Institutional Shareholder Services Inc. (ISS) appreciates the opportunity to comment in advance of the SEC Staff Roundtable on the Proxy Process that is scheduled for November 15, 2018.  We focus these preliminary comments on two primary areas, proxy advisory firms and the proxy process.

Proxy Advisory Firms

As a registered investment adviser, we have a fiduciary obligation to our clients to provide  advice that is in their best interest.  In the free market, our clients hire us because we provide services they value and deem to be cost-effective.  We listen to our clients and make our vote recommendations based on the governance policies they have selected – whether benchmark or customized.  Unfortunately, many of our critics confuse causation and correlation on these vote recommendations, inferring that our clients blindly follow our advice. In fact, our clients are sophisticated institutional investors who are free to follow our recommendations or not.  Often, the information that we provide to our clients is one of many different inputs they use to make their voting decisions.  They often vote in accordance with our recommendations because those recommendations are tailored to their own views on corporate governance, not because they follow our advice without thought or intention.

As illustrated by the 2013 Staff Proxy Advisory Firms Roundtable,(2013 Roundtable)[1] and confirmed repeatedly during the five years since, proxy advisers have become a surrogate for shareholders themselves in the debate regarding what kind of voice investors should have in the companies they own.  ISS looks forward to a robust and balanced discussion of the role and regulation of proxy advisory firms at the upcoming Proxy Process Roundtable.  To set the stage for this conversation, we would like to briefly address the areas of interest that Chairman Clayton identified in his statement announcing the Roundtable.[2]

Whether the Regulatory Environment Has Caused Investment Advisers to Over-Rely on Proxy Advisory Firms, and Whether the Use of Such Firms is in the Best Interest of Investment Advisers’ Clients

One of the most persistent urban legends about proxy advisory firms is that the SEC created the market for independent proxy advice by obligating investment advisers and mutual funds to vote every proxy that comes their way, and by creating a “safe harbor” that lets investment advisers outsource their fiduciary duties to proxy advisers.  Nothing could be further from the truth.

As Chairman Clayton noted in announcing the upcoming Roundtable, the proxy process is a fundamental component of shareholder engagement, which is a hallmark of our public capital markets.  Because proxy voting affects shareholder value and, in special situations, may involve the purchase or sale of securities, the standards of conduct that apply to this activity derive from the standards that apply to rendering investment advice generally.

The U.S. Department of Labor (DOL) first articulated the fiduciary implications of proxy voting thirty years ago. In a letter to the Chairman of the Retirement Board of Avon Products about proxy voting for employee benefits plans subject to ERISA, the DOL said:

In general, the fiduciary act of managing plan assets which are shares of corporate stock would include the voting of proxies appurtenant to those shares of stock.[3]

In the wake of Enron’s widely publicized failure of corporate governance, the SEC likewise recognized the fiduciary implications of proxy voting, when then-SEC Chairman Harvey Pitt gave the following guidance concerning investment advisers’ duty to vote proxies on their clients’ behalf:

We believe . . . that an investment adviser must exercise its responsibility to vote the shares of its clients in a manner that is consistent with the general antifraud provisions of the Advisers Act, as well as its fiduciary duties under federal and state law to act in the best interests of its clients.[4]

The Commission formalized this view in 2003, when it adopted new rules and rule amendments relating to proxy voting by registered investment advisers and registered investment companies. In adopting Advisers Act Rule 206(4)-6, the SEC said:

The federal securities laws do not specifically address how an adviser must exercise its proxy voting authority for its clients. Under the Advisers Act, however, an adviser is a fiduciary that owes each of its clients duties of care and loyalty with respect to all services undertaken on the client’s behalf, including proxy voting.  The duty of care requires an adviser with proxy voting authority to monitor corporate events and to vote the proxies.  To satisfy its duty of loyalty, the adviser must cast the proxy votes in a manner consistent with the best interest of its client and must not subrogate client interests to its own.[5]

Rule 206(4)-6 applies these traditional fiduciary concepts by requiring registered investment advisers to adopt written policies and procedures reasonably designed to ensure that the adviser monitors corporate actions and votes client proxies in the clients’ best interests.  What the rule does not do is require investment advisers to vote every proxy, regardless of facts and circumstances. To begin with, the rule applies only to those advisers who have explicitly or implicitly assumed voting authority over their clients’ portfolios.  Many small advisers expressly disclaim such authority and do not offer a proxy voting service to their clients.  Even where an adviser undertakes to provide this service, the obligation to vote any particular proxy depends on facts and circumstances.  In the Commission’s words:

We do not suggest that an adviser that fails to vote every proxy would necessarily violate its fiduciary obligations. There may even be times when refraining from voting a proxy is in the client’s best interest, such as when the adviser determines that the cost of voting the proxy exceeds the expected benefit to the client. An adviser may not, however, ignore or be negligent in fulfilling the obligation it has assumed to vote client proxies.[6]

Likewise, the Commission’s rulemaking on proxy voting by mutual funds does not obligate funds to vote every available proxy relating to portfolio securities, but merely requires funds to disclose the policies and procedures they use to determine how to vote proxies and to file annual reports disclosing how their votes were cast.[7]  In adopting these modest requirements, the Commission noted an increased assertiveness on the part of mutual funds in exercising proxy voting responsibilities.  The Commission attributed this trend to a number of factors, including the size of positions in particular portfolio companies that make it difficult to sell a poorly managed company’s stock; the investment policies of index funds that have the same effect; and corporate scandals that created renewed investor interest in issues of corporate governance.[8]  In other words, institutions vote proxies to maximize shareholder value and satisfy the demands of those for whom they are managing investments, not to satisfy any regulatory mandate.

Nor has the regulatory environment created a safe harbor for investment advisers who engage proxy advisory firms.  The genesis of this myth seems to be a reference to proxy advisers in the adopting release for Rule 206(4)-6.  In discussing the ways in which investment advisers could manage potential conflicts of interest that might arise in the proxy voting process, the Commission said:

Advisers today use various means of ensuring that proxy votes are voted in their clients’ best interests and not affected by the advisers’ conflicts of interest.  An adviser that votes securities based on a pre-determined voting policy could demonstrate that its vote was not a product of a conflict of interest if the application of the policy to the matter presented to shareholders involved little discretion on the part of the adviser.  Similarly, 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.  An adviser could also suggest that the client engage another party to determine how the proxies should be voted, which would relieve the adviser of the responsibility to vote the proxies.  Other policies and procedures are also available; their effectiveness (and the effectiveness of any policies and procedures) will turn on how well they insulate the decision on how to vote client proxies from the conflict.[9]

The Commission’s recognition that advisers can mitigate conflicts of interest in proxy voting by seeking the advice of an independent third party was hardly radical, since the same approach is widely utilized in other areas of investment management, such as portfolio valuation, or the appointment of a sub-adviser to make investment decisions for a discrete part of a managed portfolio.  In all these cases, an adviser who engages a third-party service provider retains ultimate fiduciary responsibility for the services performed.  The Commission recognized this fact when it said:

Nothing in [Rule 206(4)-6] reduces or alters any fiduciary obligation applicable to any investment adviser (or person associated [therewith].[10]

And that statement echoed the DOL’s position in the Avon Letter:

ERISA contains no provision which would relieve an investment manager of fiduciary liability for any decision he made at the direction of another person. . . Therefore, to the extent that anyone purports to . . . delegate to another the responsibility for such voting decisions, the manager would not be relieved of its own responsibilities and related liabilities merely because it either follows the direction of some other person, or has delegated the responsibility to some other person.[11]

ISS provides institutional investors with critical assistance in analyzing and synthesizing an enormous volume of information in a short period of time, thereby giving investors a meaningful voice in corporate governance while maximizing the efficient use of limited manager resources.  ISS’ institutional clients are keenly aware of their fiduciary duty to act in the best interests of their own clients and beneficiaries, and ISS is keenly aware of its fiduciary duty to act in the best interests of its clients.  Given the number and complexity of issues to be voted on (especially for investors with global portfolio holdings), these clients believe that their ability to satisfy their fiduciary obligations would be diminished without access to the proxy advisory services ISS provides.  We agree.

On the topic of “Main Street” investors, we think it important to point out that many of these investors participate in the equity markets through retirement or other investment accounts that are managed by institutional investors.  In addition, many U.S. households participate in the capital markets by investing in mutual funds.[12]  In this way, retail investors are ultimately the beneficiaries of the critical work that ISS does for its institutional clients.

ENDNOTES

[1]  See Transcript of Proxy Advisory Firms Roundtable (December 5, 2013), available at www.sec.gov/spotlight/proxy-advisory-services/proxy-advisory-services-transcript.txt.

[2]  Chairman Jay Clayton, Statement Announcing SEC Staff Roundtable on the Proxy Process (July 30, 2018), available at https://www.sec.gov/news/public-statement/statement-announcing-sec-staff-roundtable-proxy-process/.

[3]  Letter from Alan D. Lebowitz, Deputy Assistant Secretary to Mr. Helmuth Fandl, Chairman of the Retirement Board, Avon Products, Inc. (February 23, 1988), 1988 ERISA LEXIS 19, *5-6 (Avon Letter).

[4]  Letter from Harvey Pitt, SEC Chairman to John M. Higgins, President, Ram Trust Services (February 12, 2002).  See also Baue, Walter, “SEC Chair Calls Proxy Voting a Fiduciary Duty” (March 29, 2002) available at:  http://www.socialfunds.com/news/article.cgi/808.html.

[5]  Proxy Voting by Investment Advisers, Advisers Act Rel. No. 2106 (January 31, 2003), 68 Fed. Reg. 6585, 6586 (February 7, 2003) (Proxy Rule Release) (citations omitted).

[6] Id., 68 Fed. Reg. at 6587 (citations omitted).

[7] See Disclosure of Proxy Voting Policies and Proxy Voting Records by Registered Management Investment Companies, Investment Company Act Rel. No. 25922 (January 31, 2003), 68 Fed. Reg. 6564 (February 7, 2003).

[8]  Id. at 3, 68 Fed. Reg. at 6565.

[9]  Proxy Rule Release, 68 Fed. Reg. at 6588 (citations omitted).

[10]   Id. at note 8.

[11]  Avon Letter, 1988 ERISA LEXIS 19,*7-9.

[12] In a May 2018 speech at Temple University, Chairman Clayton noted that fifty-six million U.S. households (44% of all households) own at least one U.S. mutual fund. Jay Clayton, “The Evolving Market for Retail Investment Services and Forward-Looking Regulation – Adding Clarity and Investor Protection While Ensuring Access and Choice” (May 2, 2018), available at https://www.sec.gov/news/speech/speech-clayton-2018-05-02.

This post comes to us from Gary Retelny, president and chief executive officer of proxy adviser Institutional Shareholder Services. It is based on a comment letter, dated November 7, 2018, that he submitted to the Securities and Exchange Commission in connection with its November 15, 2018, Staff Roundtable on the Proxy Process. The full letter is available here.