Weeks ahead of a Nov. 15 roundtable the Securities and Exchange Commission has scheduled “to hear investor, issuer, and other market participant views about the proxy process and rules,” Chairman Jay Clayton has already dropped a bombshell on proxy advisors and the investment firms that pay for their advice and recommendations.
On the morning of Sept. 14, Clayton, appearing at the monthly meeting of the SEC’s Investor Advisory Committee, released a statement announcing that, in connection with the forthcoming roundtable, the Division of Investment Management was withdrawing two 2004 “no-action” staff letters issued to Egan-Jones Proxy Services and Institutional Shareholder Services, governance and proxy advisers.
The letters, critics say, have long since allowed asset managers to skate past potential conflicts of interests by using third-party recommendations when casting annual meeting votes on behalf of shareholders who invest through their firm or its funds.
“In developing the agenda for the roundtable, the staff has been considering (among other topics) whether prior staff guidance about investment advisers’ responsibilities in voting client proxies and retaining proxy advisory firms should be modified, rescinded, or supplemented,” the Division of Investment Management wrote, reiterating another recent Clayton policy statement that, “staff guidance is non-binding and does not create enforceable legal rights or obligations.”
“Taking into account developments since 2004, the staff has determined to withdraw these letters, effective today,” the Division wrote.
An ongoing debate
To glean a better understanding of why these two staff letters are responsible for so much hand-wringing and vitriol, it is helpful to turn back the clock a bit, to the tenure of former SEC Commissioner Daniel Gallagher, a vocal critic of the “outsized role of proxy advisers.”
During a speech to the Center for Financial Markets and Policy on Oct. 30, 2013, he stressed “the need for the Commission to devote more attention to the role of proxy advisers.”
“In case anyone doubts the influence and power of the two largest proxy advisory firms, one need only look at the numbers. ISS and Glass Lewis control close to 97 percent of the market,” he said. “So how did this duopoly of proxy advisers gain such an outsized role? I’m afraid to say that the disproportionate power they wield is, in large part, an unintended consequence of the SEC’s actions.”
In 2003, the SEC adopted new rules and amendments requiring an investment adviser that exercises voting authority over its clients’ proxies to, among other things, adopt policies and procedures reasonably designed to ensure that it votes those proxies in the best interests of its clients.
A stated goal of the Commission in adopting this rule was to address an investment adviser’s potential conflicts of interest when voting a client’s securities on matters that affected its own interests, Gallagher explained.
In the adopting release, the Commission noted that “an adviser could demonstrate that the vote was not a product of a conflict of interest if it voted client securities, in accordance with a pre-determined policy, based upon the recommendations of an independent third party.”
“If the new rule was the proverbial camel’s nose poking into the tent, what followed was the equivalent of a herd of camels trampling down the tent and eating it,” Gallagher said. “Proxy advisers were quick to ask the SEC staff for guidance and clarity with respect to the new rule. The resulting pair of staff no-action letters effectively blessed the practice of investment advisers rotely voting the recommendations provided by proxy advisers, thereby, creating a de facto—but to be clear, not de jure— safe harbor.”
In one letter, for example, SEC staff advised that “an investment adviser that votes client proxies in accordance with a pre-determined policy based on the recommendations of an independent third party will not necessarily breach its fiduciary duty of loyalty to its clients, even though the recommendations may be consistent with the adviser’s own interests.”
The same letter also addressed the question of whether a proxy voting firm would be considered independent if it received compensation from an issuer for providing advice on corporate governance issues. The staff found that the mere fact that a proxy voting firm provided advice and received compensation from an issuer for its services “generally would not affect the firm’s independence from an investment adviser.”
“Taken together, the new rule and no-action letters offered a get-out-of-jail-free card to investment advisers,” Gallagher said. “All they had to do was to pay for and carry out a proxy adviser’s recommendations, and potential conflict of interest issues just wilted away. Rather than encouraging investment advisers to employ their own judgment to address and minimize any potential conflicts of interests in voting their clients’ proxies, which everyone should expect from a fiduciary, the letters cleared the way for investment advisers to shift the responsibility for those votes to third parties [that] have their own, potentially greater, conflicts of interests.”
“By exploiting the market for proxy advice, proxy advisory firms have shown way too often that they are more focused on pushing special interest agendas rather than serving investors.”
Jeb Hensarling, Chairman, House Financial Services Committee
The result of these two letters “has been to unduly increase the role of proxy advisory firms in corporate governance,” he added. “Rote reliance by investment advisers on advice by proxy advisory firms in lieu of performing their own due diligence with respect to proxy votes hardly seems like an effective way of fulfilling their fiduciary duties and furthering their clients’ interests.”
In another speech that year, to the Society of Corporate Secretaries & Governance Professionals, Gallagher expressed concern that checking compliance boxes was substituted for fiduciary responsibilities.
“The last thing we should want is for investment advisers to adopt a mindset that leads to them blindly casting their votes in line with a proxy adviser’s recommendations, especially given the fact that such recommendations are often not tailored to a fund’s unique strategy or investment goals,” he said.
Gallagher, then and since, has urged the SEC to withdraw the two staff letters replacing them with Commission-level guidance or rulemaking “to ensure that investment advisers are complying with the original intent of the 2003 rule and effectively carrying out their fiduciary duties.”
The withdrawal of the no-action letters was applauded by those who lament the growing power and ubiquity of proxy advisors.
“The proxy advisory firm duopoly is in serious need of reform and SEC attention,” said House Financial Services Committee Chairman Jeb Hensarling (R-Texas). “The market power of proxy advisory firms demands greater accountability for these firms’ actions and the information that they provide institutional investors. Time and again, we’ve seen their recommendations riddled with errors, misstatements of fact, and incomplete analysis. By exploiting the market for proxy advice, proxy advisory firms have shown way too often that they are more focused on pushing special interest agendas rather than serving investors.”
“The news out of the SEC is encouraging,” he added.
“It looks like the SEC, in seeking to significantly reduce the potential for proxy advisers generating recommendations that are influenced by conflicts of interest, wants to put more responsibility for the monitoring of these conflicts on the shoulders of the investment advisers, the ones ultimately responsible for shareholder voting,” said Bernie Sharfman, chairman of the advisory panel for Main Street Investors Coalition, a coalition of national financial, retirement, and manufacturing associations.
The SEC’s actions offer “a major victory,” said National Association of Manufacturers President and CEO Jay Timmons.
“For far too long, proxy advisory firms have exerted undue influence over manufacturing companies, trying to force business decisions without any regard to investors’ best interests,” he said. “This is a threat not only to manufacturing growth, but also to the savings of millions of American workers. The SEC has taken an important step to fix this unfairness … and ensure the voices of Main Street investors are not drowned out by third parties who have little stake in a company’s success.”
Tim Doyle, vice president and general counsel of The American Council for Capital Formation, had similar praise.
“It’s certainly a great first step toward genuine reform of the way these proxy advisory firms have exerted their influence over corporate governance matters,” he said in a statement. “The conflicts of interests between offering both ratings and consulting services, coupled with a lack of allowable input from companies they rate and an overall lack of transparency, had given these firms unintended influence over the shareholder proposal process. Hopefully, the withdrawal of these letters will refocus attention on the fiduciary duty owed to investors.”
Expect a fight
There is hardly unanimity, however, regarding Clayton’s views, the Division of Investment Management’s actions, and how both should play into the upcoming roundtable.
Glass Lewis, thus far, is the first proxy advisory service to offer an official response.
“While the SEC withdrew these no-action letters, the law in this area has not changed,” wrote Nichol Garzon, the forms senior vice president and general counsel. “Indeed, it has always been the law that an investment adviser, as a fiduciary to its clients, is required to take steps to avoid having a conflict of interest influence its decisions on behalf of clients.”
Investment advisers who vote proxies on behalf of their clients generally “follow policies and procedures that address how to vote proxies when the adviser has a conflict, and they are required to disclose these policies to their clients,” he added. These can include:
abstaining from voting, and giving the power to vote to the client;
following a predetermined voting policy that dictates how the adviser shall vote on particular matters;
appointing an independent third party to cast the vote on its behalf; or
voting in accordance with the recommendation of an independent third party.
“While Glass Lewis works with each client to implement the client’s respective proxy voting policy on Glass Lewis’ Viewpoint vote management platform, the formulation of the actual policy is at the sole discretion of the client,” Garzon added. “Glass Lewis does not have the discretion to deviate from a client’s instructions or to determine a vote that is not consistent with the policy specified by the client.”
The SEC’s guidance, he argued, does not explicitly state or suggest that an investment adviser must manually vote all the proxies it receives, or that it must reiterate its voting policies after each proxy statement it receives.
“Glass Lewis strongly believes that investors and issuers are both better served by preserving the independence of proxy advisory firms through the avoidance of undue influences,” Garzon wrote.
As for other SEC commissioners, Robert Jackson has weighed in. Clayton and the Division of Investment Management “suddenly raised questions about long-resolved issues regarding shareholder voting,” he wrote.
“The law governing investor use of proxy advisers is no different today than it was yesterday,” he stressed. “The Commission has long recognized that proxy advisers serve an important role in the shareholder-voting process, and these statements do nothing to change that.”
In the bigger picture, Jackson wrote, there is “broad agreement that the Byzantine system that makes it impossible to know whether investors’ votes are being counted must be fixed.”
“Over the last decade, while voting technology has made enormous leaps forward, retail investor participation in corporate elections has declined,” he wrote. “Fewer than one in three investors have their vote counted in those contests. The Commission has known this for years and it is time to act. Investors should not have to wait any longer for their votes to be counted in corporate elections.”
Jackson said he is concerned that efforts “to fix corporate democracy, will be stymied by misguided and controversial efforts to regulate proxy advisers.”
“Regulating proxy advisers has long been a top priority for corporate lobbyists, who complain that advisers have too much power,” he wrote. “There is, of course, little proof of that proposition.”
“It’s hard to imagine that, upon a survey of all the problems that plague corporate America today, the Commission could conclude that investors receiving too much advice about how to vote their shares—advice they are free to, and often do, disregard—should be at the top of our list,” he added. “In fact, the lack of competition among proxy-advisory firms is itself reason for pause, as regulation in the area risks further deepening the moat around the existing players—empowering the very firms that, some worry, already have too much influence.”