SEC shifting to more oversight of proxy firms

New guidance from the Securities and Exchange Commission could lead to major changes for proxy advisory firms and the institutional investors that utilize their recommendations each proxy season.

On Aug. 21, the commission in two 3-2 votes, approved guidance that represents a step toward greater SEC oversight of proxy advisory firms and investment advisers' reliance on proxy advisers, sources said.

The piece of guidance that is of particular concern to the Council of Institutional Investors and others is a new SEC interpretation that establishes proxy voting advice by proxy advisory firms as a solicitation. Because proxy advisory firms provide recommendations that are "reasonably calculated to result in the procurement, withholding, or revocation of a proxy" — part of the definition of a solicitation under federal regulation — "the furnishing of proxy voting advice constitutes a 'solicitation,'" the SEC guidance stated.

Proxy voting recommendations constitute a solicitation because they are "designed to influence the client's voting decision," the SEC stated in the guidance.

Of note, the guidance prohibits any solicitation from containing any statement that is false or misleading with respect to any material fact. Also, in order to avoid rule violations, a proxy firm must provide an explanation of the methodology used to formulate its voting advice; disclose any third-party information sources and the extent to which the information from these sources differs from the company's public disclosures, if such differences are material; and disclose material conflicts of interest.

Business groups like the U.S. Chamber of Commerce, which have said proxy advisory firms have too much influence and myriad conflicts of interest, applauded the SEC's decision and want more to be done. "We commend the SEC for taking a critical first step in bringing much-needed oversight to proxy advisory firms, and we hope the SEC and other regulators take further action to ensure that proxy advisory firms provide 'decision-useful' information to investors," said Tom Quaadman, executive vice president of the chamber's Center of Capital Markets Competitiveness, in a statement.

The commission's two Democrats — Robert Jackson Jr. and Allison H. Lee — dissented. At the August meeting, Ms. Lee said the guidance introduces "increased costs and time pressure into an already byzantine and highly compressed process." Moreover, it calls for "more (company) involvement in the process despite widespread agreement among institutional investors and investment advisers that greater involvement would undermine the reliability and independence of voting recommendations," Ms. Lee said.

Amy Borrus, deputy director of the Council of Institutional Investors in Washington, has similar concerns.

"Many institutional investors rely on proxy advisory reports to help inform their voting decisions and they have a stake in ensuring these votes are independent and as objective as possible and timely," she said. "If rules make it more difficult for proxy advisers to get reports to investors in a timely fashion or make proxy advisers more inclined to tilt more toward companies they review, then that's a problem."

Gary Retelny, president and CEO of Institutional Shareholder Services Inc., a proxy advisory firm that along with Glass Lewis & Co., controls about 97% of the market, said the guidance could hurt business and its clients.

Upon initial review, ISS was "concerned that the guidance will hamper our ability to deliver independent, timely and accurate research, data, insights and perspectives to aid in the discharge of (clients') fiduciary duties," Mr. Retelny said in a statement after the SEC vote.

The CII is worried about what the SEC might do next.

"Our main concern now is whether the other shoe will drop," Ms. Borrus said. "The SEC now has a hook for effectively regulating proxy advisers. If proxy advice is solicitation, proxy advisers need protections through exemptions, otherwise (proxy advisory firms) would have to file their reports with the commission on EDGAR, making them public and effectively destroying their business model."

EDGAR is the SEC's corporate filing system.

The degree of difficulty for a proxy advisory firm to obtain an exemption remains to be seen. The guidance issued in August "opens the door for the SEC to engage in future rule-making where they might attach conditions for exemptions," said James J. Moloney, an Irvine, Calif.-based partner with law firm Gibson, Dunn & Crutcher LLP.

Proxy firms could be required to allow the companies on which they're making recommendations to review their reports and provide feedback before the reports are disseminated to clients, sources said.

It's a scenario that would hurt institutional investors, Ms. Borrus said. "We think peer review tilts reports to more deference toward companies and also delays the time that reports get to investors in a very time-constrained proxy season and drive up costs," she said.

Since rule-making is a drawn out process, Mr. Moloney said what the exemptions look like could depend on the 2020 presidential election. "The conditions will depend on who's leading the ship," he said.

The guidance could also raise the threat of legal action against proxy firms, Ms. Borrus added. "The fact that the commission has now said clearly and unequivocally that proxy advice is a solicitation and subject to the (Securities Exchange Act of 1934) 14a-9 fraud rules puts a bull's-eye on the back of proxy advisers for litigation," she said. "It will be a barrier to entry for any other firms considering giving proxy advice, given the contentious nature of some of the matters dealt with in proxy reports."

While Mr. Moloney doesn't expect the guidance to result in a "windfall of litigation," at least in the near term, there could be some litigation on recommendations dealing with mergers and acquisitions, he said. "Proxy advisory firms' recommendations in a change of control contest are a big deal because they could make or break the deal," he said.

The commissioners also approved guidance that clarifies how an investment adviser's fiduciary duty relates to proxy voting on behalf of clients, particularly if the investment adviser retains a proxy advisory firm.

Gail C. Bernstein, general counsel for the Investment Advisers Association in Washington, said she is concerned the guidance will impose onerous requirements on investment advisers that will then increase costs.

The guidance, in part, tells investments advisers they bear the fiduciary responsibilities for voting proxies on behalf of clients and outlines measures they must take to exercise those responsibilities properly, said David G. Tittsworth, a lawyer at Ropes & Gray and former president and CEO of the IAA.

At the meeting in August, Commissioner Hester M. Peirce said the SEC is not building a new regulatory regime but is explaining the contours of an existing one to help investment advisers and proxy advisers carry out their responsibilities.

Ms. Bernstein disagrees with that sentiment, and said investment advisers that "want to comply with what the SEC expects of them will find that the hoops they have to jump through under this new guidance are sufficiently onerous. It could be too costly and too complex for them to vote their clients' shares."

With respect to the August-approved guidance, Mr. Moloney said it's too early to tell what its impact will be. "I don't think it's doom-and-gloom for anybody at this point," he said. "I see this as a natural part of evolution of the proxy solicitation process. This is the tip of the iceberg of future rule-makings to update and modernize the proxy system in the U.S."

In a sign proxy voting remains a priority for the SEC, its Investor Advisory Committee adopted recommendations earlier this month to require modernizations like end-to-end vote confirmation, universal proxies, and a requirement for all involved in the proxy voting system to cooperate in reconciling vote-related information.