Thanks to some curious arrangements, hedge funds are now able to vote without owning shares, and can also own shares without having any exposure to the company. One of the most troubling tactics is what the professors dub "morphable ownership," in which a hedge fund can rent shares from other investors immediately before a vote, thus effectively disguising the extent of its influence. Equally disturbing is the extreme of "empty voting," in which a fund hedges its position in a company so that while it still has voting rights, it no longer has any economic risk. In the case of M-Flex, it would appear that some degree of empty voting could have been combined with a position in the target company, potentially putting the interests of the shareholder at odds with the interests of the acquiring company. "Some of this is about fair play, but in some cases it can go beyond that–to issues of disclosure and transparency," says Hu. "Do you want someone with a negative economic interest having power in your company–perhaps dictating the fortunes of that company? You can even have situations where someone who wishes the company ill is perhaps the biggest stockholder." The "absolute worst" example the professors uncovered relates to an attempted buyout of an illustrious Hong Kong-based company earlier this year. "Basically, Henderson Land held around three-quarters of the shares of Henderson Investment and wanted to buy out the remaining 25% minority interest," explains Black. "Henderson Land apparently offered an attractive price. Most of the minority holders favored the buyout–and Henderson Investment's share price increased substantially. So far, so good."

But under Hong Kong law, the deal could be blocked by only a 10% vote of the minority shareholders. To the market's surprise, that's exactly what happened after one or more hedge funds borrowed shares in Henderson Investment. The funds borrowed enough to block the buyout, having also established a short position in Henderson Investment stock. Shares in Henderson Investment fell 17% after the vote was announced. "The hedge funds basically killed a deal which all the other shareholders would have benefited from and then profited immensely when the shares fell the next day," says Black. The high profile of the companies involved–Henderson Land has a market cap of roughly $10 billion and posted profits of $1.7 billion during the last financial year–prompted "quite a brouhaha" about the ethics of stock lending in Hong Kong, says Hu. In other countries where hedge funds have used these tactics to influence votes, it has also caught the government's attention. In Germany, for example, hedge funds played a prominent role in defeating a bid from Deutsche B??rse (the operator of the national stock exchange) to buy the London Stock Exchange in 2004. Since then, hedge funds have been the subject of scathing attacks from politicians, including one of the leaders of the country's governing coalition who labeled the funds and private equity firms "locusts." More recently, the German financial regulator has amended its equity disclosure rules to force investors to notify the market earlier when they build up stakes in a company–a move that was widely seen as an attack on hedge funds. In the U.S., however, the activity hasn't really made it onto the radar screens of company managements, investors and even regulators. The reason may be simple: The U.S. hasn't seen a case involving iconic companies like Henderson Land or Deutsche B??rse. "It will take some high-profile case where these tactics have been used to the detriment of shareholders before everyone really gets together and raises a stink about it," says Chris Young, head of M&A research at proxy voting firm ISS Proxy. Young also argues that such a case is "probably inevitable at some point."

According to Professor Black, that case may already have happened. He notes that, when Hewlett-Packard was trying to force through its proposed acquisition of Compaq in 2002–which became the most expensive proxy fight in history–rumors of empty voting were rife. "Both sides spent a zillion dollars, but it might be that the vote was won thanks to Compaq's shareholders who, in effect, obtained HP votes but hedged their economic interest. The truth is we don't know. And that's part of the problem," he says.

Secretive activities aside, what had become clear to managements and regulators is the increasingly decisive role hedge funds are playing in merger votes. These hedge fund arbitrageurs can end up holding anywhere from 30% to 50% of the total shares in a typical mid-cap merger these days, says Alan Miller, the New York-based co-chairman of specialist proxy law firm Innisfree M&A. As a result, a large chunk of Innisfree's business now comes from companies who, in some way, "feel threatened" by hedge funds.

Of course, there's nothing wrong with merger arbitrage per se–at least when it's in the open. Spectres of manipulating votes–and markets–only come into play when funds resort to questionable tactics, such as disguising ownership or determining the outcome of a merger when either all a shareholder's risk is hedged or when it is not in the interest of the company. Barry Barbash, the Washington D.C.-based head of the asset management practice at Willkie, Farr & Gallagher, characterizes the area as "squishy–there's a lot of murkiness around these subjects. I think, for a lot of lawyers, it comes down to gut feeling, and there are a lot of hedge fund managers who haven't developed that gut feeling yet."

ISS Proxy's Young says he has heard that the SEC is looking into the issues highlighted by Black and Hu and adds that "from a common-sense perspective, I would hope that regulators would be concerned about the potential for abuse and would be looking at possible remedies." The SEC refuses to comment.

As things stand, say Hu and Black, there's no regulation preventing hedge funds using these techniques. They propose changes to the current Byzantine web of SEC disclosure regulations, which would simplify the system and attempt to bring both hidden and empty voting to light. Until that happens, says Black, "this is a scandal waiting to happen." And if regulators can't or won't act to protect companies and investors, more companies may be forced–like M-Flex–to try and protect themselves.