On August 21, 2019, the Securities and Exchange Commission (“SEC”), in response to increasing concerns that proxy advisory firms hold excessive sway over voting results, issued guidance (the “2019 Advisor Guidance”)1 that provides investment advisers with recommendations to help facilitate compliance with their proxy voting responsibilities when relying on proxy advisory firms. However, as described below, the subtext of the 2019 Advisor Guidance is intended to be more sweeping and significant:
- In order to fulfill their fiduciary obligations when voting, investment advisers may not be able to rely on the recommendations of proxy advisors absent significant additional assessments from, and reviews of, their proxy advisors.
- Even with their additional scrutiny of proxy advisors, investment advisers following the 2019 Advisor Guidance are strongly encouraged to consider the voting recommendations made by proxy advisors on a basis that is more tailored to the circumstances of each company, thereby potentially obviating many of the efficiencies generated from “outsourcing” this voting function.
- The additional disclosures regarding conflicts of interest of proxy advisory firms create a “Catch 22” that could complicate investment advisers’ reliance on the recommendations of proxy advisors that provide consulting services to the companies for which they also provide voting recommendations.
The 2019 Advisor Guidance represents a small victory for public companies and their trade groups, including the US Chamber of Commerce and the National Association of Manufacturers, against the proxy advisory industry.
The Proxy Advisor Business Model
Proxy advisors’ business models are premised significantly on their ability to provide voting recommendations and related analysis of a subject company on a subscription basis to their investment adviser and other clients. Certain of these advisors, most notably Institutional Shareholder Services Inc. (“ISS”), have business models that also generate significant revenue from one side of the organization (in ISS’s case, ISS Corporate Solutions Inc.) providing consulting services to subject companies regarding their governance practices, many of which are ultimately the subject of the voting recommendation provided by the other side of the firm.
US federal securities law regulates proxy soliciting materials by generally requiring the public filing of such materials and subjecting such materials to liability under US federal securities laws. The ability of proxy advisors to avoid filing their voting recommendations publicly is critical to their subscription business model. In order to do this, proxy advisors must fall within an exemption from filing that was specially crafted by the SEC to apply to proxy advisors.2 Among other things, this exemption requires that the proxy advisor discloses to the investment adviser “any significant relationship with the registrant or any of its affiliates, or a security holder proponent of the matter on which advice is given, as well as any material interests of the advisor in such matter.” The staff of the SEC (the “Staff”) issued guidance in June 2014 (the “2014 Guidance”)3 that a relationship generally would be considered “significant,” or a “material interest” would exist, if knowledge of the relationship or interest would reasonably be expected to affect the recipient’s assessment of the reliability and objectivity of the advisor and the advice. The Staff also stated that once a proxy advisor assessed that its relationship with an issuer was “significant” or “material,” it is not sufficient to provide such information to the investment adviser only upon its request, but such information should be provided affirmatively.4
Impact of the 2019 Advisor Guidance
Conflicts of Interest
The 2019 Advisor Guidance requires investment advisers to review the adequacy of the policies and procedures of a proxy advisor to identify, disclose and address a broader range of actual and potential conflicts of interest than were referenced in the 2014 Advisor Guidance. In addition to the potential conflict between the proxy advisor and the subject company relating to the provision of proxy voting recommendations and voting services,5 conflicts to be considered include conflicts related to activities other than providing proxy voting recommendations and voting services and conflicts that may result from relationships that the proxy advisor has with lenders, shareholders or significant sources of business.6 Moreover, the 2019 Advisor Guidance implies that conflict of interest disclosure to investment advisers related to the provision of consulting services to subject companies is unlikely to be adequate absent disclosure of the amount of compensation paid by the issuer to the proxy advisor. The investment adviser must also consider the proxy advisors’ use of technology to make conflicts disclosures readily accessible.
The impact of disclosing to investment advisers the fees paid to ISS by public companies should not be underestimated. Ultimately, the SEC may be seeking to put investment advisers in the “Catch 22” position of requiring such fee information in order to judge whether a conflict exists, but after having received such information, being forced to conclude that the fees create a conflict that makes it difficult to rely on the voting recommendation. Of course, auditors have faced, and largely overcome, a similar concern regarding their independence based on concerns relating to the provision of non-audit services alongside audit services. It remains to be seen if more substantive disclosures regarding the absolute and/or relative fees paid to ISS for consulting with issuers will raise concerns among investment advisers.
Enhanced Proxy Advisor Procedures and Disclosures
Proxy advisors generally seek input on an annual basis as to the formulation of their proxy voting policies for the subsequent year. For example, each summer, ISS publishes its annual policy survey soliciting input from companies, investors, and other interested parties on potential changes to its voting guideline policies for the upcoming proxy season. The survey is the initial step in its annual global benchmark policy formulation process. ISS uses the feedback received from the survey as one factor in determining whether to modify existing policies and/or introduce new policies that will inform its voting recommendations for its proxy advisory clients for the upcoming proxy season. Building on this existing state of affairs, the 2019 Advisor Guidance cautions investment advisers that they should rely on voting recommendations from proxy advisors only if the proxy advisor has an effective process for seeking timely input from issuers and proxy advisory firm clients with respect to, for example, its “proxy voting policies, methodologies, and peer group constructions, including for “say-on-pay” votes.”
The SEC has, in particular, noted the importance of peer groups in the analyses provided by proxy advisors. The 2019 Advisor Guidance directs an investment adviser to consider how the proxy advisory firm incorporates appropriate input in formulating its methodologies and construction of issuer peer groups. Ultimately, this all drives toward more transparency by proxy advisors on their selection of the peer groups, many of which differ from the peer group used by the issuer to determine compensation.
Individualized Review of Proxy Recommendations
A key benefit offered by proxy advisors to small and medium sized investment advisers is that they allow the investment adviser to focus on its core competency of financial analysis and investing while outsourcing the proxy voting analysis. While it is increasingly accepted that a wide range of governance-related factors impact investment returns, it requires significant work for each investment adviser to assess such factors. This is one reason for the appeal of relying on a proxy advisor. Nevertheless, as fiduciaries, such reliance was always qualified and the 2014 Advisor Guidance indicated that investment advisers should consider “the adequacy and quality of the proxy advisory firm’s staffing and personnel; the robustness of its policies and procedures regarding its ability to…ensure that its proxy voting recommendations are based on current and accurate information.” The SEC further admonished that the investment adviser should “ascertain that the proxy advisory firm has the capacity and competency to adequately analyze proxy issues, which includes the ability to make voting recommendations based on materially accurate information.”
The 2019 Advisor Guidance expands this considerably and seeks to impose obligations on investment advisers that significantly undermines their ability to rely on proxy advisor recommendations without undertaking considerable, company-specific analyses:
- With respect to peer groups that feature significantly in issuer proxy statements and proxy advisor analyses, the SEC states that “an investment adviser should also consider how the proxy advisory firm, in constructing peer groups, takes into account the unique characteristics of the issuer, to the extent available, such as the issuer’s size; its governance structure; its industry and any particular practices unique to that industry; its history; and its financial performance.” While this will likely force more disclosure by proxy advisors as to their methodologies, it is hard to avoid the implication that investment advisers need to review with care, on an individualized basis, the formulation of peer groups by proxy advisors on a company-by-company basis.
- With respect to voting recommendations, the investment adviser is directed to consider policies and procedures that provide for consideration of additional information that may become available regarding a particular proposal, such as subsequently filed additional definitive proxy materials or other information conveyed by an issuer or shareholder proponent to the advisor that would reasonably be expected to affect the adviser’s voting determination.
- In connection with matters that are “highly contested or controversial,” such as acquisitions or contested elections, the investment adviser should consider whether a higher degree of analysis may be required when considering a proxy advisor’s voting recommendation.
- In the case of potential factual errors, potential incompleteness, or potential methodological weaknesses in the proxy advisory firm’s analysis for a particular issuer, the investment adviser’s policies and procedures should be reasonably designed to ensure that its voting determinations are not based on materially inaccurate or incomplete information.
Proxy Advisor Liability for Voting Recommendations
The 2014 Advisor Guidance set forth the position of the Staff that proxy voting advice constitutes a solicitation subject to the US federal securities laws both for filing and liability purposes.7 In parallel with issuing the 2019 Advisor Guidance, the SEC issued a separate analysis stretching over 12 pages reaffirming that position (the “2019 Proxy Solicitation Position”).8 The SEC highlighted the fact that proxy advisory firms provide their voting recommendations to their investment adviser clients, often shortly before a shareholder meeting, with the expectation that those recommendations will be used by the adviser to fulfill their fiduciary duties when making voting decisions.
The 2019 Proxy Solicitation Position refers to the exemption from public filing with the SEC provided by Rule 14a-2(b)(3) described above; however, it also notes that the SEC is considering recommending rule amendments to address proxy advisory firms’ reliance on this exemption. As noted above, a public filing requirement for proxy advisor voting recommendations would fundamentally undermine their subscription business model.
The other impact of being a “solicitation” is the reaffirmation that proxy advisor voting recommendations are subject to Rule 14a-9, which (i) 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, and (ii) requires that such solicitation must not omit to state any material fact necessary to make the statements therein not false or misleading. It should be noted that Rule 14a-9 does form the basis for a private right of action by a shareholder.
The 2019 Proxy Solicitation Position notes that Rule 14a-9 also extends to opinions, reasons, recommendations, or beliefs that are disclosed as part of a solicitation, which may be statements of material facts for purposes of the rule and for which disclosure of the underlying facts, assumptions, limitations, and other information may be needed so that these views do not raise Rule 14a-9 concerns. Echoing themes reflected in the 2019 Advisor Guidance, the 2019 Proxy Solicitation Position includes suggestions as to the types of information proxy advisors should consider disclosing to shareholders in order to avoid a potential violation of Rule 14a-9:
- Voting Advice Methodology: An explanation of the methodology used to formulate its voting advice on a particular matter (including any material deviations from the provider’s publicly-announced guidelines, policies, or standard methodologies for analyzing such matters) where the omission of such information would render the voting advice materially false or misleading. With respect to voting advice methodology, the SEC noted that, to the extent that the proxy voting advice is materially based on use of peer group companies selected by the proxy advisory firm, the disclosure may need to include the identities of the peer group members.
- Third-party Information: To the extent that the proxy voting advice is based on information other than the registrant’s public disclosures, such as third-party information sources, disclosure about these information sources and the extent to which the information from these sources differs from the public disclosures provided by the registrant if such differences are material and the failure to disclose the differences would render the voting advice false or misleading.
- Conflicts of Interest: Disclosure about material conflicts of interest that arise in connection with providing the proxy voting advice in reasonably sufficient detail so that the client can assess the relevance of those conflicts.
1 The 2019 Advisor Guidance is available here.
2 Rule 14a-2(b)(3).
3 Staff Legal Bulletin No. 20, “Proxy Voting: Proxy Voting Responsibilities of Investment Advisers and Availability of Exemptions from the Proxy Rules for Proxy Advisory Firms.”
4 ISS includes the following language at the end of its reports. By requiring investment advisers to approach ISS to obtain information about ISS’s relationships with issuers, ISS appears to have concluded that its relationships are neither “material” nor “significant”:
The issuer that is the subject of this analysis may have purchased self-assessment tools and publications from ISS Corporate Solutions, Inc. (formerly known as ISS Corporate Services, Inc. and referred to as “ICS”), a wholly-owned subsidiary of ISS, or ICS may have provided advisory or analytical services to the issuer in connection with the proxies described in this report. These tools and services may have utilized preliminary peer groups generated by ISS’ institutional research group. No employee of ICS played a role in the preparation of this report. If you are an ISS institutional client, you may inquire about any issuer’s use of products and services from ICS by emailing [email protected].
5 Examples provided in the 2019 Advisor Guidance include conflicts arising from the provision of recommendations and services to issuers as well as proponents of shareholder proposals regarding matters that may be the subject of a vote.
6 Examples provided in the 2019 Advisor Guidance include whether a third party with significant influence over the proxy advisory firm has taken a position on a particular voting issue or voting issues more generally.
7 Foreign private issuers are exempt from US proxy solicitation rules. Accordingly, the filing and liability provisions referenced in the 2019 Proxy Solicitation Position do not apply to proxy advisor reports promulgated with respect to foreign private issuers. While the exemption from US proxy solicitation rules is highly beneficial for foreign private issuers, proxy advisors nonetheless have a highly significant impact on such issuers.
8 The 2019 Proxy Solicitation Position is available here.
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