Florida SBA Supports Proxy Access and Advisory Firm Transparency

Michael McCauley is Senior Officer, Investment Programs & Governance, of the Florida State Board of Administration (the “SBA”). This post is based on an excerpt from the SBA’s 2011 Corporate Governance Report by Mr. McCauley, Jacob Williams and Lucy Reams. Mr. Williams and Ms. Reams are Corporate Governance Manager and Senior Corporate Governance Analyst, respectively, at the SBA. The complete report is available here; further information regarding the SBA’s governance activities, including proxy voting data, is available here.

Proxy Access

The SEC passed a new rule which would give shareowners greater “Proxy Access” and an avenue to challenge unresponsive directors. By a 3-2 vote, the SEC gave individual (or groups of shareowners) who held 3 percent ownership for 3 years the right to put candidates on corporate ballots. Shareowners would be able to nominate at least one director and as much as 25 percent of a board. In September, the Business Round Table and the U.S. Chamber of Commerce filed legal challenges to the rule arguing that the SEC failed to adequately measure the costs imposed on companies. As a result, the SEC put a hold on the implementation of Proxy Access until the legal questions are resolved, with its earliest application occurring in 2012 if it passes the legal challenges.

In an August 2009 comment letter to the SEC, and as part of a follow up letter in January 2010, SBA staff described the value and efficacy of the ability of shareowners to nominate director candidates. Both letters are available on the SEC’s website. Some opponents of proxy access raised concerns about the short and long-term effects of allowing investors to nominate their own board representatives, focused on special interests and the potential for disrupting board continuity as well as the labor market for directors.

However, it is difficult to conceive that a candidate seeking to represent special interests could achieve victory in a board election. Special interests are by definition limited to a minority of shareowners. If elected by a majority or preponderance of shares, such an agenda can no longer be considered “fringe” or special interest. For this reason, SBA staff does not consider the claim that a small minority could impose their will on the majority of investors. The SEC’s proposal provided further protection against such a scenario by requiring disclosure designed to highlight any such interests or relationships.

Opponents of proxy access also suggested that the presence of directors elected via facilitated nomination may cause disruption in the boardroom and affect the functioning of the overall board. Judging by the vitriol in past particularly heated and personal proxy battles waged, this is not an entirely unreasonable speculation. However, if the minority slate proposed through the proxy access vehicle is successful in winning board positions, it is then legally incumbent upon each board member to act in the best interests of all shareowners according to the board’s fiduciary duty. A director or directors who are disruptive to the point that it impedes the board’s functioning must be dealt in this legal regard, and as this potential is not limited to directors who have been elected through the facilitated nomination process, SBA staff does not support any rationale tied to restricting proxy access for minority slate candidates for this reason. As it is shareowners that ultimately bear any cost, investors are more likely to favor their ability to cast votes that take into account any such possibility.

As SBA staff serve in a fiduciary capacity, the importance of a director’s pride or reputation cannot be placed above the priority of ensuring our invested companies have the most qualified and well-equipped directors. If a candidate desires the opportunity to assist in the oversight and management of a firm, it should be worth the chance that the candidate may ultimately be unsuccessful in their bid for a seat on the board. It is our opinion that a well-qualified director candidate will assume this risk. These are paid positions of considerable importance and responsibility, and in the interest of shareowners, it cannot come with a guarantee of tenure or election. Further, competition in this area may discourage less qualified individuals, as noted in the SEC proposal, and thereby increase the overall quality of the board.

Shareowner Activism

The SBA actively monitors the governance structures of individual companies, and may take specific action intended to prompt changes at those companies. For example, the SBA frequently discusses proxy voting issues and general corporate governance topics directly with public companies in which shares are held. The SBA routinely interacts with other shareowners and groups of institutional investors to discuss significant governance topics, helping to stay abreast of issues involving specific firms and important legal and regulatory changes.

As new governance-related rules and regulatory proposals are publicized, the SBA periodically submits formal comment to regulatory oversight bodies such as the Securities & Exchange Commission, the New York Stock Exchange, the Financial Accounting Standards Board and the Public Company Accounting Oversight Board. During 2010, the SBA submitted formal regulatory comments to the SEC, the Financial Services Agency of Japan, and to the NASDAQ Stock Market. On October 20, 2010, the SBA submitted a comment letter to the SEC covering the regulation of proxy advisory firms, securities lending impact on voting, empty voting, OBO/NOBO, over/under voting, efficiency of the voting chain, and dual record dates, among other topics.

Proxy Advisory Firms

Proxy advisory firms play an important role in helping pension fund managers fulfill their fiduciary duties with respect to proxy voting by providing an analysis of issues on the ballot, executing votes and maintaining voting records. Without proxy advisors and the services they offer to clients, the SBA would find it difficult to analyze and vote the volume of proxies demanded through our extensive global equity holdings. The global integration of the financial markets and the rise of complex multinational corporations have exacerbated the types and volume of proxy issues before shareowners.

As a result, the role of independent proxy advisory firms is critical to assist investors in decoding voting items and providing valuable advice to shareowners. It is reasonable to expect proxy advisory firms to provide clients with substantive rationales for vote recommendations; minimize conflicts of interest and disclose the details of such conflicts; and correct material errors promptly and notify affected clients as soon as practicable.

The SBA actively uses the recommendations of proxy advisory firms to assist in making voting decisions. As a client, the SBA routinely critiques the proxy recommendations, research models, analytical framework, and governance policies of each of our external proxy advisory firms. Such client feedback is vital to maintaining relevant and accurate proxy recommendations. Proxy advisory firms should provide relevant research which supports their recommendations and disclose, to an extent, the methods upon which they make their recommendations. Proxy advisory firms are one of the few significant participants in the voting process that are not generally required to be registered or regulated by the Commission. SBA staff believes there should be additional transparency surrounding the application of policies and varied analytical methodologies used by proxy advisory firms and supports additional regulation of the industry, including requiring all proxy advisory firms to register with the Commission as investment advisors.

Because of the possibility for conflicts of interest to arise for proxy advisory firms who consult companies on some of the same issues for which they provide shareowner recommendations, SBA staff supports proxy advisory firms being subject to regular audits in order to provide assurance that there are strong internal controls within the advisory firms, which prevent conflicts of interest from occurring. Independent external audits of proxy advisory firms’ models and advice would also serve to ensure to clients the soundness and proper application of stated analyses and policies. Although the SBA’s own experience with the quality and accuracy of proxy advice has been very good, there may need to be more examination of the frequency (and materiality) of research errors to ensure investors can rely on proxy advisory firms’ recommendations.

SBA staff support the disclosure by proxy advisory firms of their methodologies, guidelines, assumptions and rationales used in making their voting recommendations, as long as no proprietary methods or sources are released. External auditing of proxy advisory firms may provide greater discipline in the way vote recommendations are determined, thereby ensuring a better proxy voting system.

Although most investors do not believe that proxy advisory firms have undue control or are overly powerful in their role as advisors, for many institutional investors they are a major source of information with which proxy voting decisions are made. Some issuers and other market participants contend that proxy advisory firms have too much influence. SBA experience, combined with relevant market-wide voting patterns, strongly contradicts this assertion.

For example, data on director elections clearly illustrates proxy advisory firms’ limited influence. Of 15,044 baseline client recommendations for director nominees in 2010 by Institutional Shareholder Services (ISS), 13 percent were “withhold” or “against.” The actual statistic for SBA proxy voting, for the same time period, stock universe, and director ballot item, was 25.1 percent (“withhold” or “against” votes). Of the 1,879 nominees receiving “withhold” or “against” baseline recommendations with available voting results, less than 5 percent failed to receive majority support from shareowners. The average shareowner support for nominees with a “withhold” or “against” baseline recommendation from ISS was 77 percent.

SBA staff has measured the correlation of the SBA’s actual voting decisions with several of the major proxy advisory firms. The relationship between actual SBA proxy votes and the firms’ recommended votes vary greatly, not only among different proxy advisory firms but also across different types of voting issues and time periods. SBA staff believes that proxy advisors’ clout has been greatly exaggerated by many organizations which are divorced from the actual procedures used by institutional investors to make voting decisions. Such pundits may not have an adequate understanding of the investment decision making process and organizational context of large institutional investors. Investors’ use of proxy advisors’ services, whether governance research or vote execution, does not equate to the “outsourcing” of voting decisions. It is critical to recognize that proxy advisors’ clients retain the ability to vote however they choose and in accordance with their own written voting guidelines. The SBA independently develops its corporate governance principles and proxy voting guidelines, but does rely heavily on the external research and synthesis of issuer filings performed by proxy advisory firms, in order to supplement the evaluation of ballot items. In sum, investors are ultimately accountable for proxy voting decisions cast in their own name and on behalf of their beneficiaries.

As a long-term shareowner, the SBA considers company engagement to be an important element in maximizing shareowner value. During fiscal year 2010, the SBA engaged with numerous companies to address a wide range of corporate governance issues including improving voting standards for director elections and their sustainability reporting.

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