United States: SEC Adopts Amendments Regarding Proxy Advisory Firms (Updated)

This post is a revision of my earlier post, updated to reflect the adopting release for the final rule and the supplemental guidance.

Earlier this week, at a virtual open meeting, the SEC, by a vote of three to one, adopted new amendments to the proxy rules, modified from the original proposal issued in November last year, regarding proxy advisory firms (see this PubCo post). The amendments make proxy voting advice subject to the proxy solicitation rules and condition exemptions from those rules for proxy advisory firms, such as ISS and Glass Lewis, on disclosure of conflicts of interest and adoption of principles-based policies to make proxy voting advice available to the subject companies and to notify clients of company responses. The amendments also provide two non-exclusive safe harbors designed to satisfy the conditions to the exemptions. The SEC also voted by the same margin to publish new supplementary guidance for investment advisers addressing how advisers should consider company responses in light of the new amendments to the proxy rules. SEC Chair Jay Clayton observed that the final rules and guidance are the product of a 10-year effort-commencing with the SEC's 2010 Concept Release on the U.S. Proxy System-which has led to "robust discussion" from all market participants. The original proposal issued in November generated substantial comment and criticism, and the SEC took much of it into account in developing the final rule, which now only "encourages" what had been imperative in the proposal-namely that proxy advisors conduct a review and feedback process with issuers.

The amendments will become effective 60 days after publication in the Federal Register, but affected proxy advisors will not be required to comply with the Rule 14a-2(b)(9) amendments until December 1, 2021. The long transition period does not apply to the amendments to Rule 14a-1(l) and Rule 14a-9. The supplemental guidance for investment advisers will be effective upon publication in the Federal Register.

Background

Many companies, as well as business lobbies such as the Business Roundtable and the National Association of Manufacturers, have repeatedly raised concerns about proxy advisory firms' concentrated power and significant influence over corporate elections and other matters put to shareholder votes, which has led to questions about whether they should be subject to more regulation and accountability. (See, e.g., this PubCo post, this PubCo post and this PubCo post.) In particular, companies had expressed concerns that the analyses of proxy advisory firms were rife with factual errors, omissions and methodological weaknesses that "could materially affect the reliability of their voting recommendations and could affect voting outcomes, and that processes currently in place to mitigate these risks are insufficient." What's more, some companies contended that they did not have adequate opportunities to review the advice, engage with the firm and correct the errors on a timely basis, impairing the accuracy, transparency and completeness of the information available to voters. Although proxy advisors have taken some steps to share information with companies (see this PubCo post), those opportunities have been limited in some cases to larger companies, were not timely or were otherwise inadequate to address company concerns.

In response to these calls for action, in November last year, the SEC proposed rule amendments designed to build on market processes currently in place, providing a mechanism for enhanced engagement between proxy advisory firms and companies. The proposal clarified that the term "solicitation" includes any proxy advisor voting recommendations, and it conditioned exemptions from the filing and information requirements of the proxy rules for those solicitations on the proxy advisor's making specified disclosures about conflicts of interest and compliance with an issuer review and feedback process regarding the firm's advice. More specifically, the proposal required, as a condition to reliance on the exemptions, that the proxy advisory firm provide companies (and certain other soliciting persons) with at least two opportunities to review and provide feedback on the advice before dissemination to the firm's clients, with the review time varying based on how far in advance of the shareholders meeting the definitive proxy was filed. In addition, the proposal required proxy advisors to include, upon request, in their proxy voting advice a hyperlink to the company's (or other person's) written statement of its views on the advice. (See this PubCo post.)

Many companies supported the proposal, arguing that companies do not otherwise have a timely and effective method for conveying their views about proxy voting advice prior to voting. Nevertheless, the proposal drew fierce criticism from a number of quarters. Commenters complained that there was insufficient evidence of frequent errors or deficiencies on the part of proxy advisors to mandate this costly and time-consuming process. In addition, they contended that requiring advance review of proxy voting advice by companies would give those companies an unfair advantage by allowing them to influence the advice at a critical stage. Some also complained that the feedback framework was too rigid and not workable logistically and would impede proxy advisors' ability to provide timely advice. Moreover, they said, some proxy advisors have already implemented feedback systems, and companies already have available other "counter-speech" measures. Some suggested that the mandatory hyperlink was "compelled speech" in violation of the First Amendment.

Various organizations weighed in. The Council of Institutional Investors expressed concern that the requirement that proxy advisors share advance copies of their recommendations with issuers could interfere with the relationship between institutional investors and proxy advisory firms as their agents. In CII's understanding, proxy advisory firms are agents of institutional investors, not of issuers. And, according to CII, there is no reason to believe that institutional investors feel the need for prior review by issuers of the work product of their agents, the proxy advisors. Rather, investors would prefer that the proxy advisory firms be completely independent of companies. The SEC's Investor Advisory Committee recommendation also disparaged the proposal as unlikely to reliably achieve the SEC's own stated goals, ultimately advising the SEC to go back to the drawing board and republish a new proposal. The committee contended that the proposal was almost futile without addressing in parallel more basic proxy plumbing issues (as the Committee had previously recommended) (see this PubCo post), and that none of the SEC's actions at issue adequately identified the underlying problems that were intended to be remedied, provided a sufficient cost/benefit analysis or discussed reasonable alternatives that might have been proposed. (See this PubCo post.)

At the open meeting

At the open meeting, Clayton remarked that, given that approximately 72% of domestic stock market value is held by institutional investors (through which retail investors participate in the market), to the extent that investment professionals look to proxy advisors for advice "when voting the shares of Main Street investors, it is important that (1) they do so in a manner consistent with their fiduciary obligations, and (2) that they have access to transparent, accurate and materially complete information on which to make their voting decisions. By affirming and modernizing the implementation of these principles, today's recommendations will help ensure that the interests of Main Street investors and the obligations of those who vote on their behalf will not only be better aligned, but better decisions will be made."

Commissioner Elad Roisman, who has honchoed the proxy-process rulemakings through the SEC, said that there have been growing calls for the SEC to provide more oversight of proxy advisors as institutional ownership of the public markets has

In particular, he noted that it is universally acknowledged that proxy advisors "play a significant role in the proxy voting system," and that their clients "believe their advice is material and market-moving." He also highlighted the application of the new supplemental guidance regarding the fiduciary duties of investment advisers in the context of their use of "robo-voting" features, which "(1) pre-populate clients' electronic ballots with the businesses' voting recommendations, and (2) automatically submit those ballots for counting. With the help of such features, a client could effectively 'set-it-and-forget-it,' allowing the proxy voting advice business to produce recommendations that determine the client's vote, without further action by the client."

Commissioner Hester Peirce approved of the final rules as a "measured" change, particularly the modifications to the original proposal that made the final rules more principles-based: "[t]hese principles-based procedural requirements provide proxy voting advice businesses flexibility to determine the best way to meet the rulemaking's objectives, while respecting the value of the service that proxy voting advice businesses offer and the compressed time periods within which they operate. The safe harbors are just that-proxy voting advice businesses should not feel tethered to the safe harbors when developing their policies and procedures." In her view, the "final rules achieve the Commission's objective of ensuring that investors and their advisers who rely upon proxy voting advice are provided with more transparent, accurate, and complete information. The rules achieve this goal without imposing unduly burdensome requirements on proxy voting advice businesses given the significant time constraints of the proxy voting process."

Commissioner Allison Lee, who dissented on both counts, objected to the rule changes and guidance as "unwarranted, unwanted, and unworkable." According to Lee, the new rules will

Lee also noted her objection to the codification of "a new interpretation of what it means to solicit a proxy under Exchange Act Section 14(a) that departs from the Commission's historical interpretation of that term. The interpretation largely ignores the significance the Commission has traditionally given to the distinction between solicited and unsolicited advice."

Although the final release reflects modifications in response to public comment (46 in favor, 159 in opposition), to Lee, all the changes do is make the rules less objectionable, but still don't justify it; the final rules may be "less prescriptive in terms of issuer intervention," but much of that flexibility "is abrogated by the safe harbors which, as is well understood, will become the de facto rules." The release indicates that the rule changes will provide shareholders with "a more complete mix of information," but that is not a good reason, in Lee's view, to "justify the forced consideration of issuer views that these rules require, particularly over the objection of investors." In addition investors, the purported beneficiaries of the rule changes, widely opposed the proposal, she said. And, the final changes are so different from the proposal that it's unclear from comments or economic analysis what the costs, delays and disruption are likely to be.

Finally, she asserts that, even if the rules no longer mandate company pre-review, the final rules still recommend it, introducing "delay and uncertainty by effectively requiring proxy advisors to provide their clients with notice of multiple events." So, notwithstanding mitigation of some of the defects in the proposal, she contended, "the final rules will still make it harder and more costly for shareholders to cast their votes, and to do so in reliance on independent advice. That means it will be harder for shareholders to make their voices heard-and harder for them to hold management accountable. That's less accountability on climate risk, less accountability on executive pay, less accountability on diversity, on human capital, worker safety, and the list goes on."

Rule amendments related to proxy voting advice

The amendments are designed to provide investors who use proxy voting advice "more transparent, accurate, and complete information on which to make their voting decisions, without imposing undue costs or delays that could adversely affect the timely provision of proxy voting advice." The adopting release recognizes-indeed reiterates-the tremendous power and influence of proxy advisors: proxy voting advice "implicates interests beyond those of the clients who utilize it when voting." In what way? First, there are millions of retail investors whose shares are held and voted on their behalf by institutional investors. But perhaps more significantly, given the ability of institutional investors-the clients of proxy advisors-to "affect the outcome of the vote on a particular matter through their voting power, the proxy voting advice guiding the clients' votes potentially affects the interests of all shareholders of the registrant, the registrant, and the proxy system in general."

In response to comments, the final rules made significant modifications to the proposal in a number of respects to provide more flexibility to proxy advisors and to minimize potential disruptions that could impair their ability to provide timely voting advice to their clients.

Proxy voting advice as a "solicitation"-Rule 14a-1(l). The term "solicitation" includes not only requests for proxies, but also any "communication to security holders under circumstances reasonably calculated to result in the procurement, execution, or revocation of a proxy." In 2019, the SEC issued an interpretative release concluding that, when proxy advisors provide voting advice to their clients, they are generally engaged in solicitations. (See this PubCo post.) That position was not new-it was originally set forth in a 1964 release and reiterated in 1979 and 2010.

In the new amendments, the SEC revised the definition of "solicitation" in Rule 14a-1(l) to codify its "longstanding view that proxy voting advice generally constitutes a 'solicitation' under Section 14(a)." More specifically, under the amendments, a "solicitation" includes "any proxy voting advice that makes a recommendation to a shareholder as to its vote, consent, or authorization on a specific matter for which shareholder approval is solicited, and that is furnished by a person who markets its expertise as a provider of such advice, separately from other forms of investment advice, and sells such advice for a fee." However, the determination "ultimately depends on the specific nature, content, and timing of the communication and the circumstances under which the communication is transmitted."

In response to comments objecting that the plain meaning of "solicitation" must involve intent to obtain proxy authority, the SEC contended that dictionaries in circulation at the time Section 14(a) was enacted "indicate that the term 'solicit' had other meanings that did not depend on the interest or subjective intent of the person engaging in the solicitation. The term 'solicit' also meant '[t]o move to action.' Under this definition, what matters is not the subjective intent to obtain a proxy, but rather the effect on a recipient's proxy vote. A person solicits a proxy by influencing a shareholder to act." Similarly, the SEC contends, the courts "have articulated a broad definition of the term 'solicit.'" It would be inconsistent with the overarching purpose of Section 14(a) "if a person whose business is to offer and sell voting advice broadly to large numbers of shareholders, with the expectation that their advice will factor into shareholders' voting decisions, were beyond the reach of Section 14(a)." In a change from the proposal, new paragraph (v) codifies the SEC's view that "solicitation" excludes any proxy voting advice furnished "only in response to an unprompted request."

Exemptions-Rules 14a-2(b)(1) and 14a-2(b)(3). To the extent that proxy voting advice is a solicitation, in the absence of an exemption, proxy advisors would be subject to, among other things, the requirement to file and furnish definitive proxy statements. However, the SEC has a different goal in mind. To that end, the SEC has crafted new conditions applicable to these exemptions "fashioned both to elicit adequate disclosure and to enable proxy voting advice businesses' clients to have reasonable and timely access to transparent, accurate, and complete information material to matters presented for a vote...."

The new amendments affect Rules 14a-2(b)(1) and 14a-2(b)(3), which provide exemptions from the information and filing requirements of the proxy rules, state that proxy advisory firms can rely on these exemptions if they satisfy conditions set forth in new Rule 14a-2(b)(9):

Disclosure of conflicts of interest. First, under the new rule, to rely on the exemption, proxy advisors will be required to disclose prominently, either in the voting advice or in an electronic medium used to deliver the proxy voting advice, information regarding (i) an interest, transaction or relationship of the proxy advisor (or its affiliates) that is "material to assessing the objectivity of the proxy voting advice in light of the circumstances of the particular interest, transaction, or relationship" and (ii) any policies and procedures used to identify, as well as the steps taken to address, material conflicts of interest arising from the interest, transaction or relationship.

The release observes that proxy advisors can be involved in a variety of conflicts of interest. As one example, a proxy advisor may be providing voting advice to its clients on proposals at a company while at the same time earning consulting fees from that company for providing advice on corporate governance and compensation policies. This and other potential conflicts raise the possibility that the proxy advisor could be swayed by its own business interests, calling "into question the objectivity and independence of its advice." For example, the adopting release notes that it may be appropriate for a proxy advisor to

To be in a position to assess the impact, the SEC believes, the proxy advisor's clients would need to be informed about the conflict. As adopted, Rule 14a-2(b)(9)(i) establishes a principles-based requirement, based on a standard of materiality, applicable to proxy voting advice provided in reliance on the exemptions in Rules 14a-2(b)(1) and (b)(3). Although many commenters argued that proxy advisors already provide adequate disclosure about conflicts, the SEC considered it advisable to set minimum, principles-based standards.

Notice of proxy voting advice and response. Second, Rule 14a-2(b)(9)(ii) will require a proxy advisor, as a separate condition to the availability of the exemptions in Rules 14a-2(b)(1) and (b)(3), to adopt and publicly disclose written policies and procedures reasonably designed to ensure that:

• Companies that are the subject of proxy voting advice "have such advice made available to them" at or prior to the time when the advice is disseminated to the proxy advisor's clients (Rule 14a-2(b)(9)(ii)(A)); and
• The proxy advisor provides to its clients "a mechanism by which they can reasonably be expected to become aware of any written statements regarding its proxy voting advice" from the subject companies, in a timely manner before the shareholder meeting (or, if no meeting, before the votes, consents, or authorizations may be used to effect the proposed action) (Rule 14a-2(b)(9)(ii)(B)).

As noted above, the SEC's original proposal required, as a condition to the exemption, that proxy advisors provide companies (and certain other soliciting persons) with at least two opportunities to review and provide feedback on the advice before dissemination to the firm's clients. And, as discussed above, the proposal elicited a storm of opposition. Nevertheless, the SEC continued to believe that some action was necessary: existing proxy advisor programs for issuer feedback have not been universally adopted or made available for all companies, and current counter-speech measures were inadequate if companies did not receive timely notice to provide a response, especially in light of the "high incidence of voting that takes place very shortly after a proxy voting advice business's advice is distributed to its clients."

Notably, however, some commenters had urged the SEC to "consider a more flexible, principles-based, and less intrusive solution." And that's the direction the SEC took in the final rules, opting for less prescriptive, more principles-based approach that, in its view, still achieves the objectives of the proposal-to facilitate more informed proxy voting decisions by enabling investor access to more complete and robust information and discussion of proxy voting matters. The new amendments "articulate a set of principles, distilled from the proposed rules, upon which a proxy voting advice business may design its own policies and procedures."

The new amendments do not, however, mandate that proxy advisors engage with companies in a review-and-feedback process-a process that some might characterize as a core element, if not the core element, of the original proposal. As the release indicates, the new rule "does not dictate the manner or specific timing" for proxy advisors to interact with companies, instead leaving it to the discretion of the proxy advisor as to how best to implement its own policies and procedures. Nor does the new rule require proxy advisors to allow companies to review proxy voting advice in advance of its dissemination to the proxy advisor's clients, instead merely encouraging proxy advisors to further the objectives of the rule by providing that opportunity to the extent feasible. Likewise, to the extent that, after dissemination to clients, the proxy advisor revises or updates the advice in light of subsequent events or otherwise, the proxy advisor is not required to make that information available to companies, as the SEC views that type of mandate as too burdensome. To avoid practical challenges raised with regard to the proposal's requirement to provide a hyperlink to the company's response, the SEC has shifted instead to a principles-based requirement, permitting the proxy advisor to determine its specific manner of compliance, regardless of whether the voting recommendation is adverse to the company's position.

In response to comment, to the extent that proxy voting advice is based on custom policies or the proxy voting advice is provided as to non-exempt solicitations (i.e., solicitation subject to Rule 14a-3(a)) regarding certain mergers and acquisitions or contested matters), the SEC has excluded it from the notice requirement of Rule 14a-2(b)(9)(ii). The exception applies only to the portions of the proxy voting advice relating to the applicable M&A transaction or contested matters and not to proxy voting advice regarding other matters presented at the meeting. However, where a matter is closely related to the transaction or contested matter, such as an advisory vote on golden parachute payments in connection with the M&A transaction, the exception would also be applicable to that matter. Note that the proxy voting advice is still considered a solicitation requiring disclosure of conflict-of-interest information.

Safe harbors. The amendments also include two new, non-exclusive safe harbors for proxy advisors with regard to the required written policies and procedures:

• Making proxy advice available to subject companies. With regard to making proxy advice available to subject companies under Rule 14a-2(b)(9)(ii)(A), under the first safe harbor, a proxy advisor will be deemed to have satisfied the requirements if its written policies and procedures are reasonably designed to provide companies with a copy of its proxy voting advice, at no charge, no later than the time it is disseminated to the advisor's clients. Proxy advisors may include in their policies and procedures two conditions that impose requirements on a subject company: (A) to file its definitive proxy statement at least 40 calendar days before the shareholders meeting and (B) to expressly acknowledge that it will use the proxy voting advice only for its internal purposes and/or in connection with the solicitation and that it will not publish or otherwise share the advice except with the company's employees or advisers. The SEC notes that the 40-day provision takes into account the necessary practice of proxy advisors to perform much of their work only after the filing of the definitive proxy statements and the resulting time pressure they face to deliver their analyses on a timely basis in advance of the meeting. Because the SEC has completely eliminated any requirement for company review and feedback, it believes that "the rule does not create the risk that such advice would be delayed or that the independence thereof would be tainted as a result of a registrant's pre-dissemination involvement." However, providing for contemporaneous access, rather than advance review, still allows the company an opportunity to file additional soliciting material in response to the advice. Although, to qualify for the safe harbor, the proxy advisor could not impose more restrictive terms in its required acknowledgement of use of the advice than in paragraph (B), it could, however, impose more tailored or restrictive conditions without reliance on the safe harbor, so long as the policies "do not unreasonably inhibit timely notice" to the company under the principles-based requirements of Rule 14a-2(b)(9)(ii)(A).

• Making clients aware of company responses. With regard to a "mechanism" to make clients aware of company responses, the second safe harbor provides that a proxy advisor will be deemed to have satisfied the requirements of Rule 14a-2(b)(9)(ii)(B) if its written policies and procedures are reasonably designed, upon notice from a subject company, to provide notice to its clients that receive the proxy voting advice that the subject company intends to file or has filed additional soliciting materials (Rule 14a-6) responding to the advice, including an active hyperlink to those materials on EDGAR when available, either (i) on the proxy advisor's electronic platform or (ii) through email or other electronic means. The safe harbor is designed to enable clients of the proxy advisor to "stay informed of, and timely consider, additional information with respect to the proxy voting advice" that the company considers to be material to the vote. Proxy advisors will be permitted to specify how the company must notify the advisor that it has filed or intends to file a supplemental proxy filing, provided they comply with the broad outlines of the safe harbor. The SEC noted that, if a company notifies a proxy advisor of its intent to file additional soliciting materials, then the proxy advisor "should consider whether, for purposes of complying with this safe harbor requirement, it needs to send two separate notices to the business's clients: (1) one notice regarding the registrant's intent to file and (2) another notice regarding the registrant's actual filing."

The SEC also makes clear that proxy advisors can always structure their policies outside of the safe harbors so long as, under the facts and circumstances, they are reasonably designed to ensure that the conditions of the exemption are satisfied; the safe harbors are not intended to be the de facto means by which the conditions are satisfied. Factors to be taken into account in assessing the adequacy of policies outside of safe harbors include the length of time provided for a company to respond, whether information is promptly conveyed to the company, efficiency of the mechanism to notify clients so as to allow sufficient time for consideration of a response and the reasonableness of any fees charged to companies.

Rule 14a-9. Rule 14a-9, which applies even to exempt solicitations, prohibits any proxy solicitation from containing false or misleading statements with respect to any material fact or omitting to state any material fact necessary to make the statements not false or misleading. Currently, the rule provides four examples of misleading information. The amendments modify Rule 14a-9 to include examples of when material omissions in proxy voting advice could be considered misleading within the meaning of the rule. More specifically, the amendments provide that "failure to disclose material information regarding proxy voting advice, 'such as the proxy voting advice business's methodology, sources of information, or conflicts of interest' could, depending upon particular facts and circumstances, be misleading within the meaning of the rule." In response to concerns raised about a lack of clarity, the SEC decided not to include in the final amendments a proposed example of failure to disclose the use of standards or requirements in proxy voting advice that materially differ from relevant standards or requirements that the SEC sets or approves.

Supplemental guidance regarding proxy voting responsibilities of investment advisers

In September 2019, the SEC issued Guidance Regarding Proxy Voting Responsibilities of Investment Advisers, addressing how the fiduciary duty and rule 206(4)-6 under the Investment Advisers Act of 1940 relate to an investment adviser's proxy voting on behalf of clients (see this PubCo post). The September guidance discussed the extent to which an investment adviser can "outsource" to proxy advisory firms and still fulfill its fiduciary duty to its clients by conducting reasonable due diligence, addressing conflicts and providing full disclosure. The guidance recommended that investment advisers satisfy their own fiduciary duties of care and loyalty and obligations to act in their clients' best interests, in part, through careful oversight of proxy advisory firms (i.e., investment adviser as "enforcer"), such as by monitoring and analyzing the methodology and processes of proxy advisory firms, including their processes for engagement with companies and procedures to address errors.

The new supplemental guidance is intended to assist investment advisers in assessing how to consider the additional information that may become more available as a result of the new amendments discussed above. In particular, the supplemental guidance advises how investment advisers should consider company responses to proxy advisor recommendations resulting from the new amendments, including where the investment adviser uses a proxy advisor's robo-voting system. For example, the supplemental guidance advises that the investment adviser should consider

The supplemental guidance also addresses disclosure obligations and client consent when investment advisers use robo-voting services.

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.