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SEC guidance may change how companies interact with proxy advisors

Executive Compensation

By Stephen Douglas , Brian Myers and Steve Seelig | October 30, 2019

Institutional investors have much to consider before relying on a proxy advisor voting recommendation.

The Securities and Exchange Commission (SEC) recently issued guidance on how proxy advisors conduct business with their institutional investor clients and with public companies. The "principles-based" guidance will require proxy advisors and institutional investors to react, which will influence how the proxy voting process could change for companies.

Institutional investor duties when using proxy advisors

Prior SEC actions to withdraw two of its "no-action" letters put institutional investors on notice that they would need to update policies and procedures that describe how their proxy votes serve their investor clients' best interests when a proxy advisor is retained. The SEC guidance does not prescribe precise steps as to how institutional investors would meet their duty of care and loyalty when relying on proxy advisor recommendations (see the SEC fact sheet), so we will need to wait and see how investors react.

Institutional investors must answer two key questions, as put forth in the guidance, with the most profound implications falling under the first question for companies whose proxies are being voted.

1. What should an institutional investor consider if it retains a proxy advisory firm to assist in discharging its proxy voting duties?

When considering whether to rely on a proxy advisor voting recommendation, an institutional investor should determine whether the proxy advisory firm has:

  • The capacity and competency (including staffing, personnel and/or technology) to adequately analyze the matters put to a vote
  • An effective process for seeking timely input from issuers and advisory firm clients on voting policies, methodologies and peer group constructions, including for say-on-pay votes
  • Adequately disclosed its methodologies so that its clients can understand how voting recommendations were formulated, including the use of third-party information sources as a basis for those recommendations
  • Disclosed when and how the advisory firm would expect to engage with issuers and third parties

We would expect the proxy advisors to include the above details in their standard reports to clients to help them satisfy these requirements. The two largest proxy advisors — Institutional Shareholder Services (ISS) and Glass Lewis — offer varying degrees of detail around due diligence on their websites, including capacity and competency, benchmark policy formulation and update processes, benchmark policies and high-level guidelines for vote recommendations (often case-by-case), issuer engagement opportunities and conflict of interest policies. It is unclear how much the SEC guidance will drive the need for more targeted disclosures for each voting recommendation and what additional detail institutional investor clients or issuers might request.

The SEC guidance could have stopped after listing the above items without additional comment; however, in response to received comments, it went further to identify specific issues that institutional investors should consider:

Peer group selection: How a proxy advisor formulates its peer groups, including, where relevant, consideration of how the proxy advisory firm, in constructing peer groups, accounts for the unique characteristics regarding the issuer, to the extent available (e.g., the issuer's size, governance structure, industry and any particular practices unique to that industry, history and financial performance)

Use of accurate information: The effectiveness of the proxy advisory firm's policies and procedures for obtaining the current and accurate information that guides its voting recommendations (more insight should be sought into the proxy advisor's methodologies in formulating its voting recommendations, which may include factors unique to a specific issuer or proposal)

Company engagement: The proxy advisory firm's engagement with issuers, including questions of accurate information, and how the firm communicates the issuer's view about its voting recommendations in a timely and efficient manner

Proxy advisor conflicts of interest: A proxy advisory firm's policies and procedures regarding how it identifies and addresses conflicts of interest, with the onus falling on the proxy advisory firm to provide information on whether it has adequate policies and procedures to identify, disclose (i.e., context-specific, non-boilerplate disclosure) and address actual and potential conflicts of interest

The guidance notes these conflicts can range from providing consulting services to issuers or proponents of shareholder proposals, to affiliations the proxy advisor may have with third parties (e.g., as a shareholder, lender or significant source of business that might have a position on a particular voting issue) that could influence its recommendations. It is not enough for investment advisors to understand these potential conflicts.

Investment advisors will now need to examine when and if these potential conflicts will mean they can no longer rely upon a proxy advisor recommendation. It may be that the next step is for institutional investors to examine more deeply whether these potential conflicts actually influence voting recommendations, with that analysis based on empirical data now accessible on perceived conflicts.

2. What steps can an institutional investor take to demonstrate it is voting in a client's best interest?

This second question from the guidance moves the focus from the function of the proxy advisor to additional steps the institutional investor should take before it casts a vote. The guidance suggests that before casting a vote, institutional investors may need to:

  • Poll their investor clients on how they wanted to vote on a particular issue
  • Conduct research by studying supplemental company filings in addition to the proxy advisor recommendations
  • Proactively ask the proxy advisor for more analysis for especially contentious issues

ISS and Glass Lewis offer market-based benchmark voting policies, based on established best practices around corporate governance. In addition, each helps institutional investor clients implement custom voting policies that overlay vote recommendations to meet individual philosophies and needs.

It's uncertain whether institutional investors will demand more customized reports or targeted analyses from proxy advisors based on newly customized voting policies (e.g., labor unions and pension funds), or whether they may determine that submitting a vote and/or use of proxy advisors is not appropriate under certain circumstances.

Applicability of the federal proxy rules to proxy voting advice

The second piece of SEC guidance from the Division of Corporate Finance helps to define proxy advisors' legal obligations to the shareholders they advise, providing the power to compel proxy advisors to comply with requests for information they receive from their institutional investor clients.

The most important condition is that solicitations cannot contain any statement with material facts that are false or misleading, including an omission of information that would render the proxy voting advice materially false or misleading.

The guidance suggests that a proxy advisory firm may need to disclose the following information to maintain its exemption:

  • An explanation of the methodology used to formulate its voting advice on a particular matter
  • The source of third-party information (other than information publicly disclosed by the registrant) used to develop its proxy voting advice
  • Information about material conflicts of interest that arise in connection with providing the proxy voting advice in reasonably sufficient detail so that the client can assess the relevance of those conflicts

Going forward

The real changes in the proxy voting process are still to come as proxy advisors and institutional investors consider potential adjustments to their processes.

The SEC may issue further guidance on this matter in the near future, including possible proposed regulations.

1 The no-action letters detailed investment advisor responsibilities regarding potential conflicts of interests of proxy advisory firms.


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