getting rid of some or most of their economic ownership. Although typically used in the US as tax deferral techniques these can be readily adapted for empty voting.

A 2004 public instance of empty voting illustrates the potential risks from empty voting. Perry Corp., a hedge fund, owned 7 million shares of  King Pharmaceuticals.   In late  2004, Mylan Laboratories  agreed to  buy King in a stock-for-stock merger at a  substantial premium, but Mylan’s  shares  dropped  sharply when  the deal was announced.  To help  Mylan obtain shareholder approval for the merger, Perry bought 10% of Mylan, becoming Mylan’s largest shareholder. But Perry fully hedged the market   risk associated  with its  Mylan shares. Perry thus had 10% voting ownership and zero economic ownership.  Including its position in King, Perry’s overall economic interest in Mylan was negative. The more Mylan (over) paid for King, the more Perry stood to profit.

When Perry filed its 13D it disclosed the 10% ownership of Mylan but not the offsetting hedge. A company named Hugh River which was controlled by Carl Icahn opposed the merger. He bought suit on an alleged 13D violation and eventually the case was settled.

That being said it is far from clear that empty voting techniques are illegal. Classic corporate legal theory prohibits vote selling by transferring voting rights to a vote buyer. However, many of the techniques discussed above don't involve vote selling. Moreover, on the disclosure front, 13D (and 13G) were written in the 1970's  before swaps and OTC derivatives existed and other disclosure rules (e.g. Section 16, 13F and mutual fund rules) don't quite cover the "empty voting" waterfront either. In short the consensus is that there are plenty of holes in the disclosure system.

Next, the flip side of "empty voting" - morphable (hidden) ownership.