PrefBlog

Empty Voting has assumed some importance in the Tembec takeover:

This week Oaktree said it intends to solicit proxies from those opposed to the deal. Oaktree opposes the US$807 million “flawed” transaction for what it terms “a flawed and poorly timed process;” for the lack of explanation for the “material gap between Rayonier’s offer and Tembec’s intrinsic value,” and because of its view that a standalone Tembec would be a better alternative.

Oaktree also raises the issue of empty votes, illustrating that comment by referring to the activities of Fairfax Financial, Tembec’s largest shareholder, which had a 19.99 per cent stake when the transaction was announced on May 25. (At that time, Rayonier and Tembec said Fairfax was “supportive of the transaction.”)

Now, thanks to a series of stock sales, with the last being for 14.2 per cent of Tembec — a sale announced on June 19, which so happens to be the meeting’s record date — Fairfax “no longer beneficially owns, or has control or direction over any of the outstanding share,” according to a filing. Fairfax issued three press releases (June 9, June 15 and June 19) indicating sales of its Tembec shares.

Note that this does not necessarily fall under the heading of “empty voting”, assuming that the shares in question were transferred on or prior to the record date, since the purchaser would then be entitled to the votes. Fairfax would be casting “empty votes” if they actually held the shares on the record date and cast the votes they were therefore entitled to while contracted to sell them; the question would then be the ’empty support’, if I can call it that, whereby Fairfax is touted as being ‘supportive of the transaction’ but then does not actually cast its votes.

The Globe’s story states that the issue actually is Empty Voting, but details and legal documents are hard to come by!

Fairfax subsequently sold its position in Tembec in the days that followed. But because it was an investor as of the so-called record date – the cutoff used by companies to establish who their shareholders are – it might be entitled to vote the stake it held at that time despite the fact it has since cashed out.

Such a situation, known as empty voting, remains relatively rare in Canada but a few cases have come up that were contested in court. Oaktree says Tembec and Rayonier potentially misled investors into thinking Fairfax backed the merger for its long-term value. And it says Fairfax should not be allowed to vote on the proposal because it no longer has an economic interest in Tembec.

It will be recalled that such empty voting (or debt decoupling, or any one of many sobriquets) is important in the CDS market:

In the primer on CDS I referred to a paper by Hu & Black regarding debt decoupling:

We have also heard from bankruptcy judges that they sometimes see odd behavior in their courtrooms, which empty crediting might explain. For example, one judge described a case in which a junior creditor complained that the firm’s value was too high, even though a lower value would hurt the class of debt the creditor ostensibly held.

There has been lots written about this issue, notably with respect to Telus:

In my recent paper, Empty Voting Revisited: The Telus Saga, I analyze the various instances of this important legal battle and develop regulatory implications.
…
The ensuing courtroom battle between Telus and Mason is legion. The complicated story line involved (inter alia) two major court decisions. First, the Court of Appeal for British Columbia ruled on the validity of Mason’s request for a shareholder meeting (TELUS Corporation v Mason Capital Management LLC, 2012 BCCA 403). In essence, the Court upheld the request. Crucially, the Court held that Mason’s risk exposure and its potential status as ‘empty voter’ did not allow the Court to disregard the valid calling of the meeting. Two months later, the Supreme Court of British Columbia, in a separate proceeding, approved a ‘plan of arrangement’ (a restructuring mechanism under Canadian law), as proposed by Telus. The Court held that the ‘empty voting’ situation was indeed one of the factors that had to be taken into account for assessing the fairness of the arrangement (In re TELUS Corporation, 2012 BCSC 1919). These two somehow contradictory decisions are important because they illustrate how courts are struggling with responding to the empty voting problem more generally. As I explain in the article, only where the law provides for discretionary, substantive court control, Courts will be able to take the risk exposure of shareholders into account.

Empty voting ultimately calls for regulatory responses globally. As I elaborate elsewhere, regulators should be guided by two main principles: first, transparency: disclosure of significant empty positions is paramount to any market reaction; and secondly, regulators should introduce a right to disenfranchise risk-decoupled shareholders under certain circumstances (as opposed to a voting restriction ipso iure).

Robert M. Yalden, Jeremy Fraiberg and Andrew MacDougall of Osler issued a call to arms in 2012:

Why hasn’t something been done before now?

Although empty voting has long been recognized as a concern, to date almost nothing has been done to address it. The Canadian Securities Administrators’ Notice and Request for Comment dated December 18, 2008 on proposed NI 55-104 Insider Reporting Requirements and Exemptions stated that the CSA was aware of and reviewing issues on empty voting. On July 14, 2010 the U.S. Securities and Exchange Commission issued a Concept Release on the U.S. Proxy System requesting comments on potential regulatory initiatives to improve proxy voting in the U.S., including initiatives to address empty voting. More recently, one of the key initiatives in the Ontario Securities Commission’s Statement of Priorities for 2012-13 is to improve the proxy voting system by conducting an empirical analysis to review concerns raised about its accountability, transparency and efficiency and facilitate discussions amongst market participants to improve the system.

One reason that nothing has been done to address empty voting is that some degree of empty voting is an unavoidable consequence of the need under our proxy voting system to set a record date for voting that precedes the meeting date. There are also practical difficulties in establishing enforceable rules to protect the integrity of the vote. Another reason is the desire to avoid regulations that might impede the benefits to market liquidity of share lending arrangements and derivative transactions. But a key reason is the lack of empirical evidence as to the extent of the problem.

And all this was foreshadowed by Latham & Watkins, a US law firm:

While somewhat of an over-simplification, our corporate statutes and
accompanying judicial decisions are premised on a paradigm of:

• • relatively low volatility in share ownership,
• • the purchase and sale of shares in face-to-face (or near face-to-face) transactions,
• • physical embodiment of shares in the form of share certificates,
• • transfer of shares through the manual assignment of negotiable share certificates and their reissuance to new owners through physical delivery to and by transfer agents and registrars,
• • a coincidence of record and beneficial ownership, or at most a relatively simple (one tier) system of “street name” holdings, and
• • perhaps most fundamentally, the ability to link beneficial ownership to specific share certificates.

…
This question is not simple. After all, a believer in free markets and market efficiency would presumably view the residual equity position in a corporation as consisting of a bundle of rights, with the right to vote being merely one stick in that bundle. In the context of an efficient market analysis, if an investor chooses to sell or otherwise dispose of its right to vote (as it does when it lends the stock for a fee), why is that bad? Why is it different from selling some of the economic up-side or buying protection against the economic down-side through selling call options or buying put options? And if it is permissible for the owner of the vote to dispose of the voting right, how can it be wrong for another investor to buy the voting right? After all, the investor is acquiring voting rights in an open market and at a cost which in theory reflects the value of the rights. If there is no proxy vote or contest then pending or in sight, presumably the vote has little value. If the transaction is in the midst of a proxy contest or other controversial vote, presumably the vote has greater value and the acquirer will have to pay that much more.
…
The long gap between record date and meeting date is anachronistic and a vestige a long gone era of physical stock certificates trotted around lower Manhattan for manual clearing, transfer and registration. With modern technology, there is no apparent need to retain an advance record date concept to manage shareholder voting. Rather, the record date could be as late as the close of business on the night preceding the meeting, with a voting period (i.e., the time for which the polls remain open) at or in conjunction with the meeting lasting several hours or perhaps a full working day. Assuming the various book entry systems supporting the equity markets could be made to “talk to each other” electronically, voting could likewise be electronic, and a “real time” voting system should be feasible.

Such a real time voting system would need accommodations from the SEC. Physical proxy statement delivery in advance of the meeting to all voters could no longer be mandated by the proxy rules.

Falk Bräuning and Kovid Puria publish some interesting research in a Boston Fed paper, Uncovering Covered Interest Parity: The Role of Bank Regulation and Monetary Policy Uncovering Covered Interest Parity: The Role of Bank Regulation and Monetary Policy:

Covered interest parity (CIP) is a concept holding that the interest rates paid on two similar assets that only differ in their denominated currencies should, after controlling for any foreign exchange rate risk, be the same. Fulfilling this condition depends on the idea that international capital mobility is largely frictionless. More specifically, the theory underpinning CIP predicts that converting the amount borrowed in a foreign currency using the foreign exchange (FX) spot market, while simultaneously hedging the resulting exchange rate risk using a foreign exchange forward contract, should result in a cross-currency basis equal to zero. (Such a simultaneous spot purchase and forward sale of foreign currency is called an FX swap, a contract in which investors essentially borrow in one currency and lend in another currency.) Because the U.S. dollar is the dominant global currency used in international trade and finance, trades against the dollar account for about 90 percent of the activity that occurs in the FX swap market. The ten largest global banking institutions account for two-thirds of the trades in the FX swap market, with nonfinancial corporations and other investors also using the FX swap market to hedge foreign currency risk or engage in arbitrage activity.

Historically, the CIP relationship was so stable across countries that it came to be regarded as one of the few binding laws in economics. Prior to the 2007–2008 financial crisis, the cross-currency basis was close to zero for all pairs, but after the crisis began, large violations of CIP were present, especially with respect to the U.S. dollar. When the European sovereign debt crisis arose in early 2010, the cross-currency basis also widened, but then flattened out by late 2012. While credit risk and liquidity risk have subsequently remained low, since mid-2014 large and persistent violations of CIP have been observed, resulting in substantial increases in the cost of borrowing U.S. dollars in the FX swap market. This paper analyzes the driving factors behind these most recent deviations in the CIP condition.
…

• •More stringent post-crisis bank regulations increased the cost to banks of providing dollars to the FX swap market, and lowered their incentives to engage in CIP arbitrage. A key regulatory change for U.S. banks, effective on January 1, 2013, essentially acted as an adverse supply shift, particularly for banks with lower Tier 1 capital ratios. The authors estimate that banks with a 1 percentage point lower capitalization ratio reduced their FX swaps by 19 percent more than did banks with average capitalization ratios.
• •The key factor behind the recent widening of the cross-currency basis is the surge in demand for assets denominated in U.S. dollars, a situation that stems from international monetary policy differences and related interest rate differentials between the United States and other countries. This demand effect, coupled with U.S. banks reducing their participation in the FX swap market, means that the supply of dollars is no longer perfectly elastic. This situation has created a higher forward premium beyond what is predicted under the CIP condition.
• •The Federal Reserve’s provision of dollar swap lines with other central banks has allowed foreign central banks to supply dollars directly to their counterparties. The authors find that European banks obtain more dollar liquidity from the European Central Bank when the cost of borrowing dollars in the FX swap market is high, and that subsequently the cross-currency basis between the U.S. dollar and the euro decreases.

It is my belief that many of today’s economic problems are the result of disruption; we are experiencing change at a historically unprecedented pace. The Industrial Revolution and the Renaissance combined weren’t NUTHIN’ compared to what’s been happening since 1980. And usually the effects of disruption are difficult to foresee:

Japan thought it was on track to beat deflation. Then came the Amazon effect.

The country’s retailers have been cutting prices in response to the rise of online rivals like Amazon.com Inc., disrupting what had seemed like perfect conditions for Japan to get the stable dose of inflation it has long been looking for.

In part as a result, Japan’s central bank is likely to lower its price forecast for the current financial year at its policy meeting on Thursday, said people familiar with its thinking. That reflects continued resistance to price rises, despite Japan’s longest economic expansion in 11 years and its tightest labor market in decades. The Bank of Japan is also likely to raise its view on the economy while keeping its policy settings on hold, the people said.

A red letter day today! Aided by a small bump in the GOC-5 rate, the calculated median YTW for the FixedResets subindex is greater than its mean current yield for the first time since 2008!

Yesterday’s BoC policy rate hike continues to cause turmoil for Canadian bonds:

Canadian government bonds extended their slump, pushing two-year yields to the highest since 2013, the day after the Bank of Canada raised interest rates for the first time in seven years and signaled more tightening may be ahead.

Yields rose across maturities. The Canadian dollar was little changed near a one-year high rallying 1.3 percent Wednesday.

While the decision to boost rates was expected by a majority of economists surveyed by Bloomberg, investors were surprised by the Bank of Canada’s effort to downplay weak inflation and signal that the economy’s output gap will close earlier than previously forecast.
…
There’s a 74 percent probability that policy makers led by Governor Stephen Poloz will increase rates again this year, according to overnight index swaps data compiled by Bloomberg, which would reverse the two cuts the central bank carried out in early 2015 to counter the effects of falling oil prices. There’s also a 26 percent chance of two additional hikes this year.

Yields fell back a bit as the day wore on – the Canada five-year closed at 1.53%.

The big news of the day was the Canadian policy rate hike, but Yellen’s remarks were also important:

Federal Reserve Chair Janet Yellen said the U.S. economy should continue to expand over the next few years, allowing the central bank to keep raising interest rates, while also stressing a gradual approach to tightening as the Fed monitors too-low inflation.

“Considerable uncertainty always attends the economic outlook,” Yellen said Wednesday in remarks delivered to the U.S House Financial Services Committee. “There is, for example, uncertainty about when — and how much — inflation will respond to tightening resource utilization.”
…
On monetary policy, Yellen didn’t diverge far from the comments she made at a press conference after the June policy meeting. She sounded slightly more cautious on the inflation outlook, while sticking to an expectation for continued rate hikes and maintaining the initiative to begin reducing the Fed’s balance sheet “relatively soon.”

PerpetualDiscounts now yield 5.24%, equivalent to 6.81% interest at the standard equivalency factor of 1.3x. Long corporates now yield a little under 3.85%, so the pre-tax interest-equivalent spread is now 300bp, a slight (and perhaps spurious) widening from the 295bp reported July 12.