Unless you’re an electrician, you probably don’t think about the wires running through the walls of your house—until, that is, you get a shock.

The stock market has similar hidden wiring. Normally, it works well. Stock trades settle, dividends are paid, proxy votes get recorded. So we don’t think about how it all happens. Recently however, that hidden infrastructure has increasingly come into sharper relief, for the same reason we pay attention to wiring: Various companies, executives, and investors have been shocked by shorts.

More specifically, the practice of shorting stocks has taken the spotlight. Several spotlights, in fact. CEOs past and present, from Overstock’s Patrick Byrne to Enron’s Ken Lay, have accused short sellers of attempting to ruin their companies. Entwistle and Cappucci, a law firm, has filed a class action lawsuit against the top Wall Street brokerage firms servicing hedge funds, alleging that they have profited by facilitating widespread “naked” short sales, the illegal practice of selling shares without actually borrowing them first. And two professors have documented a growing trend of investors “decoupling” the voting power of shares from the economic risk of owning them. The International Corporate Governance Network, a group representing some $10 trillion in institutional assets, has issued a report on stock lending, a practice which enables shorting by providing shares to borrow (see related studies and reports at the bottom of the box at right).

First, let us acknowledge as good capitalists that nothing is illegal or immoral about shorting stock. It assists price discovery and orderly markets. Moreover, short-sellers have a history of uncovering corporate wrongdoing. In fact, we believe shorting is salutary overall.

That said, we are also aware it is controversial, often misunderstood, and subject to abuse. Part of the controversy, surely, is that short-sellers appear to benefit from others’ pain. But another reason for its notoriety may be that the mechanics behind short sales are surprisingly little-known and a bit complicated.

Living On (Un)Borrowed Shares

The general concept is well-understood: An investor who thinks a particular stock is going to decrease in value shorts the company’s shares by first “borrowing” them, and then selling them into the market with the hope of buying them back later at a lower price. In effect, except for the “borrow,” short selling is the mirror image of a traditional stock buy.

Ah, but that’s the key issue: the “borrow” or “loan.”

Corporate executives now have a new set of questions to ask in contested situations. It’s no longer enough to know the share register...now you may need to know who has the right to vote those shares.

For a short sale to be legitimate, the shares of stock have to actually be located, and “borrowed” from a “lender.” The lender may be a pension fund, mutual fund, insurance company, wire house, or any other institutional investor with an inventory of shares. A short-seller agrees to “borrow” the stock, and repay it to the lender later.

The failure to do that is at the heart of the lawsuit against the world’s top prime brokers. In the suit, plaintiffs claim that the prime brokers—the institutions which facilitate short sales by their hedge fund clients—systematically failed to locate borrowed shares, and, instead, simply sold naked shorts and kept track of them through bookkeeping entries. The suit focuses on the improper economics of that arrangement; in effect, the prime brokerage clients allege they paid for a service they didn’t get. And of course, the suit’s allegations are unproven.

Nonetheless, the implications for corporate officers are clear. Having to find a “borrow” effectively acts as a brake on the amount of short sales for two reasons. First, institutions don’t have to provide the “borrow” in the first place. In theory, if no borrows are available, no shorts can occur. Second, the “lenders” may recall the “loan” by recalling the “borrow” (repurchasing the shares) at any time. Such actions can create a “short squeeze,” where a short-seller can’t find another willing lender from which to borrow the shares. If that happens, the short seller must close his position, driving the stock higher (remember, for a short to close the position he must buy shares). If, however, the short is “naked,” there is no need to close the position, since no lender is there to recall the shares.

Economic vs. Ownership Rights

The contracts governing short sales are quite different from your car loan or mortgage. As the ICGN report explains: “Lending inherently entails transfer of title from the lender to the borrower for the duration of the loan. Most economic rights of the lender can be preserved through contractual agreements with the borrower. Those involving the issuer, however, such as the right to vote … cannot be preserved in this way.” In other words, voting rights stay with the shares, no matter the economic arrangements. That basic fact can create a plethora of problems in change-of-control situations. For example, investors intent on affecting the outcome of a takeover may borrow shares to gain the voting rights, then hedge away their economic risk.

The distinction between economic rights and ownership rights is more than semantic; it can decide the fate of a corporation. That’s the conclusion of two well respected scholars, Henry T.C. Hu and Bernard Black, both at the University of Texas (Black is also affiliated with the European Corporate Governance Institute). They have found that hedge funds and other investors are increasingly decoupling economic risk from ownership in change-of-control situations, most famously Perry Capital’s 9.9 percent voting position in Mylan Laboratories during King Pharmaceutical’s aborted takeover attempt in 2004. But also in the takeover battles between AXA and Mutual of New York, and in a proxy contest at Australian firm Coles Meyer.

While the mechanics of this “empty voting,” as Hu and Black term it, vary slightly from case to case—and though the immediate hedge may be a derivative transaction (often called a “contract for difference,” or CFD in the United Kingdom) or an option contract—a short sale often figures somewhere in the chain of counterparties that have enabled that hedge.

Interestingly, the researchers also note that the ability to separate voting and economic interests may give investors the ability to hide their economic or voting interests by sidestepping disclosure rules.

So, what does all this mean to corporate executives and investors? First, as Hu and Black point out, our entire corporate governance regime assumes integrated share ownership. The ability to decouple voting rights and economic interest may be a long-term threat to business as usual.

More immediately, corporate executives now have a new set of questions to ask in contested situations. It’s no longer enough to know the share register. Now you may need to know who has the right to vote those shares. Corporate officials responding to activist pressure should always ask how much of a company they own outright, rather than allow phrases like “economic interest in” to confuse the situation.

Also, Compliance Week readers may want their general counsels to monitor Entwistle and Cappucci’s allegations. Should the case result in governance changes, the absolute number of shorts may decrease.

Finally, corporations that routinely lend securities from their pension funds or elsewhere may want to review the ICGN’s rules for responsible lending, which can be found in the box above, right.

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