Stock Loans, Shareholders, and Finders

We have written about a number of problems that arise in the context of shareholder voting.  One of them concerns the problem of overvoting, when shareholders vote more shares than they actually possess.  This often occurs where brokers lend shares (the shares are actually sold) and provide voting rights to the lenders and borrowers.  Loan transactions can last a day or months.  See Complaint in SEC v. Simone, ED NY, Sept. 2007 ("Stock loan transactions may stay open for as little as one trading day or as long as several months or even a year.").  

In that regard, we note that the US Attorneys Office and SEC have been investigating improper activity in the rarified area of stock lending.  Most recently, the FBI arrested four people in connection with the investigation.  The arrests apparently arose out of the investigation into "stock-loan finders."

In the realm of stock loans, retail brokers typically lend and prime brokers (those covering positions for hedge funds and other institutional investors) typically borrow.  Conduit brokers borrow from retail brokers and lend to prime brokers, profiting on the spread.  Conduit brokers in particular employ the services of stock loan finders.  Finders were traditionally used by conduit brokers to locate "hard-to-borrow" shares although their services have become less necessary given technological advances in the market.  

The indictment in US v. Caccioppoli, 1:07-cr-00708-JB, ED NY, Sept. 19, 2007, describes a typical stock-loan transaction and the method used to compensate the lender. 

• When the stock-loan transaction was consummated, the borrower paid the cash or other collateral to the lender and, in exchange, the lender delivered the securities to the borrower.  The lender could then earn interest on the cash collateral by using the cash to make low risk short-term loans to other financial institutions.  When a stock-loan transaction involved securities that were widely available, the lender would typically keep a portion of the short-term interest as a lending fee and pay the remaining interest, often referred to as a "rebate," back to the borrower.  When a stock-loan transaction involved securities for which the supply was limited, often referred to as "hard to borrow" securities, the lender generally kept all short-term interest earned on the collateral provided by the borrower, and, in addition, the borrower generally paid a fee, known as a "negative rebate," back to the lender.

According to the allegations made by the SEC, persons within brokers engaged in collusive arrangements with finders, paying fees to companies they controlled or obtaining kickbacks.  The allegations indicated that this occurred in circumstances where the finders performed no services. 

Stock loans have proven to be a murky area that can sometimes result in problems with voting.  The entire area requires greater transparency, more than the snapshot provided by this litigation.