October

To Vote, or Not to Vote, That is the Question

By Oğuzhan Karakaş, CERF Fellow

With the advent of the financial engineering and technology, the fabric of the financial securities is changing. While this change has certain advantages such as bringing the costs down, it also has unintended consequences such as impairing the associated voting rights in the securities. A potential reason underlying this issue is the oversight in the design of the new financial securities and the underlying regulations: in contrast with the cash flow rights, the non-cash-flow-related contractual rights of the securities, including the right to vote, or the right to sue, tend to be overlooked.

Contemporaneously, the U.S. Securities and Exchange Commission (SEC) has been inquiring and debating about the “proxy plumbing” – extensive problems, ranging from over-voting to under-voting, associated with the complex, dated, and inefficient infrastructure supporting the proxy voting system. A recent recommendation of the SEC Investor Advisory Committee on proxy plumbing argues that SEC intervention is necessary for the overhaul of the system.[1]

In the article “Phantom of the Opera: ETF Shorting and Shareholder Voting”, CERF Fellow Oğuzhan Karakaş and research collaborators Richard Evans (University of Virginia), Rabih Moussawi (Villanova University), and Michael Young (University of Virginia), find that short-selling of Exchange Traded Funds (ETFs) lead to “phantom shares” of the underlying that are not voted. This unintended consequence is due to the underlying shares held as collateral or a hedge by the securities lenders or authorized participants/broker-dealers. The authors show that phantom shares (i) are costly, since they do not convey voting rights to the ETF owners, but are sold at the full price of share, which reflects both cash flow rights and voting rights; (ii) create inefficiencies within the voting process by leading to under-voting; (iii) are positively related to voting premium, particularly during the contentious votes; and (iv) are associated with poor governance such as value-reducing acquisitions.

Regulatory concerns regarding the above-mentioned findings would arguably be even more pronounced during times market is bearish and/or when the corporate votes are very valuable. A solution could be to incorporate the distributed ledger technology (commonly known as “blockchain”) into the proxy system, as also discussed at the recommendation of the SEC Investor Advisory Committee on proxy plumbing.