One major benefit to the Direct Registration System is being able to directly vote on shareholder matters, without the possibility of those votes being fractionalized or skewed. While beneficial owners also receive shareholder voting rights, under some circumstances beneficially owned shares do not have their votes equate to a whole vote for each share owned, or in some cases do not have their votes cast at all. Brokers have the discretion to decide which votes are cast without any accountability for shareholder democracy.
Let’s first review the framework around shareholder voting, how it works for most investors, and the consequences and risks that have been identified with that system repeatedly over the last few decades.
As covered in Cede-ing Ownership, investors typically do not carry record ownership of their shares, and instead are listed as the “beneficial owner”. Holders of record (directly registered shareholders) have the right to claim economic value of shares and to exercise their voting rights directly with the company through the chosen transfer agent. Similarly, beneficial owners are able to claim the economic value of shares and voice their preference of voting rights through their broker-dealer. Shares are legally fungible, meaning that any share should be identical to any other share – but in practice and in the context of voting rights, this is not always the case.
If you are a beneficial shareholder holding stock through a traditional broker, then your proxy voting materials will be sent to you. Proxy voting refers to ballots cast on behalf of a shareholder, as the beneficial owner is not a registered shareholder with the corporation. The investor receives materials detailing the issues to be voted on, along with a form to return to their broker indicating how they want their shares to be voted and legally designating the broker as their “proxy” for voting purposes. The proxy voting process is SEC regulated. While adding middlemen to the chain of voting does introduce time delays and potential for complication, it is not the primary concern that would lessen the impact of voting rights.
The main concern is that beneficial votes will be worth less than 1 vote, compared to the expected 1 share 1 vote through the DRS, a phenomenon called share dilution. Share dilution originates most often through share lending. When shares are lent out in this way, it can lead to more than one beneficial owner having the right to vote for that share. In this circumstance broker dealers may choose to fractionalize the vote in order to achieve the correct number of votes for shares issued, or not cast some votes at all. Record owners, such as brokers, can in some circumstances lend shares without the consent or knowledge of the beneficial owner. This lending is common, as the lender collects a fee from the borrower. This is one of the ways fee-free brokers make money from account holders.
When a share is borrowed, the borrower receives rights associated with beneficial ownership- including voting rights. However, the beneficial owner on the books of the lender ALSO maintains these rights. This is a recognized issue- while the shares are out on loan from the beneficial owner, the borrower of those same shares will ALSO receive proxy materials for voting. The broker is under no obligation to tell you that your vote will not be counted equally. The voting rights go to the buyer who received the borrowed shares at settlement. These “extra” shares which are created through the lending process – which have full and legal rights to share voting – are referred to as “phantom shares” . This can multiply quickly, creating fractional votes and inconsistencies in true shareholder democracy, yet remains completely legal. Due to these phantom shares, any given broker may receive proxy vote instructions for a number of shares which exceeds the amount of shares they are supposed to express intent for with the company.
In these cases where an imbalance occurs between the number of securities on deposit in the broker's DTC account, and the number of securities credited on its records to its customer accounts, the broker has two options. The first option is to allocate to each of its customers one vote for each share credited to the customer's account. However if too many votes are submitted, the second option is for the broker to decide which votes will count, or decide which customers (or itself as a holder of securities) will get to vote and how many shares they get to vote. When your shares are directly registered on the ledger of the issuer with their transfer agent, however – share lending does not occur. Transfer agents are not functionally able to facilitate share lending. There is also a direct line for exercising voting rights between the shareholder of record and with the issuer – so there is no opportunity for voting dilution.
1. Trimbath, S. - Naked, Short and Greedy - p.31
2. 2007 Speech by SEC Director Erik R. Sirri
3. 1991 Report by Mr. Conyers on Short-Selling Activity in the Stock Market
4. 2008 Law paper by Grant M. Hayden and Matthew T. Bodie: One Share, One Vote and the False Promise of Shareholder Homogenity