September 19, 2018

Farient Alert: SEC Rescinds Guidance Providing Regulatory Support for Using Proxy Advisors

On Thursday, the SEC rescinded two guidance letters from 2004 that will potentially reduce the influence that ISS has on, among other things, Say-on-Pay votes.

These guidance letters informed investment managers that outsourcing their proxy voting decisions to proxy advisors would satisfy their obligations as fiduciaries to vote their shares while avoiding potential conflicts of interest with regards to companies whose funds they may be managing. For example, if Vanguard has proxies to vote for a company in one of its index funds, and that company also uses Vanguard in managing its pension fund, Vanguard could conceivably be influenced by its business relationship with that company to vote with management on the proxy matters. By essentially delegating to ISS or Glass-Lewis the votes on its shares in that company, Vanguard would be “cleansed” of potential allegations of conflict, based on the 2004 letters. With that guidance rescinded, Vanguard and others can choose to vote according to their own determination of the merits of each proxy resolution, which may or may not correspond to proxy advisor recommendations.

Critics of these SEC guidance letters have argued that they effectively institutionalized proxy advisory firms, especially ISS, as de facto regulators without the oversight required of actual regulators, and that over-reliance on such firms may not be in investors’ best interests.

ISS’s business model is arguably built largely on regulatory requirements, especially the 2003 SEC rule mandating that investment managers disclose their proxy voting policies (and votes) and the 2010 Dodd-Frank Act mandating Say-on-Pay, among other provisions. Many of the larger institutional investors have built internal governance expertise to guide voting decisions, using ISS data to help them screen companies to target, while smaller funds have generally found it more cost effective to meet these requirements by essentially outsourcing their votes to ISS. The larger firms, however, have also outsourced many of their votes due, in part, to the 2004 guidance letters because they are more likely to sell investment management to the companies that they also invest in.

Research indicates that ISS has gained significant influence over shareholder voting and, consequently, on corporate governance policies. As their influence has grown, ISS’s dominance has been increasingly challenged by public companies and certain governance critics who have focused on ISS’s own potential conflicts of interest and the quality of the research and standards behind their recommendations.

Following more recent SEC guidance for casting their votes in their client’s best interest should provide investment managers a strong basis for defending their voting decisions, even as they reduce their reliance on proxy advisors. The impact of this rescission is not expected to be very significant in terms of how investors generally oversee compensation governance. But it does portend continued push-back on ISS’s influence as the SEC prepares for its November roundtable on potential regulation of proxy advisors.

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