The SEC's Proxy Advisory Firm Guidance
Updated: Oct 8, 2019
At first glance, with the issuance of "Guidance Regarding Proxy Voting Responsibilities of Investment Advisers" and "Interpretation and Guidance Regarding the Applicability of the Proxy Rules to Proxy Voting Advice" it might appear as if the Securities and Exchange Commission can now check the box that it “did something” on proxy advisory firms ("PAFs") and move on. Actually, there's a lot more to it than that.
This is Kind of a Big Deal
The fact the Commission is releasing written guidance about PAFs at all is pretty significant. Those who have been around remember the days corporate secretaries and governance professionals railed about the influence and MO of PAFs, telling the Commissioners and their staff about the all the ways PAFs unfairly influenced corporate proxy voting with zero transparency or accountability to the corporations upon which they passed judgment based on questionable methodology and acted as a kind of shadow regulator with no opportunity for input or recourse(*)... and the Commissioners and staff members would look at them, expressionless, then politely thank them for their comments and encourage them to submit their thoughts through the formal written comment process. This would happen year after year. After a certain point, it was clear the Commission did not want to get anywhere near regulating PAFs or even acknowledge there was an issue. They'd be willing to listen, but that's about it.(**) Congress probably didn't know enough about proxy voting to know what PAFs were, and even if they did, they had bigger fish to fry. So, now for the Commissioners⏤not just the staff⏤to issue two very formal releases on the same day is a pretty significant milestone for long-time PAF critics. It's not a rule or law, but it's arguably more significant than anything we've seen from the Commission itself since PAFs were made exempt from the proxy solicitation rules.
[Notes: (*)PAFs would eventually open their policy-making process to broader stakeholder input and make some changes to their practices to address corporate criticisms. (**)The Commission eventually sought public comment about the US proxy system, including the role of PAFs, in 2010, and the staff issued guidance on PAFs in 2014.]
In his remarks, Chairman Clayton said the release of these Guidance and Interpretation documents "is just a first step," which may also foreshadow significant moves on "proxy plumbing" and shareholder proposals, the two other main topics of the November 2018 Roundtable on the Proxy Process hosted by the Commission. In the meantime, we've heard nothing about the bill in Congress that, if enacted, would pave the way for full-on regulation of PAFs. That bill received bipartisan support on the House floor in 2017.
The Proxy Advisory Business Isn't Going Away
Some of you will recall I started out as a pretty harsh and vocal critic of PAFs⏤ISS in particular. But, I've long since changed my tune. For a while now, I've said PAFs are legitimate, private, for-profit business that provide necessary types of services in the proxy voting system that will probably have to exist in some form for the foreseeable future. So, for people who want to put them out of business, that ain't going to happen. Investors can't afford to do all that work in-house, so they outsource it, like companies do for many things. Since the votes rarely matter to them, most investors look for the cheapest option to fulfill what is essentially a compliance exercise. Just vote, and you've complied. There really are no "right" or "wrong" votes that someone can sue on or a regulator can act on.
Despite being sold to new owners for not much money every few years, the major PAFs never go under. My conclusion is the core service of PAFs does not make for a great business model (I'm guessing their margins are thin), but since there is a definite need in the marketplace, someone will be willing to own one realizing it won't be a very profitable part their larger enterprise, but will generate some cash and create opportunities to cross-sell higher value services.
What Really Needs to Happen
I've also said efforts to shut PAFs down or strangle them are misguided and a waste of resources, especially when the primary strategy of those efforts is to focus attention on conflicts, transparency, and accuracy. You can try to regulate PAFs into submission on those three things, but success on that front is not going to change what you don't like about them, which is their influence on voting outcomes and the seemingly arbitrary and unfair nature of their voting recommendations. You can find horror stories about inaccuracies in PAF voting reports, but those are very uncommon each year and rarely (if ever?) determine the pass-fail outcome. And, it's highly unlikely you'll be able to force PAFs to show corporations drafts of their voting reports far in advance and make the reports public. Try that and the PAFs will sue on First Amendment grounds and tie things up in the federal courts for years.
Like like using video instant replay to overturn bad calls in sports, focusing on conflicts, transparency, and 100% accuracy is a noble cause and hard to argue against, but there are downsides. Success on the conflicts/transparency/accuracy front will only raise the costs of voting for the funds, which costs will inevitably get passed on to the actual people investing their hard-earned pay, whom Chairman Clayton refers to as "Mr. and Ms. 401(k)." Ever look at those management fees for your mutual fund and ETF holdings? That's where this is going to show up. And those costs won't get us anything really impactful in return. It's certainly not going to make the unhappy corporates much happier.
The fundamental problem is on the user (investor) side, not the service provider (PAF) side. Despite the gospel of investor advocates who insist funds don't outsource their thinking and voting to PAFs to the point where they "blindly follow" PAF voting recommendations, we know there are those that do. How many? Definitely enough to embarrass a board on a Say on Pay vote or director re-election or prop up a shareholder proposal. It's always going to depend on the company's mix of investors, what's being voted on, etc., but the evidence some major institutional investors place their voting decisions entirely in the hands of PAFs is, based on my limited experience, undeniable. Basically, we've been focusing on the wrong actors.
What really needs to happen is throwing sunshine on the funds that heavily rely on PAFs. That's where some novel disclosure requirements on the use of PAFs could get interesting and actually influence behavior, much like increased disclosure requirements on executive compensation had profound effects on exec comp design (for better or worse) and the use of corporate perks. Here are some things I'd like to see.
Require funds to disclose to their holders (i.e., Mr. and Ms. 401(k)):
1) Whether they hire PAFs, and if so, why, which ones, for what types of services, and how much they spend on each of those PAF each year.
2) The process they use to choose PAFs. How often are the those choices reviewed? Who is involved? To what extent does the fund's board of directors/trustees oversee the PAF selection and renewal process?
3) The process they use after annual meetings to satisfy themselves their votes were cast on time and in the way they wanted. If they found errors or anomalies, tell us about them.
4) Whether they make use of PAFs' off-the-shelf proxy voting guidelines or customize a form document to create their own. If they use off-the-shelf ones, which ones? (Some PAFs have different sets of standard voting recommendations for particular types of funds (e.g., plans established under the Taft-Hartley Act).) If they create customized policies, disclose them (or a substantially material summary) somewhere.
The Commission's Interpretation and Guidance documents make a lot of suggestions for what funds and investment advisors should consider when hiring and using PAFs, but they don't go the next step of requiring them to disclose these important things to the ultimate beneficiaries. They need to. The Commission practically provides a roadmap for the kind of disclosure I'm talking about when it states on page 5 of the Guidance (footnotes omitted):
When making voting determinations on behalf of clients, many investment advisers retain proxy advisory firms to perform a variety of functions and services. Some of these are administrative, such as providing the investment adviser with an electronic platform that enables the adviser to manage voting mechanics more efficiently. Other services provided by proxy advisory firms relate to the substance of voting, such as: providing research and analysis regarding the matters subject to a vote; promulgating general voting guidelines that investment advisers can adopt; and making voting recommendations to investment advisers on specific matters subject to a vote. We understand that these voting recommendations may be based on a proxy advisory firm’s own voting guidelines or on custom voting guidelines that the investment adviser has created. We understand further that custom guidelines, where they are used, may be more or less detailed, depending on the level of instruction an investment adviser has provided to a proxy advisory firm. Contracting with proxy advisory firms to provide these types of functions and services can reduce burdens for investment advisers (and potentially reduce costs for their clients) as compared to conducting them in-house.
Really? Please do tell! As a holder of mutual fund and ETF shares, I'd love to know more about this mysterious world.
Yes, these types of disclosure requirements would add more work and increase costs for funds that use PAFs and their holders. But, they would actually get at the core issue by making fund managers and proxy voting committees really think about why and how they use PAFs and how the disclosure will make them look. Nobody wants to put out disclosure that makes them appear "irresponsible" and "lazy."
One area where I actually would like to see PAFs have to disclose more is when they make voting recommendations on shareholder proposals submitted by their own clients. Arguably, they shouldn't be making recommendations on those proposals at all because this is an actual (as opposed to a perceived) conflict. However, in Corporate Governance Land, disclosure can cure pretty much anything, so that's what we've done. But, let's see if we can make that cure more efficacious. Here's how I think it should work: If Amber Lager Enterprises (ticker symbol: ALE) has a shareholder proposal from the National Union of Line Standers and Seat Holders (NULSSH) up for a vote at the next ALE annual meeting, any PAF that issues a voting recommendation on NULSSH's proposal (for or against) should have to disclose whether NULSSH is a client, how much money they were paid by NULSSH, and for what kind of services since ALE's last annual meeting. That disclosure should appear right next to the voting recommendation on NULSSH's proposal in the ALE proxy voting report and wherever else that recommendation gets discussed. Either do that or refrain from making a voting recommendation on NULSSH's proposal at ALE.
That seems fair and analogous to corporate proxy disclosure requirements for transactions with related persons. More importantly, those disclosures would help inform voters about the existence and extent of real conflicts before they vote. To me, that would be worth whatever costs it adds.