The Price of Your Vote: Proxy Choice and Securities Lending

On October 7, 2021, BlackRock announced that, beginning in 2022, institutional clients would have the opportunity to direct the voting of shares held by index funds.  Some commentators heralded this change as “a catalyst for others in [the investment management] industry” and a move that would “expand the voting choice options for investors,”[1] though others were noncommittal or downright skeptical.[2]

Did BlackRock bury the lede?  Consider the following fine print: “BlackRock will determine eligibility criteria under this program based upon . . . financial considerations, including the decision to lend securities.”[3]  In an era of rock-bottom management fees, lending shares to short sellers[4] is an important source of revenue for the fund industry.[5]  The message is clear: For BlackRock, shareholder empowerment only goes so far.  When the price is right, BlackRock will trade away its clients’ votes for short sellers’ cash.

Disenfranchising investors in exchange for lending revenues is not a new practice.  In a paper with Edwin Hu and Haley Sylvester, I show that, in the wake of SEC guidance released in August 2019 allowing greater flexibility in securities lending, index funds recalled fewer shares on loan prior to shareholder meetings.[6]  The change is concentrated in stocks with high index-fund ownership.  Even when it comes to proxy fights, stocks with high index ownership see a marked increase in shares available for lending immediately prior to the meeting.

Subjecting proxy choice to the whims of the securities lending market is particularly troubling.  Suppose a BlackRock fund client has put in the time to research and express its preferences on an issue on the corporate ballot, overcoming the rational apathy inherent in collective action problems like voting.  Strong short-selling demand could nonetheless lead BlackRock to discard those preferences and pocket lending revenues instead.  This is problematic for several reasons.

Reason #1: Who Really Pockets the Cash?

For one, little is known as to exactly how much of a fund adviser’s lending fees are retained by the adviser as opposed to distributed to fund clients.  One industry source reported in 2018 that “BlackRock reserves 25-28.5% of the securities lending revenue made on U.S. equities for the BlackRock affiliate it uses to handle the securities lending, BlackRock Institutional Trust Company (BTC).”[7]

To be sure, BlackRock claims that it is able to offset a substantial fraction of its ETF management fees via income from securities lending, e.g., as much as 79 percent of the management fee for the iShares Russell 2000 Growth ETF in the first quarter of 2021.[8]  But that is a sleight of hand, because BlackRock fund management fees are paid to BlackRock itself.[9]  In theory, if securities lending revenues were to increase, BlackRock could also raise its management fee and de facto extract a share of that increase in lending revenues.  Because the competitive pressure to attract client assets is a function of the net management fees those clients pay, it would make sense for institutions like BlackRock to develop predictive models that tie a fund’s management fee to securities lending revenues to preserve the competitiveness of the net fee.

To illustrate the conflict between securities lending and value creation, suppose that BlackRock considers whether to recall its shares to vote in a proxy fight. [10]  For simplicity, suppose that BlackRock owns enough shares of firm X to determine the outcome of the vote, and if approved, the vote would generate a 1 percent increase in firm X’s value.  Further suppose that a short seller is willing to pay 1 percent in annualized lending fees to borrow shares of firm X over the record date of firm X’s shareholder meeting.

BlackRock faces a choice: collect 1 percent by lending its shares or recall its shares for voting, approve the proposal, and thereby increase the value of firm X’s stock by 1 percent.  The latter is less appealing because BlackRock only collects a fraction of that increase in portfolio value.  This choice becomes even more compelling when considering that lending fees are virtually certain, whereas the outcome of the vote may be less so – in part because BlackRock cannot be sure how other shareholders might vote.  A bird in the hand is worth two in the bush.

To get a sense for the magnitude of these incentives, a study forthcoming in the Journal of Finance found that “the average institution gains an extra $129,000 in annual management fees if a stockholding increases 1% in value, considering both the direct effect on assets under management and the indirect effect on subsequent fund flows.”[11]  Using the figures in that study, the average institution holds $7 billion in exposure to a given firm (on average).[12]  A 1 percent annualized lending rate would yield $7 million in lending revenues.  Simple arithmetic yields a break-even point between securities lending and increasing firm value of 1.84 percent.[13]

That is, an adviser who pockets more than 1.84 percent of lending revenues would rationally prefer lending securities to short sellers at an annualized rate of 1 percent over increasing firm value by 1 percent.  That break-even point of 1.84 percent is far below estimates of 25-28.5 percent for BlackRock’s share of lending revenues on U.S. equities, suggesting that BlackRock has a powerful incentive to lend securities at the expense of creating firm value.

Reason #2: Systematic Stewardship vs. Lending Fees

Even if lending fees were paid entirely to investors, another concern is that securities lending may undermine the incentives for systematic stewardship identified by my Columbia colleagues Jeffrey Gordon (see here) and John C. Coffee (see here).  Professor Gordon makes the point that index funds are highly diversified and thus have powerful incentives to take actions that maximize portfolio-wide value, like reducing climate change and other systematic risks.[14]  And Professor Coffee analyzes the rise of so-called “systematic activists” who agitate for corporate change that is value-enhancing for a portfolio as a whole rather than any single firm.[15]

Securities lending undermines systematic stewardship because the borrowers are short sellers, whose incentives differ from diversified investors.  While a large literature shows that short selling enhances the efficiency and liquidity of the capital markets,[16] the lending rate that a short seller is willing to pay is a direct function of the expected return to a short position.  Because short positions typically reflect idiosyncratic information about a single firm, there is no reason to think that diversified investors would recuperate the value of lost voting opportunities from short sellers.  The mismatch between a diversified investor’s preference for portfolio-wide value creation and a short seller’s idiosyncratic expected return makes the latter a poor tradeoff for the former.

Reason #3: Shareholder Welfare vs. Cash Flows

Yet a third reason why disenfranchising proxy voting for securities lending is troublesome is that some shareholders may have pro-social preferences that extend beyond cash flows.[17]  Subjecting proxy voting choice to “financial considerations” including “the decision to lend securities” inherently exchanges cash flows for other determinants of shareholder welfare.  A fund that collects securities lending fees instead of recalling its shares to vote on a pro-social shareholder proposal is implicitly using the lending fee as a price at which to cash out those investors’ pro-social preferences.

In general, there is no reason to believe that funds are particularly informed at valuing clients’ pro-social preferences.  This concern is especially compelling when clients have made the effort to specify those preferences.  Even if lending rates unexpectedly increase between the date of indicating the proxy vote choice and the record date, there seems to be little justification to discard clients’ expressed preferences absent affirmative evidence that the lending rate adequately compensates clients for taking away their pro-social votes.

Policy Solutions

For all these reasons, it is critical to reform the disclosure rules governing securities lending by mutual funds as well as enhance the transparency of the securities lending market more generally.[18]  On the former, the SEC’s proposal just two weeks ago to require that a mutual fund include the volume of securities on loan when calculating the quantity of shares “entitled to vote on a matter” is an excellent step forward, because it would give investors transparency into the volume of shares that may have been disenfranchised in exchange for lending revenues.

But this sort of limited, annual disclosure of lending volumes is not enough.  The SEC should go further to consider more fundamental reforms to the securities lending market, including real-time disclosure of lending transactions, rates, and volumes available for lending.  This information is currently provided by firms like IHS Markit and FIS Global for a fee, but investors would benefit from publicly available data on securities lending transactions.  Such data would be consistent with SEC Chair Gensler’s recent focus on transparency in derivatives markets, as lending contracts are a kind of derivative and have largely remained outside the scope of existing disclosure rules.

ENDNOTES

[1] Michael Mackenzie & Attracta Mooney, BlackRock to give clients the right to vote, Financial Times (Oct. 7, 2021), https://www.ft.com/content/4e8a4b14-3450-4be3-8526-2cc184f0ebfe.

[2] The president of Soundboard Governance had a pragmatic response to the announcement, noting that the move would ”allow [BlackRock] to say that they are putting voting power back into the hands of the beneficial asset owners” and ”deflect some of the criticism that BlackRock has received.” Andrew Ross Sorkin et al., BlackRock’s Transfer of Power, N.Y. Times (Oct. 8, 2021), https://www.nytimes.com/2021/10/08/business/dealbook/blackrock-shareholder-voting-power.html.  Even supporters of increased shareholder engagement were tepid in their praise. A senior director at the Human Society of the United States remarked that ”[w]hatever BlackRock’s motivation, dividing up even part of that power seems like it‘ll be a good thing.” Id. One journalist predicted that many institutional investors will ”stick with the status quo, and let BlackRock decide.” John Foley, BlackRock brings Shareholder Democracy to the Few, Reuters (Oct. 8, 2021), https://www.reuters.com/breakingviews/blackrock-brings-shareholder-democracy-few-2021-10-07/.

[3] Working to expand proxy voting choice for our clients, BlackRock (emphasis added), https://www.blackrock.com/corporate/about-us/investment-stewardship/proxy-voting-choice (last visited Oct. 8, 2021).

[4] Under Regulation SHO, broker-dealers are generally obligated to locate a security for borrowing prior to executing a short sale.  Rule 203(b)(1) (“locate requirement”) of Regulation SHO provides that “[a] broker or dealer may not accept a short sale order in an equity security for its own account, unless the broker or dealer has: (i) Borrowed the security, or entered into a bona-fide arrangement to borrow the security; or (ii) Reasonable grounds to believe that the security can be borrowed so that it can be delivered on the date delivery is due; and (iii) Documented compliance with this paragraph (b)(1).” 17 C.F.R. § 242.203(b)(1).

[5] See, e.g., Jesse Blocher & Robert E. Whaley, Passive Investing: The Role of Securities Lending (working paper, Nov. 6, 2014), https://acfr.aut.ac.nz/__data/assets/pdf_file/0010/29917/WhaleyPassive-Investing.pdf (finding that “exchange traded funds (ETFs) can earn significant revenue from securities lending, on order of the size of the ETF’s expense ratio”).  For the year ending March 31, 2021, BlackRock reported $29.3 million in net securities lending income for the iShares Core S&P Small-Cap ETF and investment advisory fees of $29.5 million.  iShares by BlackRock, 2021 Annual Report, https://www.ishares.com/us/literature/annual-report/ar-ishares-core-s-and-p-etfs-03-31.pdf, at *117.

[6] Edwin Hu, Joshua Mitts & Haley Sylvester, The Index-Fund Dilemma: An Empirical Study of the Lending-Voting Tradeoff, Colum. L. & Econ. Working Paper No. 647 (2021), available at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3673531.

[7] Lara Crigger, Is Securities Lending Good For ETF Investors?, ETF.com, Feb. 26, 2018, https://www.etf.com/sections/features-and-news/securities-lending-good-etf-investors?nopaging=1.

[8] BlackRock, Unlock the Potential of your Portfolios: iShares Securities Lending 3 (2021), https://www.ishares.com/us/literature/brochure/securities-lending-unlocking-portfolios-en-us.pdf

[9] BlackRock, Understanding ETF Fees on iShares.com 2 (2021), https://www.ishares.com/us/literature/brochure/a-guide-to-fee-presentations-en-us.pdf (“Management Fees are the fees paid by an iShares Fund to BlackRock Fund Advisors (BFA).”).

[10] This is not merely a theoretical example.  For one case, Hestia Capital Partners LP and Permit Capital Enterprise Fund LP took stakes in GameStop in 2019 and launched a proxy fight in 2020.  At the time of that proxy fight, BlackRock, Fidelity, Vanguard, and State Street owned 43.57 percent of GameStop, but only 5 percent of their votes were accounted for in the shareholder vote.  Dawn Lim, How Investing Giants Gave Away Voting Power Ahead of a Shareholder Fight, Wall St. J., Jun. 10, 2020, https://www.wsj.com/articles/how-investing-giants-gave-away-voting-power-ahead-of-a-shareholder-fight-11591793863.

[11]  Jonathan Lewellen & Katharina Lewellen, Institutional Investors and Corporate Governance: The Incentive to Be Engaged, J. Fin. (forthcoming, 2021), https://onlinelibrary.wiley.com/doi/10.1111/jofi.13085?af=R.

[12] This calculation is obtained from Table III, Panel B of Lewellen & Lewellen (2021) by multiplying the value-weighted AUM of $440.45 billion by the variable “%Incentives_Direct,” which is defined as the weight of an average firm in the institutions’ portfolio (1.59 percent).  That yields approximately $7 billion.

[13] $129,000 / $7 million = 1.84 percent (approximately).

[14] Jeffrey N. Gordon, Systematic Stewardship 2-3 (Eur. Corp. Governance Inst., Law Working Paper No. 566, 2021), https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3782814.

[15] John C. Coffee, Jr., The Coming Shift in Shareholder Activism: From ”Firm-Specific” to ”Systematic Risk” Proxy Campaigns (and How to Enable Them) (last revised Aug. 24, 2021) (manuscript at 1-2), https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3908163.

[16] See, e.g., Pedro A. C. Saffi & Kari Sigurdsson, Price Efficiency and Short Selling, 24 Rev. Fin. Stud. 821 (2011).

[17] See, e.g., Oliver Hart & Luigi Zingales, Companies Should Maximize Shareholder Welfare Not Market Value, 2 J. L., Fin. & Acctg. 247 (2017).

[18] For an excellent treatment of the broader disclosure issues raised by securities lending prior to shareholder meetings, see Scott Hirst & Adriana Robertson, Hidden Agendas in Shareholder Voting (working paper, 2021), https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3833304.

This post comes to us from Joshua Mitts, associate professor of law and Milton Handler Fellow at Columbia Law School.

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