Wealth Management and Financing July 29, 2021

Environmental, Social, and Governance Factors in Securities Lending

Investment professionals see increasing demands from their clients for consideration of environmental, social, and governance (ESG) factors in finance and wealth management decisions. At first glance, securities lending transactions might seem to be distant from the direct impact that an investor can have on an investment target’s ESG policies. Nonetheless, the securities assets that investors place into a lending environment and the lender’s and custodian’s management of that environment can have a significant ESG impact.

Recognizing this, the Pas Asia Securities Lending Association recently announced guidelines for an initiative called the Global Framework for ESG and Securities Lending GFESL). These guidelines lay out a best approach that beneficial owners of securities can adopt when they incorporate securities lending and stock loans into their greater wealth management strategies. When investors are evaluating whether to enter into a securities lending transactions, the guidelines encourage them to consider voting rights, transparency in the borrowing and lending transaction, collateral and cash reinvestment, lending transactions that span the record date of the underlying collateral, short sales, and rehypothecation of the collateral at the end of a lending period.

As to voting rights, the guidelines encourage investors to anticipate if or when votes on significant corporate matters will be put in front of shareholders and to factor control of voting rights into decisions as to which securities to use as collateral in a securities lending transaction. Lenders in collateralized stock loan transactions may be able to accommodate an investor’s desire to vote on ESG issues with different contractual provisions that address which party controls voting rights in the securities that are used as collateral in a transaction.

Increased transparency in a securities lending transaction might reflect an enhanced ESG framework. Although lenders will generally not impose use-of-funds restrictions on loan principal balances, borrowers that have an ESG focus reinvest liquid cash that they receive in a stock loan transaction for more sustained ESG purposes.

Any stock loan transaction with a term of more than one year will likely cover the record date of the securities comprising the collateral. Investors who are focusing on ESG issues will need to place greater consideration on voting rights and their opportunity to exercise voting control over the collateral when they evaluate the pluses and minuses of a securities lending transaction.

Excessive short sales activity in any security may be a warning sign of weak management. Short selling already improves efficiency in share pricing and overall liquidity in the market for the underlying securities. Investors can structure securities lending transactions to increase short interest in a particular stock and to send signals to management without ceding total control or fully liquidating their positions in that stock. The same philosophy holds for rehypothecation and unwinding of securities lending transactions at the end of a loan term.

Overall, the ability of both borrowers and lenders to use stock loans and securities lending as a tool to focus an issuer’s attention on ESG factors will continue to grow as more investors come to understand their ability to affect management decisions that might have an ESG impact. Securities lending can therefore be much more than a tool for investors to realize the cash liquidity of their securities assets without selling them. In this sense, an informed investor can use stock loan transactions as a fully functional tool in a well-devised wealth management strategy to accomplish ESG goals and strategies.