"Banks Forgot Who Was Supposed to Own Dell Shares," Bloomberg View, July 14, 2015

11 Jul 14, 2015 1:37 PM EDT

Bloomberg View

Here are three stylized facts about stocks:

  1. Nobody owns stock. What you own is an entitlement to stock held for you by your broker. But your broker doesn't own the stock either. What your broker owns is an entitlement to stock held for it by Cede & Co., which is a nominee of the Depository Trust Company, which is a company that is in the business of owning everyone's stock for them. This system sounds convoluted but actually makes it easy to keep track of things: If I sell stock to you, I don't have to courier over a paper share certificate, or call up the company and have it change its shareholder register. Our brokers just change some electronic entries at their DTC accounts and everything is cool. 
  2. If you own stock in a company that gets acquired for cash, you can ask a court to second-guess the merger price and give you the fair value of your stock in cash. A court will "appraise" your stock and order the surviving company in the merger to pay you what it's worth (plus interest), which may be more or less than the deal price. But to get the appraisal, under Delaware law, you need to follow some procedures. In particular, you have to demand appraisal in writing from the company before the shareholder vote, you have to vote against the merger (or abstain), and you have to own the stock continuously from the time you demand appraisal until the merger closes.
  3. Every time Fact 1 and Fact 2 interact, the result is invariably nonsense.

So for instance, Merion Capital objected to the 2012 buyout of Ancestry.com by Permira Advisors and demanded appraisal. But Merion was not an aggrieved long-term shareholder. It was an "appraisal arbitrage" investor, in the business of seeking appraisal, and it started buying Ancestry.com stock four days after the record date for the shareholder vote. (The vote was held on Dec. 27, 2012, but you needed to own the stock as of Nov. 30 to vote.) Merion met most of the requirements for appraisal: It demanded appraisal before the shareholder vote, didn't vote for the merger (since it couldn't vote), and owned the stock continuously from demand until closing. But it couldn't prove that its shares hadn't been voted in favor of the merger: It had bought the shares in anonymous public transactions, so for all it knew the people who owned those shares as of the record date had voted in favor of the merger.

Ancestry.com argued that Merion should have to prove that its shares hadn't been voted for the merger, which would have sunk its appraisal demand since that would be more or less impossible to prove. But the Delaware court said no. Remember Fact 1: Merion never owned Ancestry.com stock, and neither did the people who sold the stock. The only owner was Cede & Co. And Cede & Co. voted against the deal. Of course Cede & Co. also voted for the deal -- it "held 29 million shares of Ancestry.com, of which about 10 million either voted 'no' or abstained," meaning that the rest voted yes -- but enough of its shares voted no to "cover" Merion. 

One level goofier: T. Rowe Price vocally and consistently objected to the 2013 buyout of Dell, sought appraisal for its Dell shares, and then found out that it had actually voted in favor of the buyout, according to its SEC filings. Like, by accident. It just forgot, or something; it's very weird, and not rendered less weird by T. Rowe's statement that it was "aware of a discrepancy in the communication of our voting instruction on the Dell buyout." Oops! From Fact 2, you would think that this would foreclose T. Rowe's appraisal efforts, since unlike Merion it had demonstrably voted in favor of the deal, and the appraisal rules say that that disqualifies you.

Except for Fact 1: T. Rowe Price never owned any shares, and so it never voted any shares. Its ownership, its voting, everything were as shadows flickering on the wall of a cave. Everything that any shareholder thinks it does, Cede & Co. actually does. And, again, Cede voted (enough of) its shares against the deal, so Cede could get appraisal. Here's T. Rowe's lawyer:

"I think the case law is rock solid and the only thing that counts is how the record holder votes its shared," Grant said in an interview. "To me it is cut-and-dried that all of the stock holders who sought appraisal will be entitled to appraisal."

Except! Here's an even goofier thing from yesterday:

A Delaware judge on Monday found that because owners of 922,975 Dell shares failed to continuously hold their stock during the buyout process, they forfeited their rights to challenge the deal price. He blamed legal precedent and quirks of the country’s arcane stock-management system, and expressed frustration at his own ruling.

One of those owners was a T. Rowe Price fund. Oops again! (The others were portfolios at Northwestern Mutual and Manulife, and the Milliken and Curtiss-Wright retirement plans. Most of the T. Rowe funds that voted in favor of the deal don't seem to be affected.)

The story -- from yesterday's opinion -- is a little bonkers, although each individual step just about makes sense. When shareholders demand appraisal, DTC separates out their shares from the rest of the shares that it holds. That way, when the merger closes, DTC can surrender the non-objecting shares, get the merger consideration, and distribute it to the shareholders who didn't want appraisal, while keeping separate the shares that did ask for appraisal. Fine.

But the way that DTC separates out the shares is by getting a separate paper stock certificate for each holder seeking appraisal:

DTC does this by causing the issuer's transfer agent to issue a paper stock certificate for the number of shares held by the beneficial owner. The paper certificate is issued in Cede's name, so the same record holder continues to hold the shares for purposes of the Continuous Holder Requirement. 

Fine, a little weird, but fine. Now you've got a paper certificate in Cede's name. What do you do with it?

As a matter of course, DTC does not act as a custodian of paper stock certificates for its participants, even if those certificates are issued in Cede's name. A participant can pay to have a vault at DTC for its certificates, but that is a separate service. Unless a participant has arranged for a vault, DTC will contact the participant and deliver the paper certificate to the participant for safekeeping.

Okay now we are moving pretty far away from the efficiency benefits of DTC, but whatever. Just courier over the paper certificates to the objecting investors' brokers. 

But here another back-office procedure kicked in. For various understandable business reasons (insurance requirements, recordkeeping for internal audit, mitigating risk of theft, etc.), some banks and brokers only hold stock certificates that are issued in the names of their own nominees.

Umm. Wait.

JP Morgan's and BONY's internal policies do not permit them to hold paper certificates unless the shares are titled in the names of their own nominees. The custodial banks therefore instructed Cede to authorize the shares to be re-titled in the names of their nominees.

On August 5, 2014, Cede endorsed the Funds' certificates to the custodial banks. Over the next three weeks, the custodial banks arranged for the Transfer Agent to reissue the shares in the names of their nominees. The Transfer Agent reissued the shares held for Milliken and Manulife in the name of Hare & Co. and the shares held for Curtiss-Wright in the name of Mac & Co., which are BONY‘s nominees. The Transfer Agent reissued the shares held for T. Rowe Price in the name of Kane & Co. and the shares held for Northwestern in the name of Cudd & Co., which are JP Morgan's nominees.

There is a lot going on here, not least of which is that apparently every custodial bank has an assortment of adorably named monosyllabic partnerships that serve as its share-ownership nominees. (Also there is a meaningful typo: I'm pretty sure that August 5 was in 2013, when the rest of this happened, not 2014.)

But do you see the problem? In normal terms, T. Rowe owned its shares on June 12, 2013, when it demanded appraisal, and it owned them on Aug. 5, and it owned them continuously until the merger closed on Oct. 29, 2013. "There is no dispute that the Funds continuously held their shares as beneficial owners through the effective date of the merger," says the court.

But in the goofball alternate universe of legal ownership, of which the normal everyday "ownership" is merely a shadow, T. Rowe never owned the stock, and on Aug. 5, the ownership changed:

There is no dispute that on Dell's records as maintained by the Transfer Agent, legal ownership of Funds' shares changed from Cede to the four current nominees: Mac & Co., Kane & Co., Hare & Co., and Cudd & Co.

All of that had nothing to do with the T. Rowe fund or the rest of these investors, but it was enough to sink their appraisal claims: "When the shares were re-titled, the Funds lost their appraisal rights." To get appraisal, a shareholder needs to own shares continuously through closing, and the shareholder -- Cede & Co. -- sold these shares in August. So: no appraisal.

Nobody, including the judge who decided the case, is happy about this. Because it is nonsense! Cede & Co.! Mac & Co.! Kane & Co.! Hare & Co.! Cudd & Co.! Come on! These are not real things. Anyone involved in the Dell deal would be baffled if you told him that the controlling shareholder was Cede & Co., and that Cede had sold a block of stock to Mac & Co. Cede and Mac and Cudd and friends exist in a parallel universe whose intersections with the actual economic world tend to be creepy and uncomfortable. 

Whom do you blame for this? I mean, the judge blamed Delaware law, and that is fair enough. As he notes, "Federal law looks through Cede and recognizes the custodial banks and brokers as record holders"; if Delaware did the same -- or looked through all the way to beneficial owners -- it would have saved the appraisal claims here. (On the other hand, looking through to real owners might doom appraisal arbitrage strategies like Merion's.)

But it would also be reasonable to put some blame on JPMorgan and Bank of New York Mellon, the custody banks who changed the ownership. They are two of the three biggest custodian banks in the world, and they had one job! All they had to do was not cross out the name "Cede & Co." and write some other silly name on some stock certificates. (Or, if the temptation was too great: Pay for a vault at DTC.) Presumably JPMorgan and BoNY will find a way to avoid re-titling appraisal shares in the future, but it's a little embarrassing they hadn't done so already. Yesterday's decision may be a bit of a surprise, but it is not, like, a secret that appraisal procedures are finicky and that continuous ownership is an important requirement. Getting this wrong, and costing customers their appraisal claims, seems almost deliberately perverse.

But I'm sure it wasn't deliberate. The financial system is built up in layers of abstraction over some vast and unwieldy machinery. The machinery is complicated in part in order to make the abstraction simple: You can buy stock with a click of a mouse because armies of people devote their careers to the legal niceties and operational maintenance and integration of all this back-office apparatus. Sometimes the machinery pokes out a bit through the fabric of the abstraction, and someone has to file it back down to make things smooth again. Really, though, considering how complicated the machinery is, it's amazing that this doesn't happen more often.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Click here to read the entire article with footnotes: http://www.bloombergview.com/articles/2015-07-14/banks-forgot-who-was-supposed-to-own-dell-shares