Institutional Shareholder Services, Inc. (ISS) fired a broadside at the SEC with a federal lawsuit filed on October 31, 2019, in Washington, D.C. The action claims that the Commission acted unlawfully in August 2019 when it issued an interpretative release on proxy advisors. In that release, by a 3-2 vote, the SEC expressed its opinion that proxy advisory services are solicitations under the proxy rules and are subject to the Rule 14a-9 antifraud provisions. The timing of the lawsuit is particularly interesting, because the Commission is set to propose rulemaking on November 5, 2019, to formalize restrictions on proxy advisors as agency regulations.
The ISS Arguments
The ISS complaint makes a series of both procedural and substantive arguments against the validity of the interpretive release. Initially, the firm argues that the interpretations are improper because they are substantive rules that the SEC promulgated without the notice and comment procedures required under the Administrative Procedure Act (APA). At the August open meeting, Chairman Jay Clayton took a rather unusual step and, in a prepared move, asked Michael A. Conley of the Commission’s Office of General Counsel to confirm that the releases were not rulemaking measures subject to the APA and that the law did not require the SEC to engage in extensive economic analysis. Conley stated that the measures do not change the law or impose additional substantive obligations, and as such they do not trigger the APA or the economic analysis requirements.
In rejecting the agency’s view, the ISS complaint asserts that none of the statutory exceptions to the APA’s rulemaking requirements applied to the release, and that the release involved substantive rulemaking, and not “not an interpretative rule, general statement of policy, or rule of agency organization, procedure, or practice rather than interpretations of existing rules.” According to ISS, the release constitutes rulemaking because “it sets a binding norm for private parties that affects their individual rights and obligations.”
The advisory firm also argues that the SEC acted in an arbitrary and capricious manner in issuing the interpretations. The complaint states that the SEC failed to satisfy the requirement that agencies must provide “reasoned explanations” for its actions “because the SEC has radically changed its regulatory treatment of proxy advice without even displaying awareness that it is changing position.”
The most significant substantive argument put forth by ISS is that the interpretations exceed the SEC’s statutory authority under Exchange Act Section 14(a) and is contrary to the statute’s language. The advisory firm argues that “the provision of proxy advice is not a proxy solicitation and cannot be regulated as such” by the SEC. Advisory firms are not engaged in a solicitation, argues ISS, because they have no intent to “maintain or gain control of a corporation through solicitation of the corporate voting rights of the shareholders.”
According to ISS, advisory firms are adequately regulated under the Investment Advisers Act, and it is improper to subject the firms to regulation under the Exchange Act. The complaint states that proxy advisers offer their clients proxy voting advice on ballot measures that could affect share prices, such as
mergers and acquisitions and director nominations, particularly in contested director elections. In addition, when proxy advisers offer advice or recommendations on ballot measures regarding corporate transactions such as mergers, acquisitions, or spinoffs, they are engaged in advising others as to the advisability of investing in, purchasing or selling securities. Finally, a proxy advisor “issues or promulgates analyses or reports about securities,” which ISS does in its company reports. In light of these functions, ISS argued that “the most natural regulatory regime for firms providing proxy voting advice is the framework that applies to investment advisers under the Advisers Act.”
In a call with me this week, Nell Minow, corporate governance expert and co-founder of ISS, stressed the importance of proxy advisors in the process of shareholder democracy. She explained that advisory firms are an important source of independent information for investors, and confirmed that the investor customers who use the services are not calling for regulation. According to Ms. Minow, there is no requirement for institutional investors to purchase these services and no obligation to follow the advisor’s recommendations. “Their clients are sophisticated financial professionals subject to the strictest fiduciary standards, and those clients have a choice of providers,” she stated in a recent comment letter, adding that “it is the very definition of prudence for these experts to avail themselves of independent research relating to buying/selling or voting securities.”
J.W. Verret, an associate professor of law at the George Mason University Antonin Scalia Law School, takes a sharply different view. He told me that the SEC is on solid ground as it seeks to expand Exchange Act regulation to proxy advisory firms. In his view, expanded regulation could eliminate potential conflicts of interest and would move investment advisers to take proactive steps to comply with their fiduciary duties when voting proxies. He said that the interpretation addresses the ultimate customer, who is the retail investor, and that retail investors would benefit from enhanced disclosures by advisory firms.
The Open Meeting Backdrop
The treatment of proxy advice as a solicitation has not historically been a concern, because these communications have been exempt from the proxy informational and filing provisions under Rule 14a-2(b)(1) and (3). These provisions exempt communications when a person is not seeking authorization to act as a proxy, and for “the furnishing of proxy voting advice by any person ... to any other person with whom the advisor has a business relationship.”
The open meeting scheduled for November 5 could significantly change that landscape, however. In August, SEC Chairman Jay Clayton stated in his open meeting discussion that “these exemptions commonly relied upon by proxy advisory firms were adopted decades ago and warrant a fresh look to determine whether changes are needed.” The open meeting agenda calls for the Commission to consider changes to the Rule 14a-2 exemption “that would provide for disclosure of material conflicts of interest and set forth procedures to facilitate issuer and shareholder engagement, to provide clarity to market participants, and to improve the information provided to investors.”
As of this writing, we have no information on what specific measures the SEC will consider. Rumors abound, but we won’t know until the Commission releases more information closer to meeting time. Will the lawsuit dissuade the Commission from acting on the measure in a few days? That is doubtful, but the Commission has canceled several open meetings lately.
The Deference Question
The proxy advisory firms will likely challenge any final rulemaking that emerges out of this rulemaking process. The challenges could bring up the often controversial question of judicial deference to agency actions. Both Auer deference (which recently survived a Supreme Court challenge largely intact), dealing with courts respecting an agency interpretation of its own statutes, and Chevron deference dealing with an agency interpretation of the statutes it administers, could both be in play. As Prof. Verrit told me, the D.C. Circuit Court “has been tough on SEC with respect to policy choices, and subjected them to heightened cost-benefit analysis,” invalidating several rules. He noted, however, that the courts are usually highly deferential to the SEC taking an expansive approach to defining securities law terms, such as a “solicitation.”
Such a challenge would present an interesting twist on the question of judicial deference to agency interpretations. Critics of the administrative state have argued against the courts relying on administrative interpretations of their own. Those critiques have generally come from conservative jurists and observers. For example, Justices Gorsuch (when he was on the Tenth Circuit) and Thomas have authored opinions that strongly criticized the deference doctrine. In this case, however, it will be corporate interests that will be urging the courts to uphold the SEC’s interpretation of the Exchange Act and affirm the rulemaking.