Public companies decry what they see as the outsized influence of proxy advisory firms on shareholder votes, while the institutional investors that are the clients of these firms support what they consider to be essential services and maintain that these firms’ influence on voting decisions is overstated. This controversy over the role and impact of proxy advisory firms on the corporate governance of public companies has been ongoing for more than a decade.
The debate came to a head in late July when the Securities and Exchange Commission (SEC) amended its “Proxy Rules” to add a new rule governing voting advice provided by proxy advisory firms (the “Final Rule”). (The SEC uses the term “proxy voting advice business,” but this article uses the more common nomenclature). The Final Rule has been challenged by Institutional Shareholder Services, Inc. (“ISS”), the largest proxy advisory firm; ISS has also challenged the substantially similar Interpretation and Guidance (the “Guidance”) issued by the SEC in August 2019.
State corporate laws generally provide that shareholders may either cast their votes in person at a shareholder meeting or give their proxy to others (often a representative of the company) to cast their votes. The SEC has had authority to regulate the “solicitation” of proxies since the enactment of the Securities Exchange Act in 1934. As explained in its release adopting the Final Rule (the “Adopting Release”), the SEC has promulgated rules regulating proxy solicitation under Section 14(a) of the Exchange Act since 1935 and has amended them periodically in response to market developments. The focus of these rules, as with many of the federal securities laws, is “full and fair” disclosure: persons who solicit proxies (including the public company) must publicly file their proxy solicitation materials and other required information in advance with the SEC, unless an exemption applies.
Proxy advisory firms provide recommendations to their fee-paying clients on how to cast their votes at shareholder meetings. Their recommendations are usually accompanied by written analysis based on the firms’ research and benchmark voting guidelines. Their clients are usually institutional investors, such as pension funds and mutual funds, who either vote their proxies directly or delegate the voting decisions to their external investment managers. As share ownership has become largely institutional (rather than individual), the impact of the advice provided by proxy advisory firms has also become more significant.
Among the several reasons for this is that institutional investors are voting annually on thousands of ballot items for hundreds of portfolio companies (and generally over a short period of time, since in the U.S. most annual meetings are held between late February and the end of June—a.k.a. “proxy season”). For an explanation of the proxy “ecosystem,” see a 2010 SEC Concept Release and also here. Some academic and other studies (summarized in footnote 481 of the Adopting Release mentioned above) indicate that a vote recommendation by a major proxy advisory firm can affect about 25% of votes cast.
Public companies have raised concerns about whether the underlying facts proxy advisory firms’ rely on for their recommendations are inaccurate; whether the rationales for the recommendations are sufficiently transparent; and whether the firms have conflicts of interest (potentially undisclosed) that influence their recommendations. Companies have also raised concerns that institutional investors cast their proxy votes soon after the vote recommendation issues, without the chance to consider any response that the company may have to that recommendation, including potentially to correct underlying factual errors. The Final Rule seeks to address these concerns.
After the SEC issued the Guidance in 2019, ISS challenged that action in the DC District Court. When the SEC quickly moved to propose a rule along the same lines as the Guidance, the case was put in abeyance pending a final rule. Soon after the final rule was published, ISS renewed its case by filing an amended complaint and motion for summary judgment, asking that both the Guidance and the Rule be vacated as arbitrary and capricious, contrary to law, and unconstitutional. Since the case is based entirely on legal arguments, there is no need for discovery, and an abbreviated briefing schedule was agreed among the parties. The SEC filed its response and cross motion for summary judgment on October 30, 2020. Final responsive briefings by the parties in the case will be completed by December 9, 2020, after which the court will set a hearing date.
The SEC amended the Proxy Rules to provide that the vote recommendations of proxy advisory firms are “solicitations” within the meaning of the Securities Exchange Act, which regulates solicitations heavily. At the same time, the new rule exempted vote recommendations from the rules requiring that proxy solicitation materials and other information be filed, as long as the proxy advisory firms comply with certain conditions. These conditions include enhanced disclosure obligations (including specifics about potential conflicts) and a requirement that a proxy advisory firm (i) provide the public company a copy of its vote recommendation before or at the same time it provides it to its clients, and (ii) provide clients “with a mechanism by which they can reasonably be expected to become aware of any written statements regarding the advice filed by the [public company] in a timely manner before the shareholder meeting. The rules are effective as of November 2, 2020, with a deadline of December 1, 2021, for compliance with the disclosure and procedural conditions.
In its complaint, ISS makes a number of claims that one would expect in a challenge to an agency’s rulemaking. Three are of particular interest: (i) the SEC has redefined the term “solicitation” inconsistent with the plain meaning of the statute and the purpose of Exchange Act Section 14(a); (ii) an alternative means for regulating the proxy advisory business of ISS is available under the Investment Advisers Act of 1940 (the “Advisers Act”); and (iii) aspects of the rule violate the First Amendment.
ISS challenges the SEC’s alleged expansion of the meaning of the statutory term “solicitation,” arguing that while a person who “solicits” proxies urges shareholders to vote a certain way in order to achieve a specific outcome in a shareholder vote, ISS has no interest in a particular outcome. It cites dictionary definitions from the 1930s in support of its view as to what was understood to be the plain meaning of “solicit.” The SEC, in defending the Final Rule, argues that the activity is within its own traditional treatment of the term, citing other dictionary definitions and maintaining that since 1956 that it has defined proxy solicitation to “include any communication to shareholders under circumstances reasonably calculated to result in the procurement, withholding, or revocation of a proxy.” Further, the SEC argues that the Final Rule is a codification of its “long-standing” views that proxy voting advice falls within this definition. It tells the court that its interpretation of the term “solicitation” is subject to the deferential two-step Chevron test, and should be upheld.
ISS has registered with the SEC under the Advisers Act, while the other two major proxy advisory firms (Glass Lewis and Jones-Eagan) have not; those firms reportedly rely on the so-called “publishers’ exclusion” from registration. ISS also argues that the SEC’s concerns about proxy advisory firms’ potential conflicts of interest are addressed by the Advisers Act. Under relevant case law, the Advisers Act has established a federal fiduciary duty, under which the “duty of loyalty” has been interpreted to include elimination or disclosure of potential conflicts of interest and the avoidance of false or misleading statements. Advisers registered with the SEC are required in Form ADV to make detailed disclosures to their clients, including about potential conflicts.
In noting that not every proxy advisory firm is registered under the Advisers Act (and thus subject to a federal fiduciary duty), the SEC defends its decision to regulate proxy voting advice under the Exchange Act by asserting that (i) the Advisers Act and Section 14(a) serve “distinct, though overlapping” regulatory purposes, and (ii) their choice of the Exchange Act “safeguards the interests not only of the clients of proxy voting advice businesses—the solicited shareholders—but also of the company’s other shareholders, the company, and the broader proxy voting system.” It notes as well that Congress has created overlapping regulatory regimes in other provisions of the federal securities laws
ISS further asserts that the rule violates the First Amendment by conditioning exemption from the proxy rules on the proxy advisory firm providing its vote recommendation to the public company and providing a mechanism for the public company’s response to be accessible to the firm’s client. It argues that this constitutes “viewpoint discrimination,” in that it elevates one viewpoint (that of the public company) over others, and that the rule is thus, under Supreme Court precedent, subject to the “strict scrutiny” tier of review. Under this kind of review, ISS argues that the SEC did not narrowly tailor the Final Rule to achieve its claimed interests and that laws that “seek to commandeer one person’s speech to facilitate someone else’s” have been invalidated by the Supreme Court as unconstitutional “compelled speech.”
The SEC’s response to the First Amendment argument is that the exemption conditions warrant “at most” the level of scrutiny that applies to commercial speech, which is a lower standard than strict scrutiny and therefore easier for an agency to meet. It avers that courts have analyzed First Amendment claims under the federal securities laws differently than in other circumstances, as these laws reflect a comprehensive regulatory regime which requires a different balance of interests and thus a lesser standard of First Amendment scrutiny. The SEC alternatively argues that the Final Rule will withstand any level of First Amendment scrutiny.
The challenge to the Final Rule has already drawn an amicus filing in support of ISS by the Council of Institutional Investors (joined by a number of public pension funds, each of whom identifies as an ISS client), an amicus brief in support of the SEC led by the U.S. Chamber of Commerce and joined by several other trade associations, and an a motion to intervene (with a conditional cross motion for summary judgment) from the National Association of Manufacturers seeking to uphold the rule.
Whatever the D.C. District Court decides, an appeal to the D.C. Court of Appeals seems highly likely. Keep an eye on this case as it moves through the courts.