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E-MailThe following post comes to us from Yafit Cohn, Associate at Simpson Thacher & Bartlett LLP, and is based on a Simpson Thacher memorandum.
Commissioner Daniel M. Gallagher of the Securities and Exchange Commission (“SEC”) authored a working paper, published last month by the Washington Legal Foundation, regarding the outsized power and influence of proxy advisory firms. [1] In his paper, Commissioner Gallagher provides his view of the most important aspects of Staff Legal Bulletin No. 20 (“SLB 20”), in which the SEC staff recently “moved toward addressing some of the serious issues” resulting from the emergence of proxy advisory firms as a dominant player in American corporate governance. Notably, Gallagher also offers some critical advice to public companies engaging with proxy advisory firms.
Staff Legal Bulletin No. 20
SLB 20, issued on June 30, 2014, provides guidance regarding the duties and obligations of proxy advisory firms and investment advisers who retain such firms. [2] While expressing concern that the SEC’s guidance “does not go far enough,” Gallagher regards SLB 20 as “a good initial step in addressing the serious deficiencies currently plaguing the proxy advisory process.” Specifically, Gallagher notes that SLB 20 clarifies three important principles:
- Flexibility in Proxy Voting Arrangements. An investment adviser and its client need not agree that the investment adviser will vote every proxy. Rather, “an investment adviser and its client have flexibility in determining the scope of the investment adviser’s obligation to exercise proxy voting authority.” [3]
- Continuing Duty to Monitor Proxy Advisers. An investment adviser that has retained a proxy advisory firm is required to adopt and implement policies and procedures that are reasonably designed to provide sufficient ongoing oversight of the proxy advisory firm. This duty includes ensuring that the proxy advisory firm has the capacity and competency to address conflicts of interest and to make voting recommendations based on current and materially accurate information.
- Disclosure of Proxy Advisers’ Significant Relationships. To the extent that a proxy advisory firm would like to avail itself of certain exemptions from the proxy rules, it must disclose to recipients of voting recommendations any “significant relationships” or “material interests” in the matter subject to the voting recommendation. This disclosure must enable the recipient to understand the nature of the relationship or interest; boilerplate language will not suffice.
Commissioner Gallagher’s Advice
In addition to highlighting the key aspects of SLB 20, Gallagher offers advice to public companies regarding the second of its three core principles—investment advisers’ continuing duty to monitor proxy advisory firms. Gallagher notes that where a proxy advisory firm issues a recommendation based on materially false or inaccurate information, the issuer sometimes has difficulty getting the proxy advisory firm “to acknowledge these claims, much less review them and determine whether to revise its recommendation in light of the corrected information.” [4] While Gallagher “encourage[s] companies to attempt to work with proxy advisers,” he also stresses the importance of companies bringing such “misconduct by proxy advisers to the attention of their institutional shareholders.” Gallagher advises that if a company experiences “difficulties in getting the proxy advisory firm to respond to the company’s concerns about the accuracy of the information on which the recommendation is based” and contacts its institutional investors in this regard, the company should copy Gallagher’s office on its correspondence.
The Potential Importance of Gallagher’s Advice
Gallagher’s advice seems to address the heart of the issue surrounding proxy advisory firms, which Gallagher termed a “classic agency problem.” As some commentators have observed, proxy advisory firms (unlike management or boards of directors) have neither a financial interest in the companies for which they advise voting choices nor a fiduciary duty owed to the corporations about which they are making recommendations. Additionally, with each of the major proxy advisory firms run as a for-profit entity, some have noted that the natural economic interest of proxy advisory firms is to increase their own profits for financially-oriented owners. As a result, these critics have concluded that proxy advisory firms—hired to determine which voting decisions maximize shareholder value—have no incentive to make the correct determination and are not accountable to the public.
So “how do we make sure that the investment adviser is voting [ ] shares in the investor’s best interest, and not the adviser’s?” [5] It is this fundamental question that Gallagher appears to tackle by encouraging companies to converse directly with investment advisers regarding unresponsive proxy advisers (and to copy his office on correspondence). Gallagher’s advice seems aimed at ensuring that investment advisers have “skin in the game”—that they are reminded of their own fiduciary duties and thus have an incentive to act in investors’ best interests.
While SLB 20, in itself, may not result in meaningful changes regarding the influence of proxy advisory firms—particularly because it does not address the “agency problem”—Gallagher’s advice suggests that public companies may have at their disposal a tool to amplify the intended effects of SLB 20. It remains to be seen whether companies will show a willingness to initiate potentially uncomfortable dialogues with their institutional investors in an attempt to advance the bulletin’s objectives.
Endnotes:
[1] See Commissioner Daniel M. Gallagher, “Outsized Power & Influence: The Role of Proxy Advisers,” Washington Legal Foundation (August 2014). (Discussed on the Forum here.)
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[2] See U.S. Securities and Exchange Commission, Division of Investment Management & Division of Corporation Finance, “Proxy Voting: Proxy Voting Responsibilities of Investment Advisers and Availability of Exemptions from the Proxy Rules for Proxy Advisory Firms,” Staff Legal Bulletin No. 20 (June 30, 2014).
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[3] Id.
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[4] Gallagher, “Outsized Power & Influence: The Role of Proxy Advisers,” at 14-15.
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[5] Id. at 2.
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2 Comments
Proxy advisory services have no agency cost problem. They have a far more important and less conflicted interest than economic ties to the companies they evaluate. They have the economic tie of the fees they receive from customers who are not required to purchase their services and who have a variety of options to choose from. That is the definition of a free market. Customers purchase the products provided by proxy advisory services because they believe they add value. They also mitigate the collective choice problem inherent in voting proxies, where the expense of analyzing individual issues can be greater than the benefit to a particular investor, even a large one, but the benefit of many investors having that analysis and thus making a more informed choice on voting is worthwhile for all investors. SLB 20 will not, as the author here notes, result in “meaningful changes” because extensive testimony (including mine) and comments made it clear that no change was necessary and in fact would be detrimental.
According to a recent FT article http://tinyurl.com/lj9rb4f Frost Consulting estimates that the sell side research community generates $23.5bn a year from equity investors. That is a direct cost to savers and seems to be of dubious value according to the same reports.
Despite the massive size of that industry, especially compared to the proxy research industry, we hear little from either the SEC or issuers about the quality of their work and problems with “accuracy”.
We clearly have twin track regulation when it comes to protecting investors’ interests. Services designed to support equity ownership are disproportionately criticized, nay vilified, while all the time the “Wall Street Walk” is actively encouraged through fostering the sell-side analyst regime.
The shareholder voting research industry works to already very high standards under intense pressure. As Nell has testified, as ESMA has discovered, there is no evidence of abusive behaviour or unfair treatment of clients. Perhaps the SEC and issuers should be thinking about how they can contribute to informed voting by investors – where is the focus on asset owner and asset manager conduct? Where is the focus on improvements on, for example, less AGM bunching or more use of XBRL?
The Commissioner is, with respect, grandstanding for political effect and is stepping into dangerous territory – the regulation of free speech and freedom of expression. The proxy services witch-hunt is a distraction from fixing the very problems of proxy plumbing. The Stock Transfer agents’ and issuers’ questions about use of their fees by the banks and their dominant intermediary remain unanswered; the opening up of competition in proxy vote servicing go un-addressed.
If there is any tittle-tattle that should be going on, it should be on the part of the issuers thinking about the serious harm to shareholders that comes from a proxy voting process which is not fit for purpose rather than the odd typographical error.
Given the parlous state of financial services post-crash, is Commissioner Gallagher really saying that a handful of small but dedicated and professional service providers is his #1 priority for protecting investors?