SEC Chair Clayton: Proxy Plumbing May Be Back on the Agenda

Today, SEC Chairman Jay Clayton addressed the participants of the PLI 49th Annual Institute on Securities Regulation in NYC.  His prepared, written remarks stated: 

Over the years, participants in the proxy process – companies and shareholders alike – have expressed concerns about a variety of proxy matters. In 2010, the SEC solicited input on several proxy matters in a concept release on the U.S. proxy system.[14] Since that time, the SEC staff has taken steps to enhance the proxy process, but calls for action are becoming more frequent and are growing louder. [15] It is clear there are still opportunities for improvement. I believe the Commission should consider reopening the comment file on the 2010 “Proxy Plumbing” concept release to solicit updated feedback from market participants about what works and what does not work in our proxy system.

Great idea.  Unfortunately, the SEC seems to have a lot of other things to do, and proxy plumbing might only appear on its "Long-term Agenda".   

Did the SEC staff Foist Proxy Advisor Reforms on the Backs of Investment Advisers?

After reflecting further on SEC Staff Legal Bulletin No. 20 that was issued yesterday, a word comes to mind: indirection.  Consider Q&A 3 and 4 below.  It seem as though the SEC staff is trying to affect the behavior of proxy advisers indirectly by hammering on the investment advisers (i.e., the proxy adviser's clients).  Notwithstanding the headline, maybe indirect regulation is the right approach.

Question 3.  What are some of the considerations that an investment adviser may wish to take into account if it retains a proxy advisory firm to assist it in its proxy voting duties?

Answer.  When considering whether to retain or continue retaining any particular proxy advisory firm to provide proxy voting recommendations, the staff believes that an investment adviser should ascertain, among other things, whether the proxy advisory firm has the capacity and competency to adequately analyze proxy issues.⁶  In this regard, investment advisers could consider, among other things: the adequacy and quality of the proxy advisory firm’s staffing and personnel; the robustness of its policies and procedures regarding its ability to (i) ensure that its proxy voting recommendations are based on current and accurate information and (ii) identify and address any conflicts of interest and any other considerations that the investment adviser believes would be appropriate in considering the nature and quality of the services provided by the proxy advisory firm.

Question 4.  Does an investment adviser have an ongoing duty to oversee a proxy advisory firm that it retains?

Answer.  The staff believes that an investment adviser that has retained a third party (such as a proxy advisory firm) to assist with its proxy voting responsibilities should, in order to comply with the Proxy Voting Rule, adopt and implement policies and procedures that are reasonably designed to provide sufficient ongoing oversight of the third party in order to ensure that the investment adviser, acting through the third party, continues to vote proxies in the best interests of its clients. ⁷  In addition, the staff notes that a proxy advisory firm’s business and/or policies and procedures regarding conflicts of interest could change after an investment adviser’s initial assessment, and some changes could alter the effectiveness of the policies and procedures and require the investment adviser to make a subsequent assessment.  Consequently, the staff has stated that investment advisers should establish and implement measures reasonably designed to identify and address the proxy advisory firm’s conflicts that can arise on an ongoing basis,⁸ such as by requiring the proxy advisory firm to update the investment adviser of business changes the investment adviser considers relevant  (i.e., with respect to the proxy advisory firm’s capacity and competency to provide proxy voting advice) or conflict policies and procedures.

SEC Staff Guidance on Proxy Voting

"The [SEC] staff recognizes that investment advisers and proxy advisory firms may want or need to make changes to their current systems and processes in light of this guidance.  The staff expects any necessary changes will be made promptly, but in any event in advance of next year’s proxy season."  

Those are the SEC staff's parting words in its guidance issued on June 30, 2014 to investment advisers and proxy advisory firms.  In the so-called "staff legal bulletin No. 20", the "Division of Investment Management is providing guidance about investment advisers’ responsibilities in voting client proxies and retaining proxy advisory firms.  The Division of Corporation Finance is providing guidance on the availability and requirements of two exemptions to the federal proxy rules that are often relied upon by proxy advisory firms."   

The guidance takes the form of 13 Q&As, and it is available here. https://www.sec.gov/interps/legal/cfslb20.htm

Here is Q&A No. 5:

Question 5.  What are an investment adviser’s duties when it retains a proxy advisory firm with respect to the material accuracy of the facts upon which the proxy advisory firm’s voting recommendations are based?

Answer.  As stated above, it is the staff’s position that an investment adviser that receives voting recommendations from a proxy advisory firm 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.9  For example, an investment adviser may determine that a proxy advisory firm’s recommendation was based on a material factual error that causes the adviser to question the process by which the proxy advisory firm develops its recommendations.   In such a case, the staff believes that the investment adviser should take reasonable steps to investigate the error, taking into account, among other things, the nature of the error and the related recommendation, and seek to determine whether the proxy advisory firm is taking reasonable steps to seek to reduce similar errors in the future.

How likely is this going to happen? How are investment advisers to learn of material factual errors in proxy advisor reports - will public companies promote a "fact check" website? 

And here is Q&A 10:

Question 10.  If a proxy advisory firm provides consulting services to a company on a matter that is the subject of a voting recommendation or provides a voting recommendation to its clients on a proposal sponsored by another client, would the proxy advisory firm be precluded from relying on Rule 14a-2(b)(3)?
Answer.  In order to rely on Rule 14a-2(b)(3), a proxy advisory firm would need to first assess whether its relationship with the company or security holder proponent12 is significant or whether it otherwise has any material interest in the matter that is the subject of the voting recommendation and disclose to the recipient of the voting recommendation any such relationship or material interest.  Whether a relationship would be “significant” or what constitutes a “material interest” will depend on the facts and circumstances.  In making such a determination, a proxy advisory firm would likely consider the type of service being offered to the company or security holder proponent, the amount of compensation that the proxy advisory firm receives for such service, and the extent to which the advice given to its advisory client relates to the same subject matter as the transaction giving rise to the relationship with the company or security holder proponent.  A similar inquiry would be made for any interest that might be material.  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. 

Stay tuned for more.

ESMA Says Proxy Advisor Industry Doesn't Need EU Regulation - It Needs A Code of Conduct

The European Securities and Markets Authority (ESMA) recently determined that no additional EU regulation concerning proxy advisors is warranted at this time. The ESMA found that additional regulation was not justified because it had not been provided with clear evidence of market failure in relation to how proxy advisors interact with investors and issuers. However, it did identify several concerns and recommended that the industry develop a code of conduct. In two years the ESMA may reconsider its position if no substantial progress has been made. The Final Report of the ESMA can be found here.

Background

In March 2012, ESMA published a Discussion Paper on proxy advisors, seeking input of stakeholders on several key issues relating to the proxy advisory industry, and asked whether market participants see any need for policy action in this area. ESMA viewed the Discussion Paper as an opportunity to gain evidence on the extent to which “market failures” related to the activities of proxy advisors may exist, the extent to which EU-level intervention might be appropriate, and what ESMA’s role might involve.

The Discussion Paper noted that if evidence demonstrates that there are market failures (e.g., so that advice given cannot be said to be accurate, independent and reliable) and these market failures give rise to regulatory concerns, there might be increased need for the introduction of measures to address such concerns. Such measures would ultimately aim to achieve better outcomes through the shareholder vote process (e.g., by minimizing factual errors contained in reports, mitigating or eliminating conflicts of interest that impair the independence of any advice and enhancing the level of transparency in the proxy advisor market).  Even without clear evidence of market failure, some regulatory initiatives may be considered as necessary in order to prevent potential risks.

The Discussion Paper invited contributors to provide ESMA with their input on 12 questions, which ranged from the degree of influence of proxy advisors on investors’ voting to the key issues related to the offer of their services, ending with the existence of a need for any policy action in this area. A total of 63 comment letters were received (57 were non-confidential and are available here.

Final Report

After analysis of the inputs received, ESMA concluded in the Final Report that it has not been provided with clear evidence of market failure in relation to how proxy advisors interact with investors and issuers. On this basis, ESMA currently considers that the introduction of binding measures would not be justified. However, based on its analysis and the inputs from market participants, ESMA considers that there are several areas, in particular relating to transparency and disclosure, where a coordinated effort of the proxy advisory industry would foster greater understanding and assurance among other stakeholders in terms of what these can rightfully expect from proxy advisors. Such understanding and assurance will help to keep attention focused where it belongs, namely on how investors and issuers can, from their respective roles foster effective stewardship and robust corporate governance, and ensure efficient markets. Consequently, ESMA considers that the appropriate approach to be taken at this point in time is to encourage the proxy advisory industry to develop its own Code of Conduct. 

While ESMA will facilitate the establishment of the work on a Code, ESMA states that the Code will need to be drafted and adopted by the proxy advising industry itself.  In two years the ESMA may reconsider its position if no substantial progress has been made.

Observations

So why did the ESMA not recommend additional EU regulation, and only suggest an industry code of conduct?  The Final Report states:

“The rationale for this decision mainly relies on the feedback coming from the market. ESMA asked specifically whether stakeholders consider that there is market failure in relation to how proxy advisors interact with investors and issuers. The feedback did not provide any clear examples of such market failure.” 

I had expected that feedback from issuers would reveal some “market failure” examples.  However, after reading several of the letters it became apparent that most did not provide much detail.

 The Hundred Group

 For example, the letter written by The Hundred Group:

“The Hundred Group represents the views of the finance directors of FTSE 100 and several large UK private companies. Our member companies represent almost 90% of the market capitalisation of the FTSE 100, collectively employing over 7% of the UK workforce and in 2011, paid, or generated, taxes equivalent to 13% of total UK Government receipts.”

The Hundred Group’s seven page letter was big on concerns and suggestions but weak in any actual examples of “market failure.”  I’m not sure if there was one concrete example in the letter. In any event The Hundred Group was wary of the introduction of additional regulation, either at the national or European level. In its experience, regulation risks significant unintended consequences.  It preferred the development of an industry code, along national lines, against which advisors measure their compliance and which provides a framework for institutional investors to govern their use of proxies.

On a more interesting side note, The Hundred’s Group’s letter also had recommendations concerning the conduct of institutional investors:

“Investors should be required to notify the company of any intention to vote against a resolution with at least 14 days notice, in order to give the company the opportunity to engage in a dialogue with the investor. If this were to happen in every case, the need to understand the advisor’s methodology diminishes, although we would still find it helpful if any deviations from a standard model were being employed.”

“In our view there should be an ownership threshold above which an institution should retain the responsibility for both engagement and the voting decision – we recommend that this is set at a maximum of 1% of the voting capital of the company. In the case where the ownership level is lower and an institution relies on the advice of the proxy [advisor], a mechanism should be in place which allows the investor to understand and challenge the proxy’s advice.”

EuropeanIssuers

A letter from EuropeanIssuers.  

"EuropeanIssuers is the first and only pan European organisation created to promote the interests of issuing companies. It represents the vast majority of publicly quoted companies in Europe. Its members are national associations and companies from 14 European countries counting together some 9.200 listed companies with a combined market value of some € 5.000 billion."

Its four page letter states that its members do not favor binding EU regulation.  A majority of the members prefers either an EU-wide industry code or an EU recommendation which can be implemented in national codes or regulation as appropriate.  I didn’t find concrete examples of market failures in the EuropeanIssuer’s letter either.

Manifest Information Services

Manifest Information Services is not an issuer, but I found its letter interesting. In fact, it points out what I perceive to be a flaw in the Discussion Paper, and why I believe respondents did not identify specific examples of “market failure” from which ESMA might have been educated. Although the Discussion Paper refers to “market failures,” none of the 12 specific questions requesting comment refer specifically to “market failure.”  As Manifest points out, the Discussion Paper “does not state whether the problems referred to are, or if there has already been, a market ‘failure’ or simply feels there is potential for a market ‘failure’. Indeed, ESMA does not even explain what market failures might be, such as a failure of securities markets, investment markets, markets for research, markets for access to issuers and so on.”  While I am not suggesting there is evidence of systemic market failures due to proxy advisers, I am saying that the Discussion Paper could have been clearer, which could have resulted in more examples. Alternatively, the lack of examples could also stem from issuer apathy towards responding to, or lack of awareness of, the Discussion Paper, or there just is no evidence.

In any event, Manifest’s 37 page letter is a stimulating read. To give you a flavor, it starts out with “We question the regulatory competence under which ESMA has taken it upon itself to investigate this issue,” and it ramps up after that.

ExxonMobil calls for Full Disclosure by Proxy Advisers

Exxon Mobil has supplemented its comment letter on the proxy plumbing concept release -- focusing on the subject of full disclosure by proxy advisers.  The company is one of the most widely held public companies in the U.S.A., with over 2.5 million registered and beneficial shareholder accounts. The new letter has the four following recommendations:

1. Proxy advisers should disclose how the methodologies they use to assess pay-for-performance were developed, and why they believe those methodologies provide an appropriate basis for their voting recommendations.
2. Proxy advisers must ensure that all information they publish which could affect an investor’s voting decision is accurate and not misleading.
3. Proxy advisers should fully disclose the involvement of any third party in the formulation of particular voting recommendations.
4. The SEC staff should remind investment managers of the need to monitor the performance, on an ongoing basis, of any proxy advisers on which a manager may rely.

The letter then goes into detail on each one.

What you might find interesting are the attachments that Exxon uses to support some of its points, with a focus on Institutional Shareholder Services (ISS). Attachment I is Exxon’s analysis that suggests ISS’ short-term relative total shareholder return emphasis is not an accurate predictor of longer-term positive results for shareholders.  Attachment II are copies of correspondence ExxonMobil submitted to ISS last proxy season with respect to the adviser’s GRId matrix. “While ISS did correct some of the errors we identified in the initial GRId report, uncorrected flaws in the design and implementation of GRId carry the potential to confuse or mislead shareholders in a number of areas including . . ..”

A copy of the letter is at http://www.sec.gov/comments/s7-14-10/s71410-313.pdf.