When a speaker uses the phrase ‘fungible bulk’ close to the beginning of the speech, you know you need sit up and take notice.
The phrase was used by Delaware Vice Chancellor J. Travis Laster during a keynote speech at the recent Council of Institutional Investors (CII) conference in Chicago. What was most notable about a speech about proxy plumbing – not, you would think, the most riveting subject ever – was how riveted the audience was. But when you drop bombs like: “The votes ‘for’ and ‘against’ a proposal purport to provide an exact vote tally, but that is an illusion” you know you are going to have the attention of an audience of shareholders.
Laster’s complete speech is available on the CII website. It begins: “Today I want to encourage you to start a takeover. I want you, the institutional stockholders of America, to take back the voting and stockholding infrastructure of the US securities markets.” The current operators of the system have no incentive to change it, he says, because that would take away their monopoly revenue stream. Laster also quoted the CII’s own Amy Borrus who brought attention to “the difficulty beneficial owners have in determining whether their votes have been received in time and tabulated accurately”.
Laster traces today’s proxy plumbing problems to the SEC’s solution to the problem that, in order to buy and sell shares in the modern era, it was no longer satisfactory to have a little chap in a cap and a mackintosh bring them round to your broker in a leather satchel.
To solve this issue, the SEC implemented a policy of ‘share immobilization’ and brought an end to the physical movement of securities. What resulted was that most beneficial owners of stock now register their shares in the name of Cede & Co, the nominee of the Depository Trust Company (DTC). The brokers and banks that make up the DTC hold the shares of their clients, the beneficial owners, in fungible bulk; meaning that there are no specifically identifiable shares directly owned by DTC participants.
Then Laster told a story which caused the audience to gasp in amazement.
It was the tale of T. Rowe Price’s attempts to vote its shares against a merger it opposed (RI coverage). To get the firm’s instructions, DTC had “to transfer its state law voting authority” to T. Rowe’s ‘participant’, State Street by executing an omnibus proxy in State Street’s favour. Then State Street outsourced to Broadridge Financial Solutions the collection and implementation of voting instructions from T. Rowe Price by giving Broadridge a power of attorney to allow it to execute proxies on State Street’s behalf. T. Rowe Price used ISS to help transmit its voting instructions. Typically the firm used a computerized system that automatically generated default voting instructions for ISS. But the default voting instruction for a management-supported merger was to vote in favour.
T. Rowe Price changed this so it could vote against the merger, checking that the instruction was properly entered three times.
But the merger meeting was adjourned, meaning ISS had to send out a new record of voting intention that replaced the thrice-checked ‘no’ vote. T. Rowe Price was unaware of this and its system issued its default response to vote in favour. ISS received these new instructions and sent them to Broadridge, which then executed its proxies in accordance.This, according to Laster, cost T. Rowe Price $200 million and a lot of bad press. Other examples were enumerated. In a contested proxy at Yahoo!, for example, millions of votes were said to have been mislaid.
Apparently, a leading Delaware lawyer Gil Sparks has estimated that, in a contest where the margin is less than 10% “there is no verifiable answer to the question ‘who won?’”. Laster pointed to research by Professor Yair Listokin of Yale Law School, who concluded that proposals sponsored by management are “overwhelmingly more likely to win… by a very small amount than to lose by a very small amount—to a degree that cannot occur by chance.”
So, he concludes, companies are highly unlikely to want to change the system. And the SEC, which put out a well-received 2010 concept release on proxy plumbing, doesn’t have the time to change the system.
But to what? Laster proposes distributed ledger technologies. These are far too complicated to explain here, but they solve the problems Laster is talking about. Everyone knows how many shares they own and can vote, and which way they have voted them. All these ledgers are public and transactions have to be verified and verifiable. It even makes it easier for companies to communicate with their shareholders and only send proxies to those who actually own their shares.
I spoke to Ken Bertsch, the CII’s Executive Director. “The CII has been concerned for many years at the complexity of proxy plumbing. It’s old technology that at times can result in problems and, as a general matter, is very expensive for shareholders. Moving to distributed ledger technology,” he continued, “makes a huge amount of sense in terms of pursuing the potential for a system not based on fungible bulk. The new technology could give us the opportunity to replicate the old paper chase version of shares, which collapsed but could be doable given the power of computing, blockchain innovation, and the cloud. It all seems to hold promise for a much better system.
“We are wrestling with the problem of how to deal with the challenge that Vice Chancellor Laster made to investors at our conference. There are a lot of organisations doing work on distributed ledger technology, which seems to hold the potential to provide a system that is reliable and, transparent and can provide confidentiality. But it must be stable from a cybersecurity standpoint.”
What is the CII doing to help change the system? Bertsch said: “Various parties out there working on it have contacted us since the speech, but we are in an educational phase right now. We know Broadridge is working on it, NASDAQ too, and a private company is working on the Delaware initiative that Vice Chancellor Laster mentions in the speech. One of his fears is that if investors do not engage as distributed ledger technology is developed for securities intermediation generally and custody and proxy voting in particular, we could end up with a suboptimal system from the standpoint of investors.”
Laster concluded his speech: “The plumbing needs to be fixed. A plunger exists. The takeover doesn’t have to be hostile. It can be friendly. But it needs to be done.” The challenge is out there.