Via Shearman & Sterling
As part of its overall review of how the federal proxy rules apply to proxy voting advice by proxy advisory firms, the Securities and Exchange Commission (SEC) published two interpretive releases in August 2019, aimed at proxy advisory firms and investment advisers that use their services when voting proxies of securities held in client accounts.
The first release (the “proxy solicitation guidance”) addresses how the federal securities laws apply to the advice provided by proxy advisory firms under the federal securities laws. Among other things, the SEC said that providing proxy voting advice constitutes a “solicitation” for purposes of the securities laws.
The second release (the “investment adviser guidance”) addresses how investment advisers can fulfill their obligations to their clients to vote the proxies of securities held in their accounts, including factors that advisers should consider when retaining proxy advisory firms.
Taken together, these interpretive releases reflect the SEC’s ongoing concerns about the role of proxy advisory firms in the U.S. proxy system and signal that the SEC will likely be taking additional steps to regulate the activities, and use, of proxy advisory firms.
In this client alert, we summarize the SEC’s two releases and how they may affect proxy advisory firms and investment advisers that retain them.
Institutional investors and investment advisers rely on proxy advisory firms to help them satisfy obligations with respect to exercising shareholder voting at companies in which they invest. Public companies carefully monitor the policies of proxy advisory firms, which serve as a basis for their voting recommendations, because of the strong correlation between proxy advisory firm voting recommendations and institutional investor and investment adviser voting practices on many matters presented before shareholders. Public companies also engage proxy advisory firms on an ongoing basis to assist them with matters that they present before shareholders, such as a new compensation plan. The two main proxy advisory firms are Institutional Shareholder Services, Inc. (ISS) and Glass, Lewis & Co. (Glass Lewis). Many companies consider the policies of ISS and Glass Lewis in designing their board structure, executive compensation, disclosure and other governance practices in order to avoid a negative vote recommendation with respect to a matter before shareholders or, worse, a vote against re-election of directors. Although proxy advisers do not comprise the sole force driving corporate governance practices (various large institutional investors play a considerable role, too), they have a significant voice.
Many public companies hold the view that proxy advisory firms have an outsized voice and, importantly, have avoided the appropriate level of oversight and regulation commensurate with their influence. On the other side, many institutional investors hold the view that proxy advisory firms are an important part of the system. They assert that the analysis provided by proxy advisory firms is an important input in their voting process, but not determinative. As expected, proxy advisory firms challenge the claims that they do not adequately disclose conflicts of interest, that they do not devote sufficient resources to develop the recommendations they issue and that their recommendations are based on erroneous information.
Critics of the proxy voting process have made little headway in achieving reform. There has been, however, considerable discussion about it. In 2010, the SEC published a concept release on the proxy voting process, which included a section on the role of proxy advisory firms. Additionally, a number of roundtables over the years have addressed the role of proxy advisory firms. Moreover, SEC Commissioners have spoken publicly on the topic. Congress has taken aim at proxy advisory firms too. Over the years, there have been a number of bills proposed in the House of Representatives that sought to impose strict regulatory requirements on proxy advisory firms. This guidance issued by the SEC is the first meaningful step the SEC has taken on this subject since 2014, when it released Staff Legal Bulletin 20 (SLB 20) to provide guidance about the availability and requirements of two exemptions to the federal proxy rules that are often relied upon by proxy advisory firms.
PROXY ADVISORY FIRMS
The solicitation guidance interprets the term “solicitation” in Rule 14a-1(l) under the Securities Exchange Act of 1934 to generally include providing proxy voting advice, which would include the recommendations provided by proxy advisory firms. The SEC stated that in its view “such voting advice provided by a firm marketing its expertise in researching and analyzing proxy issues for purposes of helping its clients make proxy voting determinations (i.e., not merely performing administrative or ministerial services) should be considered a solicitation subject to the federal proxy rules because it is ‘a communication to security holders under circumstances reasonably calculated to result in the procurement, withholding or revocation of a proxy.’” According to the release, if a proxy advisory firm is basing its recommendations on a client’s own tailored voting guidelines or if a client disregards the recommendation, it would still constitute a solicitation. A proxy advisory firm is still, however, able to rely on the exemption from the information and filing requirements provided by Rule 14a-2(b)(1) of the Exchange Act. Thus, proxy advisory firms, for now, do not need to file their reports with the SEC. The SEC indicated in the release that the Staff was developing a proposal “to address proxy advisory firms’ reliance on the proxy solicitation exemptions in Exchange Act Rule 14a 2(b).” The implication of this statement suggests that the Commission is considering eliminating the filing exemption in 14a-2(b)(1), which would be a profound change to the activities of proxy advisory firms.
The release also contains related guidance regarding the application of the anti-fraud provisions in Exchange Act Rule 14a-9, which prohibit any solicitation from containing false or misleading statements or omitting to state a material fact necessary to make the statements included not false or misleading. The solicitation guidance indicates that where a solicitation includes “…opinions, recommendations, or similar views…disclosure of the underlying facts, assumptions, limitations, and other information may be needed so that these views do not raise Rule 14a-9 concerns.” This is particularly important for proxy advisory firms because their reports are full of opinions and recommendations. Failure to provide the adequate level of analysis to support a recommendation could be viewed as a violation.
The release identifies the following examples of the type of information that may be required to be disclosed to avoid a potential violation of Rule 14a-9:
- explaining the methodology used to formulate voting advice on a particular matter (including any material deviations from the provider’s publicly announced position);
- disclosing third-party information sources to the extent that the proxy voting advice is based on information other than the registrant’s public disclosures, highlighting material differences; and
- disclosing 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.
Proxy advisory firms will evaluate their recommendations and communications in light of the solicitation guidance, but we do not think the guidance alone will result in significant change to how proxy advisory firms operate. It remains to be seen, for example, whether certain aspects of proxy reports, such as black box evaluations of compensation practices or rationales for establishing peer companies, will evolve towards more detailed and transparent disclosures.
The solicitation guidance represents an initial step towards proxy advisory firm regulation, confirming that the SEC recognizes the role of these firms in the proxy voting system (and the sway of their voting recommendations) and is examining the appropriate level of oversight. In the absence of further regulatory attention, this latest SEC intervention will serve primarily as a reminder and declaration of the expected standard.
Notably, the solicitation guidance stops short of other proposed reforms such as: (i) requiring registration of proxy advisory firms under the Investment Advisers Act of 1940; (ii) increasing transparency on the internal controls, policies, procedures, guidelines and methodologies of proxy advisory firms; and (iii) requiring proxy advisory firms to provide public companies with copies of their draft reports, in advance of dissemination to their clients, to permit correction of inaccurate information.
Concurrently with the solicitation guidance, the SEC took a step toward indirect regulation of such firms by issuing the investment adviser guidance, which addresses the interrelationship between an investment adviser’s fiduciary duty to clients and the proxy voting rule (Rule 206(4)-6 under the Investment Advisers Act of 1940 (the Advisers Act)), particularly when the investment adviser retains a proxy advisory firm.
Federal fiduciary duty and the proxy voting rule under the Advisers Act
The U.S. Supreme Court and other federal courts have stated that the Advisers Act established a fiduciary duty for investment advisers, made enforceable by the Advisers Act’s antifraud provisions. Although the term “fiduciary duty” does not explicitly appear in the language of the statute, the SEC has provided guidance on the fiduciary duties of investment advisers.
The SEC has clearly stated that an investment adviser’s fiduciary duty under the Advisers Act consists of a duty of care and a duty of loyalty with respect to services undertaken on the clients’ behalf. These duties, by extension, include proxy voting.
The investment adviser guidance builds on both that fiduciary framework and the proxy voting rule. The investment adviser guidance provides that an adviser’s fiduciary duty, as it applies to proxy voting, requires: (1) that an investment adviser that exercises voting authority with respect to client securities adopt and implement written policies and procedures reasonably designed to ensure that the investment adviser votes proxies in the best interest of its clients; (2) that the adviser disclose to clients how they may obtain information regarding how the adviser voted with respect to the client securities; and (3) that the adviser describe its proxy voting procedures and make them available upon request.
Below, we summarize the SEC’s investment adviser guidance.
Proxy voting responsibilities of investment advisers
How may an investment adviser and its client, in establishing their relationship, agree upon the scope of the investment adviser’s authority and responsibilities to vote proxies on behalf of that client?
An investment adviser is not required to accept the authority to vote client securities, regardless of whether the client undertakes to vote the proxies itself. If an investment adviser does accept voting authority, it may agree with its client, subject to full and fair disclosure and informed consent, on the scope of voting arrangements, including the types of matters for which it will exercise proxy voting authority. While the application of the investment adviser’s fiduciary duty in the context of proxy voting will vary with the scope of the voting authority assumed by the investment adviser, the relationship in all cases remains that of a fiduciary to the client.
What steps could an investment adviser that has assumed voting authority on behalf of clients take to demonstrate that it is making voting determinations in a client’s best interest and in accordance with the investment adviser’s proxy voting policies and procedures?
An investment adviser should consider how its fiduciary duty and its obligations under Rule 206(4)-6 apply to multiple clients. Where an investment adviser undertakes proxy voting responsibilities on behalf of multiple funds, pooled investment vehicles, or other clients, it should consider whether it should have different voting policies for some or all of these different funds, vehicles or other clients, depending on the investment strategy and objectives of each.
An investment adviser should also consider whether certain types of matters may necessitate that the adviser conduct a more detailed analysis than what may be entailed by application of its general voting guidelines, to consider factors particular to the issuer or the voting matter under consideration.
What are some of the considerations that an investment adviser should take into account if it retains a proxy advisory firm to assist it in discharging its proxy voting duties?
When an investment adviser is considering whether to retain or continue retaining a proxy advisory firm to provide research or voting recommendations as an input to the adviser’s voting decisions, an investment adviser should consider, among other things, whether the proxy advisory firm has the capacity and competency to adequately analyze the matters for which the investment adviser is responsible for voting. In this regard, investment advisers could consider, among other things, the adequacy and quality of the proxy advisory firm’s staffing, personnel and/or technology.
An investment adviser also would consider whether a proxy advisory firm has adequately disclosed to the investment adviser its methodologies in formulating voting recommendations, so that the investment adviser understands the factors underlying the proxy advisory firm’s voting recommendations. Returning to the discussion above, this piece of the investment adviser guidance closely tracks with the SEC’s apparent interest in more transparency of proxy advisory firm processes and is a clear effort to motivate investment advisers, and potentially other institutional investors, to inquire further—in effect, driving change at proxy advisory firms by pushing the firms’ customers to look further under the hood.
What steps should an investment adviser consider taking if it becomes aware of potential factual errors, potential incompleteness or potential methodological weaknesses in the proxy advisory firm’s analysis that may materially affect one or more of the investment adviser’s voting determinations?
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. This means understanding the potential for factual errors, incompleteness or methodological weaknesses in the proxy advisory firm’s analysis. An investment adviser that has retained a proxy advisory firm for research or voting recommendations as an input to its voting determinations should consider including in its policies and procedures a periodic review of the investment adviser’s ongoing use of the proxy advisory firm’s research or voting recommendations.
In reviewing its use of a proxy advisory firm, an investment adviser should also consider the effectiveness of the proxy advisory firm’s policies and procedures for obtaining current and accurate information relevant to matters included in its research and on which it makes voting recommendations. This means considering the proxy advisory firm’s engagement with issuers, its efforts to correct any identified material deficiencies in its analysis, its disclosure to the investment adviser regarding its sources of information and methodologies used in formulating voting recommendations, and its consideration of factors unique to a specific issuer or proposal when evaluating a matter subject to a shareholder vote. Again, this aspect of the investment adviser guidance tracks closely with the SEC’s apparent interest in driving more transparency from the proxy advisory firms.
How can an investment adviser evaluate the services of a proxy advisory firm that it retains?
To comply with Rule 206(4)-6, an investment adviser that has retained a proxy advisory firm to assist substantively with its proxy voting responsibilities and carrying out its fiduciary duty should adopt and implement policies and procedures that are reasonably designed to sufficiently evaluate the proxy advisory firm in order to ensure that the investment adviser casts votes in the best interest of its clients. For example, a proxy advisory firm’s policies regarding conflicts of interest or its conflicts of interest themselves, could change after the investment adviser’s initial assessment of the proxy advisory firm, and these changes could materially alter the effectiveness of the proxy advisory firm’s policies and may require the investment adviser to make a subsequent assessment. Thus, an investment adviser should consider policies to identify and evaluate a proxy advisory firm’s conflicts of interest that can arise on an ongoing basis, and should consider requiring the proxy advisory firm to update the investment adviser regarding business changes the investment adviser considers relevant. An investment adviser should also consider whether the proxy advisory firm appropriately updates its methodologies, guidelines and voting recommendations on an ongoing bases, including its response to feedback from issuers and their shareholders.
Is an investment adviser who has assumed voting authority on behalf of a client required to exercise every opportunity to vote a proxy for that client?
Not necessarily. The investment adviser guidance provides two examples of when an adviser is not required to vote proxies for a client.
First, if an investment adviser and its client have agreed in advance to limit the conditions under which the investment adviser would exercise voting authority, as discussed above, the investment adviser need not cast a vote on behalf of the client where contemplated by their agreement.
Second, an investment adviser that has voting authority may refrain from voting a proxy on behalf of a client if it has determined that refraining is in the best interest of that client. This may be the case where the investment adviser determines that the cost to its client of voting the proxy exceeds the expected value to the client. In making such a determination, the investment adviser may not ignore or be negligent in fulfilling the obligation it has assumed to vote client proxies and cannot fulfill its fiduciary responsibilities to its clients by merely refraining from voting on the proxies. This means that before refraining from voting under the circumstances described in this second situation, an investment adviser should considerer whether it is fulfilling its duty of care to its client in light of the scope of services to which it and the client have agreed.
Comparison to prior Staff positions
In 2014, in SLB 20, the SEC provided guidance regarding an investment adviser’s responsibilities in voting client proxies and retaining proxy advisory firms
SLB 20 was a Staff position, while the 2019 guidance is an SEC interpretive release. Interpretive releases are not law, but they provide statements as to the position of the Commission itself, rather than the Staff. An interpretive release represents a more authoritative interpretation than Staff guidance.
As to substance, the 2019 guidance and SLB 20 often cover the same ground, but the guidance generally does so in more detail. The 2019 guidance does not withdraw SLB 20 or directly state that it is superseding it.
The investment adviser guidance stops short of prescribing specific steps that an adviser must take to comply with the law. Rather, this is “principles-based guidance” and leaves room for the adviser to tailor its own compliance program based on its specific information. On the other hand, it does include numerous examples of practices that “should be considered.” Investment advisers will be well advised to give thought and care to these, and when a particular practice suggested by the guidance might not be implemented, there should be appropriate consideration of both the suggested practice and its alternatives.
It is unclear how proxy advisory firms and investment advisers will react to the new guidance. Will proxy advisory firms engage with companies before issuing a report? Will proxy advisory firms devote more personnel to the reviews they conduct in connection with the voting recommendations they issue? Will there be a change in disclosures of conflicts of interests and the basis of recommendations? How will investment advisers change their compliance policies and procedures concerning proxy voting advisers? Will investment advisers modify their reliance on proxy advisory firms?
We expect investment advisers will focus on how the investment adviser guidance affects their interaction with proxy advisory firms. We also expect investment advisers to revisit their practices and their interactions with proxy advisory firms. Notwithstanding these general predictions, the precise outcome will only become apparent through time and interpretation.
The proxy advisory firms themselves will presumably pay close attention to the investment adviser guidance. It is reasonable to expect that they will develop various inputs and informational packages that investment advisers can use in responding to the SEC’s expectations for advisers suggested by the investment adviser guidance.
While the investment adviser release is ostensibly directed towards regulating investment advisers, the guidance could be seen as an indirect approach to regulating proxy advisory firms by modifying their interactions with investment advisers. Investment advisers may demand changes from the proxy advisory firms in light of the guidance.
There is a tension between the relationship of proxy advisory firms and the two target audiences of the SEC’s releases: public companies and investment advisers. Public companies generally support SEC initiatives to encourage restraint among such firms, but investment advisers may be concerned that too much “censorship” of proxy advisory firms will restrict valuable services that such firms provide to investment advisers, which supports their business model.
As we get closer to the kickoff of the 2020 annual meeting season, all eyes will watch for change. Additionally, everyone will be watching for subsequent rulemaking that the SEC foreshadowed when it issued the guidance, which we expect will attempt to turn the screws a little tighter on the activities of proxy advisory firms.
For further assistance in evaluating the guidance or the recommendations of proxy advisory firms with respect to your company, please reach out to your Shearman & Sterling contacts.
 See “Commission Interpretation and Guidance Regarding the Applicability of the Proxy Rules to Proxy Voting Advice.”
 See “Commission Guidance Regarding Proxy Voting Responsibilities of Investment Advisers.”
 The 2010 release sought public comment on proxy advisory firm services, potential conflicts of interest that may exist for proxy advisory firms and users of their services, and the transparency and accuracy of recommendations by proxy advisory firms. See “Concept Release on the U.S. Proxy System.” For information on the most recent roundtable, see the 2018 Roundtable on the Proxy Process. Most recently, several Commissioners issued public statements (in support and dissent), concurrent with the release of the August 2019 guidance. See Public Statements.
 See SEC Staff Legal Bulletin No. 20, Proxy Voting Responsibilities of Investment Advisers and Availability of Exemptions from the Proxy Rules for Proxy Advisory Firms (June 30, 2014).
 Securities and Exchange Commission Interpretation Regarding Standard of Conduct for Investment Advisers, 84 FR 33669, at 33671–72.
 See, e.g., EC v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 194 (1963).
 See “SEC Adopts Interpretive Guidance on Investment Adviser Fiduciary Duty.”