Today, ISS filed suit against the SEC and its Chair, Jay Clayton (or Walter Clayton III, as he is called in the complaint) in connection with the interpretation and guidance directed at proxy advisory firms issued by the SEC in August. (See this PubCo post.) That interpretation and guidance (referred to as the "Proxy Adviser Release" in the complaint) confirmed that proxy advisory firms' vote recommendations are, in the view of the SEC, "solicitations" under the proxy rules and subject to the anti-fraud provisions of Rule 14a-9. In its complaint, ISS contends that the Proxy Adviser Release is unlawful and its application should be enjoined for a number of reasons, including that the SEC's determination that providing proxy advice is a "solicitation" is contrary to law, that the SEC failed to comply with the Administrative Procedures Act and that the views expressed in the Release were arbitrary and capricious.
Interestingly, the litigation comes right before the SEC is scheduled to consider and vote (on November 5) on a proposal to amend certain exemptions from the proxy solicitation rules to provide for disclosure, primarily by proxy advisory firms such as ISS and Glass Lewis, of material conflicts of interest and to set forth procedures to facilitate issuer and shareholder engagement and otherwise improve information provided. There are various rumors circulating about the details of the proposal, including this Reuters article stating that the proposal would require proxy advisory firms to "give companies two chances to review proxy materials before they are sent to shareholders." (Note that also on the agenda is a proposal to "modernize" the shareholder proposal rules by changing the submission and resubmission requirements.) Whether the firms' advice is a "solicitation" takes on particular significance given that the SEC's anticipated proposal appears to be predicated on the firms' reliance on the exemptions from the proxy solicitation rules.
SEC Interpretation and Guidance
Rule 14a-1(l) provides that a solicitation includes communications seeking to influence votes and communications to security holders "under circumstances reasonably calculated to result in the procurement, withholding or revocation of a proxy." The SEC's interpretation and guidance regarding the proxy rules at issue here emphasizes that proxy voting advice by proxy advisory firms constitutes a "solicitation" within the meaning of the Rule, regardless of whether the person is seeking authorization to act as a proxy and even if the person seeking influence is indifferent to the outcome.
According to the SEC, proxy advisory firms typically provide clients with proxy voting advice that describes the specific proposals and provides a "vote recommendation." They may also "make recommendations for a particular investment adviser based on the advisory firms' application of the investment adviser's voting criteria." The voting recommendations are typically provided with the expectation that the investment adviser will use them to assist in fulfilling their fiduciary duties when making their voting decisions. That idea is underscored by the timing of the recommendations "shortly before shareholders' meetings." In addition, proxy advisory firms typically "market their expertise in researching and analyzing" proposals and are paid a fee. In the SEC's view, that voting advice is "unsolicited." As a result, the SEC believes that "proxy voting advice provided by proxy advisory firms generally constitutes a solicitation subject to the federal proxy rules." That view generally still holds even if the proxy advisory firm is providing recommendations (not ministerial services) based on its application of the investment adviser's own tailored voting guidelines, and even if the client does not follow the advice. The SEC noted that, while, over time, it has "broadened the definition of 'solicitation' in the context of what was needed or appropriate in the public interest or for the protection of investors, consistent with the purposes of the Exchange Act," still, in "addressing communications by those who may not be seeking proxy authority for themselves or who may be indifferent to the outcome of a vote, the Commission did not narrow the definition of solicitation to exclude these communications, but instead enacted rules to exempt them from the information and filing requirements of the federal proxy rules while preserving the application of the proxy anti-fraud provision, Rule 14a-9." The SEC noted that, as long as the proxy advisory firms comply with the applicable conditions, they may still rely on the Rule 14a-2(b) exemptions from the proxy rules' information and filing requirements, including relief from the obligation to file a proxy statement. As noted above, however, a proposal to amend those exemptions is expected next week.
In addition, in the interpretation and guidance, the SEC underscored that the anti-fraud provisions of Rule 14a-9 are applicable to proxy advisory firms' soliciting communications. That Rule prohibits any solicitation, even exempt solicitations, from containing any "statement which, at the time and in the light of the circumstances under which it is made, is false or misleading with respect to any material fact." In addition, the "solicitation must not omit to state any material fact necessary in order to make the statements therein not false or misleading." According to the interpretation, "Rule 14a-9 also extends to opinions, reasons, recommendations, or beliefs that are disclosed as part of a solicitation, which may be statements of material facts for purposes of the rule." In support of that position, the SEC cites Virginia Bankshares, Inc. v. Sandberg, from 1991, in which SCOTUS found a board's recommendation to provide "statements of material facts because '[s]uch statements are factual in two senses: as statements that the directors do act for the reasons given or hold the belief stated and as statements about the subject matter of the reason or belief expressed.'" The interpretation and guidance provides advice regarding the types of disclosures that would be appropriate to avoid Rule 14a-9 concerns.
As discussed in this article from Compliance Week, guidance, sometimes referred to by critics as "regulatory dark matter," as has been "one of the more contentious debates in compliance and legislative circles." In this speech, SEC Commissioner Hester Peirce expressed her concern for SEC staff guidance and interpretation that she seems to view as sometimes runaway or out-of-control and, sometimes, too much under the radar. (See this PubCo post.) Critics argue that "over time 'guidance' has taken on a life of its own and either supplanted rulemaking or wedged resulting rules into previously unintended and unexpected matters." In addition, in April, the Acting Director of the Office of Management and Budget distributed a memo designed to limit rules and guidance that federal agencies issue, particularly outside of the notice-and-comment process. In September last year, SEC Chair Jay Clayton issued a statement intended to make clear his view of the distinction between SEC rules and regulations—which are adopted in accordance with the APA, have the effect of law and are enforceable by the SEC—and staff guidance, such as the CDIs and various letters and speeches, which is nonbinding and not enforceable by the SEC or others. (See this PubCo post.) Where does the guidance here at issue fit? This guidance has been adopted by the SEC, but, as discussed below, is still considered by the SEC to be just interpretive and not subject to the APA notice-and-comment requirements.
The ISS Complaint
In its complaint, ISS contends that the Proxy Adviser Release is invalid and its application should be enjoined for a number of reasons. First, ISS argues that the Release is unlawful because it "exceeds the SEC's statutory authority under Section 14(a) of the Exchange Act and is contrary to the plain language of the statute." ISS, it contends, should not be subject to the Release because it is instead subject to a comprehensive regulatory framework under the Investment Advisers Act of 1940, which imposes on ISS fiduciary standards of care and loyalty. Proxy voting advice should be regulated under Advisers Act, not the Exchange Act.
However, in the Release, "the SEC announced—for the first time—that all expert proxy voting advice rendered at the request of investors, and provided in accordance with policies designated by those investors, would also be subject to the separate regulatory regime for proxy solicitation under Section 14(a)...." As described in the complaint, ISS, as a proxy advisor, provides advice that is solicited by its clients—it does not engage in proxy solicitations: ISS "is an independent third party that is hired by an investor to provide advice and recommendations about how to vote the investor's shares..... Unlike a person or firm engaged in proxy solicitation, a firm providing proxy advice is disinterested with respect to the ultimate outcome of a shareholder vote and does not seek to achieve a certain result." Although the SEC has, over the years, gradually expanded its definition of proxy solicitation, ISS contends, "even at its broadest point, this expansion never went so far as to include proxy voting recommendations made in the context of a fiduciary relationship by expert advisers who are disinterested with respect to the outcome of the vote." In the end, ISS maintains, the "provision of proxy advice is not a proxy solicitation and cannot be regulated as such." And, to the extent the Release regulates proxy voting advice as proxy solicitation, under the APA, it should be set aside as an "agency action that is 'not in accordance with law' or is 'in excess of statutory jurisdiction, authority, or limitations, or short of statutory right.'"
Second, the Release is "procedurally improper because it is a substantive rule that the SEC failed to promulgate pursuant to the notice-and-comment procedures of the Administrative Procedure Act." The Release, in ISS's view, is "not an interpretative rule, general statement of policy, or rule of agency organization, procedure, or practice," and none of the exceptions to the APA's notice-and-comment rulemaking requirements applied. As a substantive rule that "sets a binding norm for private parties that affects their individual rights and obligations," ISS contends, the Release should have been issued after following the notice-and-comment rulemaking procedures.
At the SEC open meeting at which the SEC adopted the interpretation and guidance (giving it the benefit of legal effect), two dissenting Commissioners, Robert Jackson and Allison Lee, objected to the failure by the SEC to study the potential impact of the guidance, which they thought could be significant. Jackson expressed his concern that the guidance "may alter the competitive landscape for the production and use of that advice [from proxy advisory firms]—without addressing whether doing so might make it harder for investors to oversee management."
Among other reasons, Lee objected because the process that did not involve compliance with APA procedures, such as notice and comment, and did not weigh costs and benefits. In addition, she disagreed that the guidance did not exceed existing non-binding staff guidance because SEC guidance "commands attention and compliance....It may be that some of these specific measures are warranted, but the Commission has made a substantive policy choice without formally seeking input, justifying that choice to the public, or even identifying any benefits for investors." She also opposed the guidance related to the solicitation rules, in light of anticipated, but undefined, changes to the exemptions from those rules.
Chair Clayton countered her criticism regarding the absence of compliance with APA procedures with a pre-arranged Q&A with counsel at the table, in which counsel stated that the APA was not triggered by this action because the guidance was interpretive and no new obligations were created. Nor, he said, was an economic analysis required by SEC rules.
Interestingly, Commissioner Hester Peirce, who, as noted above, has been averse to guidance from the staff, characterized the SEC's actions in issuing the new guidance as "not building a new regulatory regime, but...explaining the contours of an existing one to help investment advisers and proxy advisors carry out their responsibilities." She greeted the guidance as a "welcome departure from our past over-reliance on staff guidance," noting that the guidance does not "prescribe what investment advisers and proxy advisors must do to carry out their responsibilities, but they describe some things these firms might consider to help them accomplish those goals." (See this PubCo post.)
Third, ISS argues that the Release is "arbitrary and capricious" because the SEC did not "provide reasoned explanation for its action....Indeed, the Release neither recognizes nor acknowledges that its conclusions contradict and depart from decades of SEC precedent recognizing that advice rendered at the request of a shareholder in the context of a fiduciary relationship does not constitute proxy solicitation." In addition, the SEC did not "explain why regulating proxy advice through the regulatory framework applicable to investment advisers under the Advisers Act is insufficient to protect the investing public and advance the SEC's regulatory goals."
In addition, ISS claims that the "Release raises serious First Amendment concerns to the extent it opens firms providing proxy advice to liability under Rule 14a-9 based on the opinions or recommendations they provide to their clients." Under the Release, proxy voting advice could be subject to SEC enforcement actions or private actions under Rule 14a-9, even if is exempt from the proxy solicitation rules. As a result, the Release "opens the door to SEC enforcement actions or potential claims by issuers who disagree with the client voting guidelines on which ISS' recommendations are based."
In the complaint, ISS asks for the following relief:
"a. A declaratory judgment holding that proxy voting advice provided in the course of a fiduciary relationship does not constitute proxy solicitation under Section 14(a) of the Exchange Act and may not be regulated as such, and that the Proxy Adviser Release is accordingly contrary to law;
b. A declaratory judgment holding that the Proxy Adviser Release is procedurally invalid under the APA because the SEC failed to promulgate it through proper notice-and-comment rulemaking procedures;
c. A declaratory judgment holding that the Proxy Adviser Release is arbitrary and capricious under the APA;
d. A declaratory judgment and permanent injunction finding the Proxy Adviser Release invalid and setting it aside;
e. An injunction prohibiting the SEC from taking enforcement action against ISS based on the interpretation of proxy solicitation set forth in the Proxy Adviser Release;
f. All other relief to which Plaintiff is entitled, including but not limited to attorneys' fees and costs."
Depending on how the case is framed, it could raise issues under the recently decided Kisor v. Wilkie, where SCOTUS decided not to overrule the decades-long deference of courts to the reasonable interpretations by agencies (such as the SEC) of their own ambiguous regulations, often referred to as Auer deference. Although the doctrine was not overruled, the Court took pains to "reinforce its limits." Auer deference, said Justice Kagan writing for the majority, "is sometimes appropriate and sometimes not. Whether to apply it depends on a range of considerations that we have noted now and again, but compile and further develop today. The deference doctrine we describe is potent in its place, but cabined in its scope." As interpreted by the Court, the regulation must be "genuinely ambiguous, even after a court has resorted to all the standard tools of interpretation"; the agency's reading must be "reasonable"; and the "court must make an independent inquiry into whether the character and context of the agency interpretation entitles it to controlling weight."
Alternatively, if the case were viewed as interpreting a provision of the Exchange Act, it could implicate "Chevron deference," which refers to the well-worn two-step test for determining whether deference should be accorded to federal administrative agency actions interpreting a statute (as opposed to its own regulation), first articulated by SCOTUS in 1984 in Chevron v. Natural Resources Defense Council. Generally, the doctrine established in that case mandated that, if there is ambiguity in how to interpret a statute, courts must accept an agency's interpretation of a law unless it is arbitrary or manifestly contrary to the statute.) (See this PubCo post and this PubCo post.)
Both Auer deference and Chevron deference have been highly politicized and come under attack in an effort to restrict the actions of the "administrative state." You might recall that, in 2016, the Financial Choice Act, which passed the House but not the Senate, provided that, in any action for judicial review of agency action (including action by the SEC) authorized under any provision of law, the reviewing court shall determine the meaning or applicability of the terms of an agency action and decide de novo all relevant questions of law, including the interpretation of constitutional and statutory provisions, and rules made by an agency. (See this PubCo post.) (Note, however, that in the Financial Choice Act Version 2.0, the repeal of the "Chevron deference" doctrine would have been delayed for two years. See this PubCo post.) Similar provisions were included in quite a number of bills that passed the House but not the Senate in 2017. (See this PubCo post.)
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.