SEC Adopts Amendments to Its Own Rules Regulating Proxy Advisory Firms

Proxy advisory services have been beset by controversy. In response, in July 2020, the Securities and Exchange Commission (SEC) issued final rules (the 2020 Final Rules) tightening regulations that govern proxy advisory firms. As we reported previously, the 2020 Final Rules, according to the SEC of 2020, were intended to help ensure that investors who use proxy voting advice receive more transparent, accurate, and complete information on which to make their voting decisions. Fast forward two years from the adoption of the 2020 Final Rules, but before the SEC began enforcing them—on July 13, 2022, the SEC adopted amendments to the 2020 Final Rules in the form of deletions and rescissions, the results of which is to eviscerate the reforms the 2020 Final Rules would have made.

As a reminder, proxy advisory firms, like Institutional Shareholder Services (ISS) and Glass Lewis, are primarily focused on advising their clients how to cast their ballot on issues up for vote at public company shareholder meetings, including the election of directors, merger transactions, and shareholder proposals. Proxy advisory clients are made up, in large part, of investment advisors and institutional investors, who typically hold the highest concentration of outstanding shares in publicly listed companies.

In this article, we will briefly summarize the 2020 Final Rules and the new amendments and discuss the practical implications of the new amendments.

The 2020 Final Rules, Explained 

The 2020 Final Rules, among other things, did the following:

• Codified Voting Advice as a “Solicitation”

In August 2019, the SEC issued interpretation and guidance (the Interpretive Release) stating that proxy voting advice given by proxy advisory firms generally would constitute a solicitation subject to the proxy rules.

Why is this important? Solicitations under the Securities Exchange Act of 1934 (the Exchange Act) are subject to anti-fraud provisions. Specifically, the applicable provisions prohibit a solicitation (e.g., proxy voting advice) 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 rule also requires that solicitations “must not omit to state any material fact necessary in order to make the statements therein not false or misleading.” The Interpretive Release was significant in that it provided insight into how the SEC viewed the issue. However, it was just the SEC’s interpretation of existing rules, not new ones.

That issue was put to bed with the 2020 Final Rules, which codified the guidance in the Interpretive Release that proxy voting advice is generally subject to the Exchange Act’s anti-fraud provisions.

• Added Conditions on Exemption from Filing Requirements

Prior to the 2020 Final Rules, proxy advisory firms typically relied upon two exemptions from the proxy rules to provide advice without complying with filing and information equirements of the proxy rules. Both exemptions, however, were adopted by the SEC at a time when proxy advisory firms did not yet play the considerable role that they now do in the proxy voting process.

While the SEC acknowledged the existence of the exemptions, its position was 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 2020 Final Rules stated that for proxy advisory firms to be exempt from the filing and information requirements to the proxy rules, they must:

1. 1. 1. Comply with disclosure requirements regarding conflicts of interest;
      2. 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
      3. 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.

The 2020 Final Rules, Subject to Judicial Challenge

The rationale for the adoption of the 2020 Final Rules was generally a desire for more transparency in how proxy advisory firms formulate their voting advice and to ensure that the advice is based on an accurate, complete, and well understood interpretation of company-related information.

Those advocating reform generally welcomed the 2020 Final Rules as an overdue measure to address what they viewed as conflicts of interests, analytical errors, and methodological biases in proxy advisory firms’ proxy voting advice.

On the other hand, proxy advisory firms weren’t as positive on the 2020 Final Rules. In fact, when the Interpretive Release was issued, ISS filed a lawsuit against the SEC asking the United States District Court for the District of Columbia to, among other things, grant a declaratory judgment and permanent injunction finding the Interpretive Release invalid and setting it aside. ISS argued that the Interpretive Release and 2020 Final Rules imposed “burdensome, time-consuming, and unnecessary obligations.”

After the 2020 Final Rules were released, ISS issued a statement indicating that it would resume its lawsuit, which it paused to give the SEC time to finalize its rules. The SEC filed a motion in October 2020, asking the court to toss out the lawsuit on the basis that ISS had provided “no supportable legal basis” for a court to vacate the rules.

Bizarrely, in June 2021, the SEC filed a motion to suspend ISS’ litigation so that the SEC could consider revisions to the Interpretive Release and 2020 Final Rules. Less than six months later, the SEC proposed amendments to its previously finalized rules, amendments that ISS supported.

In response to the new proposed amendments, SEC Commissioner Hester Pierce issued a statement that summed up the sentiment of many. Here is a notable excerpt:

“I appreciate the staff’s efforts to make this a coherent proposal. You did the best you could since nothing has changed and we have not received any new information to warrant a new rulemaking. I simply cannot pretend that this is a normal course of action for the [SEC]. A more reasonable approach would be to commit to a retrospective review of the 2020 Final Rules after three or five years to evaluate their effectiveness.”

2022 Amendments to Proxy Rules Governing Proxy Voting Advice

After all the back and forth, where did the SEC land? The amendments that the SEC proposed in November 2021 were effectively adopted as proposed (as adopted, the 2022 Amendments).

• Removed Conditions on Exemption from Filing Requirements 

As noted above, the 2020 Final Rules added three conditions for proxy advisory firms to be exempt from the filing and information requirements to the proxy rules. The 2022 Amendments remove two of those conditions as indicated by the strikethroughs below:

1. 1. 1. Comply with disclosure requirements regarding conflicts of interest;
      2. 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
      3. 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.

The SEC noted that “upon further analysis in light of continued concerns expressed by investors and others, the [SEC] concluded that the potential informational benefits to investors of these conditions do not sufficiently justify the risks they pose to the cost, timeliness, and independence of proxy voting advice.”

• Deleted Changes to the Liability Rule for Voting Advice

The 2020 Final Rules made changes to the proxy rules by setting forth examples of material misstatements or omissions related to proxy voting advice. One such example that the SEC noted as being misleading was the failure of a proxy advisory firm to disclose material information regarding proxy voting advice. The final amendments deleted this example and others.

The SEC indicated that the examples created a risk of confusion regarding the application of the liability provisions to proxy voting advice.

Interestingly, in its discussion as to why the amendments were warranted, the SEC referred to the Best Practice Principles Group (BPPG), an industry group composed of proxy advisory firms. The BPPG was formed in 2013 after the European Securities and Markets Authority (ESMA) requested that proxy advisory firms engage in a coordinated effort to develop an industry-wide code of conduct focusing on enhancing transparency and disclosure. Understanding that self-regulation was its best alternative, the BPPG was formed.

The BPPG established best practices and principles for signatory proxy advisory firms in 2014, which were updated in 2019. In connection with the update, the ESMA, among others, recommended the BPPG make certain governance enhancements. One recommendation resulted in the BPPG establishing an independent committee in 2019 to monitor and oversee the implementation of the group's best practices and principles. The committee issued its first report in 2021. The Harvard Law School Forum on Corporate Governance posted a useful summary of the report, highlighting places the report identified as needing improvement. These include improved disclosure by proxy advisory firms on topics such as staff analyst qualifications, error tracking procedures, safeguards against conflicts of interest, and whether and how companies have opportunities to offer feedback on proxy reports.

While the BPPG may be a step in the right direction, membership and compliance is voluntary, and it is not a substitute for meaningful regulation by the SEC.

Practical Implications

The SEC’s original final rules would have resulted in meaningful change. The result of the newest amendments is largely to revert to the status quo in terms of how proxy advisory firms interact with publicly listed companies. Further, the amendments effectively leave the future state of engagement between proxy advisory firms and publicly listed companies in the hands of proxy advisory firms.

As noted above, the amendments remove the conditions from the 2020 Final Rules that required proxy advisory firms to (i) engage with companies by sharing voting advice before or at the time of sharing that advice with their clients, and (ii) notify their clients of company responses to voting advice. Some may remember when ISS shared drafts of their voting advice with public companies in advance of finalizing and sending to their clients. While the process was cumbersome and frantic at times given the short period that ISS gave companies to review, many viewed it as a necessary step to ensure the final voting advice that went to ISS’ clients was devoid of any analytical errors—or at least had the benefit of companies clarifying any points that ISS may have misinterpreted.

What we are left with is a shell of the 2020 Final Rules and a reliance on proxy advisory firms to continue to voluntarily subject themselves to principles espoused by the BPPG and regulatory nudges by the ESMA.

Takeaways

While much of the regulatory ping-pong associated with the proxy advisory rules likely has origins in the change of presidential administration and new focus areas by the SEC, the amendments create an interesting and concerning precedent. In her statement regarding the amendments, Commissioner Pierce said:

“Changing course so dramatically with so little justification does not bode well for the Commission. What credibility will we have as an independent agency if our regulations so drastically swerve from one year to the next? If we keep making U-turns like this one, people might start to wonder whether the GPS we are using is calibrated to respond to political rather than market signals."