In connection with the public roundtable on the proxy voting process (Roundtable) held by the staff of the Securities and Exchange Commission on November 15, 2018, the staff of the SEC’s Division of Investment Management (IM Staff) has partially withdrawn guidance relating to the use of proxy advisory firms by investment advisers.1 Specifically, the IM Staff withdrew the 2004 Egan-Jones Proxy Services (Egan-Jones) and Institutional Shareholder Services (ISS) no-action letters, on which many investment advisers previously relied to engage proxy advisory firms for both substantive and procedural assistance in fulfilling their proxy-voting responsibilities with respect to client securities.2
However, the IM Staff did not withdraw complementary guidance in Staff Legal Bulletin No. 20 (Proxy Bulletin),3 the status of which is instead expected to be determined as part of the Roundtable’s broader review of the role of proxy firms in the proxy process.4 Although the continued effectiveness of the Proxy Bulletin should limit the legal impact of the withdrawal of the Egan-Jones and ISS no-action letters at this time, stakeholders with views regarding the use of proxy firms by investment advisers may wish to develop and submit comments to the SEC for consideration in connection with the Roundtable.
This OnPoint reviews the applicable law and guidance with respect to the use of proxy advisory firms, as well as certain themes from the Roundtable’s panel discussion regarding proxy advisory firms. Note that, following the Roundtable, SEC Chairman Jay Clayton indicated that it would be a priority for the SEC to act on staff recommendations from the Roundtable process in 2019.5 In addition, on November 13, 2018, three Republican and three Democratic Senators introduced a bill in the Senate that would require the SEC to regulate proxy advisory firms as investment advisers under the Investment Advisers Act of 1940.6
Overview of the Proxy Rule and Related Guidance regarding Proxy Advisory Firms
The Proxy Rule
In 2003, the SEC adopted Rule 206(4)-6 (Proxy Rule) under the Investment Advisers Act of 1940, to integrate into the federal securities laws certain aspects of an investment adviser’s fiduciary obligations in the context of proxy voting.7 The Proxy Rule requires an investment adviser with proxy voting authority to implement policies and procedures reasonably designed to ensure that: the investment adviser votes proxies in the best interest of its clients; and such procedures provide for the ongoing identification and resolution of material conflicts of interest that may arise between the investment adviser and its clients.8 In the Proxy Rule adopting release, the SEC indicated that one method of resolving an investment adviser’s conflicts of interest with its clients would be for the investment adviser to base its proxy-voting decisions on the recommendations of an “independent third party” pursuant to a pre-determined policy.
The Egan-Jones and ISS No-Action Letters
Shortly after the adoption of the Proxy Rule, the IM Staff published the now-withdrawn Egan-Jones no-action letter to clarify the circumstances under which the IM Staff would consider a third party to be “independent,” such that an investment adviser’s reliance on its voting recommendations could “cleanse” that investment adviser’s conflicts of interest.9 The IM Staff explained that it would generally consider a third party to be independent “if that person is free from influence or any incentive to recommend that the proxies should be voted in anyone’s interest other than the adviser’s clients.” Furthermore, the IM Staff stated that an investment adviser intending to rely on such a third party’s recommendations “should take reasonable steps to verify that the third party is in fact independent ... based on all of the relevant facts and circumstances,” which steps would include, with respect to a proxy firm, performing sufficient due diligence as to the firm’s independence and implementing procedures to address any conflicts of interest that may arise on an ongoing basis in connection with the proxy firm.
Following Egan-Jones, the IM Staff published the now-withdrawn ISS no-action letter to clarify the level of due diligence an investment adviser could reasonably perform to ascertain a proxy firm’s independence. According to the ISS no-action letter, reasonable due diligence under the Proxy Rule would not necessarily involve the investment adviser’s “case-by-case evaluation of a proxy voting firm’s potential conflicts of interest” but could instead consist of “a thorough review of the proxy voting firm’s conflict procedures and the effectiveness of their implementation.”10 Although the IM Staff cautioned that the appropriate level of due diligence would ultimately “depend[ ] on all of the relevant facts and circumstances” concerning a proxy firm and its potential conflicts, the ISS no-action letter was understood by many stakeholders to have facilitated, together with Egan-Jones, a compliance framework that permitted investment advisers facing conflicts of interest to substantially rely on proxy firms in fulfilling their proxy-voting responsibilities under the Proxy Rule, provided that the advisers could satisfy themselves as to the adequacy of the firms’ conflicts procedures. Some stakeholders interpreted the letters as having a greater impact, arguing that they facilitated the “delegation” by some advisers of their proxy voting responsibilities to proxy advisory firms.
Policy Questions and the Proxy Bulletin
Since its establishment in the 1980s, the proxy firm industry had been focused in a few firms, primarily the recipient of the ISS no-action letter, Institutional Shareholder Services, Inc. (ISS), and Glass, Lewis & Co., LLC (Glass Lewis), which ultimately has grown into ISS’s largest competitor. The consolidation of proxy advisory services in ISS and Glass Lewis led many corporate issuers to express the view that these firms held unduly significant and unaccountable influence in corporate elections and governance matters. Some observers viewed the continued growth and influence of proxy firms as a partial consequence of the Egan-Jones and ISS no-action-letters.
Partly in response, the SEC issued a 2010 concept release (Concept Release) seeking public comment on a number of issues that had been raised regarding the proxy system.11 In particular, the Concept Release inquired into: (i) the potential conflict of interest of proxy firms – like ISS – that provide both voting recommendations to investors and corporate governance consulting to issuers; (ii) the risk that voting recommendations may be based on flawed analyses or data; and (iii) the potential concern that proxy firms may base recommendations on an improper “one-size-fits-all” governance approach. Following a hearing on the influence of proxy firms held by the House of Representatives Financial Services Subcommittee in June 2013 – at which former SEC Chairman Harvey L. Pitt, advocating on behalf of the U.S. Chamber of Commerce, claimed that “ISS and Glass Lewis ha[d] become the de facto standard setters for corporate governance policies in the U.S.”12 – the SEC held a public roundtable in December 2013 to further discuss the policy questions that had been raised regarding use of proxy firms by investment advisers.
Subsequently, in July 2014, the IM Staff issued the Proxy Bulletin, which does not rescind but instead effectively restates the duties set forth in the Egan-Jones and ISS no-action letters with greater specificity and additional considerations. Citing to the now-withdrawn letters in approval, the Proxy Bulletin reaffirms that investment advisers that retain proxy firms should (i) implement policies and procedures to identify and address any conflicts of interest of the retained proxy firms and (ii) perform reasonable due diligence on proxy firms, including a thorough review of a proxy firm’s conflicts procedures and a review of any material changes thereto on an ongoing basis.13
Furthermore, in apparent response to corporate issuers’ expressed view that proxy firms’ voting recommendations may be based on flawed analyses or data, the Proxy Bulletin states that an investment adviser retaining a proxy firm should ascertain that the firm has the ability and competence to adequately analyze proxy issues. This includes the firm’s ability to make recommendations based on materially accurate information (i.e., to conduct reasonable (and ongoing) due diligence that would include a review of whether the proxy firm’s policies and procedures adequately ensure that recommendations are based on current and accurate information).14
The Proxy Bulletin also indicates that an investment adviser wanting to demonstrate compliance with its proxy policies and procedures may consider periodically back-testing samples of proxy votes cast on behalf of its clients, especially “a sample of proxy votes that relate to certain proposals that may require more analysis.” In sum, the Proxy Bulletin provides additional considerations and more specific due diligence requirements relating to investment advisers’ use of proxy firms, but does not otherwise change the compliance framework introduced by the Egan-Jones and ISS no-action letters.
The November 2018 Roundtable
Public issuers’ expressed concerns regarding proxy firms are currently a focus for the SEC and its staff,15 as well as for other government agencies.16 In July 2018, Chairman Clayton announced the Roundtable on the proxy voting process and advised the IM Staff to include the following topics in the Roundtable’s agenda:
- Whether current legal requirements have resulted in overreliance on proxy firms by investment advisers;
- Whether corporate issuers have an appropriate opportunity to contest proxy firms’ recommendations, especially when a recommendation is based on flawed information;
- Whether proxy firms are adequately transparent regarding their voting policies and procedures, such that stakeholders (including corporate issuers) may understand how proxy firms have formulated their particular recommendations;
- Whether proxy firms cause a conflict of interest by providing both voting recommendations to investors and corporate governance consulting to issuers or other conflicts of interest, and, if so, whether such conflicts are adequately disclosed and mitigated; and
- The appropriate regulatory regime for proxy firms and whether the Egan-Jones and ISS no-action letters, as well as the Proxy Bulletin, should be modified, rescinded or supplemented.
As noted above, the IM Staff withdrew the Egan-Jones and ISS no-action letters in September but did not jointly withdraw the Proxy Bulletin, which will remain in effect pending further consideration as part of the Roundtable process. Although the continued effectiveness of the Proxy Bulletin should limit the legal impact of withdrawing the no-action letters at this time,17 stakeholders with views regarding investment advisers’ use of proxy firms under the Proxy Rule may want to develop and submit comments to the SEC for consideration in connection with the Roundtable, as well as review comments submitted by other stakeholders. The SEC Commissioners and IM Staff present at the Roundtable’s panel discussions solicited additional comments to be submitted after the Roundtable.
A number of themes emerged from the Roundtable’s panel regarding the use of proxy firms, as follows:
- The panelists, which included (among others) representatives from the investment adviser, institutional investor, proxy firm and public issuer industries, generally recognized the important role that proxy firms serve in facilitating work-flow management and data aggregation and analysis for investment advisers and institutional investors.
- The potential concern that proxy firms may base recommendations on an improper “one-size-fits-all” governance approach was generally not supported by the panelists, including with respect to the representatives of public issuers; and the representatives from investment advisers, institutional investors and proxy firms generally attested that the services and processes currently provided by proxy firms are sufficiently tailored to their firms and are holding-specific.
- The primary concern expressed by the representatives of public issuers regarded the lack of a defined, consistent and viable process to correct factual errors that may influence recommendations or reports from proxy firms to their clients. The proxy firm representatives were generally receptive to this concern and discussed processes whereby public issuers could access and dispute factual errors in data before the issuance of a related recommendation or report. However, the proxy firm representatives stressed that access to such data would be provided only in a manner that would not compromise the forthcoming recommendation or report by giving public issuers advance notice of the proxy firm’s judgments or conclusions.
- The panelists generally recognized that it may be difficult to fully distinguish between factual errors made by proxy firms (which the proxy firm representatives suggested were, in any case, few) and subjective disagreements of judgment between proxy firms and public issuers. An investment adviser representative suggested that the burden of correcting such subjective disagreements may better lie with public issuers, who are able to communicate and address these disagreements directly with their shareholders prior to voting, as opposed to providing public issuers greater involvement in the preceding process of developing proxy firm recommendations, which could serve to diminish the independence of proxy firms.
- In addressing the potential conflict of interest of proxy firms that provide both voting recommendations to investors and corporate governance consulting to issuers, the panelists generally did not dispute that there are currently sufficient controls and disclosures to investment advisers and institutional investors in place to mitigate this conflict of interest. However, an investment adviser representative queried whether the SEC considers this the type of conflict that may be cured by disclosures, and a public issuer representative further considered that it may be appropriate for these disclosures to be broadened and provided in some manner to the clients of investment advisers and beneficiaries of institutional investors as well.
- When prompted, no panelist advanced the prospect of specific changes to the Proxy Rule or Proxy Bulletin. Investment adviser and institutional investor representatives expressed the concern that regulatory changes could lead to increased costs, the diminished independence of proxy firms and compressed timeframes for consideration of a proxy firm’s recommendation, if public issuers were offered the opportunity to in any way rebut the recommendation before it is issued. Furthermore, investment adviser representatives suggested that increased costs may simply lead to less proxy voting and engagement overall, as investment advisers are not mandated to vote their clients securities under the Proxy Rule. Although public issuer representatives did not offer any specific regulatory changes in this regard, a representative noted that, if the Roundtable ultimately does not produce any change to the current process, there may be a need to revisit these issues through legislation.
- Former Senator Gramm of Texas, on behalf of the American Enterprise Institute, argued that a conflict of interest exists with respect to the involvement of proxy firms and investment advisers in voting client securities on what he described as special interest issues, such as labor or social reform matters. He argued that the impact of these matters on the value of a client security may be unclear but that the vote may nonetheless advance the marketability of the proxy firm or investment adviser. He suggested that the SEC clarify that investment advisers are not required to vote client securities and that they should vote client securities only when consistent with their fiduciary duties to act in the best economic interest of their clients.
Anticipated Action in 2019
As noted above, following the Roundtable, Chairman Clayton stated in a speech on the SEC’s 2019 agenda that the SEC would act on staff recommendations concerning proxy firms sometime next year. Chairman Clayton expressed his view that “some changes are warranted” in this regard, such as (i) clarifying the appropriate relationship between investment advisers and proxy firms and (ii) requiring investment advisers to use (and thus proxy firms to generally provide) holding-specific analytics in connection with certain proxy matters.18 Additionally, Chairman Clayton stated that the Commission should consider issues related to “the framework for addressing conflicts of interest at proxy advisory firms.” Chairman Clayton did not appear to suggest that public issuers should have a more direct role or input into proxy firms’ processes. He asked instead whether shareholders currently have “effective access” to a public issuer’s potential response to information in a recommendation.
The public issuer community and its representatives will likely continue to press the SEC, other government agencies and Congress on the further regulation of proxy firms. It should be noted again, for instance, that three Republican and three Democratic Senators have introduced a bill titled the “Corporate Governance Fairness Act” that would subject proxy firms to registration as investment advisers and periodic examination by the SEC.19