The U.S. Securities and Exchange Commission (SEC) recently issued a concept release on the US proxy voting system in the United States that discusses, among other topics, the role and regulation of proxy advisory firms and proposed regulatory reforms related to them.

The SEC is considering and has requested comments as to whether the voting recommendations of proxy advisory firms serve the interests of investors, and whether the SEC should clarify existing regulations or propose additional regulations to address concerns such as conflicts of interest and the accuracy and transparency of proxy advisors’ development of voting recommendations. The SEC is seeking additional information from stakeholders on which to base its policy decisions, its assessment of the current regulatory environment, and its proposed solutions to the issues highlighted in the concept release.

The concept release is relevant not only for proxy advisors and US issuers, but also for Canadian issuers and their boards of directors for the following reasons:

  • As many Canadian proxy advisory firms are owned by US parents, new regulations in the US that affect the role or operations of proxy advisors will have an impact on how such firms conduct business in Canada.
  • Although they have not addressed the role and regulation of proxy advisory firms, the Canadian Securities Administrators are currently considering changes to the proxy voting system in Canada through proposed amendments toCommunication with Beneficial Owners of Securities of a Reporting Issuer. Due to this scrutiny of the proxy voting system, together with recent attention paid to proxy advisory firms in the media and potential impacts of US regulation, Canadian stakeholders and regulators will follow with interest the progress of the concept release and comments thereto.

Reliance on proxy advisory firms on the rise

The release notes a significant increase in investors’ reliance on recommendations from proxy advisory firms over the last 25 years. The SEC cites the growth in the percentage of shares owned by large institutional investors and their fiduciary duty to vote the shares they hold on behalf of beneficiaries as reasons for this increase. Due to the high volume of resolutions to vote on annually, the complexity of significant policy and corporate governance issues on which votes are cast, and the lack of time and resources to meet their fiduciary duties, institutional investors are increasingly reliant on proxy advisory firms for policy analysis and voting recommendations. As a result, proxy advisory firms have come to exert significant influence over voting.

Concerns regarding the role of proxy advisors

Two concerns discussed in the concept release are: (i) potential conflicts of interest or perceived conflicts of interest; and (ii) the level of accuracy and transparency in the manner in which voting recommendations are formulated.

Conflicts of interest

The concept release notes that the business models of some proxy advisory firms may give rise to the following conflicts:

  • The proxy advisory firm provides proxy voting recommendations to institutional investors and also provides consulting services to corporations seeking assistance with proposals to be presented to shareholders.
  • The proxy advisory firm provides corporate governance ratings on issuers to institutional clients while offering consulting services to issuers to help improve those ratings.
  • Owners or executives of the proxy advisory firm have significant ownership interests in or sit on the boards of directors of issuers with shareholder matters on which the proxy advisor is making voting recommendations.

In any of these situations there is the potential for conflicts of interest or the appearance thereof. If such conflicts are not adequately disclosed and managed, they can result in shareholders being misled, which could impair informed shareholder voting. Proxy advisors currently deal with this problem by creating firewalls between their investor and consultancy business lines and by disclosing general disclaimers that they may provide consultancy services to issuers on which they also provide proxy voting recommendations. However, the concept release considers whether additional measures are required.

In the concept release, the SEC outlines potential approaches it is considering to address perceived or actual conflicts of interest. These proposals include:

  • requiring more detailed disclosure by proxy advisory firms regarding the presence of a potential conflict of interest;
  • providing more guidance to proxy advisory firms who are also investment advisors regarding their fiduciary duty as investment advisors; and
  • adopting regulations similar to those that apply to credit rating agencies; for example, prohibiting certain conflicts of interest or requiring periodic disclosure of conflicts of interest and procedures to manage them.

The SEC specifically requested comment on whether it should revise the rule requiring proxy advisors to disclose to clients "any significant relationship" they have with issuers by requiring more specific disclosure regarding the presence of a potential conflict with respect to a particular proposal.

Lack of accuracy and transparency in formulating voting recommendations

The SEC noted that some commentators have expressed concerns related to accuracy or transparency in the formulation of voting recommendations by proxy advisory firms, including that:

  • voting recommendations by proxy advisory firms may be made based on materially inaccurate or incomplete data;
  • the analysis provided to an institutional client may be materially inaccurate or incomplete; or
  • recommendations may be based on a one-size-fits-all governance approach. Without addressing differences among issuers, a policy that would benefit some issuers but is less suitable for others may not receive a positive recommendation, thereby making it less likely to be approved by shareholders.

If voting recommendations are developed and made without adequate transparency and accountability for accuracy, informed shareholder voting may be impaired.

Potential regulatory measures being considered by the SEC to address the stated concerns include:

  • requiring proxy advisory firms to disclose the extent of research they conducted in making a particular voting recommendation, as well as the extent and effectiveness of controls and procedures in ensuring accuracy of issuer data;
  • requiring proxy advisory firms to disclose a communication policy that governs their interactions with issuers (both before the recommendation is made and afterward, allowing for an appeal process); and
  • requiring proxy advisory firms to file their voting recommendations with the SEC.

Request for Comment

The SEC has requested that comments be submitted on or before October 20, 2010, and does not place any restrictions on who may provide comments. The full text of the concept release can be found at, with the relevant sections found on pages 104 to 126. While the SEC has made a general request for comments, it has also requested comments on a list of 19 questions that include questions about services provided by proxy advisory firms, conflicts of interest, governance standards, the competitive structure of the proxy advisor market, use of voting recommendations by institutional investors, criteria and processes used in formulating voting recommendations and corporate governance ratings, and the form any additional oversight, if needed, should take.