LDV is a new process that matches securities lenders' loaned shares to broker securities that would otherwise go unvoted, enabling lenders to direct proxies without recalling loans. It substantially improves existing market practices, which require lenders to recall loan in order to vote proxies. Recalls are inefficient in that they reduce overall lending and borrowing revenue, and create instability in loan, borrow, and collateral portfolios.
LDV benefits all participants in the securities finance industry. Lenders are better able to exercise their corporate governance responsibilities and, since lenders recall fewer loans, overall securities lending volume and revenue increase. Loan, borrow, and collateral portfolios are more stable, allowing agents and brokers to more effectively manage investment, counterparty, and operational risks. Corporate issuers receive more proxy votes from long-term investors, allowing them to reach quorum more quickly and at lower cost, and counterbalance votes of short-term activists. Higher loan volumes also improve financial market liquidity and price discovery.
Historically, institutional securities lenders had to forgo voting rights on loaned shares because there was no mechanism to vote without recalls. Recent technology and transparency improvements in securities finance markets, however, enable loaned shares to be matched with broker shares that would otherwise go unvoted. In particular, the Agent Lender Disclosure Initiative made apparent the direct counterparty relationship between lenders and broker-borrowers and provided brokers with detailed loan data necessary to include lenders in their proxy allocation routines.
Approximately 60 billion U.S. equities go unvoted each year[1], while roughly 15 billion shares are on loan[2], suggesting that sufficient votes could be available to meet lender vote demand. However, it is unlikely that lender voting interest will be fully covered for all issues, such as those with particularly contentious proxy events or that are hard-to-borrow in securities lending markets.
Brokers administer proxy allocation routines to distribute proxies to their customers. Since broker shares are held in fungible bulk and lenders have beneficial ownership to loaned shares, brokers can include lenders in their allocation routines. After brokers allocate proxies to lenders, standard proxy processes are followed to garner and submit voting instructions and submit them to corporate issuers. For example, proxies are assigned to Broadridge accounts designated for the lenders, then are instructed by lenders or ISS on the lenders' behalf.
Regulatory and operational considerations may pose challenges to matching custodians' unvoted shares with lenders’ loan positions. In particular, custodian shares are not held in fungible bulk, as are broker shares, which presents difficulties when considering custodial allocation of proxies across lender accounts. Furthermore, custodians are not counterparties on loans, so the lenders are not beneficial owners to any of the custodians’ unvoted shares.
Existing proxy reconciliation processes are sufficient to address any potential "over-reporting" issues. For example, brokers already use post-reconciliation processes to mitigate the risk of over-reporting that may arise from assigning proxies to margin customers whose shares may have been loaned or rehypothecated.
Beneficial owners and regulators have expressed concerns about voting opportunities being directed to preferred lenders or leveraged for beneficial loan terms. In the same way that agent lending queues are designed so that lenders get equitable access to borrower demand, brokers need pre-defined and algorithmic “proxy queues” to ensure equitable assignment of voting opportunities. Furthermore, on-going auditing and validation of proxy assignments may be needed to ensure against development of a “market for votes.”
Reallocation of the loans to brokers with available proxies would increase overall lender voting opportunities. However, numerous other loan factors would need to be taken into account, such as counterparty risk assessments and credit limits, loan prices, and collateral types and quantity. Considering these factors, loan reallocations may not be in the overall best interest of lenders and borrowers, and will have to be considered on a case-by-case basis.
To the extent that lenders receive proxies through LDV, they will not have to recall loans to regain voting rights. However, broker holdings change daily and varying numbers of investors vote, so the number of proxies that can be assigned to lenders cannot be known with certainty until just before the meeting date, which is typically two months after lenders must make record date recall decisions. The number of available proxies must therefore be forecasted, taking into account factors such as each broker's customer base, the scarcity of shares in the securities lending market, and the expected materiality of proxy ballot items.