The Proxy Advisor Balance of Power May Be Shifting
The aptly termed “proxy plumbing” refers to the infrastructure underlying the proxy voting system and the SEC’s efforts to streamline and simplify it. After a number of roundtables, economic analysis, and stakeholder discussions, the SEC in late 2019 introduced both interpretive guidance and proposed rules on proxy matters.
The upshot? Plan for a lot of change in the proxy advisor landscape.
In this article, we’ll unpack the SEC’s clarification that proxy advisors engage in proxy solicitation, and the implications this has for executive compensation. We’ll start with a brief introduction of the latest events. After that, we’ll go over the implications to executive compensation, then get into the details of the SEC’s rule-making and ISS litigation in response.
In August 2019, the SEC issued interpretive guidance clarifying that proxy advisors engage in the act of proxy solicitation and, therefore, are regulated under the proxy solicitation rules in the Securities Exchange Act of 1934 (“Exchange Act”). The SEC also issued interpretive guidance clarifying the extent to which investment advisors should rely on proxy voting advice relative to performing their own independent diligence.
Then—three months later, on November 5—the SEC issued two proposed amendments to the Exchange Act, one of which adjusts and formalizes the interpretive release on proxy advisors engaging in proxy solicitation. By that time, Institutional Shareholder Services (ISS), the largest proxy advisory firm, had already filed a lawsuit against the SEC in response to the August interpretive releases.
This past January, the SEC filed an Unopposed Motion to Hold Case in Abeyance, which puts the litigation on ice until the final rules are released. This means there will not be any changes for the 2020 proxy season, but the SEC is under the gun to finalize the rules and make them public. The comments submitted to the SEC during the comment period were unusually contentious and it remains to be seen how much the final rules deviate from those proposed last November.
Implications for Executive Compensation
We’ll get back to the details of the SEC’s rule-making later. For now, let’s look at the big picture: How will executive compensation change if even a version of the proposed rule becomes law? Whatever the answer, our view is that it could be the biggest change that executive compensation has seen in a long time. Potential outcomes include:
A renewed opportunity for companies to tell their own narrative. The proposed rules create formal and direct feedback loops for companies to dispute statements made by proxy advisors and even include (via hyperlink) their counter-positions in proxy advisor reports. The current paradigm where ISS draws its conclusion with limited room for revision may be replaced by one in which investors gain a marketplace of competing perspectives and ideas. Technically this means more work for corporate issuers, but they’ll finally have a meaningful podium they can use to rebut a one-sided story from a proxy advisor.
What to do now:
- Develop recurring analytical processes to harvest metrics of interest. Most compensation teams will run basic total shareholder return (TSR) calculations for the proxy, but not much more. For a company to share a story of its own, it must procure dozens of diverse data points to analyze. This includes mimicking ISS’ own calculations and developing firm-specific metrics that are arguably more meaningful than the generic lineup crunched by ISS.
- Create a cross-functional team—think representatives from executive compensation, legal, investor relations, and outside consultants—to evaluate how active you should be in telling your own story. For example, as consultants we can develop numerous models to tell a particular story, but how proactive you should be in telling that story is a much broader decision. For an example of a very proactive messaging effort, see Abbott’s response to an ISS report from a few years ago.
Audit and fact-checking. The proposed rules subject proxy advisors to Rule 14a-9, which prohibits materially misleading misstatements and omissions. As a result, companies have a new platform for flagging errors in proxy advisor reports—but only if they develop the infrastructure to systematically pressure-test ISS’ number crunching and perform detailed reconciliations.
What to do now:
- Engage internal resources or an external firm to develop recurring processes that replicate as many ISS calculations as possible, therefore simplifying the reconciliation exercise of tying out ISS reports. We develop these processes, and we know that any organization with data access and experience building financial models can do so as well.
More opportunities for shareholder engagement. As investment advisors take up the challenge to think critically about proxy advisors’ voting recommendations, a window will likely open to enhance the quality and rigor of shareholder dialogue. Lately, many of our clients have been complaining that shareholders rebuff offers to engage, making it hard to maintain frequent dialogue. Perhaps this will change.
What to do now:
- Develop custom investor outreach materials that have a clearly defined purpose instead of just “getting together.” This is an important best practice, with or without changes in the proxy advisor landscape.
- In your outreach, be explicit in explaining what it is about your business strategy and fact pattern that proxy advisor reports are missing. This is teeing off the interpretive guidance to investment advisors stating they shouldn’t robotically follow proxy advisor policies.
More opportunities for diversity in plan design. For years, criticism has been building over homogenization in long-term incentive design and the need for incentive awards to reflect and reinforce the business strategy. It’s been hard to respond to this criticism given the pressure to be “vanilla” and fly under the radar. However, if the power that proxy advisors hold is set to diminish—and the pressure is on to get more customized analyses from investment advisors —then the time couldn’t be better to bring more diversity to long-term incentive (LTI) awards.
What to do now:
- Revisit LTI design with an eye to strategy, challenges and opportunities in retaining and motivating executives, and limitations in the current program architecture. This could entail different metrics, payout structures, and more.
The rise of EVA. 2020 marks the first full year in which ISS’ new economic value added (EVA) measure will be in use. Its complexity makes relative TSR look like a children’s coloring book. EVA is of course unrelated to the proxy solicitation rule-making, but it’s a catalyst for dissension among companies, ISS, and investors.
What to do now:
- Begin back-testing and producing your own EVA calculation processes so that if you do need to counter the story ISS tells, you’re ready.
Now let’s look at the issues the SEC weighed as they developed the proposed rules.
The SEC’s Core Issues
The SEC mainly wants securities holders to have voting guidance that’s accurate, verifiable, and serves their best interest. That may not be what the proxy advisory industry has always delivered, especially as rapid growth has given it unprecedented weight over shareholder vote outcomes.
Issue 1: Regulation of Proxy Advisors under the Exchange Act
Currently, proxy advisory firms are regulated by the Investment Advisers Act of 1940 (“Advisers Act”), which imposes a standard of fiduciary care. The proxy solicitation rules, which fall under the Exchange Act, set a much higher bar for information quality and accuracy. If the proxy solicitation rules under the Exchange Act are applied, this would materially expand the accountability imposed on proxy advisors for producing accurate information.
The SEC’s view is that the actions proxy advisory firms undertake are, in substance, solicitations that should fall under the purview of the Exchange Act. The Exchange Act defines solicitation as “a communication to security holders under circumstances reasonably calculated to result in the procurement, withholding, or revocation of a proxy.” Proxy advisors may not be engaging in this communication to empower themselves—but they’re certainly impacting proxy outcomes (or so the argument goes).
By adding language to 14a-1(l), the SEC is looking to clearly state that proxy voting advice falls within the scope of the Exchange Act. As per the proposed rule, the SEC notes 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 solicited, and that is furnished by a person who markets its expertise as a provider of such advice, separately from other forms of investment advice, and sells such advice for a fee.
As the SEC explains in its proposed amendment, “The purpose of Section 14(a) [of the Exchange Act] is to prevent ‘deceptive or inadequate disclosure’ from being made to shareholders in a proxy solicitation.” From a principles perspective, the SEC is saying it doesn’t care whether the proxy advisor is trying to consolidate power for itself (which is never the case) or simply impact proxy outcomes (which is the case), because both acts constitute solicitations as the Exchange Act defines them.
Issue 2: Exemptions to Information and Filing Requirements
Additionally, any entity or person engaging in a proxy solicitation faces certain information and filing requirements unless they can appeal for an exemption. The Exchange Act has two exemptions that exclude proxy advisors from this purview. Rule 14a-2(b)(1) exempts agents who are not seeking the power to act as a proxy for shareholders (ostensibly, ISS is just trying to sell advice) and Rule 14a-2(b)(3) exempts situations where advice comes from an “advisor.” Retaining these exemptions is important to both proxy advisors and investors who need rapid information flow.
The SEC proposed amending Rule 14a-2(b)to add new conditions to the exemptions. Basically, the SEC is willing to allow proxy advisors to remain exempt from the information and filing requirements as long as three concerns can be ameliorated. These concerns relate to potential conflicts of interest the proxy advisors have, the accuracy and completeness of the advice they give, and the need for recipients of proxy voting advice to receive counter information from the issuer in a timely fashion.
Therefore, the proposed conditions include requirements that proxy advisors:
- Disclose material conflicts of interest (and related items) and procedures in place to identify such conflicts
- Share a copy of their report with the issuing firm at least five (or even fewer, under certain circumstances) days before distributing the report to their clients
- Share an updated report, inclusive of revisions stemming from the advanced sharing, with issuers at least two days before distributing the report to their clients (this is at least partly intended to give issuers a chance to record a reply to the final voting advice)
- Include a hyperlink to the issuing company’s feedback on the report being distributed if the company duly requests it
These last three items are especially impactful. The SEC characterizes them as delivering improved dialogue between proxy advisors and issuers (before advising share-voting investors) and establishing a feedback loop between issuers and investors on the advice that proxy advisors put forth. The logic is that this improved marketplace of information will lead to fewer errors and more informed voting, thereby benefiting investors.
Finally, while the SEC would like to give proxy advisors a way to avoid the information and filing requirements, they are not exempt from Rule 14a-9, which provides a liability framework for misleading misstatements and omissions in proxy solicitations. In other words, Rule 14a-9 is the punishment clause for releasing bad information.
Failure to comply with the new exemption conditions will not automatically disqualify those exemptions as long as proxy advisors make a good faith effort toward compliance and take on remediation efforts in the event of noncompliance. An amended list of examples will be added to Rule 14a-9 to help parties gauge what constitutes misleading misstatements and omissions.
Issue 3: Obligations of Investment Advisers
The third development that bears mentioning is an interpretive release the SEC published in August 2019 clarifying expectations for investment advisors and the extent to which they rely on proxy advisor firms to inform their voting decisions.
The SEC is fundamentally worried about “robo-voting,” which describes the behavior of many institutional investors who automatically follow the voting recommendation of a proxy advisor. The guidance has six Q&A-style points that emphasize the importance of investment advisors customizing their frameworks and not overly relying on the input of proxy advisors.
The interpretive guidance is worth reading in its entirety, but the key point is that proxy advisors wield too much monopolistic influence, and additional controls should be imposed on them directly and indirectly via the entities that rely on their advice. This will further increase the onus on institutional investors to take customized approaches versus blindly relying on proxy advisor reports.
ISS’ Lawsuit Against the SEC
In response to the SEC’s interpretive August 2019 guidance, ISS on October 31 filed suit to declare the interpretive guidance unlawful. After the SEC released its proposed rules, ISS stated they would put the lawsuit on hold until they saw what the final rules would be. We suspect the final rules will be similar in principle to the proposed rules and that the lawsuit will resume in due time.
ISS’ complaint presents three reasons why the interpretive guidance is illegal:
1. ISS’ actions do not fall under the Exchange Act and the SEC does not have statutory authority to regulate them as such under Section 14(a) of the Exchange Act. It seems like ISS’ core argument is that they’re not a proxy solicitor, so it’s unlawful to put ISS under the purview of the Exchange Act when the Investment Advisers Act of 1940 is the appropriate governing regulation.
2. The SEC exceeded their rulemaking authority in the interpretive release by bypassing the notice-and-comment procedures of the Administrative Procedure Act.
3. The interpretive release is arbitrary and capricious. This argument attacks the SEC’s claim that it isn’t changing its position when, according to ISS, the change is non-trivial and there is no evidence that the regulatory framework in the Investment Advisers Act is insufficient.
Our view is that the SEC’s proposed rules from November 5, 2019 will substantially short-circuit arguments two and three. The proposed rule is intended to follow the Administrative Procedure Act and has invited extensive commentary. Additionally, the SEC explains in even greater detail the basis for its position and why its position is consistent with historical actions taken to broaden and interpret proxy solicitation in a principles-based fashion.
That leaves the first argument that the nature of ISS’ actions do not logically meet the definition of proxy solicitation. Here we’re also skeptical of ISS’ ability to prevail, given a court must effectively rule that the SEC can’t revise and amend the Exchange Act. That’s a tall order given the decades of precedent that already exist in the SEC amending the Exchange Act to fit evolving circumstances.
In any event, this lawsuit is likely to drag on for quite some time and we intend to monitor it closely.
In many respects, the SEC waited, planned, analyzed, and waited some more…before springing into action in late 2019 with a comprehensive series of interpretive releases and proposed rules. The clarity and relative suddenness of it took nearly all industry experts by surprise. But here we are, on the precipice of a major shift in the power that proxy advisors hold.
The implications for executive compensation are profound if the SEC’s proxy plumbing initiative shakes out the way we predict. Companies can become bolder and more creative in how they design LTI programs. Meanwhile, they must invest in stronger internal processes to productively deploy the new accountability they will have over proxy advisor work product. If you would like to discuss how we could help in any of these capacities, please don’t hesitate to reach out.