Back in 2010, a Bank of England press release announcing a primer on securities lending estimated the total value of securities on loan globally at around US$2.5 trillion and that pension funds generate an estimated US$800 million of revenue annually from lending their securities. That’s a lot of money.
So what is securities lending exactly? Securities lending is where a stock owner lends stock to a borrower in return for collateral, either cash, security or a letter of credit. When a security is loaned, the title and the ownership are also transferred to the borrower, both in the US and Europe. Most financial markets regard securities lending as a good thing. It plays key roles in allowing short selling, both in fixed-income and equity markets. Borrowers hope to profit by selling the securities and buying them back at a lower price. Lenders are typically paid a fee during the loan period, and, since ownership has been transferred only temporarily to the borrower, the borrower must pay any dividends out to the lender.
Securities lending transfers not only the legal ownership of equities, but also the attached voting rights. However, it is almost universal in the securities lending market for loaned securities to be subject to recall by the lender, so that the lender can exercise their voting rights.
Nevertheless, this transfer of ownership rights, albeit temporary, is of growing concern to many governance advocates. Securities lending by pension funds, usually to hedge funds shorting stock and sometimes to funds trying to add votes at company meetings, is coming under increased scrutiny. Since the issue is a loss of ownership, a break in the investment chain, the loss of rights as an owner, it is not just that a fund might not be able to vote the shares at an annual meeting unless they are recalled, it is also about whether corporate governance staff are engaging with a company at a time when shares might be on loan.
Back in 2004, Ireland’s National Pension Reserve Fund pension fund said that “securities lending improves liquidity and is therefore a good thing”. Yes, it is true that funds have a fiduciary duty to increase returns but this duty must be balanced against its governance policies. Also in 2004, in an article in Investment and Pensions Europe, Sweden’s AP3 said: “Like most fund managers, AP3 engages in securities lending whereby it conducts short-term lending of equities and bonds to counterparties with high creditworthiness and that provide full collateral.” On the other hand, back during the financial crisis, many funds stopped lending stock in financial institutions because of market volatility, including the BT and British Airways pension funds.
Norges Bank, in its strategy plan for 2014-2016 notes that making efficient use of its holdings through securities lending is an “integrated part of our management” – and that it planned to expand its lending activities “in size and scope”.Securities lending is an issue that’s been dealt with in a number of best practice statements. For example, the International Corporate Governance Network (ICGN), which warns in a best practice document: “The word ‘lending’ has itself misled many as in law the transaction is in fact an absolute transfer of title against an undertaking to return equivalent securities.” The ICGN recommends three broad principles: transparency, responsibility and consistency. Lending policies should be visible, “the votes associated with their shareholdings [should] not [be] cast in a manner contrary to their stated policies and economic interests”, and there should be a clear set of principles around when shares should not be lent or should be recalled. Borrowing shares in order to exercise their voting power is a condemned as a bad practice. The code of conduct also indicates that the returns from lending should be disclosed separately.
The Kay Review also takes securities lending to task, recommending, like the ICGN, that, at a minimum, the proceeds from lending should be disclosed separately. In addition, he says: “Some respondents took the view that investors who are long in a particular stock, and who acknowledge stewardship responsibilities, should not encourage short selling by making their stock available for stock lending.” But he does not go so far as to endorse this view, rather indicating the risks inherent in the practice and concerns that those risks are divergent with true ownership. But who is enforcing Kay’s recommendations? I spoke with a number of people who indicated that they could not remember any major UK fund disclosing the fees from stock lending separately. The only reference we could find was in 2015, when Swedish fund AP7 disclosed that the fund’s active share lending programmes through its custodian bank, Bank of New York Mellon, which are also used to increase potential returns, yielded a net income of SEK33.9m (€3.6m) in 2014, at a cost of SEK6m.
The PRI also covers securities lending in its Listed Equity Active Ownership Reporting Guidelines. These are voluntary reporting guidelines, but credit is given for those owners who disclose a securities lending programme and indicate that they recall most equities for voting. Again, not a prohibition, just a call for disclosure of the practice.
Also, a few years ago, the International Capital Market Association (ICMA), published a series of documents to guide those owners contemplating securities lending. The materials are available on the Bank of England’s Securities Lending and Repo Committee website and involved most of the relevant financial regulators as well as the Local Authority Pension Fund Forum, National Association of Pension Funds (NAPF), and the Association of British Insurers. The ICMA’s Director – Market Practice and Regulatory Policy, Lalitha Colaco-Henry, noted that new holder (borrower of the shares) can voluntarily agree to vote in line with the original holder’s wishes (and many do) but there is no obligation.
Again, the materials do not endorse the practice, they simply recognise its existence and set out guidelines both for lenders, borrowers and the agents that are frequently involved in the transaction.
In the US, according to the Council of Institutional Investors’ Interim Executive Director Amy Borrus, “The CII does not oppose stock lending, nor does it endorse it.” Its corporate governance policies only require annual meeting dates to be announced as far in advance as possible in order for “shareowners to make informed decisions regarding whether to recall loaned shares.” Its recently published proxy access best practices guide also has a section on loaned securities. This states that there is currently a “lack of clarity” as to whether securities on loan count toward an ownership threshold for the purposes of satisfying proxy access conditions. While the CII has publicly stated that they should be as long as the shareholder has the legal right to recall them, some might argue that they don’t. In the guide it also notes that: “The SEC found that share lending is a common practice, and that loaning securities to a third party is not inconsistent with a long-term investment in a company.”
It should be noted that the SEC has granted that stock lending is not a breach in continuous holding, so long as lenders had the ability to recall the shares. Thus a shareholder or group of shareholders seeking to satisfy the typical proxy access conditions – 3% ownership for three years – would not disqualify themselves from being able to nominate a director if they had leant the shares out during that three-year period.
Anne Simpson, CalPERS’ Director of Global Governance, commented that stock lending as a cash generative procedure can be very lucrative but that “governance initiatives override any lending programme and that any lent shares will be recalled prior to any vote at an annual meeting. “You can’t buy CalPERS votes,” she added.
Alicia DuBois, CFO of US fund manager Pax World confirmed that the fund met the ICGN guidelines for disclosure. She said: “We do participate in securities lending in a number of our funds. All of the lending revenue earned by the funds is reported, by fund, as a separate line item in the statement of operations in our semi-annual and annual shareholder report.” As an aside, there have been tales that individual portfolio managers who don’t lend stock have faced pressure from those higher up to do so.In the UK, Legal & General Investment Management (LGIM) noted that it does not lend securities in the UK market, but that it does elsewhere. “In principal,” the firm notes, “investors should seek that all profits from this activity are paid to them (via the fund) and that the investment manager does not charge a fee.” LGIM also provided a number of points of consideration for a stock lending program, explaining that it should be undertaken only where the expected return considerably outweighs the risk and where this risk can be controlled effectively. It also indicated that limits on the percentage of the portfolio and on the percentage of each stock that can be lent should be maintained. Securities lending should also only be undertaken in developed and well tested stock lending markets. Finally, LGIM noted that any lenders should understand the impact of stock lending on their ability to vote.
I was able to get some shareholders to speak to me about securities lending, and governance agencies were very willing to share best practices. But I could not get any securities lending agents, often the third party in a contract, to speak to me at all, such as the Bank of New York Mellon. And I could get no hedge funds to respond to my requests for comment, except to say – no comment. As I have said, securities lending is not illegal and it appears to be fairly common practice but the level of opacity from the borrowers is a concern.
The most that can be concluded from all of this are a few main points. No agency actively proscribes securities lending. Many large fundholders actively and openly engage in securities lending, though very few disclose the proceeds specifically. Continued ownership – despite the fact that ownership transfers to the borrower – is recognised by most regulatory agencies. Agents working for either lenders or borrowers are reluctant to speak openly about the practice. And borrowers are also reluctant to speak. All that can be said is that those funds which do loan securities, and shared this information, also seem to abide by the ICGN’s opinion that votes should not be leant and that shares leant must be recalled before any votes are cast.
Paul Hodgson is an independent governance analyst.