Staff Guidance and Proxy Advisory Firms (Part 1)

The staff of the Division of Investment Management and Corporation Finance recently issued guidance with respect to proxy advisory firms.  The guidance, in the form of a Staff Legal Bulletin, is here.  The advice provides some helpful guidance but left gaps.  In one instance, the guidance has the potential to raise uncertainty outside the proxy advisory firm area. 

One section addresses the fiduciary obligations of advisers with respect to voting client shares.  The guidance purports to provide advice on whether advisers must vote "every proxy."  Advice in this area would be most useful in specifying when advisers with voting authority may nonetheless refrain from voting.  After all, this is the most common situation.  See Staff Legal Bulletin No. 20 (June 30, 2014) ("We understand that in most cases, clients delegate to their investment advisers the authority to vote proxies relating to equity securities"). 

Yet the advice was quite different and had little to do with the actual fiduciary obligations of advisers.  The advice was really about possible arrangements that clients could impose on advisers.  Thus, clients could deny advisers voting authority in its entirety.  They could prohibit advisers from voting on certain types of proposals or only provide voting authority over certain types of proposals.  Clients can also require that advisers vote in a certain fashion (as in for all management proposals). 

So the take away is that it doesn't violate an adviser's fiduciary obligations to follow voting instructions received from received by clients.  One has to wonder whether there was ever much doubt about that.  See Proxy Voting by Investment Advisers, Investment Advisers Act Release No. 2106 (Jan. 31, 2003) (noting that advisers "with proxy voting authority" was obligated to act with a duty of care).  

The advice does, however, seem to encourage clients to adopt more restrictive voting arrangements with advisers.  Of course, IM does not have jurisdiction over institutional investors so cannot actually state that such arrangements are consistent with any fiduciary obligations of clients.  Clients will have to make their own determination on that matter.   

The one place where the guidance did seem to comment on an adviser's fiduciary obligations with respect to voting may well sow the seeds of confusion.  The staff specified that advisers may follow instructions from clients to always follow a particular party's recommendations (for management or for a particular shareholder proponent).  The guidance, however, suggested that the advice could be ignored upon a "determination by the investment adviser that a particular proposal should be voted in a different way if, for example, it would further the investment strategy being pursued by the investment adviser on behalf of the client." 

To the extent that this is the staff's position (the staff could have been suggesting that advisers and clients can agree to this exception), presumably the obligation to override client instructions applies in other circumstances where necessary to further the adviser's investment strategy.  This potentially adds a great deal of uncertainty and leaves advisers open to allegations of breach whenever they vote in a manner consistent with client instructions but inconsistend with their investment strategy.   


The Proxy Plumbing Release Revisited and the Need for Version 2.0

For the second year in a row, students wrote papers on a common legal topic. The papers were then collectively published as a complete issue of the University of Denver Online Law Review. This year, the topic was the Proxy Plumbing Release revisted. The issue can be found here.   

In 2010, the SEC published the Proxy Plumbing Release, a release that examined a number of important issues relating to the proxy process, including back office issues, the role of intermediaries, and the plight of retail investors. The online issue reexamines concerns raised in the Proxy Plumbing Release. In addition to topics discussed in the original Release, student article lay the groundwork for a version 2.0 that would expand the discussion of “plumbing” problems to other matters. 

The articles in the issue include:  

J. Robert Brown, Jr., The Proxy Plumbing Release Revisited and the Need for Version 2.0

Jessica Bullard, Proxy Distribution and the Requirement of Impartiality, 91 Denv. U. L. Rev. Online 93 (2014)

Julian Ellis, The "Common Practice" of Bundling: Fact of Fiction?, 91 Denv. U. L. Rev. Online 105 (2014)

Jeremy Liles, Enhancing SEC Disclosure with Interactive Data, 91 Denv. U. L. Rev. Online 121 (2014)

Christie Nicks, Voting of Partially Instructed Shares by Brokers, 91 Denv. U. L. Rev. Online 155 (2014)

Lincoln Puffer, Proxy Cards and the Requirements of Clarity and Impartiality in Titling Proposals, 91 Denv. U. L. Rev. Online 167 (2014)  

The issue demonstrates the strengths of online scholarship. The DU Law Review (through the hard work of Jonathan Gray, the online editor) was able to cite check and post the articles only a few months after submission. Because the articles are highly topical, they will likely have immediate impact in the corporate governance debate. Moreover, the articles are in the legal data bases and can therefore be found through traditional search techniques. 

This can be seen from the use of the articles published in last year's issue on the JOBS Act (something that can be found here). One of the pieces was cited by a federal district court judge. See Landegger v. Cohen, 2013 WL 5444052 (D.Colo., September 30, 2013) ("But in affording weight to these factors, a court must take a measured approach. These two factors must not be weighted so heavily so as to subsume the others in the analysis. Specifically, these factors should not swallow what is ultimately a fact-intensive definition—and one as to which the SEC Commission has been unwilling to create the necessary guidance in order to provide clarity. See . . . Samuel HagreenThe Jobs Act: Exempting Internet Portals from the Definition of Broker–Dealer, 90 Denv. U.L.Rev. 73 (2013).").  

Two others were cited in articles. See Sahil Chaudry, THE IMPACT OF THE JOBS ACT ON INDEPENDENT FILM FINANCE, 12 DePaul Bus. & Com. L.J. 215, n. 116 (2012) (citing Lindsey Anderson Smith, Note, Crowdfunding and Using Net Worth to Determine Investment Limits, 90 Denv. U. L. Rev. 127, 130 (2013)); John Wroldsen, THE CROWDFUND ACT'S STRANGE BEDFELLOWS: DEMOCRACY AND START-UP COMPANY INVESTING, 62 U. Kan. L. Rev. 357 n. 165 (2012) (citing Lina Jasinskaite, Note, The JOBS Act: Does the Income Cap Really Protect Investors?, 90 Den. U. L. Rev. Online 81 (2013)).   


Preliminary Voting Data and the Need for A Clear Federal Approach: Red Oak Fund, LP v. Digirad (Part 6)

We are discussing Red Oak v. Digirad, a Delaware case analyzing claims that arise out of the use of preliminary voting data.

So where does this leave things?

First, Digirad and Red Oak were both soliciting proxies.  As a result, Broadrdige provided both with the same preliminary information.  In theory this left them on an equal footing.    

The distribution of the information does not arise under state law.  Under federal law, there is no explicit requirement to distribute preliminary information to participants in a contest.  Moreover, Broadridge distributes and collects voting instructions on behalf of brokers.  Therefore, to the extent that there are contractual provisions that address distribution of preliminary data, they are between Broadridge and the broker.  Nonetheless, whatever the source, distribution of preliminary voting data to anyone soliciting proxies appears to be the standard practice.  

Second, under state law, management with preliminary voting data can, apparently, make statements to individual investors that are arguably inconsistent with the data without significant concern.  Some of the lack of concern arises over the difficulty in detection.  Shareholders challenging the practice will have to uncover statements made by management to other investors (or their advisers).  This will often be extremely difficult.

In addition, it is clear that the courts are likely to treat the information, even if detected, as speculative and immaterial.  In arriving at this determination, the court effectively applied a materiality standard that is inconsistent with the test articulated.  This is not the first time that this has occurred.  Delaware courts use the federal definition of materiality (important to a reasonable shareholder) but impose a significantly higher burden on shareholders.  See The Irrelevance of State Corporate Law in the Governance of Public Companies.  This was the case here.  Rather than show that the alleged misstatements were important to a reasonable investor, the court effectively required a showing that the information actually caused a shareholder to change its votes, an all but impossible standard to meet.   

Third, under state law, apparently, companies can cause mistakes in the preliminary voting tallies that are distributed to others by Broadridge, know about the mistakes, benefit from the mistakes, and still escape any concern that the court will find an unfair election.  Unless the court finds bad faith or intentional misbehavior, there is no recourse for disadvantaged investors.  Moreover, the track record of the Delaware courts suggests that they will almost never find that shareholders have met this burden.

The case, therefore, raises the potential for abuse of preliminary voting data and suggests that state law will not intervene to prevent any such abuse.  Assurances that the information is used fairly will, therefore, have to be imposed at the federal level.  Possibilities might include, among other things: mandatory disclosure of preliminary voting information to the public (by Broadridge or any recipient); prohibitions on disclosure of the information by Broadridge to anyone, a mechanism designed to facilitate the correction of preliminary tallies when errors are uncovered; and/or the execution of an omnibus proxy by the broker on behalf of street name owners, eliminating the need for voting instructions.

Any such approach has its own set of problems.  The best solution would have been to require companies to use the information in a manner that was fair to shareholders.  Red Oak, however, demonstrates that the Delaware courts have no intention of taking this route.      

The opinion and assorted filings in the case, including the transcript of the hearing, can be found at the DU Corporate Governance web site. 


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