[Editor’s Note: This and the piece that immediately follows offer a point/counterpoint on the SEC’s proxy advisor proposal.] The Council of Institutional Investors opposes the SEC’s proposal to create a new regulatory structure for proxy advisory firms.[1] The proposed rules would codify August 2019 guidance from the commission (issued with no public comment or economic analysis) that proxy advice is “solicitation” under securities law, and then create new conditions for exemptions from solicitation rules necessary to do business as a proxy advisor. CII has provided extensive feedback in response to the SEC’s request for comments on the proxy advisor regulation proposal; our main comment letter is here. Supplemental letters discuss lack of evidence in the SEC proposal, and suggest questions that the SEC should answer if it wants to do meaningful economic analysis on the proposal.
CII’s core membership consists of U.S. institutional asset owners with more than $4 trillion in assets, managed for more than 15 million beneficiaries. Our associate members include non-U.S. asset owners with more than $4 trillion in assets, and asset managers with more than $35 trillion in assets under management.
We believe that the SEC proposal is technically flawed and would do substantial damage to U.S. corporate governance; is supported with very weak empirical data and poor economic analysis; and raises significant First Amendment issues.
The proposal depends on treating proxy advisors as if they are engaged in proxy solicitation, and then, because they are not, affording them an exemption if they satisfy conditions that would impair their independence and harm investors. Institutional investors seek research, analysis, and recommendations from proxy advisors and pay for those services. The SEC believes that because proxy advisors market their services to institutional investors, “solicitation” of business somehow makes their work product proxy solicitation. In competitive free markets, firms do market their services; this is a key element in how most markets work.
The SEC proposal would create formidable barriers to entry to the proxy advisory business and likely drive one or more present players out of the business. Along with the “solicitation” guidance, it would substantially increase litigation, staffing, and insurance costs. Proxy advisors will be able to pass on some of these costs to institutional investors (to be borne ultimately by fund beneficiaries), but there is no doubt that entering the business would be much more difficult. The SEC did not seriously consider impacts from its proposal on competition.
CII believes the market for proxy advisory services already is too concentrated. Further concentration will only add to costs facing investors and reduce quality of services by proxy advisory firms, including research and analysis.
Arguably the key component of the SEC’s regulatory scheme is its proposed requirements that management of companies subject to analysis and recommendations be given the right to (1) a minimum three-business-day period to review and provide feedback on a draft report; (2) receive the “final” report at least two business days before the report is distributed to paying clients; and (3) include a hyperlink to any company response to the proxy advisor’s analysis in the advisor’s research. It is striking that in the release on the proposal, the commission does not consider First Amendment issues whatsoever. A requirement by a federal agency that a private firm’s reporting be provided to review subjects (twice!), and forced speech involved in the hyperlink, both raise substantial issues of free speech.
A significant reason some of our members switched from ISS to Glass Lewis once Glass Lewis began offering a competitive choice is because they believed ISS’ practice of providing management of some companies (essentially the 500 largest U.S. public companies) the right to pre-review reports, including analysis and recommendations, compromised the independence of the ISS analysis. We believe an effect of the SEC proposal will be to force Glass Lewis and any other similar competitor into the ISS business model. The SEC proposal would thus eliminate market choice, forcing all investors who wish to avail themselves of outside proxy advice no choice – if they want it, they must pay for what they view as conflicted advice.
I would add that the SEC uses the ISS practice to justify making management pre-review a federal mandate. But a private firm opting to take certain actions with regard to its editorial product differs from a federal government mandate restricting speech.
The SEC also failed to even consider whether any of the requirements of FINRA Rule 2241 should be applicable to the proposed requirement for company review and feedback of the research reports of proxy advisors. FINRA Rule 2241, which was intended to prevent the impairment of the independence of analyst research reports, establishes specific procedures for limiting “sections of a draft research report . . . to the subject company for factual review.”
We also have some very pragmatic concerns with the SEC proposal. The management review requirements would delay publication of reports by at least five business days (one week). Presently, ISS on average delivers its reports to clients slightly less than 20 calendar days before the shareholder meeting. The SEC-imposed requirements will compress time for proxy advisor preparation of reports or delay delivery of reports to institutional investors by at least eight calendar days, assuming that a proxy advisor considers company comments at all. The process is already very challenging, particularly at the height of the highly compressed spring “proxy season.” It is not acceptable to CII members for the SEC to make this problem so much worse. By the way, in a presumably unintended consequence (from the standpoint of company lobbyists pushing for this regulation), one effect of the SEC proposal is that any opportunity for company engagement with investors on a proxy advisor recommendation likely would disappear.
The SEC says that certain provisions in the proposal are “intended to provide an incentive for registrants and others to file their definitive proxy statements as far in advance of the meeting date as practicable.” This is done by providing the review and feedback, “final notice” and “hyperlink” privileges only to companies that file proxy statements at least 25 days before the shareholder meeting and offering an extended review period for those that file at least 45 days before the shareholder meeting. But nearly all companies currently file at least 25 days before the meeting. The SEC did not do real research to understand when companies file proxy statements, even though it has that data in-house. The Center on Executive Compensation (which advocates for executive pay) reported on February 3, 2020, that it has asked for feedback to the SEC proposal from subscribers, and “no Center Subscriber reported any plan to alter” proxy filing schedules in reaction to the rule. It is very clear that, as designed, this “incentive” will not work.
Finally, I would note that the SEC cost/benefit analysis on its proposal is exceptionally weak. For example, for purposes of estimating costs, the SEC weirdly assumed that only one-third of companies will be subject to proxy advisor reports in a given year, even though elsewhere the SEC release notes that ISS and Glass Lewis publish many more reports than that would imply every year (and the law of Delaware and other states require annual meetings). In this and other respects, the analysis is remarkably uninformed on how the shareholder meeting and proxy voting process works.
The three commissioners who supported the proposal rely on the notion that there are pervasive errors in proxy advisor reports. But the SEC’s own evidence suggests the rate of factual errors in proxy advice is extremely low, and the mechanisms that proxy advisors have in place to correct any such errors are prompt and effective. Proxy advisors have strong incentives, through the market for their research and analysis, to provide clients accurate, high-quality advice.
SEC staff involved in the rulemaking have suggested, in meetings with us, that what matters most is that the regulatory approach ensure the lowest possible incidence of error, whatever the actual rate of errors in recent reports. This implicitly is an argument for a perfection standard, which is neither economically justified nor likely to be attainable given the nature of the requirements the SEC has proposed.
In our view, the SEC staff’s suggestion that the point is to reduce errors, no matter how low their present frequency, is a fallback argument that belies awareness that error rates are low and that many of the complaints are, instead, differences of opinion and preferences on methodologies.
What the proposal actually seems designed to do (as we have been told by SEC staff) is ensure that management will be comfortable that its perspectives will be reflected in the proxy advice that investors procure. We submit that the goal of management comfort is both itself unattainable and inappropriate. Investors privately order the advice specifically to obtain independent, critical analyses of management proposals on executive pay and other matters, just as they might have sought advice from independent, buy-side stock analysts before purchasing their shares and might read independent financial analyst reports when considering whether to continue to hold the shares.
Moreover, the commission ignored strong reasons to expect that its proposals will lead to more errors, and lower quality proxy advice, for reasons ranging from further compression of time to consider recommendations to the combination of management review of reports with a heightened threat of litigation. As asset manager Baillie Gifford said in a comment letter, the latter factors may lead to “watering down of advice…, rendering the advice too bland to be of use.”
ENDNOTE
[1] Amendments to Exemptions From the Proxy Rules for Proxy Voting Advice, Exchange Act Release No. 87,457, 84 Fed. Reg. 66,518 (proposed rule December 4, 2019), https://www.govinfo.gov/content/pkg/FR-2019-12-04/pdf/2019-24475.pdf.
This post comes to us from Ken Bertsch, executive director of the Council of Institutional Investors.