Every once in awhile, a journalistic ray of light exposes how far our financial system has veered from anything resembling objective reality.
New York Times blogger Steven Davidoff, AKA "the Deal Professor," recently demonstrated how a hedge fund which does not own any "real" interest in a firm can sway a corporate election, negating core principles of ownership and shareholder rights. See Landry's and the Value of a Shareholder Vote, New York Times, June 28, 2010.
As Davidoff notes, the complex drama surrounding Tilman J. Fertitta's bid to acquire Landry's Restaurants (Rainforest Cafe, Chart House, the Golden Nugget, etc.) raises broad questions about overvoting in corporate elections and the growing influence of blocks of "phantom" shares:
What is a shareholder vote worth? Should courts discount shareholder votes by hedge funds when their shareholder activism is perceived to be in the short-term or otherwise in direct conflict with the corporation? Beyond hedge funds, how should courts treat shareholder votes by derivative counterparties with no economic interest in a transaction?
The backstory on this critical issue can be found in Rolling Stone's 2009 expose, Wall Street's Naked Swindle by Matt Taibbi. If you missed it, check it out. Taibbi provides a rare glimpse of the phantom economy -- a black hole where traders traffic in dark matter -- stocks, bonds, real estate and even U.S. Treasuries that don't exist.
Phantom assets don't show up in the brick and mortar world of three dimensions, and you can scarcely track them electronically. Yet these "counterfeit assets" exert a tremendous pull on the economy and on the net worth of investors. Taibbi explains:
Thanks to a loophole, brokers could legally counterfeit stock, promising the same shares to five different hedge funds... The fact that short sellers do not have to deliver their shares makes it possible for two people at once to think they own a stock... In this scenario, both Schmucks will appear to have full voting rights...
Susan Trimbath, a whistleblower formerly with the Depository Trust Company, sniffed out the problem more than a decade before Bear Stearns and Lehman fell. She realized that anyone could influence a corporate election simply by borrowing great masses of shares shortly before an important merger or board election. And according to Taibbi, she saw even darker implications:
Just as the lack of hard rules forcing short-sellers to deliver shares makes it possible for unscrupulous traders to manipulate a corporate vote, it could also enable them to manipulate the price of a stock by selling large quantities of shares they didn't possess.
Regulators ignored Trimbath's cry of alarm, even while rampant trading of counterfeit assets stripped legitimate shareholders of their rights, and in some cases, their net worth.
In 2005 a group called the Securities Transfer Association analyzed 341 shareholder votes taken that year -- and found evidence of over-voting in every single one. Experts in the field complain that the system makes corporate election fraud a comically simple thing to achieve...
The use of phantom assets to usurp corporate governance and sabotage share prices not only creates havoc in the market, but it also undermines capitalism's cornerstone value -- the rights associated with ownership. Surely economic reform will fail miserably unless it restores authority to legitimate shareholders -- investors who actually own shares in a company.