The US Securities and Exchange Commission (SEC) has proposed two new rules aimed at putting restrictions on proxy advisory services. The proposals reflect the first substantive modifications to the proxy voting process in the US for decades. This is an example of a theme at the SEC where they are revisiting the foundational rules of the US securities market with a view to modernize and ensure rules are fit for purpose for the current market conditions. The changes have been welcomed by some and vehemently opposed by others, creating a schism between larger and smaller investors. At the vote, Commissioner Elad Roisman acknowledged the industry discord and said the proposal drafting had “involved much line-drawing along the way.”
The proposed proxy voting changes are now subject to a public comment period which remains open for 60 days from publication. That means interested parties have until mid-January 2020 to submit comments, and it appears that a vocal and robust public debate on the various changes will ensue. The differences in opinion on the proposals were even evident in the result of the SEC vote with the commissioners split three-to-two in favor of the proposals.
The proposed rule changes are seen as a major victory for US companies, the US Chamber of Commerce, and the National Association of Manufacturers, each of whom have campaigned to curb the power of the proxy advisory firms.
Proxy voting generally refers to an asset manager (or any shareholder) who delegates their voting power to an appointed representative (a proxy) to vote in their absence at corporate shareholder meetings. Proxy voting is particularly important in the US, where investment advisers often vote proxies on behalf of their underlying client accounts. The chief responsibility of a proxy advisor is providing asset managers and asset owners research, voting platforms to help them with corporate governance, and stewardship.
But they were opposed by many institutional investors who rely on the two main proxy advisory firms, Institutional Shareholder Services (ISS) and Glass, Lewis & Co. The two firms account for 97% of proxy advice. In fact, the negative sentiment at the proxy voting firms is so strong that regardless of the final ruleset, many predict these changes are ultimately destined for the US Court of Appeals.
Many larger organizations welcome the increased efficiency that the proposals could bring to the proxy voting process, however, some investors feel they didn’t ask for these changes and the current system was working well. Some also feel the proposed rules could exclude smaller investors from the shareholder resolution process.
The SEC was spurred to take action by this years’ Business Roundtable, which claimed the current shareholder proposal process is “out-of-date.” If the new rules materially reduce investor proposals from smaller investors, then the onus (and concentration of management focus) may shift more predominantly to larger institutional investors to actively file proposals.
These rule changes are the third step by the SEC to rein in proxy advisory firms recently. The commission hosted roundtables on the mechanics of proxy firms in 2018 and in August 2019. Additionally, the agency issued legally binding “interpretation and guidance” about the extent to which investment advisers may outsource to proxy advisory firms while fulfilling their fiduciary duty to shareholders. SEC Chairman Jay Clayton said their conduct must include “reasonable due diligence, reasonably identifying and addressing conflicts, and full and fair disclosure.”
Corporate stewardship, voting records, and themes such as ESG have never been under greater scrutiny within asset management as they are today. Historically, those issues emanated first from smaller individual investors and were then picked up by institutional investors to advance. Critics of the proposals suggest that with fewer smaller investors to raise these issues, there is a chance that some may not bubble up or move as fast as they should. In truth, only time will tell.
Chairman Clayton maintained at a public hearing in Washington that these rules were necessary because of the changing nature of US public share ownership and the concentration of holdings now lying primarily with a select grouping of prominent investment firms rather than private individuals. Institutional investors now control 80 percent of public shares, compared with just 10 percent in 1950. Nonetheless, he said that just five people submitted 78 percent of all the proposals submitted by individual shareholders, which he said was out of alignment with the needs of the majority of shareholders.
One major rule change would require proxy advisers to submit their advice to the companies involved in advance of making their recommendations, and provide the firms with an opportunity to include a link to company material challenging the proxy advisors' methods and conclusions. Managers must be available to discuss any proposed changes with company management before a vote.
Another change would raise the bar for shareholders wanting to submit shareholder proposals at annual meetings or to resubmit failed proposals in subsequent years. This change aims to limit investors who may have disrupted meetings in the past and account for the majority of shareholder proposals.
Currently to be eligible to submit a proposal for consideration a shareholder must hold at least $2,000 or 1 percent of a company's securities for at least one year to be deemed eligible. Under the new rules, they must have ownership of:
- at least $2,000 of the company's securities for at least three years (locking out new investors)
- ownership of at least $15,000 of the company's shares for at least two years, or
- ownership of at least $25,000 of the company's securities for at least one year.
To resubmit a proposal that failed to pass in previous years, the bar has also been raised to make it harder to keep resubmitting proposals. The new level will be 5 percent (up from 3 percent), 15 percent (up from 6 percent), and 25 percent (up from 10 percent) of votes cast once, twice, or three or more times in the last five years. The proportional increase in thresholds means that it is extremely difficult now for small minority shareholders to have previously defeated proposals reconsidered without significantly increasing their stake in the company. This is seen as another step towards consolidating voting power in the largest institutional investors to the detriment of the smaller investor. It also adds a new provision that excludes proposals that have been previously voted on three or more times in the last five years if the number of votes declines by 10 percent compared with previous ballots.
Mixed industry reaction
The Council of Institutional Investors, which includes many fund managers and pension funds, argues that the rules will increase their costs and delay the availability of voting advice. It maintains that most of the objections raised by companies to proxy advisory services concern recommendations to vote against compensation for the company management.
“It speaks volumes that the institutional investors which hire proxy advisers are not the ones calling for new, more onerous rules such as those now being contemplated,” said Gary Retelney, president and CEO of ISS, in a statement.
Investor advocacy groups have also express concerns around the proposals which govern certain thresholds for participation in the proxy voting process. And the ISS filed a suit to block the guidance from taking effect. Many predict that given the consequential impacts on their current business model that more legal appeals are likely.
Can’t please everyone
The SEC believes that the proposed amendments appropriately balance shareholders’ ability to submit proposals and vote on corporate matters with the costs incurred by listed companies and their shareholders to conduct the proxy voting and shareholder engagement process. In a time where corporate activism, ESG, and stewardship are of peak interest in global asset management, this debate shows that while public security ownership is concentrated among a smaller number of large institutional entities, the SEC maintains there should be a transparent and efficient proxy voting process. While this concentration of ownership is obvious, advocates for the smaller investor claim that they must retain their voice and ability to engage with management of companies through the voting process. Smaller shareholders often help to bubble up pertinent issues for consideration and higher ownership thresholds would hinder their participation, some argue.
However, like plenty of regulations before this, the new rules may have some unintended consequences. The industry will continue to engage where they see it becoming more difficult for smaller stakeholders to take part in decision making and advocacy.