On October 31, 2019, Institutional Shareholder Services Inc. ("ISS"), a provider of corporate governance and investment solutions to financial market participants, announced that it filed a lawsuit1 against the U.S. Securities and Exchange Commission (the "SEC") seeking injunctive and declaratory relief in response to SEC guidance released on August 21, 2019 (the "Proxy Adviser Release"). In light of the proposed amendments published by the SEC less than a week later, this lawsuit may be the first of many battles to come.
The Proxy Adviser Release, passed by a vote of 3-22, states that (i) generally, proxy voting advice provided by a proxy advisory firm constitutes a solicitation under the federal proxy rules and (ii) Securities Exchange Act of 1934 (the "Exchange Act") Rule 14a-93 & applies to proxy voting advice. Effectively, the Proxy Adviser Release treats the advice that proxy advisers give to their clients in the same way that the SEC regulates proxy solicitations.
In its complaint, ISS argues that the Proxy Adviser Release is:
(i) unlawful because it "exceeds the SEC's statutory authority under Section 14(a) of the Exchange Act and is contrary to the plain language of the statute"
(ii) "procedurally improper because it is a substantive rule that the SEC failed to promulgate pursuant to the notice-and-comment procedures of the Administrative Procedure Act" and
(iii) "arbitrary and capricious" because, even though it marks a significant change in the regulatory regime applicable to proxy advice, the SEC did not "provide reasoned explanation for its action...indeed the [Proxy Adviser] Release neither recognizes nor acknowledges that its conclusions contradict and depart from decades of SEC precedent recognizing that advice rendered at the request of a shareholder in the context of a fiduciary relationship does not constitute proxy solicitation."
The Proxy Adviser Release notes that "persons engaged in a solicitation in the form of proxy voting advice, including proxy advisory firms, may avail themselves of the exemptions from the information and filing requirements of the federal proxy rules." However, on November 5, 2019, five days after ISS filed suit against the SEC, the SEC put forth a proposal4 (the "Proposal") that, if adopted, would amend several Exchange Act rules. These amendments would not only impose additional disclosure requirements on proxy voting advice businesses relying on the proxy rule exemptions but also potentially create a chilling effect on certain recommendation reports.5
First, the Proposal would codify the Proxy Adviser Release by amending Exchange Act Rule 14a-1(l) to add a paragraph to make clear that the terms "solicit" and "solicitation" include any proxy voting advice that makes a recommendation to a shareholder as to its vote, consent, or authorization on a specific matter for which shareholder approval is solicitated, and that is furnished by a person who markets its expertise as a provider of such advice, separately from other forms of advice, and sells such advice for a fee. The Proposal would also codify the SEC's view that voting advice provided only in response to an unprompted request would not constitute a solicitation.
Second, the Proposal would amend Exchange Act Rule 14a-2(b), which provides exemptions from the filing and information requirements of the proxy rules. Under the Proposal, proxy voting advice businesses that rely on those exemptions would be subject to, among other things, the following conditions:
(i) disclosure of material conflicts of interest included in their proxy voting advice (as well as a discussion of the policies and procedures, if any, used to identify and steps taken to address such potential and actual conflicts of interest);
(ii) an opportunity for registrants and other soliciting persons to review and provide feedback on proxy voting advice before it is issued (such period of review to be no fewer than 3 business days if the registrant files its definitive proxy statement less than 45 but at least 25 calendar days before the date of its shareholder meeting and no fewer than 5 business days if the registrant files its definitive proxy statement 45 calendar days or more before its shareholder meeting); and
(iii) upon request, provide an improved means for investors to be informed about the registrant's views on the advice (e.g., a hyperlink or analogous electronic medium in the voting advice).
Third, the Proposal would modify Exchange Act Rule 14a-9 to include examples of when the failure to disclose certain information in the proxy voting advice could, depending on the situation, be considered misleading within the meaning of the rule (e.g., failure to disclose information such as the proxy voting advice business's methodology, sources of information and conflicts of interest).
At the meeting where the Proposal was announced, SEC Chairman Jay Clayton stated that the Proposal is "rooted in two essential aspects of effective regulation - modernization and retrospective review. In today's proposals, we have examples of why modernization of regulation, including to adjust for market developments and advances in technology, is critical. Twenty years ago, the business of providing proxy voting advice was virtually non-existent. Today, there are thousands of investment advisers managing trillions of dollars in assets for our retail investors, and many of these investment advisers contract with businesses to provide proxy voting advice, which is subject to our proxy rules. Several of these proxy voting advice businesses are large and multi-faceted. Their services to investment advisers, and their effect on shareholder engagement and our capital markets more generally, are comparable to the services of other significant third-party market participants on whom shareholders rely, including auditors, rating agencies and research analysts. These market developments require our attention.”6
This attention, however, particularly the enhanced review and feedback of proxy advisers' reports, could make it more costly and more difficult to get recommendation reports out to investors in a timely manner. Registrants may use the new access provided for in the Proposal to “complain about provisions in draft reports targeting CEO pay and peer group composition rather than [remedying] errors." It also could increase tensions between incumbent and dissident director candidates who may argue with the proxy advisers on the details of the report. Additionally, some critics have said the review and feedback opportunity gives registrants an advantage over activist shareholders because registrants, already having almost unlimited discretion over their proxies, will also have the right to include their response in a proxy adviser's recommendation report. Given the scope of the Proposal, the ISS lawsuit and the question of whether proxy voting advice provided by a proxy advisory firm constitutes a solicitation under the federal proxy rules will be of particular significance.
1The full complaint is available here: https://www.issgovernance.com/file/duediligence/iss-oct-31-2019-complaint.pdf
2The two dissenting Commissioners, Robert Jackson and Allison Lee, objected to the failure by the SEC to study the potential impact of the Proxy Adviser Release.
3Exchange Act Rule 14a-9 prohibits any solicitation from containing any statement which, at the time and in the light of the circumstances under which it is made, is false or misleading with respect to any material fact.
4The SEC’s press release announcing the proposal is available here: https://www.sec.gov/news/press-release/2019-231
5The full proposal is available here: https://www.sec.gov/rules/proposed/2019/34-87457.pdf
6The full statement is available here: https://www.sec.gov/news/public-statement/statement-clayton-2019-11-05-open-meeting
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