The 2019 proxy season is well underway, and it will be a memorable one for many reasons. Initially, the government shutdown stalled the staff’s review process by closing the Division of Corporation Finance for most of January, thereby putting some issuers at risk of acting on proxy matters without definitive guidance. Issuers must also deal with a new staff legal bulletin that adds complexity, requiring board input on two common exclusionary bases. Staff Legal Bulletin 14J, concerns the Rule 14a-8(i)(5) “economic relevance” and the Rule 14a-8(i)(7) “ordinary business” exceptions. The staff will expect issuers with a year’s experience with the guidance under their belts to present a detailed explanation of their reasons for relying on these provisions to exclude proposals. This year’s proxy season is also taking place amid a growing chorus of calls for reforming the entire proxy process.
Government Shutdown Interrupts Staff Review
The 35-day government shutdown in December 2018 and January 2019 had a significant impact on the 2019 proxy season. In January 2018, the division staff responded to nearly 60 requests for no-action relief and for reconsideration of prior advice on the exclusion of shareholder proposals. This year, with the SEC effectively closed, the division staff disposed of only 15 no-action letter requests. Nine of these 15 involved requests withdrawn by the proponents. The staff has, however, made significant progress on eliminating its backlog of filings to review after returning to work in January 2019.
Delays in resolving exclusion requests also presented deadline problems for issuers. According to division policy, the staff dealt with filings, submissions and other requests for staff action in the order received. The staff noted, however, that “we recognize that companies may have impending print deadlines or that negotiations may have changed the need for the staff’s views.” Companies in the process of finalizing proxy statements without definitive advice from the staff had to decide whether to include or omit shareholder proposals from their proxy materials without the security of a no-action letter.
The Corporation Finance staff also had to address a backlog of preliminary proxy statement filings resulting from the shutdown. Under Rule 14a-6, companies that are submitting a wide range of issues must file preliminary versions of their proxy materials with the Commission at least 10 calendar days prior to the date that definitive copies of these materials are delivered to security holders (or a shorter period as authorized by the SEC upon a showing of good cause). The backlog caused by the shutdown made it difficult for the staff to get through their initial review of preliminary proxy filings and for registrants to clear up any staff comments in a timely fashion. Issuers with unresolved staff comments or filings yet to be reviewed were left in a rather uncomfortable position. These companies and their counsel had to carefully consider their situations in order to determine whether it was appropriate to mail the proxy statement without full staff review.
The graphs below show the number of requests resolved in the first three months of 2018 and 2019.
*Data used to generate graphs created by Bloomberg Law’s analysis unit represent the unit’s review of shareholder proposal no-action letter requests handled by the SEC’s Division of Corporation Finance from January 1, 2019 through March 31, 2019. The graphs were created on April 2, 2019.
Staff Legal Bulletin No. 14J Stresses the Role of the Board
Staff Legal Bulletin No. 14J (CF), expands on the staff’s previous discussions of the ability of issuers to omit proposals under the “ordinary business” exclusion in Exchange Act Rule 14a-8(i)(7), and the Rule 14a-8(i)(5) exclusion for proposals dealing with questions that lack a “meaningful relationship” to the company’s business. Previously, in Staff Legal Bulletin No. 14I, the staff advised that it “will expect” companies to include “a discussion that reflects the board’s analysis” of policy issues raised and their significance for 14-8(i)(7) questions, and a discussion of the board’s analysis of the proposal’s significance to the company for 14-8(i)(5) matters.”
The bulletin stressed that the discussions that were the most helpful “focused on the board’s analysis and the specific substantive factors the board considered in arriving at its conclusion.” Of less value were discussions that described the board’s conclusions or process, but did not discuss the specific factors considered by the board. The staff indicated that the absence of such a discussion did not create a presumption of inclusion, but noted that “without having the benefit of the board’s views on the matters raised, the staff may find it difficult in some instances to agree that a proposal may be excluded.” Similarly, “the presence of a board analysis will not create a presumption of exclusion.”
The demands of SLB 14J may put corporate counsel in an interesting predicament. Board time is at a premium, and a key concern for the corporate counsel staff is to avoid wasting board time. SLB 14I and J, however, urge boards to deliberate on matters that may be considered “ordinary” or insignificant.
Many issuers were frustrated during the last proxy season, when they often saw little return in the time, effort and cost of engaging the board on these matters and then preparing the no-action letter discussion. Companies hope that the 2018 guidance will establish manageable objectives and bring some predictability to the process.
Leading shareholder advocates have not, however, received the new legal bulletin with great enthusiasm. Sanford J. Lewis, a veteran attorney and policy advisor experienced in helping shareholders craft proposals and defending those proposals in the no-action letter process, stated that “the bulletin essentially restates the prior SEC staff and commission policies on micromanagement. But it provides few new insights to investors on how to redraft dozens of important proposals to improve the scale, pace and rigor of company responses to material issues like climate change and human rights. Those proposals need to be fairly specific to avoid exclusion on other grounds, such as vagueness. One hopes that the SEC and proponents will arrive at an acceptable balance.”
Prominent shareholder activist James McRitchie also expressed reservations about the SEC’s approach. He told Bloomberg Law that he questioned why “the staff seems bent on creating a playbook to help companies win no-action requests, while failing to offer shareholders advice on how to defeat such requests.” Nothing in the law, he noted, requires the SEC “to protect companies from their shareholders.”
During the first quarter of 2019, companies have been relatively successful in excluding proposals under the ordinary business provision, prevailing on 25 of 41 requests. Several proposals have been excluded for attempting to “micromanage” the company’s affairs.
As described in SLB 14J, a key policy consideration underlying the “ordinary business” exception is the degree to which the proposal “micromanages” the company “by probing too deeply into matters of a complex nature upon which shareholders, as a group, would not be in a position to make an informed judgment.” The Commission has explained that this consideration “may come into play in a number of circumstances, such as where the proposal involves intricate detail, or seeks to impose specific time-frames or methods for implementing complex policies.”
Proposals need not call for the company to take any direct action to be subject to exclusion. It may be sufficient, the staff advised, if the proposal called for the preparation of an intricately detailed study or report. Exclusion under this approach does not refer to the subject of the request. Rather, companies may exclude proposals for micromanagement because of the manner in which the proposal seeks to address the issue.
Proponents Targeted for Exclusion
John Chevedden, a prolific shareholder advocate, leads the list of the top proponents prompting exclusion requests in 2019.
*Data used to generate graphs created by Bloomberg Law’s analysis unit represent the unit’s review of shareholder proposal no-action letter requests handled by the SEC’s Division of Corporation Finance from January 1, 2019 through March 31, 2019. The graphs were created on April 2, 2019, and represent the shareholder proponents who have received the most exclusion requests for their proposals.
Chevedden, with 25 exclusion requests, has seen almost as many of his submissions challenged as the next three proponents combined. As You Sow, a non-profit advocacy group, has been active this year so far, with 10 exclusion requests.
Targeted Proposal Topics
During the first quarter of 2019, companies have most often targeted proposals dealing with human rights and social issues. The surprising fact from the SEC responses in the first quarter is the number of withdrawn proposals in this area. Of the 30 exclusion requests acted on by the Corporation Finance staff, proponents withdrew 13, or more than 43 percent of the proposals challenged. The staff allowed companies to exclude social and human rights proposals 13 times, while the proponents prevailed on only four requests.
Issuers targeted environmental proposals 28 times in the first quarter of 2019. The staff allowed the exclusion of nine proposals, while six proposals had to be included in issuer proxy materials. Proponents withdrew 13 proposals.
The withdrawal of proposals by proponents is generally a positive corporate governance development. These withdrawals often suggest that the parties are engaging and negotiating a settlement.
Issuers prevailed on five requests to exclude proposals dealing with executive compensation, while the staff required the inclusion of seven requests. Proponents withdrew four proposals.
The staff previously advised that proposals relating to general employee compensation and benefits are excludable under the ordinary business provision, Rule 14a-8(i)(7). However, in SLB 14J, the staff advised that proposals that focus on significant aspects of senior executive or director compensation are generally not excludable under the ordinary business exception. The staff will expect a robust discussion by the issuer of the policy basis for the exclusion.
Proposals dealing with senior executive or director compensation may be excludable under the ordinary provision “if a primary aspect of the targeted compensation is broadly available or applicable to a company’s general workforce.” The company must demonstrate that the eligibility of executives or directors to receive the compensation does not implicate significant compensation matters.
*Data used to generate graphs created by Bloomberg Law’s analysis unit represent the unit’s review of shareholder proposal no-action letter requests handled by the SEC’s Division of Corporation Finance from January 1, 2019 through March 31, 2019. The graphs were created on April 2, 2019, and present the topics that were the subjects of the most exclusion requests.
Proxy Reform Initiatives
The SEC has not undertaken a significant review of the proxy process since it issued its “proxy plumbing” release in 2010. That release called for comment on several issues, including:
- the accuracy, transparency, and efficiency of the voting process;
- problems with shareholder communications and shareholder participation; and
- the proper alignment of voting power with economic interest.
These issues remain largely unresolved nine years later. However, in November 2018, the SEC conducted a roundtable forum on the proxy process. The discussion centered around three familiar main topics:
- problems with the proxy voting process;
- the shareholder proposal system; and
- proxy advisor regulation.
Each of these proxy issues currently has a different set of stakeholders and different prospects for action in the coming period.
Proxy Process Matters
Roundtable participants from both the issuer and investment communities agreed that the proxy system faces several structural problems. As Professor John Coates of Harvard Law School said at the roundtable, “there’s room for improvement; no one, I think, has ever said publicly that they would create the system that we have today if they were doing it from scratch.”
Under the current system, the majority of exchange-traded securities are held in street name and deposited with The Depository Trust Company (DTC) and held in fungible bulk for the benefit of DTC participants. This arrangement involves several layers of intermediaries, and may result in problems establishing the chain of custody. The custodial arrangements have resulted in over-voting and under-voting of client securities, and investors often have difficulty obtaining confirmation that their shares were properly voted.
The participants proposed several measures to improve the system. The SEC could undertake rulemaking or provide interpretative guidance to improve the vote confirmation process, and provide guidance and call for technology improvements to correct errors in the voting system. A universal proxy could also be useful in contested elections, because such a proxy would make it easier to identify the last card voted.
Roundtable participants also noted the communications problems arising from the “NOBO-OBO” distinction in the SEC’s proxy rules. A custodial intermediary may not disclose the identity or other information about beneficial owners who object to such disclosure (objecting beneficial owners, or “OBOs"). The issuer also may not contact OBOs directly. With regard to non-objecting beneficial owners, or “NOBOs,” the issuer may engage in direct communications with them and obtain information about their holdings from the intermediary.
More investors have assumed OBO status in recent years. For many brokerage firms, OBO status is the default position and investors have to opt in to being NOBOs.
According to many issuers, direct communications with beneficial owners could increase retail investor participation in the proxy process and reduce costs. The SEC grounded OBO status on a desire to protect investor privacy. The rule dates to the 1980s, however, and a completely different communications environment exists today than when the rule was adopted.
Any changes in this area would involve amendments to Exchange Act Rule 14b-1. Action on this question is not currently on the SEC radar.
Unlike the general agreement by different groups of stakeholders for the need to make changes to the mechanics of proxy voting, discussions concerning the shareholder proposal process revealed a sharp divide between the issuer community and investor advocates. For example, Tom Quaadman from the U.S. Chamber of Commerce Center for Capital Markets Competitiveness asserted that shareholder proposal issues are “exactly why companies are no longer deciding to go public.” Brandon Rees from the Corporations and Capital Markets group of the AFL-CIO rejected such a notion, stating that “the average publicly listed company in the United States can expect to receive a shareholder proposal once every 7.7 years, and the median number of proposals received is one.”
Issuer representatives urged the Commission to increase the ownership thresholds for submitting proposals (from the current $2,000) and shareholder vote percentages for proposal resubmissions (from the current three/six/ten percent thresholds for proposals submitted one, two or three times in the last five years). Shareholder advocates argue, however, that the raw vote total does not tell the whole story of the impact of the role of resubmitted proposals in corporate governance. Noted governance advocate Nell Minow stated that “a resolution does not have to get a majority vote to have merit or impact.” She cited roundtable participant Michael Garland, who testified that “resolutions are just one tactic in shareholder engagement, and a proposal can often lead to conversation and compromise that would not have been possible otherwise.” In her view, if shareholder proposals constitute only four percent of proxy items and most companies receive none, resubmissions do not impose a significant burden on issuers.
It would not be surprising if the Commission proposed an upward revision in the proposal eligibility threshold to reflect inflation since the SEC set the level at $2,000 in 1998, but it is highly doubtful that the Commission would act to fundamentally change the eligibility structure for these proposals. The SEC may also make adjustments to the resubmission vote requirements, but it is unlikely that the Commission would do away with or significantly limit the ability of investors to resubmit proposals.
Potential for Proxy Advisory Firm Regulation?
Proxy roundtable participants addressed two main issues with regard to proxy advisory firms. The first involved the question of how much influence proxy advisory firms wield in the marketplace on voting decisions by their institutional investor clients. In addition, questions surround conflicts of interest faced by proxy firms, as they provide advice and ratings to their investor clients while selling consulting services to issuers.
The issuer representatives at the roundtable criticized the firms for their level of influence over institutional investors, and raised the possibility of fiduciary duty violations resulting from advisers relying on firm recommendations without a robust review process. Issuers are also concerned about a lack of transparency in the proxy firms’ recommendations processes, and an unwillingness by the advisory firms to engage with issuers to correct factual errors. Institutional investors emphasized that they utilize the data and research provided by proxy firms, but make their voting decisions in accordance with their own internal voting guidelines. The institutional participants also indicated that proxy advisory firms generally make adequate disclosures of potential conflicts with regard to their offerings of other services.
Institutional investors generally took a dim view of enhanced SEC oversight, seeing such regulation as unnecessary and as an additional expense that would be passed on to them. Leading stakeholders, including the U.S. Chamber of Commerce and the exchanges have, however, been actively lobbying for enhanced proxy firm oversight. SEC action is possible in this area, despite the objections of institutional investors and Commissioner Robert Jackson, who expressed his concern late in 2018 “that our efforts to fix corporate democracy will be stymied by misguided and controversial efforts to regulate proxy advisors.”
In an April 2019 speech, Rick Fleming, the SEC’s Investor Advocate, urged the SEC to think carefully and move slowly in the area of proxy advisor regulation. While recognizing that there are frequent criticisms of advisory firms for their conflicts of interest, factual errors in their analysis processes, and political agendas that may run counter to maximizing returns, Fleming noted that, “the investors who are paying for this service are not the ones who are expressing those concerns. The Investor Advocate suggests that the push for regulation is coming from issuers that are concerned about how proxy advisors have given asset managers “an efficient way to exercise closer oversight of the companies in their portfolios.”
Ms. Minow agreed with this idea. She stated that “proxy advisory firms produce research no one has to buy and recommendations no one has to follow.” She added that the advisory firm clients are sophisticated financial professionals subject to the strictest fiduciary standards, and those clients have a choice of providers. According to Ms. Minow, “that is a textbook example of free market efficiency and the exact opposite of a justification for government intervention.”
A recent study indicates, however, that a large group of investors may care more about the role of proxy advisors than the institutional investors described by the Investor Advocate. The study, by Spectrem Group, a wealth management research firm, working in conjunction with George Mason University law professor J.W. Verret, found that retail investors are concerned about the role of proxy advisory firms and the impact of these firms on the proxy voting process. According to the study, there is “a growing disconnect between the expectations of those everyday investors and the increasing influence of proxy advisors, companies that provide voting services to the investment firms managing retail investor money.” A majority of respondents surveyed for the study supported some SEC action to address conflicts of interest, robo-voting (the rote following by money managers of proxy advisor recommendations), transparency, recommendation errors and the need to provide issuers with an opportunity to respond to adverse proxy recommendations.
The potential for conflicts of interest in the advisory firm’s business model that could undermine the objectivity of voting recommendations is a key concern for retail investors, according to the Spectrem study. Conflicts can arise when the advisory firm sells consulting services to companies that they evaluate in their proxy recommendations. Professor Verret told Bloomberg Law that he thought that a conflict this significant could not be resolved by disclosure of the conflicting relationships. He recommended that the SEC should act to bar advisory firms from performing consulting or similar services to issuers that they evaluate.
Ms. Minow observed that advisory firm clients “are well able to evaluate and adjust for any perceived conflicts and this is exactly the kind of issue that is ideal for resolution by the market.” She told Bloomberg Law that she does not know of any examples of conflicted or compromised recommendations by a proxy advisor, or an example of a report or recommendation that was based on anything but the economic interests of investors.
The Commission does, however, seem willing to look into this area. Commissioner Elad L. Roisman stated in an address in March 2019 that “I believe it is a good time for the Commission to consider whether guidance would be helpful to asset managers as they consider how to utilize the services of proxy advisory firms. Relatedly, since proxy advisory firms rely on the proxy solicitation exemptions available under certain Exchange Act rules, it may be appropriate for the Commission to reassess whether their current practices fit within the intended scope and purpose of these exemptions.”
It is not clear whether the SEC will deal with these matters through rulemaking or Commission guidance.
Congress has also been interested in this space, as legislators have introduced bills in the 2017 and 2018 sessions.
Proxy advisory firms would be well served to take visible steps to improve transparency in their recommendations process and provide for a means of resolving factual disputes with issuers. Glass Lewis took a preliminary step toward issuer engagement earlier this year, when they announced a program that allows companies to submit feedback about the analysis of their proposals, and have those comments delivered directly to Glass Lewis’ investor clients (for a fee). Advisors that may have a conflict of interest should fully disclose the conflict to their clients. Actions such as this would be beneficial for the industry and the marketplace, but may not be enough to prevent regulatory action in the proxy advisor space.