Oversight of Proxy Voting Advisors: US and EU Regulators Converge

Stephen M. Davis is a Senior Fellow at the Harvard Law School Program on Corporate Governance and Chair of the Best Practice Principles Oversight Committee (OC) 2020-2022; and Konstantinos Sergakis is a Professor of Capital Markets Law and Corporate Governance, University of Glasgow, and Chair of the OC 2023-Present.

The proxy voting advisory and research industry, which includes leaders ISS and Glass Lewis, are increasingly at the center of a whipsaw debate between those who urge that investor stewardship be constrained and those who advocate for it to be enhanced. Regulators have long been drawn into the vortex. But until recently two of the world’s prominent market watchdogs—the US Securities and Exchange Commission (SEC) and the European Securities and Markets Authority (ESMA)—had taken opposite tacks on how to address the industry. Today they have converged on the same path, as first became clear in an under-reported October 2022 conference in Rome. There an SEC representative, speaking virtually, spelled out for the first time the Commission’s new, EU-like approach to proxy advisory and research firms.

Implications of this regulatory conjunction have immediate consequences for proxy advisors, as well as for companies and investors on both sides of the Atlantic. Before we address those effects, however, it is important to spotlight the two regulators’ perspectives.

ESMA’s road has been consistent. In 2013, facing issuer calls to install hard rules on proxy advisors, the Authority instead asked the industry to develop its own code of best practice. Five rival firms—ISS, Glass Lewis, Manifest, PIRC, and Proxinvest (now part of Glass Lewis)—collaborated to respond with global-scope principles that tackled service quality, potential conflicts of interest, and communications. Federated Hermes’s EOS arm later joined the original group of signatories.

ESMA welcomed the Best Practice Principles but pressed for an independent body of stakeholders to provide assurance that signatories would meaningfully apply the commitments. Thus was born a fresh concept, which ESMA dubbed “monitored self- regulation.” An international Oversight Committee (OC), also known as the Independent Oversight Committee (IOC), was created composed of a chair plus six investor representatives, three executives from issuers, and two scholars. Its terms of reference define its purpose as to (1) assess annual compliance reports against the Best Practice Principles filed by each of the signatories; (2) convene an annual Open Stakeholder Forum on the proxy voting and advisory industry; (3) address complaints; and (4) consider revisions to the principles.

ESMA approved this architecture in 2019 and, in turn, shelved plans for hard rules, at least until it next reviewed if monitored self-regulation was delivering progress. That next ESMA appraisal was launched in October 2022. It included a hearing in Paris in November  and an online, market-wide call for evidence on the Shareholder Rights Directive, including on proxy voting advisory and research firms, their Best Practice Principles, and the OC itself. Feedback from the Paris hearing suggested that investors are generally comfortable with the principles and the OC review process, while issuers are pressing for greater corporate representation on the OC. ESMA will report its findings to the European Commission, which is set to release its assessment and roadmap in July 2023.

The SEC, by contrast, took a zig-zag route to its present stance. Following years of issuer complaints, in July 2020 the Commission adopted—on a party-line vote—Rule 14a-2(b)(9)(ii) that, among other things, would have compelled greater corporate input on advisors’ analyses sent to investor clients. Before the measure could come fully into effect, however, the SEC, newly configured with a Democrat-appointed majority following the November 2020 US general election, first announced that it would not enforce the rule. Later the Commission rescinded it, also on a party-line vote, citing widespread investor opposition to the Trump-era action. Still later the SEC released a proposed rule that removed most of the previous regulations on proxy advisors.

In explaining this about-face, the SEC cited proxy advisory firms’ Best Practice Principles and OC oversight as important, market-based initiatives that could largely achieve improvements that had been the target of Trump-era rule-making. Further, at the OC’s October 11 2022 Open Stakeholder Forum in Rome, US SEC special counsel Valian Afshar, a lead staffer on the topic, delivered remarks amounting to the Commission’s first expansive public views on monitored self-regulation of the proxy advisory and research industry. “The IOC,” Afshar said, “is uniquely positioned to enforce Signatory compliance with the Best Practice Principles.” He added, “I believe the IOC’s independence and diverse composition…can incentivize it to take that enforcement role seriously, at least within the scope of authority granted to it in its terms of reference.” Afshar continued that the OC’s monitored self-regulation process can work better than “market-based incentives to hold proxy advisors accountable.” And he concluded that “the IOC so far appears to be continuing to function as it was intended and I look forward to continuing to review the IOC’s annual reports, as well as individual proxy advisor assessment reports in the years to come.”

Afshar’s comments, together with statements in the Commission’s November 2021 release, make clear that the SEC has now joined ESMA in preferring monitored self-regulation over rule-making as a means to address issuer concerns regarding advisors’ proxy voting analysis and advice. Both watchdogs are now relying on the OC to monitor accuracy, integrity, and responsiveness of the proxy voting advisory/research industry.

What does this international regulatory convergence now mean for proxy advisors, institutional investors, and corporations? The most material impact is, of course, on the industry. ISS and Glass Lewis, as the dominant players, will be under particular scrutiny by regulators and others regarding the extent to which the duo respond, or resist, service improvements proposed by the OC.

What are these? The IOC’s latest annual report spells out public recommendations it made alongside confidential communications to each signatory of the Best Practice Principles as part of its second annual review of industry compliance statements. First, the Committee acknowledged modest reforms adopted by signatories following the OC’s inaugural round of assessments. These included superior disclosure from proxy advisors on the diversity, numbers, workload, and skill sets of staff. Such transparency, in the OC’s view, better enables stakeholders to assess the advisor teams conducting proxy voting research. The OC further noted progress among signatories in offering more information on conflicts of interest and how they are managed, a key factor in drawing stakeholder confidence.

However, the Committee urged four major additional steps that it felt could enhance market trust in proxy voting advisory and research firms. These are here drawn, in some cases verbatim, from the annual report. First, on service quality, the OC noted that performance hinges on a wide variety of factors, including an advisor’s internal ability to converse in and understand the language, culture, legal context, and ESG frameworks prevalent in each market it covers. The OC asked signatories to more fulsomely explain how they equip themselves and structure staff resources to address local, sectoral, or company-specific issues so that research output matches such needs.

Second, the OC encouraged signatories to disclose robust data and explanations on fact-checking and error-tracking, together with remediation practices on both corrections and how lessons may be applied to avert similar errors in the future.

Third, the OC recommended that proxy advisors explain clearly if they feature a process for corporate feedback and, if not, why not or, if so, whether it varies by market, company size, or other factors. The Committee acknowledged that timely feedback has the potential to improve product accuracy, but that it must be weighed against the practical risk of cutting into voting windows available to investor clients and the need to safeguard the independence of advice and analysis. The OC asked advisors to disclose (1) the extent of research information it provides to issuers for their feedback—for instance, does the signatory send research plus recommendations? Does it send all research that will go into the final report, or only part?; (2) whether the signatory provides companies with any advance notice as to when to expect a report to review; (3) how much time a signatory generally gives companies to respond; and (4) whether any fees are required for companies to have access to reports on them before they are published.

Finally, the OC observed in its first cycle of reviews that signatory compliance reports were thinnest in discussing complaints procedures. It encouraged each to expand sections on this topic in their next statements, including with as much quantitative and qualitative analysis as possible. The Committee held that each firm has an explicit obligation under the Principles to feature effective procedures for handling complaints from issuers or others, and that such procedures must demonstrate responsiveness and timeliness. Therefore, the OC wrote, each advisor should make clear (1) whether it offers one or more channels for complaints and whether they differ by complainant or market; (2) how it manages complaints; (3) by when it commits to respond to complaints; (4) whether and how it offers an appeal process; and (5) that complainants may have the option of escalating issues to the OC itself. Some signatories acted on this request in their second-year compliance statements. However, the OC restated its recommendation in its second cycle of reviews in 2022 and awaits signatory reactions in upcoming compliance statements. Presumably ESMA and the SEC will also be looking carefully at proxy advisor responses on this and other major areas of improvement proposed by the OC.

For institutional investors, the convergence of watchdog approaches in Europe and the US implies that regulators in both jurisdictions may apply heightened scrutiny on the extent to which asset owners and asset managers exercise due diligence when reviewing, selecting, and periodically monitoring a proxy voting advisory and research firm it may hire. This due diligence is considered part of their fiduciary duties. But the advent of annual advisor compliance statements together with OC oversight reports provides investors with new tools to use. Regulators will likely want assurance that investors are indeed using them.

Finally, some companies or business associations (for example, Euroissuers, the Business Roundtable, Society for Corporate Governance, the Confederation of British Industry, and other such collective bodies) may continue to press for what they see as regulatory relief from misdeeds of proxy advisors. But at least for now, regulators are signaling that the issuer focus on advisor performance improvements must shift to the monitored self-regulation architecture represented by the Principles and OC oversight. That implies greater company or association attention to channels of feedback and complaint offered by this framework rather than pursuit of controls through securities regulators or the courts. Whether such channels deliver, both for investors and companies, will be a test of the market’s capacity to police itself. Otherwise, regulators are waiting.

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