Steven Davidoff Solomon writes for The New York Times, July 21, 2015
It turns out that mutual funds may not be that great at keeping track of the stocks they own. The latest evidence comes from a legal battle over the $24.9 billion management-led buyout at Dell.
After the Dell deal was made in 2013, about 2.7 percent of shareholders objected to the purchase price of $13.75 a share, exercising what are called appraisal rights. The shareholders filed suit in a Delaware court, arguing that the buyout price was too low and asking the court to determine the fair value of Dell shares.
These last stalwarts of the Dell buyout opponents included funds advised by T. Rowe Price and Morgan Stanley. Most other shareholders, including Carl C. Icahn, who threatened to exercise appraisal rights, folded and took the $13.75 for each of their shares. Who can blame them? Appraisal involves a convoluted court proceeding and all the costs that go with it.
Add to the problems with appraisal rights the fact that the United States system of share ownership is even more bizarre. Five funds holding 922,975 shares that dissented from the Dell buyout, including T. Rowe Price’s fund, found this out last week when their case was dismissed.
In his opinion, Vice Chancellor J. Travis Laster of the Delaware Chancery Court gave a startling reason: The five funds didn’t really own their shares the way they thought they did.
How could a mutual fund lose track of its ownership?
The answer is that in the United States, most people who think they own shares actually do not.
Instead, in the United States most shares are held through a nominee system. Shareholders are what we call beneficial owners — they have a right of ownership, but one that is not reflected in the actual legal title of the shares.
Individuals buy stock through brokers like Charles Schwab. The brokers then purchase the stock on the investor’s behalf. But the brokers that hold these shares do not actually own them. Instead, the shares are held by a superentity called Cede & Company in an arrangement administered by the Depositary Trust and Clearing Corporation. More than 800 brokers and other institutions that hold stock are members of the D.T.C.C. and hold shares at Cede.
The bottom line is that when you look at your brokerage statement, the shares listed are most likely owned by Cede on your behalf.
This system was set up after the back-office brokerage and paperwork crisis of the 1960s, when brokerage houses could not keep up with an ever-increasing number of trades. Back then, anytime a trade occurred, it needed to be recorded with the company and a new stock certificate issued. The brokers could not keep up, and a number of them folded because of faulty record-keeping.
To keep up with the increasing ownership, the system was overhauled. Today, when a trade occurs, there is no need to issue a new stock certificate. Instead, an entry is simply made by the brokerage house internally and at Depositary Trust and Cede. If you think about it, this is the only way the system can handle billions of shares a day.
Like everything, though, this system of share ownership is imperfect.
That is what these five Dell shareholders found out when they exercised appraisal rights and encountered the law’s very particular requirements.
The Delaware appraisal law requires that dissenters own their shares from the time of dissenting until the completion of the deal. In other words, there must be continuous ownership.
But the rule assumes a world in which people directly hold certificates. This is not surprising, since the rule was adopted well before the Depositary Trust system was set up.
Here is where the problem occurred. The fund holders thought they owned their shares throughout this time period. They did not.
Instead, when the funds exercised their appraisal rights, Cede transferred the shares held by the funds to new nominees at the brokers (including JPMorgan Chase and Bank of New York Mellon) representing these funds. While beneficial ownership remained, actual ownership changed — a violation of the continuous ownership requirement.
Why did this occur? It’s not clear, but it was most likely a result of simple back-office errors. Matt Levine of Bloomberg View cast blame on JPMorgan Chase and Bank of New York Mellon, writing, “Getting this wrong, and costing customers their appraisal claims, seems almost deliberately perverse.”
Unfortunately for the funds, Vice Chancellor Laster held that this transfer disqualified them from exercising appraisal rights. While they were beneficial owners of the shares, title changed, violating the continuous ownership requirement.
The judge recognized that this was unfair, but he stated that his hands were tied by Delaware law, which recognized only the actual holder of record as the owner of shares.
The only remedy now is for the funds to go to the Delaware Supreme Court, the higher state court, and persuade it to change the rules, something Vice Chancellor Laster seemed to want.
It is almost so arcane you could cry. But it raises bigger issues about both share ownership and appraisal rights that are being swept under the rug.
That most shareholders do not actually hold title to their shares is for the most part a meaningless technicality. But it still raises all sorts of issues as people try to track these shares.
For example, the system of voting shares is a mess because of this ownership problem. T. Rowe Price mistakenly voted yes for the Dell deal when it meant to vote no. And in the battles between hedge funds and companies to elect directors, the voting system still cannot allow for a universal ballot, one where all the nominees of each side are on one card, since people cannot track all the information needed down to beneficial owners.
Beyond the share tracking issue, there is perhaps a bigger point about appraisal rights.
In the last few years, more and more shareholders have tried to exercise appraisal rights. Many of them are hedge funds that buy shares specifically to take their chances in court. But others are shareholders like T. Rowe Price that think they deserve a better deal.
That was always the purpose behind appraisal rights — to allow shareholders that thought they had received a bad deal to go to court and get the fair value for their shares.
Now that appraisal rights are being exercised regularly, however, companies are fighting back, trying to find every technicality to throw out these suits.
A proposal before the Delaware Legislature to cut back these cases by barring people with less than $1 million in shares from exercising appraisal rights, among other steps, did not succeed in part because many companies felt it did not go far enough in halting the tide of appraisal rights cases.
But the Dell case is a warning. Appraisal rights are there to protect shareholders from underpriced deals. Instead of wrangling about technicalities or rewriting the statute to cut back on these actions, Delaware should perhaps write an appraisal statute that works with the share ownership rules.
One could blame the T. Rowe Price fund and the others for this fiasco. Yet they are really the victims here, tripped up by an unnecessarily arcane system of shareholding in the United States. The lesson here is: Don’t hate the player. Hate the game.