BERLIN, GERMANY – MAY 22 2019: Some of these shareholders of Daimler AG did their homework before … [+]
The Securities and Exchange Commission, SEC, recently issued new rules effectively changing the way proxy advisory firms operate as part of larger efforts to update rules governing corporate elections. Prior to the annual meeting of shareholders for tens of thousands of issuers, these firms review annual reports and proxy statements on behalf of their clients—pension funds, endowments, mutual funds, hedge funds and other investment managers. These clients outsource their due diligence to the two major proxy advisory firms who, in turn, hire seasonal workers to analyze the statements.
The SEC has had its eye on investment advisors’ execution of proxy voting since the release of new guidance last August which clearly stated: “To satisfy its fiduciary duty in making any voting determination, the investment advisor must make the determination in the best interest of the client and must not place the investment advisor’s own interests ahead of the interests of the client.”
For the layman, that means no shortcuts are allowed.
However, corporations have complained for years that, in some instances, the proxy advisory firms’ statements and vote recommendations are based on incomplete or inaccurate information. When the corporations counter, the proxy advisory firms have seldom changed their recommendations or even responded. Other investment advisors and investors, including those who are not clients of the proxy advisory firms, often follow their lead and “robo-vote” in lockstep, suggesting that they are not satisfying their own fiduciary duty to execute their voting responsibilities in line with their clients’ best interest in maximizing the return on their investments.
Corporate issuers and others in the investment business were frustrated with this mindless block voting or “robo-voting” led by the proxy advisory firms.
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In an attempt to address this concern, the SEC issued the rules and guidance to ameliorate the situation. It now requires proxy advisors to simultaneously distribute their recommendations to their clients as well as to the issuer and to alert clients when an issuer submits a response to the proxy advisor’s recommendation. This is a significant improvement on the current system, where not all issuers are able to see recommendations and engage with proxy advisors in a timely manner or easily communicate concerns or disagreements on recommendations with their shareholders. It will also make it easier for investors to properly review contentious items when there is a disagreement between the proxy advisor and the issuer.
Ultimately, this solution is a compromise for the business community, which wanted a pre-review period where issuers could see reports before they were finalized and distributed to clients, in an effort to have any concerns addressed before institutional investors used the reports to vote their shares. However, proxy advisors opposed any review process—which would, of course, have required more work at a higher level than the typical seasonal worker can undertake, and the SEC rolled back the final rule to address this concern.
The SEC guidance, therefore, strikes at the heart of the proxy advisors’ business model and squarely affixes responsibility back onto the clients who had outsourced their voting to the advisors: “An investment advisor should consider, for example, whether its policies and procedures address circumstances where the investment advisor has become aware that an issuer intends to file or has filed additional soliciting materials with the Commission after the investment advisor has received the proxy advisory firm’s voting recommendation but before the submission deadline.” In other words, “robo-voting” on issues where issuers have raised concerns is now viewed by the Commission as an abdication of the advisor’s fiduciary duty.
The SEC also addressed the critical disclosure of proxy firm conflicts of interest. Institutional Shareholder Services, the largest proxy advisor, currently markets its services to corporate issuers, so the issuers can be assured that the proxy firms know them well. The implication of course is that if a corporate issuer contracts with a proxy firm, then the proxy firm will go easy on the proxy votes. Prior to this rule, the investors had no way of knowing if a corporate issuer had paid fees to the proxy advisor. Now investors will also need to consider this information when relying on proxy advisors, per the Commission’s August 2019 guidance.
Unfortunately, the two companies still maintain a monopoly-like stranglehold on the proxy advising business. Monopolists typically improve margins by reducing services. These new rules do not solve the market domination but may improve services.
For the corporate issuer, there are useful strategic responses to consider. If there is any doubt about the foundation of a proxy advisor’s recommendations, the issuer should mount an affirmative defense disputing the recommendation and digging into the proxy advisor’s work product. The dispute will also serve to put robo-voters on notice that something about the advisor’s recommendation may be incorrect.
The second response is to ignore proxy advisors when they call to solicit consulting engagements in order “to know the issuer better.” Eliminate the implied quid pro quo.
The third response for issuers is to investigate if their own retirement fund managers use the proxy advisor firms. If they do, make a change.
The best approach, in the interest of competition, may be to seed a new competitor company that does not take shortcuts and lives up to the requirements of probity and the loyal exercise of fiduciary duty. This will also provide investment advisors with further incentive to heed the SEC’s guidance.