After a unanimous vote at its June 14, 2010, open meeting, the Securities and Exchange Commission issued a Concept Release on the U.S. Proxy System (Release Nos. 34-62495; IA‑3052; IC‑29340), commonly referred to as the “proxy plumbing concept release.” The Concept Release can be found at: http://www.sec.gov/rules/concept/2010/34-62495. pdf.
The Concept Release considers the proxy system as a whole, provides background on the current proxy distribution and voting process, and discusses the following three topics:
- Accuracy, transparency and efficiency of the voting process;
- Communications and shareholder participation; and
- Relationship between voting power and economic interest.
The Concept Release requests comments with regard to these topics, as well as general comments or concerns related to the proxy process. The SEC noted the inter-related nature of the various aspects of the proxy system and requested that commenters consider additional consequences of changes to one aspect of the system. The comment period is open until October 20, 2010. The SEC website has posted over 40 comment letters to date, and certain Commissioners have met individually with commenters.
Many have noted that the Concept Release is not likely to result in large-scale rule changes in the near future. The SEC has a large rule-making workload as a result of the Dodd-Frank Act, and the Concept Release is the first step in a comprehensive fact-gathering process with a goal of eventually reforming and fine-tuning the U.S. proxy system.
Accuracy, Transparency and Efficiency of the Voting Process
Over-Voting and Under-Voting
In this section, the Concept Release describes how brokers and other securities intermediaries sometimes credit their client accounts with more votes than the clients actually hold through DTC or in other ways. These discrepancies can occur when a selling broker “fails to deliver” on a trade because the clearing agency will allocate the failure to an arbitrary buying broker. Although that broker will not actually be credited for the shares through DTC, it will credit its customer accounts. Discrepancies can also occur due to securities lending, which occurs when customers buy shares on margin and the broker has the right to lend the shares (along with the associated voting rights). The customer is generally not notified that its shares have been loaned and, therefore, may assume it has the right to vote those shares.
The Concept Release considers two main reconciliation methods and acknowledges that some brokers use a hybrid approach to reconcile the discrepancies between the number of shares credited to customer accounts and the number of shares actually held through DTC. These methods are currently not regulated and, therefore, a broker-dealer will tend to reconcile in the manner advantageous to the particular firm or its client base.
In a pre-reconciliation method (generally used by brokers with more institutional investors), a broker will allocate its total permitted votes to its customers before sending voting instruction forms (VIFs). The advantage to this method is that all votes cast by the broker’s customers are counted and covered by the broker’s permitted votes for shares held at DTC. The disadvantages are that it can be a more expensive method for brokers to implement and the votes of the broker can be under-utilized if customers allocated votes do not return instructions (called “under-voting”). Companies concerned about obtaining a quorum, especially after the revisions to NYSE Rule 452 further limiting discretionary voting by brokers, may not advocate this method because of the risk of under-voting.
In a post-reconciliation method (generally used by brokers with more retail investors), a broker will receive VIFs from its customer accounts and then determine whether the votes actually submitted by its customers outnumber the votes that broker is credited on its position listing with DTC. This method may be less costly because the broker does not need to go through the process of allocating votes among its customers unless it receives VIFs for more shares than in may vote in the aggregate.
In both the pre-reconciliation and post-reconciliation methods, brokers holding proprietary accounts in the issuer’s stock may forego their own vote of those shares in order to credit their customer accounts with a greater number of votes.
The Commission requests comment on whether brokers should disclose their reconciliation process and which method is best suited to protect investors’ interests, including whether brokers should allocate the votes from their proprietary accounts to customers and whether votes should be allocated to fully paid securities before those purchased on margin.
The Concept Release discussed the concern of some beneficial owners that they are unable to confirm that their votes have been timely received and accurately recorded by the vote tabulator. Beneficial owners cast votes through a broker or other intermediary, which uses a proxy service provider to send the votes to the vote tabulator. The participation of multiple parties in the process, where no single participant has all of the information necessary to confirm a particular beneficial owner’s vote, makes it impossible under the current regime to confirm any individual beneficial owner’s vote.
The SEC noted that this lack of transparency could impair confidence in the proxy system. Some might argue, however, that investors have a competing interest in maintaining the anonymity of their identity and voting record. As a potential regulatory step, the Concept Release suggests an anonymous tracking ID for objecting beneficial owners and requested comment on various other aspects of this issue.
Voting by Institutional Securities Lenders
Institutional investors will often lend out their shares in order to earn more income. The voting rights to these shares are generally transferred with the loan. As a result, in order to vote the shares on any material proposals, the institutional lender must terminate the loan and get the securities back from the borrower. A timing issue arises, however, because issuers are not required to disclose the meeting agenda in advance of the record date. As a result, institutional lenders may be unable to determine when and whether to recall the shares in order to have the right to vote the shares as of the record date.
A proposed response would be to incorporate an agenda, which may be subject to change, into the existing NYSE and other SRO requirements for advance notice of a record date and make the agenda publicly available. Alternatively, issuers could be required to disclose agendas on a Form 8-K, in a press release, or on a website posting.
The Commission also requested comment on whether investment companies should be required to disclose the percentage of shares beneficially owned by a fund that were actually voted (as opposed to those shares that were lent to another party).
One of the Concept Release topics that has garnered numerous comments is the discussion of proxy distribution fees. Issuers are required to reimburse brokers and other securities intermediaries for the reasonable expenses of distributing proxy materials to beneficial owners. Brokers usually use a proxy service provider to distribute the materials, and the service provider often bills the issuer directly. An issuer has no control over the selection of the proxy service provider or the fees negotiated or incurred through the proxy distribution process. The NYSE and other SROs have a set fee schedule of maximum reimbursement rates, and these are the rates that are commonly charged. Many issuers are concerned that the fees charged are not reasonably related to the actual costs of proxy solicitation and, therefore, do not reflect reasonable reimbursement. In addition, the NYSE and other SROs have not adopted a maximum fee schedule for a notice and access delivery model, and a number of issuers have expressed concern about fees charged when an issuer elects to use notice and access.
The Commission expresses its view in the Concept Release that this would be an appropriate time for the NYSE and other SROs to examine the existing fee schedule to determine whether it continues to reasonably reflect the actual costs of proxy solicitation. The Concept Release also suggests that an alternative approach is the creation of a centralized data aggregator that has access to information from all securities intermediaries regarding the beneficial owners of an issuer’s securities. These records could be transferred to an agent of the issuer, which would serve as the distributor of the proxy materials. This would allow the issuer to choose the proxy service provider and create a more competitive marketplace.
Some of the comments received to date indicate that public companies consider the lack of competition and the fee structure unfair. One commenter stated, “Companies should be able to select the distributors of their communications and should not be forced to pay for a system in which proxy fees and intermediary services are determined by third parties.” Another commenter submitted a copy of a letter to FINRA dated July 2009, arguing that the expense charged by a service provider was unreasonable because the fee was based on the distribution to 3,349 beneficial owners but resulted in only 9 submitted votes.
Communications and Shareholder Participation
Issuer Communications with Shareholders
The Concept Release also addressed communications with shareholders who hold shares through a securities intermediary (“in street name”) and the challenges issuers face in reaching those shareholders. The use of a centralized netting facility and depository is considered essential in order to process the $1.48 quadrillion dollars in annual transactions in the U.S. markets but creates obstacles to communication between issuers and the beneficial holders of their stock. Investors who hold shares in street name elect status as either an objecting beneficial owner (OBO) or a non-objecting beneficial owner (NOBO). OBOs are estimated to account for 52 percent to 60 percent of all public company shares. Some brokers may use this as the default status when opening new accounts. Issuers may request lists of NOBOs in order to communicate directly with those shareholders; however, the expense of obtaining these lists can be prohibitive for widely held public companies.
The Concept Release discusses suggestions such as the 2004 Business Roundtable proposal to eliminate OBO status completely, creating a more direct and efficient communication process between issuers and their shareholders. Under this proposal, shareholders who wished to remain anonymous to the issuer would incur the cost of holding shares through a separate nominee. Advocates of this proposal have also suggested segregating the functions of beneficial owner data aggregation and proxy communications distribution. This would allow issuers to choose proxy service providers and encourage competition, as discussed above in the distribution fee section.
The Altman Group, a proxy solicitation and corporate governance consulting firm, has suggested a more iterative change in the rules, which would require that the identity of all beneficial owners be made available to issuers once a year, in preparation for the annual meeting. Additionally, suggestions to increase investor education regarding the election of OBO status or a requirement to renew the election were mentioned in the Concept Release.
The SEC also recognized that the elimination of OBO status (either completely or once annually) may infringe on the privacy rights of investors. For example, institutional investors may elect OBO status in order to protect competitive information such as investing strategies.
Retail Investor Participation
The SEC noted the historically low levels of retail investor voting, which has recently been compounded by the NYSE prohibition on broker discretionary voting in uncontested director elections and the increased number of companies using majority voting. The result for some companies is difficulty obtaining either a quorum or necessary votes for directors in a majority voting system. The SEC noted that some people have argued the new notice and access rules, allowing website posting of proxy materials, have resulted in an even further decline in retail participation.
Several methods of increasing retail participation are discussed, including many webbased information sources. These include the SEC’s own addition to its website at www.investor.gov/proxy-matters, suggestions that broker websites should include information regarding upcoming proposals and the related proxy materials, creation or improvement of online forums designed to encourage discussions among investors of upcoming issues for a vote, and improved use of the internet to distribute proxy materials.
The most controversial proposal to increase retail participation discussed in the Concept Release is advance voting instructions (also referred to as “client directed voting”). Under this suggestion, when an investor opens an account with a broker, they would give advance voting instructions that would guide the broker’s vote of their shares on all upcoming matters. The instructions could include: voting in accordance with (or against) the board’s recommendations; voting in accordance with a particular interest group or proxy advisory firm’s policies; or voting in proportion to the broker’s instructed votes. The instructions could be revoked at any time or with regard to any particular issue or proposal.
This type of system is currently prohibited by the proxy rules and creates a tension with the policy objective of obtaining informed investor votes. The Concept Release notes that instructions may be more or less detailed. More specific voting instructions may be more likely characterized as an informed vote. For instance, indicating a particular subject matter, such as corporate governance or executive compensation, where the instructions are to vote in accordance with an interest group or proxy advisory firm’s policies, would make the grant of discretion less broad and lessen concerns about uninformed votes.
The Concept Release also discusses the potential to require or allow data-tagging, similar to the recently implemented XBRL rules for financial statements and other information, in order to expedite investor access to the information contained in proxy materials. The SEC requests comment on which parts of the proxy materials, if any, are best suited for data-tagging.
Voting Power and Economic Interest
The separation of the voting rights from an economic stake in the issuer and the resultant misalignment of voting power has been a matter of concern in recent years.
Proxy Advisory Firms
The Concept Release examines the role of proxy advisory firms in influencing shareholder votes. Proxy advisory firms are often used by institutional investors to analyze and recommend voting positions on proposals for shareholder vote, including director elections, shareholder proposals and board-recommended corporate actions. These same proxy advisory firms also serve as consultants to issuers to help recommend corporate governance practices. The Concept Release notes that RiskMetrics Group (recently acquired by MCSI, Inc.) is generally noted to be the dominant firm in the industry and requests comment on the effects of this lack of competition.
The Concept Release considers two issues around proxy advisory firms – conflicts of interest and lack of transparency or accuracy. Given its dual role, a proxy advisory firm may have a conflict when it issues a recommendation to institutional investor clients and simultaneously serves as a consultant on the same matter for its issuer client. A conflict can also exist if the proxy advisory firm rates issuers’ corporate governance and is hired by issuers to advise on corporate governance practices. One proposed approach to this problem is to change the exemption for proxy advisory firms from the proxy rules and require specific disclosure regarding the presence of a potential conflict. The Concept Release also suggests interpretive guidance requiring more thorough disclosure of any relationship (such as consulting services) with the issuer or other interested party.
The second issue is that proxy advisory firms may make recommendations on materially inaccurate or incomplete information. The Concept Release mentions several approaches that may address this concern, for example, requiring that issuers be shown a draft of the recommendation before it is finalized to review for errors or requiring proxy advisory firms to disclose certain information regarding its recommendations.
The SEC seeks comment on the role of proxy advisory firms and the types of regulation needed to protect investors, whether issuers are influenced by proxy advisory firms’ recommendations to modify or change proposals or adopt specific governance policies, and whether existing procedures by proxy advisory firms are sufficient to ensure recommendations are based on accurate and complete information.
Dual Record Dates
The Concept Release addresses the 2009 change to Delaware corporate law allowing separate record dates for notice of meetings and the right to vote at the meetings. Under this new law, the record date for the right to vote shares can be the same day as the meeting. Issuers may be inhibited from using this optional aspect of Delaware law because current proxy rules require materials to be made available to shareholders entitled to vote in advance of the meeting.
The Concept Release recognizes the pros and cons of changing its rules to allow issuers to implement a separate record date for voting rights set closer to the meeting. Two record dates may allow meetings where more of the voting shareholders also have an economic interest in the issuer. (With one record date, when trades occur between the record date and the meeting, some voters no longer hold an economic stake in the issuer.) On the other hand, inadequate time for investors to receive and consider proxy materials may lead to uninformed voting decisions. The SEC requests comment on whether to allow dual record dates and, if so, to whom proxy materials should be distributed – shareholders entitled to notice of the meeting or those entitled to vote at the meeting.
Empty Voting and Decoupling
The final topic addressed in the Concept Release is the issue of empty voting – where the person or entity holding the right to vote shares in an issuer does not also hold an economic interest in the issuer and, therefore, may not be assumed to be voting with the goal of increased shareholder value, which is a foundational assumption in the operation of U.S. corporate governance. In fact, some voters may benefit if the share price of the issuer decreases. Economic and voting rights can become separated or “decoupled” in various ways: when investors lend their securities (and the associated voting rights); when shareholders engage in hedging transactions, such as credit derivative swaps or put options; when trading occurs between the record date and meeting date; and when a plan trustee votes an employee stock ownership plan’s unallocated shares.
The SEC requests comment on the ways in which decoupling can occur and the nature and extent of that decoupling and the effects on shareholder voting. The SEC also asks for comment as to whether the beneficial versus detrimental effects of decoupling can be identified and disclosed. Proposed regulatory responses include required disclosure by investors holding empty voting power (based on the premise that disclosure would allow other investors to recognize the importance of their own vote and encourage more participation) and a more drastic proposed change to allow investors to vote by proxy only to the extent of their net long position, or their net economic position in the issuer’s equity.
While the comments solicited by the Concept Release are still coming in, the SEC is undertaking the first step toward systemic reform. As a broad overview of the proxy system, the Concept Release contains some general recurring themes. These themes include an emphasis on greater disclosure requirements, as opposed to regulatory responses that directly address the issues at play – for instance, disclosure by brokers of which reconciliation method they use, disclosure by proxy advisory firms of potential conflicts of interest, and disclosure by investors of empty-voting positions. Another theme is the repeated tension between encouraging a greater voting percentage (improving retail participation, decreasing the risk of under-voting, allowing dual record dates) and the policy objective of informed investor votes.