The Background: The Securities and Exchange Commission ("SEC") published guidance affecting proxy advisory firms and the investment advisers that rely on them as a follow-up to its November 2018 proxy process roundtable.
The Issue: The guidance tasks investment advisers with the responsibility to hold proxy advisory firms accountable for their methods and procedures, including the accuracy of the information they use and their disclosure of conflicts of interests.
Looking Ahead: The guidance is another step in the SEC's efforts to improve proxy voting. Although this reform is welcomed by corporate America, it remains to be seen how investment advisers will interpret and implement the SEC's guidance when voting clients' shares. While we commend the SEC's action on this important topic, we believe the SEC should take further steps in reforming the proxy voting process.
On August 21, 2019, the SEC published two interpretive releases relating to proxy voting matters as part of its ongoing proxy reform initiative. The first clarifies the responsibilities of investment advisers with respect to proxy voting and the employment of proxy advisory firms. The second addresses the application of the proxy rules to proxy voting advice given by those firms. Although Commissioner Hester Peirce noted that the guidance did not build a "new regulatory regime," the interpretations place proxy advisory firms on notice that the accuracy and reliability of their reports is paramount and seeks to leverage investment advisers to drive accountability of proxy advisory firms.
Proxy Voting Responsibilities of Investment Advisers
The first release addresses the responsibility of investment advisers in discharging their fiduciary duties to clients in the context of proxy voting, especially in evaluating proxy advisory firm recommendations. The guidance challenges a key operating assumption that partially motivates investment advisers' use of proxy advisory services, namely, that their fiduciary duties to vote in each client's best interests require them to vote on every issue at every annual meeting.
Specifically, the guidance explicitly provides that investment advisers are not required to vote on behalf of their clients on every issue or even at every meeting. In fact, an investment adviser may refrain from voting if such action is in a client's best interests or if the vote may not reasonably be expected to have a material effect on the value of a client's investment. Significantly, the guidance also explicitly states that investment advisers and their clients may customize their voting arrangements to define the scope of their voting authority and responsibilities. For example, clients may authorize the investment adviser to vote on specified matters, or according to management's recommendations, or may specify when the investment adviser should refrain from voting.
To us, this premise is important in the overall concept of voting a proxy. We believe that advisers may not fail to vote because it is difficult or impacts their profits, at least without express permission from clients (which, of course, could not be obtained in the real world). More importantly, by explicitly recognizing that investment advisers can take client instructions, it raises the question of whether they should do so. We believe the answer is a resounding "yes."
The guidance also makes clear that investment advisers cannot fulfill their fiduciary duties to make voting determinations in a client's best interests solely by relying on a third party's recommendations. Specifically, the mitigation of a potential conflict of interest would depend on how effective an investment adviser's steps were in insulating its voting decision from the potential conflict. Instead of just relying on a third party's recommendations, the investment adviser should consider several factors, including whether its internal policies and procedures allow it to consider additional information that may become available or whether the adviser must use a heightened degree of analysis on controversial or contested matters.
In our view, this SEC interpretation effectively prohibits so-called "robo-voting"—the submission of a substantial amount of proxy votes immediately after the release of proxy advisory firms' recommendations—especially on potentially contested matters, where a company can reasonably be expected to respond to a proxy advisor's negative recommendation through additional proxy materials. Further, in any vote, an adviser would not want to cast votes immediately following the release of a proxy advisory firm's recommendations because it could not know at that time if a company would release additional information, and the guidance states that it should consider any additional company information before voting.
The guidance also instructs investment advisers that consult proxy advisory firm voting recommendations to consider whether the firm has adequate capability to assess the relevant voting issues, a timely process to evaluate company feedback, sufficient disclosure of its methodologies, and acceptable procedures to handle conflicts of interests. The consideration of these factors will naturally lead investment advisers to monitor proxy advisory firms' processes and procedures more closely.
Interestingly, the guidance notes that adequate disclosure of conflicts of interests would include identifying whether a shareholder proposal proponent or "an affiliate of the proponent" is or has been a client of the proxy adviser. This raises the question of who qualifies as an affiliate—would a co-filer of a shareholder proposal, an entity aligned with the proponent through a special interest organization, or an entity receiving funding from the same source as a proponent be considered an affiliate? Additional SEC guidance may be necessary as investment advisers and proxy advisers consider how to meet their compliance obligations.
The new guidance also cautions investment advisers to take proactive steps to reasonably ensure that their votes are not based on materially inaccurate or incomplete information, and to evaluate specific aspects of proxy advisory firms' practices and procedures surrounding solicitation of company feedback and efforts to correct inaccuracies identified as a result. The guidance also directs investment advisers annually to review and document the adequacy of their policies and procedures to ensure they are casting votes in their clients' best interests. Accordingly, through this guidance, the SEC has addressed several of the primary complaints of companies about proxy advisory firms—factual inaccuracies; inconsistency and opacity in analyses, methodologies, and recommendations; a "one-size-fits-all" approach; and inadequate disclosure and mitigation of conflicts of interest.
Application of Proxy Rules to Proxy Voting Advice
The second interpretive release reiterates the SEC's view that the provision of proxy voting advice by proxy advisory firms generally constitutes a "solicitation" subject to the federal proxy rules (barring certain exemptions), including Rule 14a-9's prohibition against materially false or misleading statements. This reminder not only stresses the importance of accuracy in proxy advisory firms' reports in general (including opinions, reasons, recommendations, or beliefs that could be considered statements of material fact) but will also require proxy advisers to "show their work" for these disclosures.
In particular, the guidance suggests that it may be necessary for proxy advisory firms to explain the methodology they use to formulate recommendations, to cite to third-party information sources (including any material differences from the company's disclosures), and to disclose conflicts of interest in order to avoid potential Rule 14a-9 violations. Doing so would directly address concerns of companies that have questioned the validity of information sources underlying proxy adviser recommendations and that have encountered factual errors in proxy advisory firms' final reports.
The guidance may ultimately reach even beyond companies' complaints. It is unclear whether the SEC's interpretation of a "solicitation"—and therefore Rule 14a-9—extends to other communications intended to influence shareholders' voting decisions, such as proxy advisers' voting policies or similar communications from ESG rating firms.
Overall, the new guidance should spur proxy advisory firms to meaningfully increase the transparency of their processes and methodologies and to focus on the accuracy and company-specific aspects of their reports after dialogue with companies. The guidance encourages better engagement and will drive higher quality analysis, ultimately benefitting the retail owners whose savings are affected by the votes cast.
Corporate America will welcome the effort to address issues and challenges that companies have long raised, but it remains to be seen how investment advisers will implement this new guidance. Regardless, the releases reflect a key step in ensuring that shareholder votes are based on sound analysis, one that will hopefully precede additional actions consistent with the SEC's stated intentions, including a fresh look at the rules related to proxy solicitation exemptions relied upon by proxy advisers.
To us, this is a good first step toward addressing a fundamental flaw of the current proxy voting system. The vast majority of assets under management at the largest institutional advisers are derived from savers, not investors: teachers, factory workers, carpenters, and others who are trying to save money to pay for their children's educations, their own retirements, and similar long-term needs. These are "moms and pops" who want safe, stable returns, not hedge funds looking to wring every penny out of their assets under management, quarter after quarter, in order to obtain their "2 and 20" returns.
These investors do not want their advisers supporting proxy contests, takeover bids, and de-mergers, and they do not want companies to fire people to protect their quarterly profits every time the economy dips. They do want their companies to invest for the long term, and, most importantly, they want long-term stability and predictability—the opposite of the fundamental orientation of the major proxy advisory firms today, which are oriented to Wall Street, not Main Street.
It could be said that investment advisers should do their best to implement voting policies that their clients—the real owners here—want, and not follow the hot-money orientation now routinely followed by the major proxy firms.
Three Key Takeaways
- Investment advisers relying on proxy voting recommendations will need to consider the competency and adequacy of proxy advisers, including their resources, methodologies, and analyses, in order to fulfill their fiduciary responsibilities to clients.
- As proxy voting advice remains subject to Rule 14a-9's prohibition against materially false or misleading statements or omissions, proxy advisers will need to carefully consider and address the validity of their information sources and any holes in their analysis.
- The SEC has taken a significant step in its efforts to improve the proxy voting process, and we anticipate that further reforms focusing on topics such as shareholder proposal thresholds are on the horizon. We encourage the SEC to take additional steps to truly reform proxy voting in the United States.