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We model corporate voting outcomes when an informed trader, such as a hedge fund, can establish separate positions in a firm's shares and votes (empty voting). The positions are separated by borrowing shares on the record date, hedging economic exposure, or trading between record and voting dates. We find that the trader's presence can improve efficiency overall despite the fact that it sometimes ends up selling to a net short position and then voting to decrease firm value. An efficiency improvement is likely if other shareholders’ votes are not highly correlated with the correct decision or if it is relatively expensive to separate votes from shares on the record date. On the other hand, empty voting will tend to decrease efficiency if it is relatively inexpensive to separate votes from shares and other shareholders are likely to vote the right way.

The impact of hedge funds on corporate governance has received considerable attention recently as the rise in popularity of hedge funds has coincided with an increased focus on governance in general. Much of the attention has been devoted to “activist” funds that take significant stakes in firms and then advocate for change.2 However, other more subtle strategies undertaken by hedge funds or other strategic traders can also significantly affect the efficiency of the corporate governance system. In particular, recent work has shown that some funds may use “empty voting”—a practice whereby they accumulate voting power in excess of their economic share ownership—to manipulate shareholder vote outcomes and generate trading gains. This practice is possible even when one share, one vote is the explicit rule. It can be accomplished, for example, by borrowing shares of stock on the record date or hedging economic exposure in the derivatives markets. Hu and Black, 2006 and Hu and Black, 2007 provide a number of examples where such behavior seems to result in perverse voting incentives. In one case, a hedge fund acquired votes by borrowing shares, then voted against a buyout proposal and apparently profited from a short position when the share price dropped following the vote.3 These authors suggest that some form of regulation, starting with additional disclosure requirements, may be necessary to curb the negative effects of such activities. Regulators have expressed significant concern over empty voting, particularly given the boom in the hedge fund industry and the increasing number and importance of items requiring a shareholder vote. The Wall Street Journal (January 26, 2007, p. A1) quotes Securities and Exchange Commission chairman Christopher Cox as saying that the practice of empty voting “is almost certainly going to force further regulatory response to ensure that investors’ interests are protected...This is already a serious issue and it is showing all signs of growing.” Many large institutional shareholders are examining their share lending practices in response to these concerns. In addition, some companies have recently amended their bylaws to force additional disclosure of complex transactions in their securities due to concerns about corporate governance implications (The Wall Street Journal, July 14, 2008, p. B4). On the other hand, Christoffersen, Geczy, Musto, and Reed (2007) argue that “vote trading” in the share lending market can increase efficiency because information about proposals can be costly to acquire. Uninformed shareholders who are not willing to pay the cost to become informed can sell their votes to informed parties in order to increase the efficiency of the voting outcome. Of course, this argument requires that the vote buyer and vote seller have coincident interests, which often seems to be violated in the examples cited by Hu and Black, 2006 and Hu and Black, 2007. To date, there is no agreement on whether empty voting constitutes a significant problem that should be regulated. Importantly, the literature does not currently provide an integrated theoretical framework to help assess the tradeoff between increased information efficiency and the cost of possible manipulations via empty voting. In this paper, we develop a theoretical model to explore this tradeoff. We derive the optimal share and vote position of a strategic trader that has the ability to acquire unique information about the value of a management proposal and the ability to acquire votes separately from shares. We show that while the trader may sometimes reduce efficiency by ultimately selling to a net short position and then “voting the wrong way” (from a firm value perspective), the cost of these possible manipulations can be offset by a greater probability that the trader will “do the right thing” and vote to maximize firm value. In other words, in equilibrium both the presence of the strategic trader and the ability to separate votes from economic ownership can increase overall efficiency by making the “right” outcome more likely. This occurs when either the establishment of an empty voting stake on the record date is relatively expensive or other shareholders’ votes are not very highly correlated with the true state. However, we find that a negative efficiency effect is likely when separating votes from shares is relatively inexpensive and other shareholders are relatively likely to vote the right way. Our analysis deals with deviations from the one share, one vote rule, on which there is a large existing literature dating back to at least Manne (1964). Much of the modern literature focuses on how the one share, one vote rule affects the efficiency of the market for corporate control (see, e.g., Harris and Raviv, 1988, Grossman and Hart, 1988 and Burkart and Lee, 2008), or how disparities between cash flow and voting rights held by insiders affects efficiency (e.g., DeAngelo and DeAngelo, 1985 and Gilson, 1987). These studies generally focus on long-term deviations from one share, one vote that are codified in the corporate charter. An important recent exception is Kalay and Pant (2009), which shows that the ability to separate economic and voting interests via derivatives markets can increase efficiency by allowing shareholders to extract more surplus in a control contest. Like Kalay and Pant (2009), we examine short-term deviations arising from activities in the derivatives or share lending markets. However, we focus on how these deviations affect the efficiency of voting by outsiders on regular proposals (as opposed to control contests). We think of outsiders as parties who do not make proposals themselves, but face uncertainty over whether an insider's proposal is value-increasing or instead self-serving. There are many types of proposals other than proxy contests or takeover bids for control that can have important value implications for the firm. Examples include proposals for the purchase of another firm, a divestiture, or a change in the corporate charter (often involving a takeover defense). In our model, the firm's management initially proposes an action that requires shareholder approval. The proposed action may be either good or bad (i.e., its approval may either increase or decrease firm value), and its value is not observable at this stage. All shares are initially held by atomistic shareholders. After the proposal is announced, a single strategic trader can buy or sell shares in a transparent market prior to the record date (i.e., with no noise trading) and can also acquire “extra” votes in excess of its economic ownership by paying a convex cost. This cost represents, for example, increasing difficulty in finding shareholders from whom to borrow shares, or the increasing cost of finding counterparties to hedge a large economic interest. On the record date, voting interests are set according to share or vote ownership on that day. After the record date, there is a significant time lag before the actual date of the vote, so the strategic trader is able to further adjust its economic ownership (but not its voting interest) as well as learn about the value of the proposal.4 At this intermediate trading stage, however, the market is not completely transparent because there is noise trading by atomistic investors. Finally, on the voting date the strategic trader votes according to its economic incentives, as determined by its net economic position in the firm, while the voting of atomistic shareholders is effectively random. We do not explicitly model the atomistic holders’ voting decisions; the important feature is that their behavior induces randomness in the final voting outcome. Our assumptions are meant to reflect the realities of corporate governance in the United States. Christoffersen, Geczy, Musto, and Reed (2007) report that there is a significant time lag between the record date and the meeting date (a median of 54 calendar days in their sample) as opposed to the relatively short time between the announcement of the agenda and the record date. Thus, it seems reasonable that there would be little ability to trade strategically prior to the record date (which corresponds to our assumption of a transparent market at that stage), but a significant opportunity to gather information and trade less transparently between the record and voting dates. It is important to note that we highlight two ways in which empty voting can occur in the U.S. corporate governance system. In addition to the lending and derivatives markets, there is also the time lag between record and voting dates. Even if voting and economic interests have to be aligned on the record date, it is possible to divorce the two prior to the voting date by trading in the stock market during the intervening period. Our model allows us to separate the two effects. As will become clear, we find that the ease with which votes and shares can be separated on the record date is of key importance with respect to whether empty voting helps or hurts efficiency. In our model, we find that the strategic trader optimally trades to a long economic position on the record date while simultaneously acquiring “extra” votes, both of which set the stage for the possibility of future trading gains. The number of extra votes acquired depends on the cost of the votes versus the value (in terms of larger expected trading profits) of the increased ability to affect the vote outcome. For the bulk of the analysis, we assume that the cost of separating votes from ownership is high enough that the trader will not acquire enough votes to single-handedly determine the voting outcome. The trader's economic position on the record date is driven by a separate tradeoff. On the positive side, a larger economic stake increases the trader's voting power. This is valuable when extra votes are costly. On the negative side, greater economic ownership reduces expected trading gains for two reasons. First, the “future self” of the trader will be concerned with protecting the value of its stake in addition to maximizing trading gains. This “commitment effect” of owning an economic stake on the record date thus reduces expected future trading profits. Second, the strategic trader's position reduces overall market depth. In equilibrium, the extent of the long position is determined by the expected amount of noise trading between the record and voting dates, and the ease with which votes can be acquired separately from shares on the record date. After the record date, the strategic trader plays a mixed strategy; it either buys additional shares and then votes to maximize firm value, or it sells to a net short position and then votes to minimize firm value. We find in our benchmark model that the presence of the strategic trader is good for efficiency overall when the other shareholders’ votes are not highly correlated with the correct decision, or when the ability to separate shares and votes on the record date is highly restricted. Because of its long position on the record date, the strategic trader tends to “vote the right way” more often than not, increasing the probability of a correct decision in these situations. As market depth increases, the optimal long position on the record date increases, intensifying the positive effect. Thus, we find that allowing for trading gains by a strategic trader can increase efficiency even though the trader sometimes engages in value-reducing strategies. Also, since the strategic trader would not acquire any votes or shares in the absence of possible trading gains, noise trading improves voting efficiency. The positive efficiency effect we document for these cases is driven by the fact that the strategic trader has unique value-relevant information that other shareholders do not have. If the strategic trader brought no new information to the model, there would be no possibility of an efficiency improvement, but manipulation could still be possible. As such, our model provides a framework for determining whether and how an informed trader's unique information is ultimately reflected in the final voting outcome and thus firm value. On the other hand, we go on to show that efficiency can be reduced by the strategic trader when other shareholders’ votes are sufficiently biased toward the correct decision and it is not too expensive to separate votes from shares on the record date. Intuitively, when it is easy to separate votes from shares on the record date, the trader chooses a smaller long position and the commitment effect is attenuated. In these cases, the trader's efficiency-reducing votes are relatively more likely than its efficiency-enhancing votes to change the actual decision if other shareholders are likely to vote the right way on their own. Thus, the negative effects can start to outweigh the positive ones. This occurs despite the fact that the trader brings value-relevant information to the table. We also investigate how changes in the underlying parameters affect the trader's strategy as well as overall efficiency. We find that making it easier to separate votes from economic ownership on the record date tends to decrease the trader's economic ownership (in order to maximize trading gains by avoiding the commitment effect, as noted above). This increases the probability that the trader will go net short and vote the wrong way later. However, the net effect on efficiency can be positive when votes are not too cheap, since the additional votes also increase the trader's ability to affect the voting outcome. This increased ability to affect the outcome can outweigh the higher probability of voting the wrong way. This result can be reversed, however, if votes are cheap enough and the correlation between others’ votes and the correct decision is high enough. Our results can provide some guidance on the efficacy of proposed regulatory reforms designed to curb or eliminate the negative effects of empty voting. For example, Hu and Black, 2006 and Hu and Black, 2007 advocate additional disclosure requirements as a reasonable starting point. In the framework of our model, disclosure of an “empty voting” position on the record date would have no effect, because we already assume that the market maker observes the strategic trader's actions at that stage. Disclosure of a change in economic position relative to voting rights between the record and voting dates would have the effect of reducing or eliminating any trading profits the strategic trader could otherwise generate. This would reduce the trader's willingness to gather information and vote. Thus, the efficiency effect of such a rule would depend case by case on whether the model predicted a positive or negative effect from the trader's presence. Overall, our results imply that regulators should consider the possibility that curbs to empty voting behavior could be costly in cases where there is significant uncertainty about the value of a proposal. One issue we do not formally analyze is how the equilibrium would change if the strategic trader entered the model with an ex ante long or short position in the stock. The effect of this will be for the trader to have an initial bias toward protecting firm value (if initially long) or destroying firm value (if initially short). The trader's anticipation of the commitment effect discussed above will then cause it to choose a record-date position that is increasing in its initial ownership. If the trader arrives long, the record-date position is increased and the commitment effect is strengthened, leading to a higher likelihood of a positive efficiency effect. However, if the trader arrives short, the record-date position is decreased, possibly even to a net short position, implying a higher probability of a negative efficiency effect. Another issue that is not explicitly considered in our model is the possibility that the quality of managers’ project decisions could be positively correlated with either their ability or the extent of agency problems in the firm. In other words, bad project proposals may be more likely when managers have low skill or in firms with more severe agency problems. In this situation, the strategic trader's information about the quality of the project translates into information about the manager or firm's overall quality, which may not be known by the market. While we do not formally model this possibility, it has interesting implications since it could result in some positive efficiency effects from empty voting even when the strategic trader votes the wrong way. In particular, when the strategic trader votes in favor of a bad proposal there will still be an efficiency cost of the proposal being more likely to be accepted, but there could be a countervailing positive effect of causing the manager's type to be revealed more quickly than it otherwise would. This could increase efficiency if it led to greater price efficiency or an earlier opportunity for managerial discipline or turnover. Furthermore, this effect could be intensified if the strategic trader were able to condition its pre-vote trading on a good versus bad project (which we currently do not consider). In such a setting, a correlation between manager or firm type and project quality is likely to induce some asymmetry in the strategic trader's strategy for good versus bad projects—it is likely to make the trader go short and vote the wrong way more often with bad proposals (and thus bad managers) than with good ones because the fundamental value is lower in those cases, making a short position even more attractive. We believe this is an important avenue for further research.

Our model is stylized, but it nevertheless provides a number of useful empirical implications. Most obviously, it implies that empty voting behavior should result in both positive and negative outcomes from an efficiency perspective. Thus, the negative anecdotes described by Hu and Black, 2006 and Hu and Black, 2007 should be only one side of the story. However, it is likely that direct, large-scale evidence of favorable (or unfavorable) empty voting behavior would be difficult or impossible to gather. Our model can also guide less direct empirical investigations. For instance, with slight adjustments to the model, we could predict which types of firms and proposals are more likely to be targeted by strategic empty voters. In particular, if we add an information cost that the strategic trader must pay after the record date to become informed about the value of the proposal, the model would predict that such traders are likely to target firms where the strategy is most profitable. This would tend to be firms with: (a) high liquidity (high αZαZ), which could be measured by trading volume or a statistic summarizing the dispersion of share ownership; (b) potentially important pending proposals (high ΔvΔv), which could be measured either directly by looking at types of proposals, or indirectly using a proxy for the quality of corporate governance; (c) greater availability of “extra” votes (high View the MathML sourceαX¯), which could be measured by volume and specialness in the lending market, dispersion of ownership, or the availability of derivatives to hedge economic exposure; and (d) voting outcomes that are uncertain (i.e., the vote is fairly likely to go either way) but where relatively few votes are needed to swing the result (which would correspond to a tighter distribution of non-strategic votes). This last point could again be related to the quality of corporate governance (outcomes are likely to be less certain when bad proposals are more likely). Another example could be a vote with a supermajority rule where a high percentage is needed for approval of the proposal. The distribution of share ownership between institutions and individuals could also be important if different types of shareholders have different information or voting incentives. Our model would therefore predict that more empty voting activity should occur in these types of settings. Direct evidence could be sought by looking at share lending volumes around record dates and/or share trading by certain types of investors (such as hedge funds) before and after record dates. The comparative statics in Proposition 3 could also be tested in this context. Furthermore, the model provides predictions about when the actual decisions are likely to be more efficient when empty voting occurs. Thus, an indirect test of the model could focus on ex post measures of how voting outcomes affect firm value. As noted in the Introduction, our results may also provide some guidance on the efficacy of proposed regulatory reforms designed to curb or eliminate the negative effects of empty voting. For example, Hu and Black, 2006 and Hu and Black, 2007 advocate additional disclosure requirements as a reasonable starting point. In the framework of our model, disclosure of an empty voting position on the record date would have no effect, because we already assume that the market maker observes the strategic trader's actions at that stage. The effect of a rule requiring disclosure of a change in economic position relative to voting rights between the record and voting dates depends on how the rule is implemented. If the rule made it more difficult for the trader to hide its trades from the market maker, this would have the effect of reducing or eliminating any trading profits the strategic trader could otherwise generate. Thus, the rule could reduce efficiency if it causes the trader not to accumulate votes in the first place (which is likely if there is a cost to gathering information about the quality of the proposal) in cases where the trader's presence improves efficiency. As noted previously, such cases are likely when either separating shares from votes is not very expensive or other shareholders’ votes are not too highly correlated with the correct decision. Otherwise, such a rule is likely to improve efficiency. Extending the model to allow for initial holdings by the strategic trader would lead to some additional implications (as noted in the Introduction). In particular, if the strategic trader were an existing blockholder with a long position, it would have an increased incentive to protect the value of its initial stake, meaning that its record-date stake would be increasing in the size of its initial position. Thus, the commitment effect would be intensified and the trader's actions would be more likely to increase efficiency. Indeed, if initial ownership were large enough, the trader may actually find it optimal to forgo trading gains, instead buying enough shares and/or votes to ensure that the vote outcome always maximizes firm value.13 On the other hand, if the trader arrived with an initial short position, its record-date position would be reduced (potentially to a net short position) due to the existing incentive to decrease firm value, and the trader's presence would be more likely to decrease efficiency overall. While our model provides a coherent framework for addressing the efficiency consequences of empty voting, there are a number of issues that remain unexplored. First of all, it would be interesting to allow for some correlation between managers’ project selection and their ability. As noted in the Introduction, if project choices are correlated with managerial ability or agency problems, empty voting could have additional efficiency implications. Furthermore, it would be interesting to study how the results would change if there were multiple strategic traders who compete to generate trading gains. It would also be interesting to study the interaction between a strategic trader with no initial interest in the stock (such as in our model) and an existing large shareholder who could also act to influence the vote outcome. Finally, we would like to more closely investigate specific mechanisms by which shares and votes can be separated, such as the share lending market. For example, if the uninformed shareholders were not all atomistic, how would they analyze the decision of whether to lend their shares on the record date? How would this affect pricing in the lending market? Our framework should provide a platform for exploring these issues in the future.