On August 21, 2019, the US Securities and Exchange Commission (SEC) issued new guidance regarding the role of proxy advisors in the proxy voting process. This guidance is expected to play an important role in the upcoming 2020 proxy season, as the SEC seeks to further define the proxy voting obligations of registered investment advisors while promoting greater accountability on the part of the proxy advisory firms.

The SEC's August guidance was followed by an announcement on November 5, 2019 of proposed rules governing proxy advisors and their investment advisor clients. These rules are, in the words of the SEC, intended to "improve [the] accuracy and transparency of proxy voting advice." If adopted, the proposed rules would significantly alter the manner in which proxy advisors interact with both issuers and investment advisors.

The August 2019 Guidance

On August 21, 2019 the SEC issued two new releases regarding the proxy process. In the first of these releases, the SEC stated that proxy advisor recommendations constituted solicitations under the Commission's proxy rules. While the release did not seek to limit the proxy advisory firms' ability to rely on certain exemptions to the information and filing requirements of the proxy rules, it did make clear that proxy advisor recommendations are subject to the antifraud provisions of Rule 14a-9 of the Securities Exchange Act of 1934 (Exchange Act). The release also recommends that proxy advisory firms disclose additional information regarding the proxy advisor's methodology, information sources and conflicts of interest.

In the second release, the SEC discussed the obligations of investment advisors, particularly in connection with their retention and use of proxy advisory firms. The SEC emphasized the need for investment advisors to have policies and procedures in place to adequately oversee proxy advisory firms and ensure that the needs of each individual issuer are taken into account.

While the SEC's releases stated that the Commission did not consider its August 2019 guidance to represent a substantive change in policy, the largest proxy advisory firm, Institutional Shareholder Services, Inc. (ISS), has taken a decidedly contrary position. ISS commenced litigation against the SEC on October 31, 2019 in the federal District Court for the District of Columbia. In that case, ISS is seeking to set aside the SEC's August 2019 guidance as a fundamental change in law that exceeds the SEC's jurisdiction and violates the federal Administrative Procedures Act. The outcome of this litigation will likely affect the impact of the August 2019 guidance and may influence further SEC regulation of proxy advisors.

The Proposed New Rules

On November 5, 2019, the SEC voted 3-2 to propose additional rules for the regulation of the proxy voting process. If adopted, these additional rules would increase regulation of proxy and increase the ability of public companies to monitor and respond to the advisors' voting recommendations.

In light of these SEC actions, investment advisors should perform a review of their policies, procedures and practices on a clientby-client basis before the start of the 2020 proxy season. Proxy advisory firms should establish detailed policies to ensure that their recommendations are materially accurate to avoid liability under Rule 14a-9, and to assure investment advisors that proxy advisor recommendations are in the best interests of the client.

For their part, public companies should take note of the SEC guidance, as it provides a greater opportunity for issuers to dispute adverse voting recommendations that can be challenged as factually or analytically flawed.

While the outcome of the ISS challenge to the SEC's guidance and the ultimate outcome of the proposed new rules remains to be seen, the SEC has clearly signaled its intention to take action to curb the outsized influence of proxy advisory firms.

Background and History of the Proxy Advisory Process

Under Rule 206(4)-6 of the Investment Advisor's Act of 1940 (Advisor's Act), investment advisors must adopt policies and procedures reasonably designed to ensure that proxies are voted in the best interests of their clients.1 However, the perceived requirement to adopt policies to vote every share with respect to every shareholder vote imposes significant economic burdens on investment advisors who do not wish to maintain the staffing levels or resources that would be needed to evaluate all management and shareholder proposals.

Outsourcing this work to third party proxy advisory firms has been seen as the most convenient way to minimize this economic burden.

Further, investment advisors have a fiduciary duty to develop proxy voting guidelines that are free from conflicts of interest that often occur when the advisor is voting on matters affecting an issuer in which the advisor's clients hold an economic interest or where the advisor provides consulting services to that same issuer. The SEC had issued guidance allowing investment advisors to fulfill their duties to avoid conflicts by relying on the voting guidelines of a third party proxy advisor.

However, as the influence of proxy advisory firms has increased, so has controversy surrounding their increasingly large role in the proxy voting process. This controversy has been fueled by the fact that opinions regarding proxy advisory firms have often tended to fall along party lines, with proponents of proxy advisory firms leaning left and critics in the business community leaning right.For a discussion of the problems relating to proxy advisory firms, see Frank M. Placenti, "Are Proxy Advisors Really a Problem."

Detractors of the role that proxy advisors play in the proxy voting process often cite concerns about investment advisors' near slavish reliance on voting advice from proxy advisory firms. Others charge that proxy advisors do not devote sufficient resources to creating their voting advice and that they use erroneous or misleading information as a basis for their opinions. Still others have raised concerns that proxy advisors often have conflicts of interest, undermining the fiduciary duties that investment advisors owe to their clients. The fact that two proxy advisory firms, ISS and Glass Lewis & Co. (Glass Lewis), dominate the industry with a 97% market share exacerbates these alarms. In response to these concerns, the SEC has been conducting an overall review over the past several years, examining how federal proxy rules apply to proxy voting advice.

The Noose Begins to Tighten on Proxy Advisors: The SEC's 2004 No Action Letters and Their 2018 Withdrawal

In 2004, the SEC issued two no action letters regarding proxy advisory firms that greatly enabled the growth and power of proxy advisory firms.

The first letter was issued to Egan-Jones Proxy Services (EganJones) on May 27, 2004, and the second letter was issued to ISS on September 15, 2004. Taken together, these letters stated that an investment advisor could fulfill its fiduciary duties to its clients to vote in an informed manner and without an impermissible conflict of interest by relying on the opinion of an independent third party proxy advisory firm.

The May 2004 Egan-Jones letter posited that a third party proxy advisory firm could be considered independent even though it receives compensation from an issuer for separately providing advice to the issuer on corporate governance issues. The letter also listed additional requirements for investment advisors relying on such proxy advisory firms, such as obtaining ongoing information from any proxy advisory firm to determine that the proxy advisor is, in fact, independent and impartial.

In the September 2004 letter to ISS, the SEC further stated that, rather than a case by case evaluation of a proxy advisory's firm's potential conflicts, investment advisors could fulfill their fiduciary duties if they, among other things, examine the proxy advisory firm's conflict procedures and the effectiveness of their implementation.

In June 2014, the Divisions of Investment Management and Corporation Finance also issued Staff Legal Bulletin (SLB) No. 20, which was based on these two no action letters and provided guidance on investment advisor's fiduciary duties in connection with retaining proxy advisors. SLB No. 20 was widely interpreted as a signal from the SEC that investment advisors should refrain from uncritical reliance on the recommendations of proxy advisory firms. Nevertheless, data continued to show that many investment advisors voted in accordance with the advice of proxy advisory firms in an alarming percentage of cases – often approaching 100%. See, The Realities of Robo-Voting, The American Council for Capital Formation, November 2018.

In response to these growing complaints, on November 2018 the SEC held a roundtable to allow corporations and institutional investors to express their concerns about the conduct of proxy advisors. As a prelude to this roundtable, on September 13, 2018, the SEC withdrew the 2004 Egan Jones and ISS no action letters, indicating an intent to reevaluate the standards currently in place to police proxy advisors. The SEC's withdrawal of the Egan Jones and ISS letters placed into question the extent to which an investment advisor could depend on the advice of proxy advisory firms and signaled a sea change in the attitude of the SEC toward proxy advisors.

The SEC's August 2019 Guidance

On August 21, 2019, the SEC issued long-awaited guidance regarding the applicability of proxy rules to proxy voting advice and the responsibilities of investment advisors. This guidance was approved by a 3-2 vote, largely along party lines. In his August 21 remarks, Commissioner Elad Roisman insisted that the SEC was not engaged in new rulemaking, but instead just clarifying and elaborating on its existing interpretations. As a result, the SEC's announced view was that it was not required to seek public comment before issuing the guidance, allowing the guidance to take effect immediately after publication in the Federal Register.

The SEC's guidance was reflected in two releases. In the first, Commission Interpretation and Guidance Regarding the Applicability of the Proxy Rules, clarified that the SEC considers a proxy advisor's recommendation to be a solicitation under the federal proxy rules. In the second, Commission Guidance Regarding Proxy Voting Responsibilities of Investment Advisors, the Commission clarified its view of the policies and procedures investment advisors should adopt to better fulfill their fiduciary duties to clients.

mportantly, in its guidance, the SEC explained that it considers proxy advisory opinions to be solicitations under Rule 14a-1(l) of the Exchange Act and, therefore, subject to the federal proxy rules. Under Rule 14a-1(l), a solicitation includes a "communication to security holders under circumstances reasonably calculated to result in the procurement, withholding or revocation of a proxy." The SEC release stated that when proxy advisory firms market their expertise in researching and analyzing proxy issues, and proceed to give a voting recommendation, this advice is "reasonably calculated" to affect proxy votes, even in cases where the proxy advisor bases its recommendations on the client's own, tailored voting criteria or when the investment advisor chooses not to follow the recommendation.

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