The SEC Gets Serious About Proxy Advisory Services

Lawmakers have been trying to figure out how to regulate proxy advisors for years. The Securities and Exchange Commission in particular has been talking about it since 2002.

In December 2018, SEC Chairman Jay Clayton reiterated his belief that there should be greater clarity when it comes to the relationship between proxy advisory services firms and the investment advisors they serve, as well as how proxy advisory services make their recommendations.

Less than a year later, the SEC made good on its commitment to drive clarity by issuing guidance addressing both proxy advisory firms and their investment advisor clients. The SEC released new guidance in August 2019 and for that outlines what is expected of them when it comes to giving voting advice and voting responsibly.

For their part, the proxy advisors do not seem very happy with the new guidance. Institutional Shareholder Services (ISS), the largest of these services, has actually sued the SEC over the new guidance.

As a reminder, proxy advisory services like ISS and Glass Lewis analyze issuer proxy filings and make recommendations on how to vote to their investment advisor clients. Investment advisors in turn are fiduciaries for and may be voting proxies on behalf of their clients, be they institutional investors, funds, or individual investors.

Large institutional investors with diverse portfolios face a particularly high volume of corporate matters on which, as shareholders, they are expected to vote. Rather than research themselves each individual proxy sent by their portfolio clients, institutional investors often outsource the review of documents to services like ISS and Glass Lewis, and rely on their voting recommendations.

While many have explored the pros and cons to these types of services, it's hard to ignore the fact that advisory services have been under fire for things like ambiguous metrics and conflicts of interest.

SEC Chairman Jay Clayton highlights the complexity of the situation as a whole:

"In the past two decades, the proxy process has become one of increasing complexity, and also importance, to investors, issuers, and investment advisers. Commission rule changes, state law changes, corporate governance practices, technology and other factors have all increased the significance of shareholder voting in our public capital markets. This is one reason why the Commission and its staff have prioritized our work in this area. During this time, investment advisers have assumed a much greater role in our marketplace and, consequently, a greater role in the area of shareholder-company engagement.

Voting Responsibly

Proxy advisory services have a lot of power because institutional investors and their investment advisors have given it to them. While it is certainly not the case that all institutional investors follow the advice of their proxy advisors slavishly, most do rely on the proxy advisors at least to some extent—some more than others.

The SEC guidance reiterates that investment advisors cannot blindly rely on the recommendations of their proxy advisory. In the recent guidance, the SEC encourages more due diligence on the part of the investment advisor when assessing those recommendations.

The SEC cites Rule 206(4)-6 under the Advisers Act, which requires advisors with voting authority regarding client securities to "adopt and implement written policies and procedures that are reasonably designed to ensure that the investment adviser votes proxies in the best interest of its clients."

The guidelines highlight several possible and acceptable examples of voting arrangements between an investment advisor and client.

The guidance also highlights how investment advisors can evaluate "whether the investment adviser's voting determinations are consistent with its voting policies and procedures and in the client's best interest before the votes are cast," including:

Sampling pre-populated votes: Where the investment adviser utilizes the proxy advisory firm for either voting recommendations or voting execution (or both), it could assess "pre-populated" votes shown on the proxy advisory firm's electronic voting platform before such votes are cast, such as through periodic sampling of the proxy advisory firm's pre-populated votes. 44 See Rule 206(4)-7(b) under the Advisers Act. 45 Id. 16

Consideration of additional information: Where the investment adviser utilizes the proxy advisory firm for voting recommendations, it could consider policies and procedures that provide for consideration of additional information that may become available regarding a particular proposal. This additional information may include an issuer's or a shareholder proponent's subsequently filed additional definitive proxy materials or other information conveyed by an issuer or shareholder proponent to the investment adviser that would reasonably be expected to affect the investment adviser's voting determination.

Higher degree of analysis: Where the investment adviser utilizes the proxy advisory firm for either voting recommendations or voting execution (or both), with respect to matters where the investment adviser's voting policies and procedures do not address how it should vote on a particular matter, or where the matter is highly contested or controversial, it could consider whether a higher degree of analysis may be necessary or appropriate to assess whether any votes it casts on behalf of its client are cast in the client's best interest.

The SEC's guidance also tackles issues such as:

• What investment advisors should take into account when retaining proxy advisory services, such as the capacity and competency of the firm to evaluate certain matters, its methodologies and how it identifies and addresses potential conflicts of interest
• The steps investment advisors should take if they become aware of potential factual errors, incompleteness or methodological weaknesses on behalf of the proxy advisory when relying on their recommendations
• How to evaluate the services of proxy advisory firms, for example, if policies and procedures change at the proxy advisory after they have been retained by the investment advisor
• The situations where it is not required for an investment advisor to exercise every opportunity to vote a proxy for a client

"These potential actions discussed in the guidance are not new," said SEC Chairman Clayton in a statement. "They should be familiar to investment advisers and other market participants. They include reasonable due diligence, reasonably identifying and addressing conflicts, and full and fair disclosure."

Advising Responsibly

The SEC also addressed the other side of the coin: the proxy advisory services themselves. In its guidance, the SEC made it clear that proxy voting advice from such firms counts as a "solicitation" under Exchange Act Rule 14a-1.

The SEC's definition of solicitation is broad, and it includes "communication to security holders under circumstances reasonably calculated to result in the procurement, withholding or revocation of a proxy."

In its guidance, the SEC explained further:

... we disagree with the view that the proxy voting advice provided by proxy advisory firms falls outside the definition of a solicitation because it should not be viewed as "unsolicited" voting advice.

We view these services provided by proxy advisory firms as distinct from advice prompted by unsolicited inquiries from clients to their financial advisors or brokers on how they should vote their proxies, which remains outside the definition of a solicitation.

Rather than merely responding to client inquiries, the communication is invited by the proxy advisory firms themselves through the marketing of their expertise in researching and analyzing proxy issues for purposes of helping clients make proxy voting determinations.

The fact that voting advice is considered solicitation makes it subject to rules under Exchange Act Rule 14a-9, which "prohibits 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."

The guidance outlined ways that proxy advisories could ensure they weren't violating 14a-9 when providing voting recommendations, including:

• Disclosing their methodology for voting advice on a particular matter.
• Disclosures about what sources were used in their decision-making.
• Disclosures about potential conflicts of interest.

In a nutshell, these guidelines will likely impact key areas of proxy advisory firms. As corporate governance expert Frank Placenti of Squire Patton Boggs has noted the new guidance 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.

Mr. Placenti's full analysis can be found here.

"The releases reiterate the Commission's views on the importance of investment advisers' voting responsibly on behalf of their clients and the applicability of our proxy rules to proxy voting advice," said Commissioner Elad Roisman in the SEC announcement.

Commissioner Roisman added, "Advisers who vote proxies must do so in a manner consistent with their fiduciary obligations and, to the extent they rely on voting advice from proxy advisory firms they must take reasonable steps to ensure the use of that advice is consistent with their fiduciary duties. In addition, proxy advisory firms, to the extent they engage in solicitations, must comply with applicable law."

Challenging the SEC, Aggressively

Proxy advisory services cannot have been surprised that the SEC was gearing up to deliver guidance that would be more explicit about the SEC's view of the proxy advisory services responsibilities and liabilities. Thus, ISS deciding to sue the SEC is a bit surprising.

The suit challenges both the process by which the guidance was issued as well as the substance of the rules. Concerning process, ISS asserts that the SEC didn't follow the appropriate rule-making process that requires a notice and comment period.

On the substance, ISS argues that it is not making proxy solicitations because it is merely providing analysis and advice. For more on the reasons that ISS believes it should not be regulated, you can read their statement, here and you can read the their complaint here.

The SEC Proposes New Rules

Notwithstanding ISS's lawsuit, the SEC remains undeterred. On November 5, 2019, the SEC released proposed rules designed to "help ensure that proxy voting advice used by investors and others who vote on investors' behalf is accurate, transparent, and materially complete."

The proposed rules include provisions for things like the mandatory disclosure of conflicts of interest a proxy advisory service may have, and the requirement that registrants have time to review and provide feedback on a proxy service's recommendations. Most importantly, the proposed rules codify the SEC's view that Exchange Act Rule 14a-1(l)'s definition of "solicitation" specifically includes the furnishing proxy voting advice.

The proposed rules are now subject to the SEC's normal 60-day comment period.

What's Next?

No one, including the SEC, will be surprised to find out that the proxy advisory services would prefer to have less regulatory oversight and less potential liability for false and misleading information.

It will take time for the case to resolve and any new rules to be implemented. However, it's hard to imagine that proxy advisors can simultaneously advise institutional shareholders to vote for or against something and at the same time argue that these activities do not constitute a solicitation as the SEC understands the term.