Halakhot of Investing in the Stock Market (6)

 

SIXTH INSTALLMENT - VARYING LEVELS OF STOCK OWNERSHIP

 

I. PREFACE

 

In the first installment of this shiur, we discussed the GENERAL question of the ownership status of the shareholder. As we explained, one point of view sees the shareholder as an owner of the company and of its assets - like an ordinary partner. The other point of view views the shareholder as a kind of creditor - he has made an investment and will receive a return, but the true owner of the company is someone else: a controlling interest, the management, or perhaps even the company itself, recognized as a legal person in halakha as it is in the secular law.

 

We also called attention to the many ways in which a shareholder resembles a silent partner (noten iska), whose halakhic status is well established.

 

We concluded that while many lenient opinions exist,  the most prominent contemporary authorities are not willing to create a blanket exemption from halakhic responsibility for the shareholder, but rather view him as a partner to at least some extent. We also pointed out that the power of the minority shareholder and his SECULAR legal status as owner are rather greater than many people are aware. However, even the stringent opinions acknowledge the high degree of insulation of the shareholder from company operations and recognize that this insulation may lead to various leniencies which, however, need to be discussed on an individual basis.

 

This installment is really a continuation of the FIRST installment, returning in the light of the latest shiurim and in the light of reader response to re-examine the GENERAL question of the status of stock ownership.

 

STREET NAME

 

A few days before Pesach, I received the following e-mail from Alan S. Cohen:

 

For the poskim who believe that a shareholder is a full partner:  do they realize that in the U.S., almost   no "shareholders" actually own the stock.  The stock is owned by the depository institution and the   "shareholder" legally only has a beneficial interest in the shares.  This is exhibited in how shares are  voted:  the depository institution tells each broker how many shares of stock the broker has an interest in.  The broker then turns around and asks those with a beneficiary interest how the shares should be voted.  Absent instruction from the holder of the beneficiary interest, the broker votes the shares  (otherwise, there would never be a quorum). Of course, this is not true for those who elect to take delivery of their shares.

 

Have the actual legalities (described above) been considered?  If not, does the answer change?

 

The phenomenon that Mr. Cohen describes is known as having the stocks "in street name," or more formally as "broker nominee name." When an investor buys stocks through a broker, the shares are formally bought by the brokerage house. No certificate is acquired by the investor nor, for that matter, by the brokerage house itself which instead maintains an account (according to Mr. Cohen, in the depository institution) - just as banks clear inter-bank transactions through joint accounts in some other bank or even the central bank.

 

As Mr. Cohen points out, an investor may elect to take delivery, that is, to ask the broker to acquire a stock certificate for him. The stock certificate is kept in a safe at the broker, and is inscribed with the investor's name. Alternatively, the investor may request to have the certificates mailed. From the moment the certificate is inscribed the investor becomes a full shareholder for all intents and purposes. However, this is done only if the investor specially requests it, and this is done relatively rarely.

 

Mr. Cohen suggests that perhaps the investor doesn't really "own" the shares at all. This is not at all dependent on the question we discussed in part I: whether a shareholder is a partner. Here the question is if the investor is really a shareholder!

 

To understand how the investor could be less than an owner, let us make a comparison to a bank account. As I pointed out in my series on "Money and Means of Payment in Halakha," a bank "deposit" is not really a deposit at all. There is no money waiting for me in the bank vault, certainly not the money I deposited. Rather, there is merely a DEBT of a certain amount which the bank owes me, as well as a certain amount of reserve cash and unlent funds which the bank keeps handy in case I should desire to redeem this loan - which I may do at any time.

 

If we were to discover that a broker likewise maintains a "reserve" of stocks for the case where some investor should desire certificates, then we would conclude that the investor is not owner of shares but merely has the right of acquiring them - much like a person who has a call option or a future on a stock, which he may IF HE DESIRES exercise at the appropriate time. This is like a bank account which allows me to "withdraw" my funds when I want, even though the funds in the meantime belong to the bank.

 

If, at the other extreme, we were to learn that the broker designates specific stock to each investor, we would lean to the conclusion that the owner is the investor, with the broker being merely an authorized agent with a special power of attorney.

 

According to the research which I was able to carry out, the actual situation is in between, and depends on whether the stocks were bought outright or on margin. I will discuss here a regular stock purchase, and only mention that someone who buys stock on margin leaves even more rights to the discretion of the broker, who may for instance lend out the margin-buyer's shares to a short seller.

 

REGULAR STOCK PURCHASE

 

Stocks which are bought outright are "segregated" - that is, the broker MUST hold adequate shares to cover ALL shares of ALL investors. If we were to call this a "reserve requirement", it would correspond to a one hundred percent reserve requirement - as opposed to the 15% or so which banks maintain. (In other words, for every $100 in active accounts, the bank keeps about $15 in quickly available funds - and far less in currency. The rest is lent out and may be available only after months or years).  The broker is not allowed to do anything with these shares - just to hold them beneficially for the investors.

 

Even so, we must point out that the investor's rights are limited. First of all, the company being invested in has NO KNOWLEDGE WHATEVER of the individual shareholder. The official list of shareholders shows that the brokerage house owns such-and-such a number of shares. The investor receives a proxy card from the broker - not from the company; and the broker itself votes the shares, in accordance with the instructions of the investor.

 

As Mr. Cohen points out, this means that if the investor does NOT give instructions, the broker may vote the shares according to its discretion. Here is a statement provided to investors through "Proxy Services," which does the proxy-voting paperwork (or on-line "net-work") for the brokerage houses:

 

If we do not hear from you prior to the issuance of the first vote, we may vote your securities in our discretion to the extent permitted by the rules of the Exchange (on the tenth day, if the proxy material was mailed at least 15 days prior to the meeting date; on the fifteenth day, if the proxy material was mailed 25 days or more prior to the meeting date). If you are unable to communicate with us by such date, we will nevertheless follow your voting instructions, even if our discretionary vote has already been given, provided your instructions are received prior to the meeting date.

 

Now, it is true that the broker MAY NOT hold less than 100% of investors' holdings. And it MAY NOT vote shares other than according to what the investors instruct. But we must distinguish between what the broker MAY do and what it CAN do.

 

For example, the broker MUST maintain and segregate shares for each shareholder. But it CAN do otherwise. If the broker itself becomes insolvent, it could be tempted to sell beneficially owned shares. Such a sale would certainly be illegal, but as far as my research indicates it would be perfectly VALID. The company would then presumably scramble to acquire enough shares by proxy day to make sure that each shareholder gets his proxy cards, and if the broker is successful then the shareholder would have no knowledge of the subterfuge and presumably no basis for legal action. (Though of course the regulatory agency would get pretty upset.)

 

Likewise, the broker MUST send proxy cards to each investor, and vote the shares in accordance with the investor's instructions. But it CAN do otherwise. Again, I am not a securities lawyer but my research suggests that such a vote would be valid and binding, though again the Securities and Exchange commission would take a pretty dim view of this.

 

The broker MUST forward all dividends to the investor. But if the broker fails to do so, the investor has a claim only against the broker, and can not complain that the company did not pay the dividend.

 

None of these is true regarding an investor with a certificate. Then the broker has no authority to sell the shares without the investor's instructions, even if the certificate happens to be in the broker's safe. Proxy cards and dividends would be received directly from the company, NOT from the broker.

 

Another example of how holding shares in street name limits the rights of the investor: Some firms have "dividend reinvestment programs" (DRIPS) whereby shares are paid out as "dividends". A street-name investor may not be able to participate, since the company does not recognize him as a shareholder.

 

Mr. Cohen wrote me in another letter: "Under some state corporate laws, certain rights of stockholders  are limited to stockholders of record and may not be exercised by beneficial holders of stock." I haven't been able to verify this, but it seems reasonable that "personal" rights should be exercisable only by shareholders whose holdings the company can verify directly. (Example of "personal" rights: some states allow shareholders to examine the company's books).

 

These findings suggest that shares of stock which are held in street name are OWNED by the broker. In turn, the broker has a separate agreement with the investor according to which all benefits and responsibilities of the stock ownership devolve on the latter.

 

IMPLICATIONS FOR SELLING SHARES THROUGH A MERE "KINYAN"

 

One implication of this status is that the suggestion made in the Pesach shiur, that the shares be sold together with the chametz, is questionable in the case of shares held in "street name". In the shiur I related to the LEGAL question of selling shares without notifying the Securities and Exchange commission. My new research confirms what I wrote, that whoever owns or even bears the certificate is the owner, whether or not SEC regulations were followed. However, we now know that in most cases there is NO certificate. Can I sell my "account" to someone else?

 

This question recalls a question we discussed in the money and means of payments series. When I write a check, have I actually transferred the bank's debt to me to the payee? Or perhaps I have only INSTRUCTED the bank to pay the payee, and only the actual presentation of the check will exercise this right? We pointed out that according to most authorities no actual transfer of rights takes place via writing a check, and we brought much evidence to support this view. Basically, selling a debt when there is no deed ("shtar"), or when the deed is not in possession of the creditor, can only be done in the presence of the debtor, and the bank is not present when I write a check. (See Shulchan Arukh Choshen Mishpat 66 and 126.) Only the bank and the broker have a definitive record of the account status which could be considered a "shtar", and so it is clear that we have an obstacle to selling the debt without their presence or consent.

 

Even the authorities who are inclined to think that the bank's debt to me CAN be transferred merely by writing a check, base their view on the fact that use of checks is so very widespread. This is obviously much different than trying to sell stocks by a "kinyan sudar" like we sell chametz, something which on the contrary is almost unheard-of.

 

Therefore, it seems certain that an owner of "street name" shares can't really sell them from a halakhic point of view.

 

IMPLICATIONS FOR THE VARIOUS PROHIBITIONS  CONSEQUENT TO BEING A PARTNER IN BUSINESS

 

What does this mean for all of our previous shiurim? Everything we wrote is valid for stocks NOT held in street name. For stocks which ARE held in street name, it seems clear that we have to distinguish which halakhic problems are dependent on OWNERSHIP, which on RESPONSIBILITY, and which on CONTROL.

 

We pointed out in the shiur on chametz that this prohibition relates to OWNERSHIP. According to most Rishonim, ownership of chametz even without possession is forbidden (though the Geonim and some Rishonim are lenient); according to most Rishonim, responsibility without ownership and possession is NOT forbidden. The material presented above strongly indicates that the investor in "street name" is NOT an owner.

 

According to the shiur on trading in forbidden foodstuffs, there also the prohibition devolves on the owner or on someone who actively comes into contact with the food. Again, the level of ownership of a street-name investor is limited. (Though the ownership of an investor seems to be at least at the level of "collateral" for the cases where that presents a problem, as discussed in that shiur.)

 

We pointed out in the shiur on ribit that this prohibition relates to RESPONSIBILITY. (We proved this from the Tosefta.) The owner of stock held in street name certainly has full responsibility for the company's loans. In fact, this is an exact parallel of the case mentioned in the Tosefta of a Jew who lends out money belonging to a non-Jew but the Jew has responsibility - this responsibility deriving from a separate agreement with the non-Jew, since the money actually belongs to the latter. It seems that the discussion regarding interest is little changed.

 

Regarding Shabbat ownership of a NON-JEWISH firm, we suggested that the main issue is CONTROL of the business. While the owner of street-name shares maintains effective control, we suggested in that shiur that the extent of control relevant for employing non-Jews is concrete "shop-floor" control which is absent as long as the Jew is not a manager.

 

Regarding a company which works with animals (on Shabbat), we need to ask ourselves if the prohibition depends on absolute OWNERSHIP or if RESPONSIBILITY is enough. The Shulchan Arukh and Rema OC 246:3-5 rule that responsibility of the non-Jew is enough to exempt the Jew. They do not relate to the opposite question: whether responsibility of the Jew for a non-Jew's animal is enough to OBLIGATE the Jew. The SA does give a lenient ruling if the non-Jew's animal is an "apotiki" (sole collateral) for the Jew and it seems from Choshen Mishpat 117:1 that the creditor has responsibility for an apotiki.  Perhaps we can learn from here that responsibility does not create obligations regarding the animal of a non-Jew. If so, then street name constitutes a leniency for this prohibition.

 

Regarding Shabbat ownership of a firm which employs Jews, the main issue is whether the investor's resources are encouraging and participating in the desecration of Shabbat. Since this shiur has not been written yet, I will be sure to relate to the distinction between direct and "street name" ownership.

 

IMPLICATION FOR INVESTING IN A BROKERAGE HOUSE, or, QUIS CUSTODIET IPSOS CUSTODES?

 

Theoretically, a problem is created in the opposite direction. Someone who owns stock in a brokerage house itself (many are publicly traded) and DOES have a certificate, seems to be an owner of a lot of chametz and other forbidden foods. Let's see how much.

 

The direct consequence of viewing the broker as owner of shares is that a brokerage house with a capital of say a half billion dollars should be considered the owner of assets many times this amount, since the value of shares in private accounts is many times the value of the broker itself. This is certainly a bit surprising, but ultimately there is nothing unprecedented in this kind of leverage.

 

However, a more eye-opening surprise is in store. We may recall that most shares of the brokerage house are themselves held in street name. It would seem to follow that the few individuals who hold certificates in brokerage houses own the entire stock market. Let's say that a few individuals, owning 5% of J.P. Morgan stock, hold certificates. They are then evidently owners of 5% of all the stock in J.P. Morgan accounts. However, much of this stock is for J.P. Morgan itself, or for other brokerage houses. These 5% owners now own, say, 15% of J.P. Morgan, plus 10% of Bear Stearns, Charles Schwab, and so on. This in turn gives them ownership of even more stock held by the brokers beneficially for investors.

 

It follows that through a kind of fantastic meta-leverage, the few cautious individuals who acquire certificates in brokerage houses - perhaps their shares are worth no more than a few tens of millions of dollars - are the "true" owners of  trillions of dollars of corporate equity.

 

While this is not impossible, I certainly find it implausible. I will suggest three alternative possibilities:

 

1. Despite all of the evidence brought above, ultimately we must consider the broker a mere agent of the shareholder, and all the broker's powers are merely a kind of power of attorney. The investor is a direct owner of shares of the companies in his account.

 

2. Really nobody owns the companies. All we have is a division of various rights among varying syndicates, with some powers vested in management, others in brokerage houses, still others in investors, others in creditors, and so on. No group has a critical mass of power and responsibility which would give them the status of owners.

 

It is true that EVERY small shareholder has no power but according to many halakhic authorities is still considered owner. But the small shareholder's impotence is due to a QUANTITATIVE lack of power. If he had numerically more shares, he would be a boss. Here the limitation is not quantitative but qualitative: even if I own fifteen percent of a company's stock, my power is limited by the power of management and, if the company is in street name, by the rights of the broker. The latter can be remedied by acquiring certificates and the former by using my controlling interest to replace the board, but as long as these steps are not taken my power is limited.

 

In this case, every publicly owned company would be the halakhic equivalent of a government-owned company. We mentioned that according to all authorities (all those I found) stock in a government company is really a kind of debt and not ownership.

 

3. The investor is not a partner in the company whose stock he holds but he IS a partner in the brokerage house - specifically, in the broker's "stock-owning" branch. After all, he does have control proportionate to his holdings in this part of the business. The end result is like that of an individual who is an actual partner in an investment syndicate, and the syndicate is the owner of companies. In this case there is actual ownership interest in the underlying assets.

 

As we pointed out in the very first shiur, the distinction between being an owner and a creditor is not a clear cut one. The rights of a shareholder are in between, and some authorities have decided one way, others the opposite. It seems clear that on the spectrum of degrees of ownership, shares held in street name are significantly farther in the "creditor" direction than shares held directly.

 

THE VBM AND THE FRUM INVESTOR

 

In passing, I would like to suggest that this interchange has really highlighted the special advantages of the VBM. The research which went into my original shiurim was fairly thorough, but a critical piece of information - "street name" - was not related to. It was easy for one of the thousands of readers to comment on this omission, and straightforward for me to bring the appropriate revisions to the exact audience who read the original version.

 

Now the total number of people who have read about the halakhot of investing in the stock market in books is certainly much greater than the number of people who receive this shiur. Yet a person reading a responsum of a Torah giant like Rav Moshe Feinstein zt"l or Rav Yitzchak Weiss zt"l is unlikely to shoot off a letter asking about the fact that stocks are in street name (even when these great leaders were alive). This is partially due to the fact that sending a letter is harder than sending an e-mail, and also because one is reluctant to ask hair-splitting questions to such awe-inspiring - and overworked - figures. And when qualifications are made in such volumes, years may be required before publication.

 

AN INFORMED QUESTIONER IS OUR BEST CUSTOMER

 

Ultimately, this series is not meant to decide halakha but rather to make the reader an informed questioner. Ideally, every reader has access to a Rav who is fully qualified to resolve difficult questions in the four sections of the Shulchan Arukh. However, being a great Torah scholar does not usually come together with intimate knowledge of financial markets; conversely someone who has little Torah knowledge can not necessarily present his knowledge of the world of business to a Rav in a way which allows the Torah scholar to apply this knowledge in a Torah context. There is an important niche for research which is halakhic but not authoritative, to tie these strands together and prepare them for an informed judgment by a qualified authority.

 

I feel that with the publication of this section, the careful reader has been left with a developed idea of what the relevant halakhic questions are regarding stock ownership and what the relevant reality is, so that a complete picture can be brought to a competent authority.