Shareholders, proxy advisers roiled by SEC

To the Republican members of the Securities and Exchange Commission, new rules for the shareholder proposal process and proxy advisers are simply a matter of achieving needed updates and ensuring efficient markets.

Institutional investors see it quite differently, as a capitulation to corporate pressure in Washington at the expense of shareholder rights.

"The SEC majority appears to be responding to political pressure. The SEC should regulate based on evidence, not pressure from CEOs," said Ken Bertsch, executive director of the Council of Institutional Investors, Washington.

The motivation is not a mystery to New York City Comptroller Scott M. Stringer, the fiduciary for the five pension funds within the $199 billion New York City Retirement Systems. "The proposed rules seek to remedy problems that do not exist but are merely false narratives put forward by corporate executives who want to limit the ability of investors to push for change and to hold them accountable for runaway CEO pay, excessive risk taking, and irresponsible and harmful business practices," he said in a statement.

There is a lot at stake for investors. "The SEC's proposals are two of the most significant actions to restrict shareholder rights in the SEC's history. There is no credible evidence to support the need for these proposals, and if adopted, they would undermine corporate accountability, entrench managements' opposition to shareholder proposals and increase costs for investors," said Thomas P. DiNapoli, the state comptroller and sole trustee of the $216.2 billion New York State Common Retirement Fund, Albany, also in a statement.

If the rules are finalized, proxy advisory firms would have to disclose more about their process and potential conflicts of interest and give companies the opportunity to make revisions before making final recommendations to clients.

The changes to the shareholder process raise the thresholds for submitting proposals, and more importantly, resubmitting them, the greatest concern to investors that say it can take years for an issue to gain traction.

The proposed updates were approved Nov. 5 by a divided 3-2 vote along partisan lines. To SEC Chairman Jay Clayton, the shareholder proposal process "is ripe for modernization and retrospective review," he said before the November vote.

To Republican Commissioner Hester Peirce, the proposed changes are a reasonable way to "help to weed out proposals whose proponents do not have a real interest in the company and proposals for which other shareholders do not share the proponent's enthusiasm."

Commissioner Elad Roisman, the point person for the proposals, argued that the SEC's core mission is not just investor protection but also maintaining fair and efficient markets, and facilitating capital formation. Anticipating the reactions, Mr. Roisman said before the vote, "some will likely say that we should have taken a heavier hand in overseeing proxy voting advice businesses. Others will oppose these measures as too drastic." He characterized it as "a first step toward receiving actionable feedback that can help us move toward a sensible modernization of our rules," and asked market participants "to let us know where we should recalibrate."

Commissioner Allison Herren Lee, a Democrat, agreed after the vote that "there is nothing inherently wrong" with changing the rules, "particularly if data suggests the need to correct some imbalance. But what does the data show about proxy voting? That the vote recommended by management carries the day some 90% of the time. Management's views nearly always prevail. That is the context in which we consider these two proposals that would tilt the scales even further against shareholders," said Ms. Lee, who voted against the proposal.

The proposed changes are now subject to a 60-day public comment period. During that time, investor advocacy groups like CII, US SIF: The Forum for Sustainable and Responsible Investing, Ceres and the United Nations-backed Principles for Responsible Investment vow to challenge SEC staff to produce data justifying the changes.

Business groups welcomed the changes after years of campaigning for tighter controls on proxy advisers that they saw as having too much influence and no process for companies to correct errors, particularly the dominant firms Institutional Shareholder Services Inc. and Glass, Lewis & Co. The new rules are designed to "facilitate issuer and shareholder engagement (and) provide clarity to market participants," the SEC said.

Aeisha Mastagni, a portfolio manager in the sustainable investment and stewardship strategies unit of the $242.1 billion California State Teachers' Retirement System, West Sacramento, doesn't see that happening by requiring proxy advisers to consult with companies.

"That methodological weakness is highly concerning to me because I think it is vague and I think it could delay our ability to vote. It causes delays in an already time-constrained proxy season and it affects my fiduciary ability to vote these proxies," she said.

Even large asset managers rely on proxy advisers for recommendations. "No institutional investor could vote their proxy without a proxy adviser," said one asset manager who declined to be identified. Others, like BlackRock Inc. and Vanguard Group Inc., are studying the lengthy proposals and plan to weigh in during the comment period.

Mike McCauley, senior officer, investment programs and governance at the $195.6 billion Florida State Board of Administration, Tallahassee, disputes that proxy advisers drive the voting outcome. "If you look at the stats, it's just not true. It leads to support levels, but that does not mean it drives the vote," he said.

Higher shareholder proposal thresholds were needed, corporate groups said, in part because of the increased concentration of stock ownership by institutional shareholders that are more likely to support shareholder proposals.

They would also help control activist investors "that cause companies to focus on political issues at the expense of company growth," said Jay Timmons, president and CEO of the National Association of Manufacturers said in a statement after the vote.

SEC Commissioner Robert Jackson Jr. argued that there could have been a more nuanced approach to dealing with gadfly investors. Instead, "what we've done is swat a gadfly with a sledgehammer," he said on a press call after the vote.

The changes to the shareholder proposal process raise the minimum amount of stock held and the time held — currently $2,000 and one year — to at least $2,000 in stock held for three years, $15,000 for two years, or $25,000 for one year. Shareholders could not aggregate their holdings with others and must be available to meet with the company to discuss the proposal.

Changes to thresholds for resubmitting proposals, last updated in 1954, are more dramatic. Currently, proposals must get 3% of shareholder support in the first year, 6% in the second year and 10% in the third year. Now, a first-time proposal would need 5% support to be eligible for resubmission in the following three years, while those submitted two and three times in the previous five years would need 15% and 25% support, respectively. Companies also gain the right to exclude a proposal if the most recent vote captured less than 50% and there was a decline in votes.

The effect "would be pretty chilling," said Mr. McCauley of Florida SBA. "I think you are going see a pretty significant decline in shareholder resolutions."

Even some well-accepted changes started out small, said Mr. Bertsch of CII. "That early warning on the part of shareholders is quite important. It is going to make it more difficult to raise new issues that we don't even know about yet."

It could take a lot of topics off ballots, and ultimately CEO accountability, said Mr. Jackson, who also sees it strengthening the hand of dual-class share issuers. "It will make it easier for CEOs to run American companies as they see fit."

Patrick McGurn, special counsel and head of strategic research with Institutional Shareholder Services in Rockville, Md., doesn't even see companies pushing that hard for the rule changes, which he thinks are driven by their lobbying groups.

"Boards have become more accustomed to sit down with investors. But would companies be willing to sit down without shareholder proposals? Going forward these conversations may not occur at all," said Mr. McGurn.

If that happens, "people are going turn to challenges to board directors. What they never consider is the unintended consequences," Mr. McGurn said.

The SEC should expect legal challenges, said John Coates, vice dean for finance and strategic initiatives at Harvard Law School. There is "almost no material evidence of errors (by proxy advisers) … there are differences of opinion. I really do think these rules are vulnerable to legal challenge. It's very likely they will not be sustained."