SEC Final Rule: Regulating Proxy Advisory Services

In July 2020, the Securities and Exchange Commission officially tightened the regulations that govern proxy advisory firms. Arguably, it's been a long time coming: While proxy advisory firms have been a useful service for many institutional investors that are faced with a high volume of corporate matters on which they are expected to vote, proxy advisory services are not without controversy.

Corporate groups have been lobbying against  proxy advisory firms for years. Complaints against proxy advisory firms like ISS range from their metrics being ambiguous to conflicts of interest and more. Many issuers also complained about not being given a chance to engage with the advisory services in a timely way in order to correct factual errors in reports issued by proxy advisory firms.

This is problematic when you consider that most boards see proxy advisory firms as the most influential party behind investors and analysts. It's also been reported that some asset managers even use software that automatically matches their ballots to the proxy advisory's voting recommendation.

For example, in a comment letter to the SEC, ExxonMobil's vice president of investor relations said that proxy advisory firms are "effectively our largest shareholders, despite having no direct stake in ExxonMobil's success."

These concerns have not fallen on deaf ears. Last year, the SEC proposed new rules that would address some of the proxy advisory firms' perceived shortcomings. In July, the SEC's final rule (in a three-to-one vote) imposes new oversight on proxy advisory firms. These rules, according to the SEC, will provide "reasonable and timely access to more transparent, accurate and complete information on which to make voting decisions."

Key highlights of the final rule include:

• Proxy advisory voting advice is codified as "solicitation" subject to regulation by the SEC.
• Proxy advisory firms now have new conditions to qualify for exemptions from filing and information requirements, including new requirements for the disclosure of conflicts of interest and disseminating voting advice to registrants at the same time (or sooner) as is given to proxy advisory firm clients.

Voting Advice Codified as "Solicitation"

Before the new SEC rules, proxy advisory firms had taken the position that their advice concerning how institutional shareholders should vote on proposals set forth by issuers was not a "solicitation" as defined in the Securities Exchange Act of 1934.

While the SEC already viewed proxy advisory firms' voting advice as solicitation, the final rule codifies this view by adding language the SEC's rules issued pursuant to the Exchange Act:

to make clear that the terms "solicit" and "solicitation" include any proxy voting advice that makes a recommendation to a shareholder as to its vote, consent, or authorization on a specific matter for which shareholder approval is solicited, and that is furnished by a person who markets its expertise as a provider of such advice, separately from other forms of investment advice, and sells such advice for a fee.

Given that this voting advice is now clearly considered solicitation, it is subject to the Exchange Act's anti-fraud prohibition on "any solicitation from containing any statement which, at the time and in the light of the circumstances under which it is made, is false or misleading with respect to any material fact."

Being subject to the anti-fraud provisions of the Exchange Act is, of course, consequential for proxy advisory firms. The final rules include examples of what might be considered misleading. As summarized by the law firm Goodwin Proctor in its excellent memorandum on this topic:

The amended rule lists the failure to disclose material information regarding proxy voting advice, such as the proxy advisory firm's methodology, sources of information, or conflicts of interest, as an example of what may be misleading within the meaning of the rule. This is consistent with the SEC's prior guidance from August 2019 where it had noted that, to the extent proxy voting advice is materially based on a methodology using a group of peer companies selected by the proxy advisory firms, it may need to include the identities of the peer group members used as part of its recommendation and the reasons for selecting these peer group members as well as, if material, why its peer group members differ from those selected by the company.

As I reported previously, corporate governance expert Frank Placenti of Squire Patton Boggs forecasted that these new rules should result in:

• More transparency and disclosure around their methodologies, analyses and third-party data sources.
• Improved rigor and processes along with more issuer input, leading to greater accuracy.
• More interaction with all issuers instead of just larger companies.

Some were concerned that the new rules could result in the SEC' deeming as solicitation any advice from any third party. This turns out to be an unwarranted concern now that the SEC has clarified that "voting advice from a person who furnishes such advice only in response to an unprompted request for the advice or a person who does not market its expertise as a provider of proxy voting advice, separately from other forms of investment advice, will not be deemed a solicitation."

The key language is "market its expertise as a provider of proxy voting advice." This language is entirely calibrated to put proxy advisory firms and only proxy advisory firms in the crosshairs of the new rules. Put differently, and as specifically confirmed by the final rule, advice offered to clients by financial advisors in response to clients' requests for advice on how to vote are not "solicitations" covered by the new rules.

Conditions on Exemptions for Filing Requirements

Proxy advisory firms historically relied on two exemptions in the Exchange Act to avoid filing and information requirements under federal proxy rules. The final rule added new conditions for these exemptions.

To be sure, the SEC believes that proxy advisory firms "should be eligible to rely on an exemption from such information and filing requirements for their proxy voting advice, but only to the extent that such exemption is appropriately tailored to their unique role in the proxy process and facilitates the transparency, accuracy, and completeness of the information available to those making voting decisions."

The new rule states that in order for these exemptions to be met, proxy advisory firms must:

• Comply with disclosure requirements regarding conflicts of interest;
• Ensure their voting advice about a registrant is made available to the registrant either before or at the time of sending it to clients; and
• Create a mechanism whereby they can make available to clients, in a timely manner, any written response by registrants to the proxy firm's voting advice,

Conflicts of Interest

Conflicts of interest can arise when a proxy advisory offers ancillary services like consulting to the registrants for which they also provide voting advice to their institutional shareholder clients. The concern is that purchasing consulting services from the proxy advisory could have an influence on the vote.

The new rule states that filing exemptions can be met so long as:

• "Any information regarding an interest, transaction, or relationship of the proxy voting advice business (or its affiliates) that is material to assessing the objectivity of the proxy voting advice in light of the circumstances of the particular interest, transaction, or relationship."
• "Any policies and procedures used to identify, as well as the steps taken to address, any such material conflicts of interest arising from such interest, transaction, or relationship."

Notice of Voting Advice

The SEC made clear that amendments in this area were "designed to facilitate more complete and robust dialogue and information sharing among proxy voting advice businesses, their clients, and registrants," and that this "would improve the proxy voting system, and ultimately lead to more informed decision-making, to the benefit of all participants, including shareholders that do not use proxy voting advice and yet may be affected by the recommendations of proxy voting advice businesses."

The final rule outlines the following:

The proxy voting advice business has adopted and publicly disclosed written policies and procedures reasonably designed to ensure that:

(A) Registrants that are the subject of the proxy voting advice have such advice made available to them at or prior to the time when such advice is disseminated to the proxy voting advice business's clients; and

(B) The proxy voting advice business provides its clients with a mechanism by which they can reasonably be expected to become aware of any written statements regarding its proxy voting advice by registrants who are the subject of such advice, in a timely manner before the security holder meeting (or, if no meeting, before the votes, consents, or authorizations may be used to effect the proposed action).

What's Next

While the SEC's final rule did not include everything outlined in the original proposed rules, many see this as a big step in the right direction.

Not everyone, however, is exactly happy. The published opinion of the SEC's dissenting commissioner is scathing: she characterizes the new rules as "unwarranted, unwanted, and unworkable."

In addition, there is pending litigation filed by ISS against the SEC. ISS has asserted that the SEC's efforts to regulate it and other proxy advisory services exceeds the SEC's authority. This litigation was stayed pending the issuance of the final rules, so ISS is now free to resume its litigation.

Unless ISS prevails in its litigation efforts, however, the rules are final and the proxy advisory firms will need to gear up to comply. If the rules remain in place,  the proxy advisory firms have until December 1st, 2021, to comply with them, which is to say in advance of the 2022 proxy season.