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Hostilities resume between the SEC and institutional investors

Stephen Davis and Jon Lukomnik | June 28, 2016

for DeAnnIs it too late to revisit a prediction we made a year ago January? Back then we forecast that 2015 would feature “an unprecedented assault on proxy advisers.” Former SEC Commissioner Daniel Gallagher had been prodding corporations to hit ISS and Glass Lewis for inaccuracies in their reports and to use new SEC protocols in Staff Legal Bulletin 20 to bring complaints to his personal office. But while bitterness against the two advisers remained high in CEO suites, critics in 2015 never opted for the open warfare we had expected. We later speculated that hostilities failed to materialize because institutional investors undertook time-consuming efforts to meet new SEC rules on monitoring proxy advisers, while the advisers, in turn, beefed up their own internal quality controls and signed up to an industry code of professional behavior. They had made themselves less of a target. So we dutifully conceded a few months ago that we’d called it wrong.

Now it seems that we were just a touch early.

Titled beneficently “The Corporate Governance Reform and Transparency Act of 2016,” a bill poised for adoption by the U.S. House of Representatives, is little short of a corporate act of war on proxy advisers. And it is driving investors and companies back into bitterly opposing camps just as constructive engagement between institutional investors and corporate boards is becoming routine. HR 5311—championed by lawmakers otherwise best known for cutting government rulemaking—would impose a skein of regulations on firms that sell advice to institutional investors on proxy voting decisions. In practice, affected companies are industry leader Institutional Shareholder Services (ISS) and rival Glass Lewis. Other proxy advisory firms based abroad but with U.S. investor clients would also be covered.

Critics claim that the proposed rules are onerous enough to drive at least one adviser, and perhaps more, out of business, or out of the U.S. market. Those that remain would find their independence crippled, it is argued. And if the only survivor of the burdensome new red tape is ISS—a realistic scenario—it would have monopoly pricing and greater influence.

Just what does HR 5311 do? For starters, it is written to imply that proxy advisers are accountable to corporations they analyze. Second, language would give companies statutory authority to preview and have complaints addressed through new, mandated procedures before voting recommendations may be issued. This would represent direct complications for Glass Lewis, which does not circulate reports to companies before releasing them. But it would provide opportunities for companies to derail reports during the brief time periods investors need reports to review. Third, the bill would oblige all proxy advisers to register with the SEC and supply regular, public reports to the Commission including on internal features—such as compensation analysis methodologies—now considered proprietary. And fourth, it outlines a network of compliance requirements that would give the SEC wide new powers to shut down a proxy adviser in the event of even a single breach. Curiously, the bill does not require a cost-benefit analysis before coming into force, even though many of its proponents want the SEC to apply such a standard before issuing new rules in other spheres.

The political assumptions behind the outbreak of hostilities may be that time is running out: The new Congress convening in January may be much more responsive to the anti-corporate, anti-Wall Street sentiment welling up in the 2016 election season. But the current scramble to blockade investors comes with high risk.

Responding to earlier pressure, the SEC’s Staff Legal Bulletin 20, issued in June 2014, had already set standards regarding proxy advisers on conflicts of interest, disclosure, and accuracy of their analytical reports on companies. But in sharp contrast to HR 5311, which relies on SEC policing and new corporate rights, that document had opted for a market solution. It placed the onus for oversight squarely on the investment advisers that hire such proxy firms. Tackling the same issues, the SEC’s European counterpart, the European Securities and Market Authority (ESMA), concluded in 2013 that “there was no clear evidence of market failure in relation to proxy advisers’ interaction with investors and issuers,” but that issuers had nonetheless “raised a number of concerns regarding the independence of proxy advisers and the accuracy and reliability of their advice.” ESMA chose to press the industry to develop its own code of best practices rather than issuing new regulations. Last December it published a report finding positive progress using its approach.

But market solutions must not have been sufficient to dampen the hostility of U.S. corporates to proxy advisers. Thus HR 5311. Behind the scenes, proponents such as the U.S. Chamber appear to have mustered expert advice on how to take in congressional support even before opponents knew the bill existed. They lined up a bipartisan steamroller; the final tally at the House Financial Services Committee, on June 16, was 41 to 18, including eight Democrats. The bill now awaits floor action in the House, but there is as yet no Senate counterpart bill.

Defenders of proxy services coalesced too late to head off the Committee. But from formal letters and a recent off-the-record roundtable it is clear that HR 5311 has ardent opposition across the investor community—from asset managers to public sector funds. The Council of Institutional Investors spearheaded a collective letter to House Financial Services chair Jeb Hensarling (R-TX) arguing that “the bill could weaken public company corporate governance in the United States; lessen the fiduciary obligation of proxy advisers to investor clients; and reorient any surviving proxy advisers to serve companies rather than investors.” Ohio PERS wrote another: “Public companies have vast resources in place … we should have tools at our disposal to offer summary or alternative views prior to voting. Proxy advisory firms provide us that level of detail and support.” Opponents fear that curbing the proxy advisory industry could force up costs, either by creating a monopoly supplier, by compelling funds to duplicate proxy advisory research in-house, or by reducing their ability to speak out at underperforming companies. Either way, the penalty would be paid by retirees and savers.

Critics float another question: Would the restrictions contemplated in the bill pass First Amendment constitutional muster? It may be an impermissible restraint on free speech. Moreover, no other comparable body must obtain pre-approval from research targets. Wrote the CII: “Financial Industry Regulatory Authority (FINRA) rules specifically prohibit the same type of pre-review of financial analyst reports. We believe this right of pre-review will give company managements substantial editorial influence on reports on their companies, particularly combined with the threat of publication delay through the heavy-handed ombudsman construct …”

Indeed, recent voting results suggest the problem isn’t blind obedience to proxy advisory firms by investors, but blind obedience to corporate management recommendations. Consider, for example, that two recent shareholder proposals calling for environmental stress-testing at ExxonMobil and Chevron received 38.2 percent and 41 percent positive votes. Those were impressive totals, but not nearly as impressive as the 98.3 percent and 99.8 percent votes recorded at BP and Royal Dutch Shell. Given the global nature of the major integrated oil producers, they would seem to have similar shareholder bases and similar business challenges. What, then, accounts for the roughly 60 percent gap in voting results? Simply this: Managements at ExxonMobil and Chevron opposed the proposals, while those at BP and Royal Dutch Shell endorsed them.

The offensive on proxy advisers is one front in a sudden eruption of corporate efforts to reverse or block rules seen as favorable to investors. Corporate critics are stirring resistance to the PCAOB’s effort to require auditors to report in more detail on critical risks. They supported U.S. Senate and House votes to reject Department of Labor fiduciary duty reforms, though President Obama vetoed the action. They endorsed legislation to roll back Dodd-Frank Act measures; defund implementation of pay ratio disclosure rules, climate change disclosure mandates, and any future action to introduce universal proxy ballots; and impose new cost-benefit analyses requirements on the SEC (HR 5429), which the CII believes would “paralyze” the agency.

Why all this just now? The political assumptions behind the outbreak of hostilities may be that time is running out: The new Congress convening in January may be much more responsive to the anti-corporate, anti-Wall Street sentiment welling up in the 2016 election season. But the current scramble to blockade investors comes with high risk. These latest measures can be framed by critics as defending unpopular corporate interests. Indeed, the initiatives could wind up backfiring by further fueling public dismay with business and congressional allies, and even enhancing prospects of a still tougher environment for CEOs in Washington in 2017. Polarization is the currency of politics as the presidential election gains steam. But is the same approach constructive in capital markets, when companies and investors can use freshly-dug engagement channels to resolve disputes? Is it even rational, when institutional investors are the ones with responsibility to make voting judgments, not their advisers? Companies have made our 2015 prediction come true, albeit late, by starting this war. But we wish they hadn’t—and before long, they might be wishing the same thing.