NY Metro Hedgefund Law & News

Morphable Shares (Hiding Voting)

Yesterday I wrote about empty voting - being able to vote shares without having an economic interest in the issuer of the shares or with having only a relatively miniscule interest in the issuer.

Today I will discuss pretty much the opposite: morphable shares which involves having an economic interest in the share issuer while not have a voting interest but pretty much having a "right" to get a voting interest.

This functions again largely through the swaps markets. A person who is long a swap is in the economic position of a shareholder but does not have voting rights. However, the counterparty who is short the swap pretty much invariably hedges the short position by holding an equivalent amount of the underlying security with the tantamont voting rights. (In fact, if the counterparty votes the shares it pretty much is an instance of "empty" voting as we discussed yesterday as the counterparty really has no economic interest in the issuer.)

However, what can often happen is that the party in the long position, at a given point in time (e.g. the date for being a shareholder of record for a critical vote)  "morphs" the long swap position into a voting position by terminating the swap and acquiring the shares of the underlying security held as a hedge by the counterparty. Then, surprise, surprise the hithertofore unknown voter surfaces as a major player in, for example, a proxy fight.

This technique was employed by Perry Corporation which at one point had been a major disclosed shareholder (under New Zealand law) of Rubicon Ltd., a public New Zealand company. Perry offloaded 31 million Rubicon shares to 2 derivatives dealers and simultaneously took a long position in the shares in an equity swap with the dealers. This arguably put Perry's voting position in Rubicon below the 12.5% of Rubicon at which it would have been required to be disclosed under New Zealand.

Low and behold, to the surprise of all (well almost all), Perry reacquired the Rubicon shares by unwinding the equity swap just in time to vote (with a 16% position) at a key annual meeting to be held by Rubicon. In ensuing litigation, Perry lost the battle (at trial) but won the war (on appeal).

The reason this "works" in practice is that as an economic matter in thinly traded issues, which virtually all of these situations involve, the equity swap counterparty in the short position virtually always has to cover by being long the underlying security. In turn, when the party in the equity swap long position wants the vote it makes market sense for the counterparty to agree to unwind the swap and "sell" the underlying security back.

Does it work legally? Yes, general opinion is that in most countries (likely including the US) it does.

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.

Beware the Small Business and Work Opportunity Act of 2007

OK - this one isn't law yet. It's a bill pending in the Senate introduced on 1/22/07.

One (of a host of items)  basic effect, if passed, will be to cap annual non-qualified income tax deferral to the lesser of (i) average of last 5 years compensation or (ii) $1 Million. Yes, there is a provision adjusting in the case where there is not 5 years of compensation.

This will set the hedge fund manager world on its ear if passed. Successful hedge fund managers who are generally sufficiently well advised to navigate the infamous Sec. 409A of the Internal Revenue Code - another nightmare of tax complexity - are accustomed to deferring way, way over $1 M per year. So this bill is not going to make them happy campers - if it becomes law.

The slated effective date is now (i.e. for tax years beginning in 2007). Folks who've overcooked their 2007 deferral election will apparently be allowed to remedy it down to the mere $1 M.

So us legal types will be keeping our eye on it. Currently the bill (S. 349) is on the Senate legislative calendar. The rumor mill says that this one has "legs". We shall see.