Your donation keeps us advertisement free


In re Tremont Securities Law, State Law, and Insurance Litigation (Elendow Fund, LLC v. Rye Select Broad Market XL Fund): The Heightened Pleading Standards for Securities Fraud Claims under the PSLRA

In In re Tremont Sec. Law., State Law, & Ins. Litig. (Elendow Fund, LLC v. Rye Select Broad Mkt. XL Fund), Master File No. 08 Civ. 1117, 10 Civ. 9061, 2013 BL 249529 (S.D.N.Y. Sept. 16, 2013), Plaintiff Elendow Fund, a small investment fund, filed suit against Rye Select Broad Market XL Fund (“XL Fund”), Rye Investment Management, Tremont Partners (“Tremont”), and other entities alleged to be directly and indirectly involved in the exchange of XL Fund investments (collectively, the “Defendants”) in an effort to recover assets lost as a result of the Bernard Madoff Ponzi scheme. Elendow Fund’s complaint made several allegations including securities fraud, control-person liability, and violations of various state-law provisions. The Defendants moved to dismiss and the United States District Court for the Southern District of New York granted the motion.

According to the allegations, XL Fund engaged in an investment strategy that entailed, among other things, investments in a fund managed by Bernard Madoff. Tremont allegedly “induced” Elendow Fund to invest in XL Fund through misrepresentations. Tremont’s alleged misrepresentations included statements about the investment strategy of the XL Fund.  Tremont also allegedly misrepresented the due diligence that it performed on fund managers.  Elendow Fund also brought claims for control-person liability.

Actions for securities fraud allegations are subject to the heightened pleading standards set out in the Private Securities Litigation Reform Act and Rule 9(b) of the Federal Rules of Civil Procedure. To meet these requirements, a complaint must identify “each statement alleged to have been misleading, the reason or reasons why the statement is misleading, and if an allegation regarding the statement or omission is made on information and belief, the complaint shall state with particularity all facts on which that belief is formed.” § 78u-4(b)(1). Furthermore, plaintiffs must also allege a “strong inference” of scienter. This requires allegations: “(1) showing that the defendants had both motive and opportunity to commit the fraud or (2) constituting strong circumstantial evidence of conscious misbehavior or recklessness.”

Elendow Fund argued that its complaint met the heightened pleading standard for securities fraud. The court, however, disagreed. The complaint did not “specifically and plausibly allege that Tremont actually knew that Madoff’s operation was a fraud.” With respect to the allegation that Tremont recklessly disregarded red flags, the court found that the complaint failed to sufficiently allege facts to establish that “the dangers posed by Madoff were so unmistakable that Tremont must have known that its representations were false.” The court further noted that Tremont recognized the risks and benefits associated with investing with Madoff, but nonetheless chose to continue doing so.  

The court also found that Elendow Fund’s allegations about Tremont’s due diligence were insufficient to plead securities fraud. Specifically, the court highlighted the fact that the complaint failed to sufficiently allege that some of the statements (the promise to perform “careful” due diligence posted on the Internet) were false. More specific representations about the level of due diligence in Tremont’s Form ADV failed because of the vagueness of the allegations. As the court reasoned:

This allegation might have been sufficient if, in context, it clearly referred to any specific representations. But this allegation appears, not alongside any allegations of actual representations, but in the formulaic recitation of the elements of count I of the complaint. In that context it is not clear what “statements described above” the allegation refers to. When an allegation couched in such generic language is completely separated from the substantive, factual allegations of the complaint, it is simply too vague to support an action for securities fraud under the applicable heightened pleading standards.  Elendow Fund’s generic allegation that it relied upon such representations as those described in the complaint is simply not adequate to push its reliance allegation over the line from conceivable to plausible.

Accordingly, the court dismissed the securities fraud claim. In absence of a primary violation, the court also dismissed Elendow Fund’s claim for control-person liability. Additionally, the court dismissed all of Elendow Fund’s state-law claims.

Therefore, the United States District Court for the Southern District of New York granted Defendants’ motion dismissing Elendow Fund’s complaint in its entirety.

The primary materials for this case may be found on the DU Corporate Governance website.


Reese v. McGraw-Hill Companies: Rehash of Claim Not Enough to Set Aside Judgment

In Reese v. McGraw-Hill Cos., No. 08 Civ. 7202 (SHS), 2013 WL 5338328 (S.D.N.Y. Sept. 24, 2013), the United States District Court for the Southern District of New York (“S.D.N.Y”) denied a motion for relief from judgment from a previous dismissal of securities fraud claims against McGraw-Hill Companies, Inc. (“McGraw-Hill”).  The court found that the newly discovered information would not have changed the outcome of the case.

Plaintiff shareholders, including lead plaintiff Boca Raton Firefighters and Police Pension Fund (collectively “BRPF”), brought claims of securities fraud based upon statements made by Standard and Poor’s (“S&P”), at the time of the financial division of McGraw-Hill. Specifically, BRPF alleged that S&P defrauded investors through misstatements made in regard to the “stringency, independence, and integrity” of the company’s credit ratings of mortgage-backed securities and collateralized debt obligations, and in regards to misstatements about the ongoing surveillance of the reliability of its ratings.

The trial court originally dismissed the suit for failure to state a claim in March 2012, and the United States Court of Appeals for the Second Circuit affirmed. In the most recent action, BRPF contended that it discovered new evidence that warranted that the 2012 dismissal be set aside through Federal Rule of Civil Procedure (“FRCP”) 60(b)(2), or alternatively, that BRPF be given the ability to amend its complaint against S&P and McGraw-Hill.

The source of BRPF’s newly discovered evidence came from a February 2013 Department of Justice complaint against McGraw-Hill, and from the deposition of an unrelated suit involving McGraw-Hill given by Frank Raiter, the head of S&P’s mortgage-backed securities. BRPF contended that this new evidence supported its motion to set aside the 2012 judgment by showing that S&P’s ratings were not independent and objective, but rather that “profits were running the show.” BRPF pointed to statements made by Raiter that stated that S&P delayed the implementation of an upgraded ratings model because the company wanted to maintain its current market share.

A motion to set aside a final judgment under FRCP 60(b)(2) is a stringent standard and should only be granted when “substantial justice” requires it. The elements of a 60(b)(2) claim include: (1) newly obtained evidence existed during the trial, (2) the party seeking a 60(b)(2) motion was justified in not being aware of the facts, (3) the evidence is admissible and would have changed the outcome of the case, and (4) the evidence is not merely cumulative or impeaching.

The trial court found that BRPF’s new evidence was not such that it would change the outcome of the original dismissal against BRPF. Even with the new evidence, BRPF did not meet the particularized requirements for showing that S&P’s statements were materially false, and constituted securities fraud under its original 10b-5 claim. 

The court likewise dismissed BRPF’s motion to amend its complaint because the newly discovered evidence would not change the outcome of the case and was untimely.

The primary materials for this case may be found on the DU Corporate Governance website.


Bricklayers of Western Pennsylvania Pension Plan v. Hecla Mining Company: Plaintiffs Fail to Meet Scienter Pleading Requirements in Mine Closure Debacle

In Bricklayers of W. Pa. Pension Plan v. Hecla Mining Co., Case No. 2:12-cv-00042-BLW, 2013 BL 260578 (D. Idaho Sept. 26, 2013), the United States District Court for the District of Idaho granted the Defendants’ Motion to Dismiss, finding that Plaintiffs’ Amended Complaint failed to sufficiently allege scienter in their Section 10(b) claim under the heightened pleading requirements of the Private Securities Litigation Reform Act (“PSLRA”).

According to the Amended Complaint, Bricklayers of Western Pennsylvania Pension Plan (“Plaintiffs”) alleged that Hecla Mining Co. and the company’s executive officers (“Defendants”) failed to disclose certain facts about the Lucky Friday Mine, specifically the Silver Shaft, which would have alerted investors to the future closure of the mine.  When the market learned that the mine would be closed for approximately one year to repair the Silver Shaft, Hecla’s stock price fell by approximately 21%.

Under a Section 10(b) claim, the Plaintiffs must prove the following elements: (1) a material misrepresentation or omission; (2) scienter; (3) a connection between the misrepresentation or omission and the purchase or sale of a security; (4) reliance; (5) economic loss; and (6) loss causation. The only element at issue in the case was scienter. According to the PSLRA, the “complaint must . . . ‘state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind’ or scienter.”

First, Plaintiffs attempted to show scienter through the application of the core operations doctrine.  “The core operations inference is a scienter theory which suggests that facts critical to a business's core operations or an important transaction must, of necessity, have been known to a company's key officers.”  The court rejected this argument, concluding that the allegations “only suggest[ed] corporate management's general awareness of the day-to-day goings on of the company's business” which was “not enough to satisfy Plaintiffs' burden.”

Plaintiffs also alleged that individual Defendants were “motivated to conceal the extent of adverse safety compliance in order to make the company more attractive” to investors. The court rejected this theory. Describing the motivations as “bare allegations,” the court concluded that general statements that the company deliberately eschewed compliance with safety regulations in order to maintain low-cost production of silver did not meet the standard for asserting scienter.

Plaintiffs further argued that Defendants were required to make certain disclosures regarding the number of safety violations in its 10-Q and 10-K forms under the Dodd-Frank Wall Street Reform and Consumer Protection Act. Plaintiffs suggested that these disclosures would have also caused Defendants to be aware of other “undisclosed issues that led to the shutdown of the mine.” The court held that Plaintiffs had not sufficiently alleged a connection between past violations and the issues that caused the closure of the mine. 

Finally, Plaintiffs alleged that the company had undertaken “an exhaustive $15 million evaluation of the Lucky Friday Mine” and that it was “absurd to suggest the evaluation did not reveal the poor safety operations and deferred maintenance issues which eventually forced the extended closure of the mine.” The court found that Plaintiffs failed to make specific allegations that the project included an inspection of Silver Shaft. 

After evaluating each individual allegation, the court, as required, conducted a “holistic review” of all the allegations together to determine that, if combined, they would create a “strong inference of intentional conduct or deliberate recklessness.” The court concluded that the allegations were not as compelling as an alternative innocent explanation that Defendants had no knowledge of the issues leading up to the mine closure and did in fact disclose any relevant citations or safety issues to its investors.

Therefore, the court granted the Defendants’ Motion to Dismiss due to Plaintiffs’ failure to prove the element of scienter. The court did grant leave for the Plaintiffs to amend the complaint a second time but was skeptical of the Plaintiffs’ ability to do so successfully.

Primary materials are available on the DU Corporate Governance Website.


A Management Friendly Philosophy Applied to Management Disputes: Klaassen v. Allegro Development (Part 3)

We are discussing Klaassen v. Allegro Development.

In Klaassen, the Vice Chancellor declined to overturn the decision by the non-management directors to terminate the CEO.  In doing so, the Vice Chancellor declined to find that the non-management directors erred by failing to provide notice of the plan to terminate the CEO.  The case is on appeal.

The management friendly nature of Delaware dictates that its Supreme Court will either reaffirm (or at least not overturn) the obligation of boards to notify the CEO in advance of an impending termination.  The Court will affirm (or at least not overturn) the obligation to provide this notice irrespective of the percentage of shares owned by the CEO.  In other words, the aftermath of the opinion will be that CEOs are entitled to advanced notice of their termination. 

This approach will effectively prevent boards from removing the CEO as a fait accompli.  As a result, the instances of CEO removal will decline.  In some cases, the obligation to inform the CEO in advance and the unwillingness to confront the CEO’s disapprobation, will cause the board to reconsider.  In other cases, the CEO will have the ability to call a shareholders meetings and/or lobby the weak links in any group of directors favoring removal.

Characterizing the right to notice as mandatory (that renders the meeting and act of removal void) is the most management friendly.  At the same time, however, this would essentially amount to a categorical rule.  This categorical rule requiring notice favors management but there may rare cases where it does not. 

By treating the failure to give notice as a voidable act, the courts retain some discretion.  Moreover, the discretion can be exercised in a management friendly manner.  At the same time, the discretion needs to be narrow so that CEOs know that in Delaware they can usually count on a right to advance notice of any termination.  CEOs will know that in Delaware, there can be no secret coups.    

So how will the case come out?  Based upon the race to the bottom, the Court will likely affirm the equitable nature of the notice requirement, specify that it is subject to equitable defenses, and make clear that the defenses are to be narrowly applied.  As to the actual decision in Klaassen, any prediction is a bit more problematic.  The Supreme Court in Delaware may change the reasoning of a lower court opinion but they are often hesitant to actually reverse.  Take a look at the way the Supreme Court in Axcelis completely rewrote the reasoning of the lower court but found a way not to reverse.  The facts in Klaassen provide room for this.  The CEO in that case waited a relatively lengthy period before challenging his dismissal.  This may be sufficient for the Court to be unwilling to disturb the Chancery Court’s findings in connection with the application of equity.

But, to go out on a limb, we predict that the Court will not just tamper with the reasoning but will actually reverse the Chancery Court opinion.  The case was written by a Vice Chancellor that has shown significant independence.  Indeed, the decision in Klaassen was to uphold the dismissal of a CEO by a non-management board.   

Moreover, under the race to the bottom, management has incentive to find jurisdictions with favorable law.  Favorable law generally means reduced liability for management, greater discretion with respect to their decision making, and limited ability of removal.  Reversing a decision that permitted removal of the CEO without advance notice will be an outcome that management will see has highly favorable.  


A Management Friendly Philosophy Applied to Management Disputes: Klaassen v. Allegro Development (Part 2) 

We are examining the decision in Klaassen v. Allegro Development.

In Klaassen, the Chancery Court conducted a tutorial on the developpment of notice requirements for directors.  The early cases set out the black letter law in the area.  Directors were required to receive advance notice of special meetings in order to have "the right to be heard upon all questions considered. . . ."  Without notice, the actions at the meeting were void.  At the same time, however, notice could not be willfully avoided.  Thus, a director could not assert the lack of notice when refusing to permit the delivery of notice in the form of a registered letter.

The courts also recognized that a "quorum obtained by trickery" was invalid.  This could occur where a director notified of the meeting failed to attend when told that it had been postponed.  In effect, the approach eviscerated the requirement of notice by denying the director of an opportunity to attend and be heard.  Trickery was not present, however, where a meeting was called on an impromptu basis (the directors were all present to attend the annual meeting of shareholders) and in a manner consistent with the bylaws.  

These cases largely provided common sense rules of the road.  Directors were required to have notice of special meetings.  Notice was ineffective if they were tricked into not attending.  Trickery, however, had to involve some type of misbehavior.  These cases largely reflected the state of the law through the 1990s.  

Beginning in the 1990s, however, the courts, as VC Laster put it, "took a very different approach to advance notice for special board meetings."  Unlike the 1980s, when shareholders could occasionally win a major governance case (recall Van Gorkom or Unocal), the 1990s began a period of decision making where this was less likely to occur.

The "very different approach" with respect to board meetings and notice occurred in the context of efforts by non-management directors to remove the CEO.  In one case, Koch v. Stearn, 1992 WL 181717 (Del. Ch. July 28, 1992),vacated as moot, 628 A.2d 44 (Del. 1993), the removed CEO, who was also a controlling shareholder,  alleged that he had been "tricked" into attending the meeting.  The "trick" was providing a notice that suggested a purpose of the special meeting that did not encompass his removal.  

In Adlerstein v. Werthemer, 2002 WL 205684 (Del Ch. Jan. 25, 2002), two outside directors sought to raise additional capital and remove the CEO.  Again, the CEO, a controlling shareholder, had no notice and again, the court invalidated the meeting (and his removal).  As the court reasoned, in the case of a controlling shareholder, equity would not permit the withholding of advance notice when done “for the purpose of preventing the controlling stockholder/director from exercising his or her contractual right to put a halt to the other directors' schemes.” 

In a third case, Fogel v. US Energy Sys., Inc., 2007 WL 4438978 (Del. Ch. Dec. 13, 2007), the doctrine was extended to directors who were not also controlling shareholders.  The CEO (who also served as chairman) scheduled a special meeting of the board.  In advance of the meeting, the three independent directors decided to fire the CEO.  Before the meeting, the three directors told the CEO that “they had lost faith in him and wanted him to resign.”  When he refused to resign, he was terminated. 

The termination was ultimately invalidated.  The Chancery Court found that “the directors deceived Fogel by not specifically warning him in advance about his potential termination.”  Although not a controlling shareholder, the court reasoned that the CEO was disadvantaged because  "had he known beforehand, he could have exercised his right under the bylaws to call for a special meeting before the board met." 

In Klaassen, the Vice Chancellor described the decision as “dramatically expanding” the existing line of authority. The case essentially required advance notice to a CEO before termination.  “If Fogel is correct, then a board with a Chairman/CEO cannot fire its CEO without first giving the CEO explicit advance notice and an opportunity to call a special meeting of stockholders at which the composition of the board might change, regardless of how few shares the Chairman/CEO owns.”

The Vice Chancellor tried to summarize the state of the law.  He reasoned that:

  • Delaware law distinguishes between (i) a failure to give notice of a board meeting in the specific manner required by the bylaws and (ii) a contention that the lack of notice was inequitable. In the former scenario, board action taken at the meeting is void. In the latter scenario, board action is voidable in equity, so equitable defenses apply. . . . this distinction fits with the general rule that the stockholders, through bylaws, may dictate the process that directors use to manage the corporation, so long as the restrictions are not so onerous as to interfere with the board's power to manage the corporation under Section 141(a). The distinction also recognizes that, traditionally, when a board took action in contravention of a mandatory bylaw, the board action was treated as void.

The Vice Chancellor found that the termination of the CEO in Klaassen was a voidable act subject to equitable defenses.  He found equitable defenses applicable and declined to overturn the termination of the CEO.  Recognizing the “unsettled questions” raised by the case, the court agreed to issue a stay pending appeal.

So what will happen on appeal? We will address that possibility in the next post.


A Management Friendly Philosophy Applied to Management Disputes: Klaassen v. Allegro Development (Part 1)

Delaware courts issue management friendly decisions.  For the most part, this means decisions that favor management over the interests of shareholders.  Or, as VC Laster recently noted, Delaware has a "director-centric system of corporate governance."  Klaassen v. Allegro Development Corp., CA No. 8626-VCL (Del. Ch. Nov. 7, 2013).  

Increasingly, however, governance cases involve disputes among directors.  What does a management friendly approach mean in that context?  Most likely, it means an approach that favors management  directors (i.e., the CEO) over non-management directors, particularly independent directors.  Whatever the failings of independent directors, they are designed to reduce the influence of management in the governance process.  A judicial approach designed to limit their influence would be very management friendly.    

This hypothesis provides an interesting template for a review of Klaassen v. Allegro Development.  The case essentially involved a dispute between a CEO and the non-management directors.  At the time of the removal, the board consisted of two directors appointed by the holders of the Series A Preferred shares, the CEO (who also owned 70% of the common shares), and two outside directors designated by the CEO but approved by the holders of the Series A Preferred shares.  As a result, the board consisted of one management director and four non-management directors.

At a meeting held on Nov. 1, 2012, the board voted to remove the CEO.  Klaassen eventually filed suit challenging the dismissal.  Among other things, he asserted that he was entitled under equity to notice in advance of the meeting of the plans of the non-management directors to remove him.  As the court characterized: The CEO "contends that a board cannot take action adverse to the interests of such an individual unless the board provides him with advance notice and an opportunity to pre-empt the board by changing its composition. An individual with this combination of capacities and rights becomes a super director whose authority trumps Section 141(a) of the DGCL." 

The CEO asserted that the failure to provide notice rendered the actions of the board void.  The board in turn asserted that the actions were at most voidable and subject to equitable defenses.  They argued for, and the Chancery Court found applicable, the equitable doctrines of laches and acquiescence.  

The case is now on appeal.  In the next post, we will examine the case through the prisim of a management friendly outcome and use it to predict the decision of the Delaware Supreme Court.   


Board Diversity and "Checking the Box"

Twitter represented one of the most publicized public offerings in 2013.  In going public, the Company filed a registration statement on Form S-1.  The Registration Statement disclosed that there were six executive officers, a group that included one woman (Vijaya Gadde, the general counsel).  She was appointed to the position shortly before the public offering. 



Jack Dorsey

  36   Chairman

Peter Chernin

  62   Director

Peter Currie

  57   Director

Peter Fenton

  41   Director

David Rosenblatt

  45   Director

Evan Williams

  41   Director


The filing of the registration statement generated significant commentary about the lack of diversity on the board.  In part, the criticism arose because of the response made by the CEO to calls for greater diversity.  In particular, he disavowed any interest in selecting board members to the extent doing so would amount to “just checking a box.”

Twitter did recently add Marjorie Scardino to the board.  As her bio posted on the Twitter site reveals:

  • Ms. Scardino, age 66, served as Chief Executive Officer and as a member of the board of directors of Pearson plc, a publishing and education company, from 1997 to 2012. From 1985 to 1997, Ms. Scardino served in several roles at The Economist Group, a media company, including as Chief Executive Officer. Ms. Scardino served on the board of directors of Nokia Corporation, a telecommunications company, from 2001 to April 2013. Ms. Scardino holds a B.A. in Psychology from Baylor University and a J.D. from the University of San Francisco School of Law.

The decision likely takes the heat off of Twitter for now (although the board continues to lack people of color).  The number of women directors in America is so anemic (around 15%) that the appointment of a single woman is generally sufficient to meet applicable standards for public companies.

Nonetheless, the incident raises important issues.  First, any high profile company that does an IPO will likely be criticized if it lacks gender diversity on the board.  Facebook is an example of where this occurred.  Presumably, this is known to the board of the company going public, either because directors have seen examples in the popular press or because they have been told by their lawyers and investment bankers assisting with the IPO.  As a result, it is somewhat inexplicable that the issue does not get corrected before the public offering occurs.

Second, public companies are, broadly speaking, operating under a "check the box" approach to diversity.  Public companies know that, for the most part, they can alleviate public pressure as long as they have a single woman or person of color on the board.  This suggests that the number of women, or people of color, are based not on a serious understanding of the benefits of diversity but upon the need to alleviate public pressure. 


The Unified Agenda and the SEC: Shifting SEC Priorities (Dodd Frank and Executive Compensation)

We are discussing the list of anticipated rulemakings and "long term" projects recently submitted to OIRA by the Commission.  One thing is for certain.  In the area of rulemaking, 2014 will be a year devoted to compensation issues. 

Dodd-Frank also remains at the forefront of the regulatory agenda, with particular emphasis on executive compensation. The Unified Agenda includes two compensation proposals, Compensation Clawback and Pay for Performance, and one final rule, pay ratio disclosure. In addition, the Commission lists as a "long term" project the completion of "Rules Regarding Incentive Compensation," the provision in Dodd-Frank that gave rulemaking authority to financial regulators with respect to large financial institution's incentive-based compensation practices.     

Compensation clawbacks has been on the Unified Agenda since the Spring of 2011.  Another Dodd-Frank provision, the Commission is required to adopt listing standards that mandate the adoption of policies by companies that require clawbacks of incentive based compensation paid to executive officers following an "accounting restatement due to the material noncompliance of the issuer . . . ." See Section 954 of Dodd-Frank. The provision has not been free from controversy within the Commission. Similarly, Pay for Performance (disclosure required by Section 953(b) of Dodd-Frank) has been on the Unified Agenda since the Spring of 2011.  

Given the pruning that took place between the Spring 2013 version of the Unified Agenda and the current version, the fact that these two provisions survived suggests that rule proposals will emerge during the next 12 months.  Both will likely generate substantial controversy.  

As for pay ratio disclosure, the Commission proposed a rule in 2013.  Proposing and adopting are, of course, two different things.  The Unified Agenda suggests that the Commission will move to a final rule during the next 12 months (the Unified Agenda lists October 2014).  This also reflects a highly debated and controversial rule.  

To the extent these projects move forward as suggested by the Unified Agenda, 2014 will be a year dominated by debates over executive compensation.  With the advent of "say on pay," the issue is already very much on the front burner in the governance area.  These rules will heighten the discussion.  


The Unified Agenda and the SEC: Shifting SEC Priorities (The JOBS Act)

We are discussing the list of anticipated rulemakings and "long term" projects recently submitted to OIRA by the Comission.     

One thing is clear from the Unified Agenda:  Rulemaking under the JOBS Act will continue to take up considerable staff time.

Proposals designed to implement Regulation A+ are on the table. So are Title V (exclusion of shares from Section 12(g) that were issued to employees pursuant to an employee compensation plan) and Title VI (applicability of Section 12(g) to banks).  Crowdfunding is on the list, although interestingly as a proposal rather than a final rule. Having already proposed rules implementing this exemption, see Exchange Act Release No. 70741 (October 23, 2013), this suggests that the Commission does not expect to complete the rulemaking during the next 12 months.  

The Unified Agenda also includes, under the category of "proposed rule stage," the implementation of Title I of the JOBS Act.  Title I governs emerging growth companies.  This item has been on the Unified Agenda since 2012.  

Most of the titles in the JOBS Act are replete with instances where the Commission is instructed to adopt rules. That is not true with respect to Title I.  In most cases, references to rules are expressed as prohibitions on their application to emerging growth companies.  See, e.g., Section 105(c) (prohibiting Commission and stock exchanges from adopting rules regulating certain actions by analysts in connection with emerging growth companies).  

There is, however, at least one significant exception. Section 106(b) amended Section 11A(c) of the Exchange Act to add a section titled "Tick Size."  Under the provison, the Commission must "conduct a study examining the transition to trading and quoting securities in one penny increments, also known as decimalization."  Once the study was done, the JOBS Act provided that "[i]f the Commission determines that the securities of emerging growth companies should be quoted and traded using a minimum increment of greater than $0.01, the Commission may . . . designate a minimum increment for the securities of emerging growth companies that is greater than $0.01 but less than $0.10 for use in all quoting and trading of securities in any exchange or other execution venue.’’

The Commission has completed the study. The study did not call for any specific rulemaking but did call for the solicitation of comments: 

  • The Staff believes that the Commission should solicit the views of investors, companies, market professionals, academics, and other interested parties on the broad topic of decimalization, how to best study its effects on IPOs, trading, and liquidity for small and middle capitalization companies, and what, if any, changes should be considered. 

The Unified Agenda does not specify the rulemaking endeavors that will be proposed under Title I of the JOBS Act.  Solicitation of comments on, or changes to, tick size may be one of them.  


The Unified Agenda and the SEC: Shifting SEC Priorities (Shifts in Priorities)

The SEC has submitted to OIRA its list of anticipated rulemakings over the next twelve months for inclusion in the Unified Agenda. A second list of "long term" projects was also submitted.  This represents the first submission by the Commission since Mary Jo White has become Chair.  More than other submissions, therefore, the lists likely provide some insight into the direction she plans to take the Commission.  

What observations can the list offer?   

The newly published list in the Unified Agenda was certainly different from prior years.  It was noticeably shorter.  The list included no "prerule stage" proposals (there were two last year).  The number of items in the "proposed rule stage" fell to 15, down from 32 in the spring of 2013 (not including the two in a "prerule stage") and 21 in 2012 (not including three in the prerule stage). 

There were a number of changes.  For one thing, the item on "proxy voting and shareholder communications" which has been on Unified Agenda since 2009 was dropped.  The dropped proposal indicates that the Division was "considering recommending that the Commission publish an interpretive release addressing issues related to proxy advisory firms, including the disclosure of conflicts of interest."  The recent Roundtable on Proxy Advisory Services notwithstanding, the Commission apparently does not intend to move forward over the next 12 months with administrative action in the area.  

In addition, the "Personalized Investment Advice Standard of Conduct," a proposal addressing the fiduciary obligations of brokers ("the provision of personalized investment advice to retail customers by investment advisers and broker-dealers"), went from Proposed in the Fall of 2011, to Pre-Rule in the Spring of 2013, and now to "long term" in the most recent Unified Agenda.  Moreover, the description changed. According to the explanation: 

  • Section 913 of the Dodd Frank Act grants the Commission authority under the Exchange Act and Advisers Act to adopt rules establishing a uniform fiduciary standard of conduct for all broker-dealers and investment advisers when providing personalized investment advice about securities to retail customers. The Commission issued a public request for information to obtain further data and other information to assist it in determining whether or not to use the authority provided under Section 913 of the Dodd Frank Act. 

 The issue of was the recent subject of a recommendation by the Investor Advisory Committee of the SEC. 


The Unified Agenda and the SEC: Shifting SEC Priorities (Overview)

The SEC has submitted to OIRA its list of anticipated rulemakings over the next twelve months for inclusion in the Unified Agenda.  See OIRA Website ("Fall editions of the Unified Agenda include The Regulatory Plan, which presents agency statements of regulatory priorities and additional information about the most significant regulatory activities planned for the coming year.").  

A second list of "long term" projects was also submitted.  Id. ("to keep users better informed of opportunities for participation in the rulemaking process, an agency may list in the 'Long-Term Actions' section of its agenda those rules it expects will have the next regulatory action more than 12 months after publication of the agenda."). 

Much of the press has focused on the SEC's decision to withdraw from the list of an item that had appeared earlier in the year titled "Disclosure Regarding the Use of Corporate Resources for Political Activities".  According to the SEC:  "The Commission is withdrawing this item from the Unified Agenda, which currently covers the period from November 2013 through October 2014, because it does not expect to consider this item within the next 12 months, but the Commission may consider the item at a future date."

The interesting thing about the change is that, while disappearing from the 12 months agenda, it did not reappear on the list of "long term" projects.  This suggests that the Commission does not intended to turn to the item in the foreseeable future.  Of course, the absence of a provision does not prevent the Agency from changing its mind.  At least for now, however, disclosure of political contributions is off the table.  

The Unified disclosure, however, says other things about the SEC's agenda.  We will pick them up in the next post.  


Rulemaking, the DC Circuit, and the Importance of Active Service

The SEC has had a difficult time in the DC Circuit.  The court has invalidated a number of SEC rules.  In some cases, the judicial analysis was linear and based upon precedent.  In other cases, such as the shareholder access case, the analysis did not comport with precedent.  These decisions have had significant consequences.  The Commission has been forced to devote much greater resources to cost-benefit analysis, resulting in other areas of the Agency's mission receiving less resources.  

The approval by the Senate of two new members of the DC circuit shifts the political balance of the full time judges.  There are now six judges appointed by Democrats (a number that will likely increase to seven) and four appointed by Republicans.  Some have discounted the shift by noting that when counting senior (retired) judges who continue to sit on appellate panels, the balance still favors Republican appointees.  

That may be true in a narrow sense.  But under the rules of appellate procedure and the DC Circuit (and the common practice among the circuits), status matters.  First, only active judges serve as the presiding judge on a panel.  See DC Circuit, Handbook of Practice and Internal Procedures ("The presiding judge of the panel is the member of the panel in active service who is first in seniority.").  Presiding judges, if in the majority, get to assign the judges who write the opinion.  See Id ("If the panel decides to issue an opinion or memorandum, the presiding judge assigns the responsibility for writing it, unless he or she is in the minority").  

Second, only judges in active service can change the rules of practice.  See Rule 47 ("Each court of appeals acting by a majority of its judges in regular active service may, after giving appropriate public notice and opportunity for comment, make and amend rules governing its practice.").  

Third, senior judges cannot vote on whether to hear a case en banc.  See Rule 35 ("A majority of the judges who are in regular active service may order that an appeal or other proceeding be heard or reheard en banc.").   En banc hearings allow the full court to overturn a panel decision.  

Fourth, and most importantly, senior judges (with two very narrow exceptions) cannot sit when the court hears cases en banc.  See 28 U.S.C. § 46(c).  Where the judges on a circuit disagree with a panel opinion, they can reverse the decision en banc.  Thus, while the DC circuit will have more Republican appointees hearing cases even after the three Obama appointees join the court, the majority of judges in active service and who sit en banc will have been appointed by Democrats.   It will be these judges who determine the policy of the circuit.   

For more on the practices of the federal court of appeals, see Neutral Assignment of Judges at the Court of Appeals.  


The Proxy Advisory Services Roundtable (Some Conclusions)

We are discussing the Roundtable recently held by the SEC on proxy advisory firms.  So what are some conclusions? 

First, proxy advisory firms serve a useful purpose that provide services advisers and institutions are willing to purchase. The need for the services is exacerbated by the increased complexity of shareholder proposals and the time crunch connected to the proxy process.  Thus, irrespective of the Egan Jones and ISS no action letters, demand for these services will continue and, given the "feedback loop" that can exist with large investors, the services will become more rather than less valuable over time.

Second, the industry is probably too concentrated but barriers to entry make this unlikely to change.  

Third, many of the issues are structural.  Because proxy advisory firms represent both institutional and corporate clients, there is an inherent conflict.  Friction is, therefore, inevitable.  

Fourth, some of the regulatory issues do not involve the proxy advisory firms as much as they implicate the duties of advisers.  Michelle Edkins, at BlackRock, recommended that advisers post their policies with respect to the use of proxy advisory firms and the resources devoted to voting decisions.

Fifth, there was no serious disagreement on the need for robust disclosure designed to alert participants about conflicts of interest.  Completeness and prominence were the most commonly mentioned needs.  Trevor Norwitz (2:34:30) suggested the possibility of increased disclosure in contests (for example the amount paid by the issuer and activist to the proxy advisory firm over a specified period of time).  Jeff Mahoney at CII (2:52:00) indicated support for more transparency in this area.  Otherwise, there was no real consensus on how issues arising from proxy advisory firms should be addressed.  There were suggestions that the advisory firms should be treated as utilities.  

Not discussed were the consequences of regulation.  There is the potential for unintended consequences.  To the extent, for example, that ISS changed its business model and no longer represented both issuers and investors, it would potentially have less need to take issuer views into account.  To the extent that more firms entered the market (despite significant barriers to entry), they may need to differentiate themselves by, for example, issuing more negative recommendations.  

Similarly, there is a third rail nature of regulation in this area.  It is clear that institutional investors and investment advisers rely on the services of the proxy advisory firms, in part because of the complexity of the voting process and the time crunch involved in making voting decisions.  Repealing the no-action letters would not necessarily reduce the reliance on third parties but would likely result in uncertainty for, or impose additional cost burdens on, advisers.  Any regulatory reform, therefore, would need to take into account the costs imposed on the advisory firms and the hostile reception that institutional investors and advisers will have to an increase in the cost structure. 

Sixth, despite an informative Roundtable and discussion of a number of issues, participants at both ends of the spectrum cautioned that, as a matter of timing, now was not the time to engage in a significant regulatory initiative.  Harvey Pitt, around minute 3:45:00, praised the Commission for addressing the issue ("The Commission is very wise to look into these issues."). He also didn't rule out possible regulation in the future. ("It may well be that some form of regulation at some point in time makes sense."). But, as he concluded, "I'd say for a whole variety of reasons today its probably the last thing the Commission itself needs to do."  

Similarly, Damon Silvers (around minute 39) stated that, "what I would urge very strongly on the Commission in this matter is is that if you are going to start going heavy at these issues of concentration and gatekeepers, this is about the last place to start.  That the really serious problems lie elsewhere."

Finally, this does not mean an absence of a role for the Commission.  Presumably the communications do and should occur between the staff at the Commission and the proxy advisory firms.  The firms have an incentive to listen to staff comments in order to reduce the risk of future regulation or the possibility of losing their exemption status from the proxy rules.  This communication will provide another avenue to convey concerns.  While the staff has limited regulatory leverage, intermediaries, such as the proxy advisory firms, likely want to avoid a change in that status. This provides an incentive to sometimes alter practices or alleviate concerns. 

The webcast of the Roundtable is here.


The Proxy Advisory Services Roundtable (The Regulatory Privilege)

We are discussing the Roundtable recently held by the SEC on proxy advisory firms.

An interesting issue that arose off and on during the day was the role played by the Commission in connection with the use of proxy advisory firms and the the creation of the current market structure.  As Commissioner Piwowar stated

  • First, the Commission issued a release in 2003 stating that “the duty of care requires an adviser with voting authority to monitor corporate actions and vote proxies,” which may have created a regulatory compliance mandate, absent extra-ordinary circumstances, to vote every share.  Second, Commission staff subsequently issued no-action letters that seem to have had the unintended effect of institutionalizing the use of proxy advisory firms to vote shares in compliance with this perceived mandate. 

The effect, according to Commissioner Piwowar, would turn voting into "a regulatory compliance issue rather than one focused on the benefits for investors."  Commissioer Gallagher referred to this as the "regulatory privilege" done through "staff level guidance."

To a large degree, the issue turned on the interpretation of two no action letters, Egan-Jones Proxy Services, SEC Staff No-Action Letter (May 27, 2004); Institutional Shareholder Services, Inc., SEC Staff No-Action Letter (Sep. 15, 2004).  The letters were discussed extensively with widely varying views.  

The role of the two letters raises a pair of issues.  The first is whether the letters encouraged the use of proxy advisory firms.  Second and, while related, conceptually distinct, did the no-action letters essentially play a role in the creation or continuance of the current market structure, one dominated by two entities. 

Former Chairman Harvey Pitt (minute 22) addressed both issues.  The two no-action letters were "not typical of no-action letters" and that they did not "interpret the rule" but "extend[ed] the rule."  The result was to "encourage portfolio managers in particular to use proxy advisory firms."

He also, however, took the position that the letters contributed to the current market structure.  

  • In addition, the Commission's approach and the market place at the time effectively entrenched an existing duopoly with two firms, ISS and Glass Lewis, which was akin to the credit rating agencies issues.  97% of the proxy advisory firm business is handled by two firms and as has been referenced control of voting decisions at least a large percentage of shares can be attributed, and has statistically, to the recommendations of proxy advisory firms.   

Yet beyond his contention that the no-action letters encouraged reliance on proxy advisory firms, something that would have created additional demand and, if anything, created additional opportunity for competitors, the statement did not explain how the two letters encouraged the "duopoly."  The Roundtable did bring out market impediments to new entrants (the business is low margin and the barriers to entry are high) but the role of the Commission in the structure of the market was less clear.   

With respect to the contention that the no-action letters encouraged reliance on proxy advisory firms, there was substantial disagreement on that point from the adviser community.  Yukako Kawata, a partner at Davis Polk, indicated "its not the no-action letters.  Its the release."  She took the position that reliance on third parties was encouraged by language in the adopting release for Rule 206(4)-6. She described the no-action letters as "great" since the gave guidance on "what you have to think about when you" when you select a third party. 

Karen Barr, General Counsel, Investment Adviser Association, (speaking around minute 1:10) also disagreed that the letters had encouraged or caused increased use of proxy advisory firms.  She stated that this was not true as a matter of practice.  "Our members' experience is not that they've increased their use of proxy advisory firms because of the no-action letters.  They've increased the use because of the complexity and number of votes."   

She also took the position that, with respect to reliance on proxy advisory firms, the no-action letters did not provide insight that wasn't in the adopting release:   

  • From our perspective, the no-action letters didn't give advisers anything other than what they were entitled to do.   They were already entitled to hire third parties.  The release adopting the proxy voting rule discussed advisers' conflicts of interest and gave a list of four ways that advisers could address their conflicts.  One of those ways was the use of an independent third party.  So the first no-action letter as Harvey pointed out said "OK we're going to interpret the word independent." Independence does not mean the independence of the proxy advisory firm in the context of the proxy voting release.  Independence means the adviser's independence so the adviser can't hire an affiliate for example to vote in the event of a conflict because that would further the conflict.

The letters, however, went on to discuss the obligation of advisers with respect to assessing the conflicts of interest by the proxy advisory firms.  As she put it: 

  • But then the SEC's staff went on to say even though you didn't ask us about the issuer's conflicts, we're going to tell you that you advisers have to really look carefully at proxy advisory firms' conflicts with issuers.  And here's an extra set of steps that you need to take to make sure that those proxy advisory firms are giving you advice free from conflict.  And in effect that ratcheted up and specified the duties of the advisers in looking at proxy advisory firms' conflicts.  From our point of view, it didn't give the advisers a free pass if you will.

As was noted, reliance on third parties was expressly permitted in the adopting release.  See Investment Advisors Act Release No. 2106 (Feb. 11, 2003) ("an adviser could demonstrate that the vote was not a product of a conflict of interest if it voted client securities, in accordance with a pre-determined policy, based upon the recommendations of an independent third party.").   To some extent, therefore, the no-action letters reiterated this view. 

The letters did, however, impose on advisers an obligation, in relying on proxy advisory firms, to take into account any conflicts by the proxy advisory firms with issuers.  They also specified how these conflicts were to be addressed.  As the Egan Jones letter stated:   

  • Procedures [put in place by the adviser] should require a proxy voting firm that is called upon to make a recommendation to an investment adviser regarding the voting of an Issuer's proxies to disclose to the adviser any relevant facts concerning the firm's relationship with an Issuer, such as the amount of the compensation that the firm has received or will receive from an Issuer. That information will enable the investment adviser to determine whether the third party can make recommendations about how to vote the clients' proxies in an impartial manner and in the best interests of the clients, or whether the adviser needs to take other steps to vote the proxies.  

Moreover, the letter noted that "the mere fact that the proxy voting firm provides advice on corporate governance issues and receives compensation from the Issuer for these services generally would not affect the firm's independence from an investment adviser."

The Egan Jones letter focused on the assessment of conflicts on a case by case basis.  The ISS letter, however, specified that this was not the exclusive method of doing so:   

  • Consistent with its fiduciary duty, an investment adviser should take reasonable steps to ensure that, among other things, the firm can make recommendations for voting proxies in an impartial manner and in the best interests of the adviser's clients. Those steps may include a case by case evaluation of the proxy voting firm's relationships with Issuers, a thorough review of the proxy voting firm's conflict procedures and the effectiveness of their implementation, and/or other means reasonably designed to ensure the integrity of the proxy voting process.  

To the extent that the Commission took steps to withdraw the two letters, the action would likely not change the right of advisers to rely on third parties in fulfilling their voting obligations.  To alter that result, the language in the adopting release would have to be changed. 

Withdraw of the letters would, however, raise uncertainty with respect to the standards imposed on advisers with respect to assessing conflicts by proxy advisory firms.  The Commission would presumably need to provide an alternative analysis.  The Commission could, for example, disavow the ability to rely on the procedures used by the proxy advisory firms and go back to requiring a case by case review as the exclusive approach.  

This would presumably require disclosure by the proxy advisory firms to institutional clients of their relationship with issuers. In fact, the firms provide their institutional clients with a list of issuers that are also clients (and the fees paid by each issuer).  Harvey Pitt, around minute 1:58, essentially suggested this.  He characterized the letters as allowing advisers to make conflict determinations without knowing about the actual conflict.   

Requiring a case by case analysis would would presumably add time and cost to the voting process, particularly with most of the activity taking place in the second quarter of the year.  Moreover, the benefits of doing so are not clearly established.  The firms have firewalls that separate the institutional and issuer businesses.  Other than an example given by Mike Ryan of a possible breach (something that Gary Retelny at ISS strongly denied), there was no strong evidence that conflicts with issuers influenced recommendations.  Trevor Norwitz (minute 2:34:30) stated that "I have no reason to believe that [the firewalls] are not holding up."

Efforts to impose additional regulations in this area would also likely have a disproportionate effect on smaller advisers.  The largest firms use recommendations as an input, rendering any conflict less important.   

The webcast of the Roundtable is here


The Proxy Advisory Services Roundtable (The View of Issuers)

Issuers and their allies raised a number of concerns about proxy advisory firms.  They ranged from industry concentration to conflicts of interest to the propensity to make mistakes in making recommendations.  The fact that the firms make recommendations yet seek business from issuers raised concerns, as Trevor Norwitz (2:37) said, about being "shaken down when approached by the governance side . . ."

Perhaps the most significant concern but the hardest to pin down was the inchoate view that the recommendations issued by the proxy advisory firms were simply wrong.  The topic came up in the context of factual mistakes.  It also, however, came up in the context of questions about untoward influence by institutional clients on recommendations.  

Trevor Norwitz (around 2:34) raised the issue directly.  He described the conflict as "insidious" and stated that "the customers have a tremendous influence over these proposals."  In a for profit business, "you have to listen closely to what your customers tell you."  He specifically stated that there had been situations where "recommendations have been changed and when the question was asked 'why' the answer was because our customers told us to."  Darla Stuckey, Senior Vice President of Policy and Advocacy, Society of Corporate Secretaries, indicated a desire to understand better "how the sausage gets made."  

A specific example of efforts to lobby the proxy advisory firms came up when Anne Sheehan, Director of Corporate Governance, CalSTRS (around minute 2:41:30) noted that she would talk with the staff of the proxy advisory firms about her own organization's proposals and "about how we want[ed] them to come out on our recommendation."  She noted that the firms did not always agree with her views, described the proxy advisory firms "fair and impartial" that took "input from all sides," and expressly disagreed with Trevor Norwitz's comments that institutional clients had "undue sway."  

This is perhaps the toughest issue to understand clearly.  On the one hand, there were allegations of untoward influence by institutions.  On the other, institutional investors denied that they had any such influence. The proxy advisory firms had in place procedures designed to give a voice to all participants in the process. 

Yet there was clear disquiet by issuer representatives about recommendations ultimately issued. Unclear was the reason for the disquiet.  Untoward influence was one possibility.  Straightforward disagreement on the merits was another.  Anne Sheehan (around 3:45:10) noted that "what I have found is that many times the errors are really differences of opinion."  As Michelle Edkins indicated, issuers can have different views on the independence of directors than those of investors.   

From the discussion, it was clear that some of the issues with proxy advisory firms were really broader concerns over changes to the system of corporate governance.  Harvey Pitt mentioned an increase in the number of shareholder proposals during the years 2000 to 2003.  Trevor Norwitz, a Partner at Wachtell (speaking around minute 41) and who described himself as "representing corporate America," noted what he described this as a "sea change" from the more "board centric model" to one where the decisions on "fundamental things" have "shifted to a very large degree to shareholders."  He traced the shift specifically to the movement from plurality to majority vote provisions, arguing that the shift gave proxy advisory firms a "big stick."

The "sea change" is, however, more than a factor of complexity or quantity.  The other big change that has occurred over the last decade or so has been the heightened organization of shareholders and, as a result, the increased likelihood that proposals will in fact pass.  

There was a time when proposals under Rule 14a-8 primarily involved matters of social importance. These proposals were mostly designed to publicize corporate practices and almost never passed.  The topics of proposals have, however, shifted significantly, particularly in recent years.  Social policy proposals are a minority and still do not pass.  Most proposals involve governance or compensation matters and they often do garner majority support.  For a list of proposals in 2013 and how they did, go here.  

Provisions that pass are usually precatory.  Say on pay is advisory.  Other proposals typically request, rather than mandate, changes because of limits under state law (shareholders cannot initiate an amendment to the articles), the greater likelihood that the staff of the Commission will not permit its exclusion under Rule 14a-8, or as a matter of strategy since a precatory proposal may garner greater support.  Nonetheless, proposals that pass create headaches for the board and sometimes result in law suits that use the shareholder vote as evidence of a breach of fiduciary obligations.  In recent years, the number of headaches has increased. 

The webcast of the Roundtable is here


The Proxy Advisory Services Roundtable (The View of Consumers)

We are discussing the Roundtable recently held by the SEC on proxy advisory firms.

The Roundtable included representation from most sides in the debate.  The criticisms of proxy advisory firms tended to garner more attention.  As a result, concerns from the issuer perspective are relatively prominent.  As Commissioner Aguilar noted, however, the debate would benefit from an understanding as to "how investors and investment advisers use proxy advisory firms, including any steps that proxy advisory firms may be taking to make sure that they meet their obligations to the clients that rely on them." 

Nell Minow (30:20), the fourth person hired at ISS, gave a brief history of the early days of ISS.  She noted that the firm had not been formed with the intent of providing voting advice but that the business model was one that largely emerged from client demand.    

Michelle Edkins from BlackRock (minute 54.40) gave a thorough description of the practices at her firm. BlackRock annually votes proxies in 3700 US companies (15,000 globally), almost all of them during the second quarter of the year. As a result, the firm has to deal with considerable "time pressure." Moreover, while she spoke for BlackRock, she noted that, from her experience, other large advisers "take pretty similar approaches on how we use" proxy advisory firms.  

BlackRock relies on proxy advisory firms to synthesize data and put it in a "consistent" format.  BlackRock independently decides whether to go beyond this information, including discussions with management. The data is therefore one of "many inputs" into voting decisions.  Moreover, BlackRock has "published policies" that are posted on the Internet, which provide issuers with insight into how voting decisions are made.    

Voting decisions were not matters of "compliance" but "economics."  She noted that BlackRock voted against one or more proposals at approximately 36% of all meetings (7% of all proposals).  With respect to say on pay, BlackRock voted against 4% of the proposals while the proxy advisory firms recommended voting against approximately 16% of the proposals.  She also made clear the symbiotic nature of the relationship with proxy advisory firms.  Edkins acknowledged that BlackRock works with the proxy advisory firms to assist them in refining their process, something she called a "feedback loop." 

The comments by Michelle Edkins more or less resolved the role of proxy advisory firms with respect to large advisers.  The other speakers addressing the topic generally acknowledged that the large advisers relied on advisory firm recommendations only as an input.  Moreover, Karen Barr, General Counsel, Investment Adviser Association, (speaking around minute 1:10), noted the highly concentrated nature of the asset management business, with the 99 largest advisory firms (with over $100 billion under management) managing over 50% of total assets managed by investment advisors.  

The elephant in the room was the approach taken by smaller advisers.  Michelle Edkins noted that advisers usually contended that voting decisions were done "in house" but that in some cases this was in fact "smoke and mirrors."  To the extent inadequately resourced, the decisions could not be made "in house." 

Karen Barr addressed the topic of smaller firms specifically.  She noted that, while the asset management industry was highly concentrated, there were almost 11,000 investment advisers and most had fewer than 10 employees ("really small businesses" she called them).  Smaller advisers tended to rely "more heavily" on advice from proxy advisory firms.  They did, however, retain "ultimate fiduciary responsibility" for voting decisions and had the right to "override" the recommendations of advisory firms. She disputed that "outsourcing" of voting decisions was a dirty word.  To the extent this occurred, advisers retained their fiduciary obligation in selecting the advisory firm.  Moreover, she noted that "thousands" of advisors do not use advisory firms.  

The discussion brought home several points.  First, investors want the services provided by the proxy advisory firms, an obvious enough point given that they pay for it.  But the comments demonstrated the role that demand played in the structure of the proxy process.  The increased complexity of voting decisions and the time crunch that arises with thousands of companies holding annual meetings during the same quarter of the year requires that a certain number of services be outsourced to these firms.

Second, the largest asset management firms use the recommendations as an input.  Smaller firms place greater reliance on these recommendations but the practice is not uniform (they have fewer resources but also likely have a smaller number of companies under management and can override recommendations of advisory firms).  

Yet the number of advisers is less important than the amount under management.  Because of the concentrated nature of the asset management industry, the discussion suggested that, for most votes,  recommendations by proxy advisory firms are more of an input than a dictate. Perhaps there is data to the contrary (suggesting that small advisers control a significant amount of assets) but it was not part of the discussion at the Roundtable.  

The webcast of the Roundtable is here 


The Proxy Advisory Services Roundtable (Plumbing Problems)

Michelle Edkins from BlackRock at around minute 59 noted that BlackRock retained ISS not only for advice but for other services as well. Some of these services arose out of the "operating environment." She described the voting environment as "highly complex, terribly inefficient" and "prone to error."  

The Proxy Plumbing Release sought to address some of these concerns.  Yet other than the concern over proxy advisory firms, nothing significant has come out of the plumbing release. Perhaps this ought to be the topic of the next roundtable.  

The webcast of the Roundtable is here


The Proxy Advisory Services Roundtable (The Issue of Concentration)

We are discussing the Roundtable recently held by the SEC on proxy advisory firms.

One of the issues in the debate that came up repeatedly was the concentration in the proxy advisory industry.  Commissioner Piwowar described proxy advisory firms as a "stable duopoly" (with the word "duopoly" becoming much repeated throughout the day).  There was some agreement on this.  Damon Silvers from the AFL-CIO (who began to speak around minute 37.10) acknowledged that the issue of concentration was "very real." Others took similar positions.  

Mike Ryan, Vice President, Business Roundtable, and former president and COO of Proxy Governance, Inc., speaking late in the day (around 2:09), made it clear, however, that this was not likely to change. Barriers to entry were simply too high.  He noted that the business was low margin.  Moreover, to enter, a firm would have to front the resources necessary to cover at least 10,000 securities (out of 40,000 globally), with approximately 4000 in the US and the remainder overseas.  The firm would also have to invest in robust technology and retain qualified staff.  At the same time, investors had incentives not to change firms.  They have invested in technology that allows them to interface with specific proxy advisory firms, making it costly to switch to a new entrant.         

The Roundtable also brought out that the problem of concentration is not limited to proxy advisory firms. Damon Silvers specifically referenced auditors (which he described it as a "quadropoly") and rating agencies.  If the concern was concentration, he indicated that, with respect to proxy advisory firms, "this is about the last place to start, that the really serious problems lie elsewhere."  

With respect to concentration, one intermediary that went unmentioned was Broadridge.  Broadridge is responsible for forwarding proxy materials on behalf of brokers.  For the most part, this is a plumbing sort of task and raises little controversy.  There have been exceptions, however.  During the JP Morgan battle over the separation of chair and CEO, Broadridge announced a policy change.  The company would no longer provide ongoing voting tallies to shareholders.  The same information would, however, be given to companies. 

Concentration is therefore a structural issue that exists in many places in the securities markets and the proxy process.  With respect to proxy advisory firms, regulatory changes can add expense and burdens to the existing firms but they are not likely to induce additional entrants into the market.   

The webcast of the Roundtable is here  


The Proxy Advisory Services Roundtable (Voting Decisions and the Need for Data Tagging)

We are discussing the Roundtable recently held by the SEC on proxy advisory firms.

A great deal of the discussion in the Roundtable was about the degree of reliance by advisers and other investors on recommendations by proxy advisory firms.  It would be much easier to discuss this issue in a concrete way if there were better data available.  One of the things that prevents the development of this type of data is the practical difficulty that arises with respect to the recovery of voting data from SEC filings.  

Mutual funds must file voting data on Form N-PX.  A description of the disclosure obligations is here.   In the current format, the Form is very difficult to use. As one commentator writing to the Investor Advisory Committee described:   

  • given how N-PX reports are currently submitted, in unstructured plain text formats, undertaking such a project requires considerable time and effort, since before one can compute these simple summary statistics, he or she needs to first reverse-engineer the formats the funds use to report their votes (and different funds do use many different formats, and even the same fund may switch from one format to another from one year to the next), then write and debug computer scripts to extract these votes, and only then it is possible to compute such summary statistics. Similarly, with unstructured data, there is no easy way to see how the voting patterns (e.g., the frequency of supporting management-proposed directors, or opposing shareholder proposals) of a particular fund evolve over time. With tagged data, such questions could be answered virtually instantly.

Michelle Edkins at BlackRock referenced the obligation to file the Form and recommended that advisers provide "high level" data about voting results.  This would be useful but an even better result would be to require the filing of the data in an interactive format.  This would allow investors and issuers to study voting patters and develop their own conclusions.  This approach is consistent with the recent  recommendation of the SEC's Investor Advisory Committee.  


The Proxy Advisory Services Roundtable (The Data)

We are discussing the Roundtable recently held by the SEC on proxy advisory firms.  

Relatively early in the day (around minute 47), Mark Chen, Associate Professor of Finance, Georgia State University, was asked to summarize the applicable data.  It was the only time he spoke of any significance but it helped frame the debate and discussion in a very useful way.

There is no question that negative recommendations by the two main proxy advisory firms can have an impact on the shareholder voting process.  Some critics of these firms view the increase in negative votes as a causal consequence of the recommendations of the proxy advisory firm.  Others see the shift as a correlation, the result of a recommendation that raises the profile of an issue.  

Professor Chen noted a group of studies that had examined the role of ISS vote recommendations "in uncontested elections and voting situations."  First, negative recommendations on management sponsored proposals are "associated with" about "13.6% to 20.6% fewer votes for management."  In the case of individual directors in uncontested elections, a negative recommendation resulted in 14% to 19% fewer votes.  Finally, with respect to say on pay proposals, some evidence indicated that a negative recommendation resulted in 24% fewer votes.  

Professor Chen also noted that the data was subject two different interpretations.  First, the data could demonstrate "total outsourcing," the rote use of recommendations by the proxy advisory firms to determine voting decisions.  Second, voting advice could instead "bring new information to the markets" that influences voting decisions.  He noted:  "At the current time, I don't believe we have the data to sort out these two interpretations."  He also noted that "free riding is not in and of itself a problem" so long as the entity making the recommendations is doing the right thing.   

The statements provided parameters for the discussion.  While there were a few speakers who essentially asserted that proxy advisory firms had an excessive ability to control voting decisions (Trevor Norwitz at Wachtell spoke about their power to vote $4 trillion worth of shares), this was not a topic that gained much traction.  Indeed, the evidence presented at the Roundtable indicated that the largest asset managers (BlackRock for example) viewed the recommendations as an input, not a controlling influence.  

Professor Chen's statements also helped elevate the importance of data in the discussion.  The most valuable comments were those made by speakers who referenced their own experiences (or those of the industry they represented) and those who could support broader claims with data.  

The webcast of the Roundtable is here