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".   

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.

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.

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.

According to the petition:

 “The refusal of brokers to disseminate information to shareholders at an online platform of their choosing is the first significant problem that needs to be addressed. The second major hurdle is the fact that proxy distribution/collection agents are presently charging significant fees to internet voting platforms to collect votes - a fee that we believe should be paid by public companies and one that proves substantially more burdensome to individual voters than institutional voters.”

Delivery of Information by Brokers

The petition describes in detail (a) the difficulties that Moxy Vote experienced in obtaining the cooperation of brokers and (b) how Moxy Vote does not fit neatly into the regulatory regime for registered investment advisers.  It also describes how a neutral website would fit within the framework contemplated for “proxy advisers” under the SEC’s proxy plumbing concept release.

Ultimately the petition states that the neutral voting platform idea should be incorporated into a proposed rule on “proxy plumbing.”  At the end of the petition letter there are proposed changes to the SEC’s proxy rules, which define a neutral Internet voting platform (“platform”), specify that a broker can satisfy its obligation to forward information to a beneficial owner of stock by transmitting such information to a platform designated by the beneficial owner, and create an exception from certain proxy solicitation rules for licensed platforms that furnish of proxy voting advice.

 Fees Reimbursement

 Mr. Eiben believes that the fee issue can be addressed without rulemaking:

"The NYSE should state that the existing fee reimbursement for collecting ballots electronically is intended to fully cover all collection costs, including any file exchanges with internet voting platforms, and that issuers must pay all of these collection costs.  Moreover, as part of its ongoing assessment of fees, the NSYE should reevaluate the appropriate reimbursement level, paid by issuers to Broadridge, for ballots collected electronically. The present amount of $0.06 per ballot does not likely provide sufficient revenue to account for the electronic voting infrastructure that has evolved over time. It is again worth noting that issuers should not fear the increase in costs here. That is, they will likely realize substantial savings relative to other forms of proxy ballot delivery and collection, as well as, more efficient means of solicitation as needed. Also, FINRA should provide guidance to brokers that they may not hire intermediaries (e.g., Broadridge) that charge a fee to anyone other than issuers for proxy collection."

The full text of the petition can be found at http://www.sec.gov/rules/petitions/2012/petn4-651.pdf, and Moxy Vote’s comment letter on the SEC’s proxy plumbing concept release can be found at http://www.sec.gov/comments/s7-14-10/s71410-181.pdf.

Let’s make believe that 80% of the 600 companies wanted to take Blackrock up on the offer, and let’s assume 75% of those have their annual meetings from April through June, and each have a half hour telephone call with Blackrock.  That’s a total of 180 hours of phone calls.  Now let’s assume that a member of Blackrock’s global Corporate Governance and Responsible Investment (CGRI) team spends an additional half hour before the call (as preparation) and an additional half hour after the call (as follow-up).  Now we are up to 540 hours.  Let’s assume half of the 20-member CGRI team spends three hours of each day on this task.  So within 18 days, a little under three weeks, they should be able to handle the task. :-)

I don’t know what prompted the CEO’s letter.  It appears consistent with Blackrock’s philosophy of engagement historically.  They say they already engage with over 1,000 companies every year (10%-15% of its investments).

It's interesting to note that according to Blackrock, for the 37 U.S. incorporated companies that did not get majority shareholder support on the "say-on-pay" vote during the past proxy season, Blackrock voted “for” pay for half and voted “against” pay on half, and it engaged with close to three quarters of these companies. Michele Edkins, the global head of the CGRI team, is quoted in the The Financial Times as saying "remuneration is a pretty small piece of the puzzle." Factors to blame for value destruction are board issues such as "succession planning, poor board decision-making, not having the right people capable of the job." For example, it appears Blackrock voted “for” pay at the Nabors Industries annual meeting last year (1 of the 37) but withheld votes against a director.

In case you are interested and in the San Francisco area on Monday evening, January 30, 2012, you can hear from three members of the CGRI team.  There is a Q&A too.  

The Financial Times earlier this year interviewed Ms. Edkins:

Ms. Edkins points to the difficulties of voting across borders, describing the process as “a nightmare.”  “It’s incredible.  In a day and age when your telephone can tell you exactly where you are in the world, you can’t vote end to end and get confirmation that has happened through a custodial voting chain.”  Global investors need to step up their efforts to simplify the voting instruction process and make it electronic, she concludes.

Proxy plumbing is a global issue.

In “The Elimination of Broker Voting: Much Ado About Nothing?”, the authors, Ali Akyola, Konrad Raffb and Patrick Verwijmerenb state:

Overall, we do  not find a convincing effect of the rule change on shareholder value, not even for those firms that  seemed to be mostly targeted by the new rule. Moreover, the probability that a particular director would be voted off the board has not increased since the rule change. . .   .

However, given the absence of wealth effects for even those firms in which we expect the strongest impact of the new rule, it appears that shareholders do not view the elimination of broker votes as an important first step,  and are not convinced that other, more value relevant, steps will be taken. .  .

Another potential explanation is that the SEC, the NYSE, shareholder activists, and proxy advisory firms acted in the best interest of investors and simply misjudged the effectiveness of the regulation ex-ante.  . .

We find that excluding broker votes, which in our sample represent 12% of the votes cast in 2009, would decrease the average approval rate by only one percent. .  . .

A more plausible explanation for our findings is that broker votes are not of substantial importance and that outside pressure has been an important factor in the SEC’s decision to change regulation. A desire of proxy advisory firms and shareholder activists to demonstrate vigilance could explain why they strongly supported the change in regulation, even if this change was unlikely to be effective.

This “more plausible explanation” is described in more detail as follows:

Our results raise questions about the role that different actors play in the initiation and adoption of regulation. Many market participants, notably shareholder activists and proxy advisory firms, strongly supported the rule change from its beginning and exerted pressure on the SEC to adopt it. The rule’s apparent futility suggests that it may be of interest to study in more detail the incentives and potential biases in decision making within these organizations regarding regulation. Rather than being unbiased agents for shareholders, these institutions may have incentives to pursue or advocate policies to enhance their own public visibility or perceived disciplinary role. Belinfanti (2009) argues that proxy advisory firms do not have appropriate incentives to act in the best interest of investors because they benefit from high barriers to entry in the proxy advisory market and bear no risk from providing bad recommendations. McCall (2011) stresses the possibility that proxy advisory firms respond to incentives such as the generation of consulting revenue and to demonstrate vigilance to subscribers and politicians. A desire of proxy advisory firms and shareholder activists to demonstrate vigilance could explain why they strongly support changes in regulation, even if these are likely to be ineffective.

Our results also raise the question to what extent the SEC’s actions are distorted by outside pressure, which relates to the political-economy approach to financial regulation that attempts to provide a positive analysis of the evolution of regulations (see Kroszner, 2000). Our findings suggest that it is interesting to open the black box of the SEC and examine more closely its motivations in the design of governance regulation. This topic has not received much attention in the corporate governance literature. A notable exception is Choi et al. (2011), who provide evidence that the SEC may have misallocated enforcement resources to less efficient investigative activities due to news coverage and media frenzy on option backdating. Their results raise the question how the media, in turn, allocates its attention and resources and which distortion may arise in this context. In a time when the SEC and its supporters recurrently complain about the lack of resources devoted by Congress to the SEC’s mission of investor protection, evidence on the effectiveness of SEC regulation is of the highest importance.

Although I have not analyzed this paper thoroughly, I am initially skeptical of the methodology employed by the study and the inferences that can be drawn from it.  But I do not dismiss the questions it raises generally.  The SEC seems to have a lot of economists now (http://www.sec.gov/divisions/riskfin/economistbios.shtml), and it is looking for more (http://www.sec.gov/divisions/riskfin/rfemployment.shtml).  Hopefully some of them are familiar with behavioral economics and that this discipline is also brought to bear in the regulatory process.  See http://ssrn.com/abstract=500203.

The paper is cited as: Akyol, Ali C., Raff, Konrad and Verwijmeren, Patrick, The Elimination of Broker Voting: Much Ado About Nothing? (December 15, 2011). Available at SSRN: http://ssrn.com/abstract=1973558

 I’ll mention a few of CIRI’s comments: 

• CIRI would propose that consideration be given to regulatory initiatives under a fair disclosure regime to require that any report/recommendation be provided to the appropriate issuer in a timely fashion, prior to the report being issued to the proxy advisor firm’s institutional clients. We understand this practice is being followed by Governance Metrics International when it creates research reports on the risk profile of corporate issuers for its investor community clients.
• CIRI would like to see advisory firm voting recommendations be provided to all issuers (not just large capitalization companies who sign up for them) in advance of the recommendations being issued to investor clients and in a manner to provide sufficient time to provide a real and meaningful opportunity for issuers to correct factual research errors or engage in a dialogue with advisory firms if contentious issues arise. While the ability of selected, large capitalization companies to sign up to receive a copy of the recommendation is an improvement, we know of at least one TSX 60 company that signed up for the report but never received it.
• Proxy advisory firms should be required to disclose (a) if and when a recommendation has been provided to the issuer, (b) the name and contact information of the research analyst responsible for the recommendation, (c) the most recent date a discussion was held with the issuer and (d) whether there was any consultation with either the issuer’s management or board prior to the recommendation.
• Proxy advisory firms should be required to establish a mandated appeals process for those issuers who have concerns about a research report that cannot be resolved through direct dialogue with the advisory firm.
• Institutional investors should be required, as we believe they are in the UK under the Stewardship Code, to disclose whether or not and to what degree they rely on the recommendations of proxy advisory firms with regard to shareholder voting issues. In addition, institutional investors should be required to disclose or certify as to the internal controls they use to ensure the integrity and reliability of the services provided to them by a proxy advisory firm.
• If not already the case, it should be mandated that votes on securities of individual issuers should have significant input from the individuals, such as the portfolio manager, or investment teams directly responsible for the decision to purchase and own the securities.

 The 200+ page Davies Report can be found at http://www.dwpv.com/shareholdervoting

This all comes as the Ontario Securities Commission continues to review the proxy system in Canada. It solicited comments earlier this year.

• Early-Stage Entitlement Confirmation:  All parties that anticipate submitting votes for a shareholders’ meeting should confirm their voting entitlements with the meeting tabulator within a defined period following the record date. The Roundtable suggests six business days.
• Encouragement of Early Voting:  All shareholders, whether large or small, institutional or retail, are encouraged to cast votes early in the solicitation period and, in any event, no later than three business days before the shareholders meeting.  This recommendation addresses a major cause of potential voter disenfranchisement – late-stage voting, making thorough analysis and reconciliation by tabulators and nominees difficult.
• Enhancements to Exception Processing:  Tabulators should promptly communicate to vote-reporting entities the reasons vote reports are being rejected.  The Roundtable believes such communication should be on the day after a tabulator identifies the discrepancy. 
• Vote Confirmation:  The proxy process should enable investors to obtain, via the Internet or other electronic means, a vote confirmation on a demand or as needed basis.  The existing Voting Instruction Form (VIF) control numbers serve as the unique identifier needed to facilitate vote confirmation.  The Report also provides for confirmation of the overall proxy system through audits and other reviews. 

Read the full report of the roundtable.