A recent report suggested that mutual funds' tendency to vote with management on proxies may be part of the reason for ballooning executive pay.

But another study by four U.S. and Canadian professors, this time on loaning shares ahead of proxy votes, raises questions about whether mutual funds, and other large shareholders, vote at all, or even more than once.

"It's a very serious concern that nobody's paying attention to," said Nell Minow, co-founder The Corporate Library, a governance watchdog group with headquarters in Portland, Maine.

Typically, borrowed shares are used for short sales and quick profits. But an increased interest corporate governance in recent years has created both a rise in proxy participation and a more aggressive marketplace with borrowers - usually high-stakes investors, such as hedge funds - seeking greater say as resolutions approach. They may hold borrowed shares for a little as 24 hours, according to the report.

"If everything is done right, the vote should go to the borrower," said Susan Christoffersen, a professor of management at McGill University in Montreal and co-author of the report, "Vote Trading and Information Aggregation." But sometimes the issue in question is so hotly contested, both the borrower and the lender want to weigh in, and both lay claim to the same share. "That creates double counting," Christoffersen said.

Sometimes, it's due to a simple lack of communication, said Chris Wloszczyna, a spokesman for the Investment Company Institute in Washington. "Frequently, different persons or departments are responsible for administering a fund's securities lending activity and its proxy activities," he said. "If this is the case, a fund may want to provide for regular communication between these individuals or departments."

Loaning securities and collecting transaction fees is not uncommon among mutual funds.

"It's free money," said Carl T. Hagberg, a shareholder communications consultant and principal of Carl T. Hagberg and Associates in Jackson, N.J. And although it's perhaps a few basis points per trade, securities lending is lucrative, raising hundreds of millions of dollars for some large funds.

Most fund prospectuses include fine print noting that the fund may engage in securities lending to raise revenue, and outline the risks. But few people read that closely or completely understand it, said Alyssa Ellsworth, a spokeswoman for the Council of Institutional Investors in Washington, which represents mainly pension funds.

"There's a potential for mischief when mutual funds lend shares," Hagberg said. And that potential only grows during proxy season.

Most cases of over-voting are anecdotal, but attention to the issue increased in February, when the New York Stock Exchange fined Deutsche Bank Securities in New York $1 million for sending duplicate and even triplicate votes for the same shares between 1998 and 2003.

"The fund has a fiduciary duty to vote the shares in the best interest of its shareholders," said Mercer Bullard, founder of Fund Democracy, a shareholders rights activist organization in Oxford, Miss.

But after studying data for a large U.S. custodian bank between November 1998 and October 1999, Christoffersen and company found that the date shareholders need to be on record in order to vote also happened to be the day when borrowed shares are most in demand, with loans increasing nearly 24%.

It's impossible to tell who is lending securities and who is borrowing from this data, but the dynamics of the system force large investors, such as mutual funds, to make a difficult choice: loan securities and collect profits, or forgo the proceeds and cast a vote.

Most firms won't lend 100% of the shares for a particular security, Wloszczyna said, but those that do should have a system to monitor upcoming votes and special meetings so that they can participate.

"If you're a shareholder, you rely on your fund family to vote in a certain way," said Jackie Cook, an analyst with The Corporate Library. To lose control of the vote for a few basis points, she said, "would betray a trust."

"A lot of mutual funds are indifferent," Hagberg said. Indexers especially, he said, might be more inclined to give up their vote, because no matter what the outcome, the content of their portfolio isn't likely to change. "They don't give a hoot!" he said.

So-called socially responsible, or other special-interest-oriented mutual funds might call back their shares, or, if that's impossible, borrow some of their own, to ensure their shareholder's values will be voiced.

A fiduciary that fails to vote the way shareholders hope may be committing a legal breach. The Securities and Exchange Commission requires lenders to recall loaned securities in time to vote if there is a "material event" such as a merger, coming up, according to Wloszczyna.

All of these competing interests and objectives leave mutual funds interested in loaning shares a third choice: vote the proxy, regardless of whether the borrower might vote.

"From a shareholder activism perspective, the vote is inextricable and a very valuable part of the share," Ellsworth said.

A mutual fund with a long-term interest in a company it holds might have a different motive than another borrower looking to puppeteer an election for short-term gains, Hagberg added.

Even in the case of indexers, Minow said, every vote counts. "You're going to be holding on to that stock until it falls out of the index, so voting in its best interest gives you all the more reason to hold on."

Unlike in the past, when few eligible votes were ever cast, beneficiaries increasingly demand that their fiduciaries be more active on proxy issues, especially pertaining to issues involving compensation, Ellsworth said.

Even if the mutual fund votes, there's always a possibility the proxy will be cancelled out by the borrower voting on the same share.

"It's a headache," Minow said, but especially in an age of increased calls for good governance and transparency, the little-examined practice of securities lending demands attention, she said. "It's pure profit, and maybe that's why nobody wants to think about it."

(c) 2006 Money Management Executive and SourceMedia, Inc. All Rights Reserved.

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