A divided SEC issued two interpretive releases dealing with proxy advisory firms and proxy voting by investment advisers on August 21, 2019. One release conveys the Commission’s opinion that voting recommendations by proxy advisory firms are “solicitations” under the proxy rules, and that the antifraud provisions apply to the proxy advice process. The second piece of interpretive guidance concerns the fiduciary obligations of investment advisers when they engage in proxy voting.

Although phrased in terms of advice and guidance, both releases could have significant impacts on how proxy firms and investment advisers conduct business. Commissioners Robert Jackson and Allison Lee entered dissenting votes on the measures.

Here’s Some “Advice”

Before diving into what the releases do, it is important to define what they don’t do, at least from the SEC’s perspective. Releases are Commission interpretations and guidance, distinct from rules or regulations of the Commission. The SEC did not issue the releases for notice and comment as required for rulemaking proposals under the Administrative Procedure Act (APA), and did not engage in the rigorous economic analysis required for Commission rulemaking. The lack of economic analysis is apparent in the page count of the releases. These two total 40 pages, standing in stark contrast to the 1300-plus pages issued by the SEC in the Regulation Best Interest rulemaking.

In a somewhat unusual move, Chairman Jay Clayton 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 affirmed that the measures do not change the law or impose additional substantive obligations, and as such do not trigger the APA or the economic analysis requirements.

Dissenting Commissioner Robert Jackson noted the lack of economic and market analysis in his objection. Commissioner Jackson stated that the guidance “may alter the competitive landscape for the production and use” of proxy advice without a full examination of the consequences. He added that “today’s guidance may make it more costly to run a proxy advisory firm, encouraging even more concentration—rather than new entrants who can give investors more choices about how to vote.” The commissioner concluded that he “would have considered the effects of today’s guidance on the competitive landscape more fully before taking these steps.”

Commissioner Allison Lee, appearing at her first open meeting, took issue with Chairman Clayton’s assertion that the guidance was merely interpretive. She initially stated that the Commission releases went beyond the previous expressions of staff views, such as in Staff Legal Bulletin No. 20. Staff advice is non-binding and cannot create legal rights or obligations, she noted. “Commission action, on the other hand, is different, and commands attention and compliance,” said the commissioner. In addition, she observed that the investment adviser release suggests several approaches to proxy advisory firm assessment that an adviser could use to meet its fiduciary duties with respect to proxy voting. She cautioned, however, that “many of those examples are presented as steps the adviser in fact should take, and a regulated entity ignores such direction at its peril.”

In her view, the releases impose new substantive requirements, such as increased issuer involvement in the proxy advisory firm’s advisory process. According to the majority, issuer input will improve voting recommendations and make them more consistent with investors’ best interests. Commissioner Lee cautioned that the Commission could not accurately assess these matters “because we have not fully gathered, analyzed, and weighed the evidence.”

The Case for Interpretive Action

Proponents of proxy advisor regulation have long criticized the “outsize influence” they claim that these firms have on public companies. Advocates for regulation, such as industry groups and business associations, also see proxy advisory firms as having “rampant conflicts of interest.” This view contrasts with those who oppose expanded SEC oversight. As the Commission’s Investor Advocate Rick Fleming stated in an April 2019 speech, “the investors who are paying for this service are not the ones who are expressing those concerns.”

Commissioner Elad Roisman, who is overseeing the SEC’s proxy initiative, began his remarks by rejecting Fleming’s view. He dismissed claims that the agency should not act on proxy advisory firms because the investors that are paying for proxy advice are not asking for protection. “To be clear,” he stated, “in this context, I do not consider asset managers to be the “investors” that the SEC is charged to protect; rather, the investors that I believe today’s recommendations aim to protect are the ultimate retail investors, who may have their life savings invested in our stock markets.” He noted that when an adviser relies on any third party for services, including assistance with compliance, the adviser remains “on the hook” for its fiduciary obligations.

Commissioner Hester Peirce observed that the measures in the release were “common sense steps.” The guidance will, in her view, “shed light on what [proxy advisors] do and how they do it.”

Chairman Jay Clayton concluded by stating that the potential actions discussed in the guidance are not new. “They should be familiar to investment advisers and other market participants,” he suggested. According to the chairman, the Commission’s actions should “should help promote a transparent and robust proxy process and transparent, thoughtful and meaningful voting determinations and investment decisions.”

The Proxy Rules and Proxy Advisors

The release produced by the Division of Corporation Finance presents two conclusions that are not controversial at first glance. The first is that proxy voting advice provided by a proxy advisory firm constitutes a “solicitation” under the proxy rules, and the second is that these solicitations are subject to the antifraud provisions in Exchange Act Rule 14a-9.

While the proxy advisory firms may quibble with me, it is not surprising that the Commission majority would consider proxy advice to be a solicitation under Rule 14a-1. The SEC has long viewed the definition broadly, stating as far back as 1956 that the proxy rules apply to any person seeking to influence the voting of proxies by shareholders, regardless of whether the person itself is seeking authorization to act as a proxy. The treatment of proxy advice as a solicitation has not historically been a concern, however, because these communications are 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.”

Things may be changing, however. The release states that “the staff is also considering recommending that the Commission propose rule amendments to address proxy advisory firms’ reliance on the proxy solicitation exemptions in Exchange Act Rule 14a-2(b).” Chairman 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.”

Additionally, in a speech earlier this year, Commissioner Elad L. Roisman stated that “it may be appropriate for the Commission to reassess whether their current practices fit within the intended scope and purpose of these exemptions.” Changes to the Rule 14a-2(b) exemptions could have dramatic consequences for the business model of proxy advisory firms, with significant increases in costs and administrative burdens.

The extension of Rule 14a-9 liability to proxy advice also does not appear particularly worrisome at first glance. After all, no firm wants to traffic in false or misleading statements in its communications. The question becomes troublesome, however, when viewing the actions suggested by the Commission to avoid running afoul of the rule.

The release notes that Rule 14a-9 “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.” Accordingly, the Commission states that providers of proxy voting advice should consider disclosing their methodology used to formulate their voting recommendations, as well as third-party sources of information beyond what is contained in issuers’ public filings.

Any required (or strongly suggested) disclosure of recommendation methodologies seems to involve the SEC in the day-to-day conduct of these firm’s businesses at a new level.

These disclosures would also involve commercially and competitively sensitive information. In addition, advisory firms may find it difficult to conduct research that requires them to reach beyond publicly-available information if the potential sources of that information could be disclosed to the client or in SEC filings.

Investment Advisers and Fiduciary Duties

A release prepared by the Division of Investment Management deals with several aspects of the impact of an adviser’s fiduciary duties on its proxy voting process. The release explains how advisers and clients may tailor their agreements to define the scope of the investment advisers’ authority and responsibilities to vote proxies on behalf of their clients. The Commission also offered guidance on how an adviser can demonstrate that it is acting in a client’s best interest and in accordance with the investment adviser’s proxy voting policies and procedures when voting proxies. The SEC suggests that advisers may want to consider having different voting policies for some or all of their clients, depending on the investment strategy and objectives of each.

The release also identifies matters that an investment adviser should consider if it retains a proxy advisory firm to assist with proxy voting. For example, the Commission recommends that advisers assess the adequacy and quality of the proxy advisory firm’s staffing, personnel and technology. Advisers also should establish policies and procedures with regard to identifying potential conflicts of interest of the proxy advisory firm.

Another suggestion is more controversial, however, and prompted a comment from Commissioner Lee. The release states that advisers should consider whether the proxy advisory firm “has an effective process for seeking timely input from issuers” with respect to its proxy voting policies and methodologies. Issuer involvement in the proxy process has long been a matter of contention between oversight advocates and proxy advisory firms. For example, in its 2010 concept release on proxy matters, the SEC asked for comment on whether increased issuer participation would provide essential oversight for proxy advisory firm practices.

Proxy advisory firms have increased their engagement with issuers on the development of general policy approaches. However, the firms have consistently asserted that they have to limit the scope of these discussions and to refrain from engagement on specific recommendations in order to maintain objectivity and satisfy research reporting timelines for clients. As described by Commissioner Lee, “efforts to force more work by more people into an already tight timeframe seem likely to reduce the accuracy of the research, or worse make the use of proxy advisory services unworkable.”

The two major proxy firms do allow issuers some input into their individual reports. Institutional Shareholder Services Inc. allows Standard & Poor’s 500 index issuers to receive a draft report for data accuracy review, and Glass, Lewis & Co., LLC has a program that allows issuers to access their reports. The Glass, Lewis program does not include access to the firm’s analysis or voting recommendations. Both firms allow a short (24 to 48-hour) feedback period for issuers. ISS and Glass Lewis both state that issuer access provides an opportunity to check data for factual errors and is not a mechanism for issuers to discuss or dispute the firms’ methodologies or analyses. The suggested actions in the release go beyond these limited access provisions currently allowed, as the SEC calls for issuer involvement in the formulation of a proxy advisor’s internal methodologies, analysis, and voting policies.

Is issuer participation actually necessary to minimize factually erroneous recommendations? According to a 2016 GAO report, the answer is no. The report stated that the “corporate issuers and institutional investors we interviewed said that the data errors they found in the proxy reports were mostly minor.”

Commissioner Lee stated that the guidance imposed substantive requirements that created “significant risks to the free and full exercise of shareholder voting rights.” According to the commissioner, the release “calls for more issuer involvement in the process despite widespread agreement among institutional investors and investment advisers that greater involvement would undermine the reliability and independence of voting recommendations.”

What’s Next?

It is likely that Commissioner Lee’s predictions will come true: the SEC recommendations “will have the practical effect of enshrining these examples in the policies and procedures of many, if not most, investment advisers and thereby increase costs for both investment advisers and proxy advisory firms.” Commissioner Jackson cautioned that the measures outlined by the SEC would be particularly burdensome for smaller advisers. He noted that smaller advisers might respond to these costs by choosing to vote less, which would cede more influence to large institutions.

The SEC is also far from finished with its proxy work. The Corporation Finance staff is considering proposing amendments to the Rule 14a-2(b) exemptions often utilized by proxy advisors. The division and the Commission did not hint at the scope of any upcoming changes to the rule, but a tightening of the exemptions could have a significant impact on the operations of proxy advisory firms. Chairman Clayton also directed the staff to consider whether the current rule definition of the term “solicitation” should be amended to codify the new interpretation.

Litigation concerning the releases is also a possibility. Despite the chairman’s statement that the guidance does not impose any new obligations, a challenge based on the decision by the Commission to forgo public notice and comment would not be surprising. The dissenting opinions by Commissioners Jackson and Lee provide a well-marked route for such a challenge.