The Corporate Governance Reform and Transparency Act of 2017 (H.R. 4015) aims to enhance transparency in the shareholder proxy systems. It does so by requiring proxy advisory firms to register with the Securities and Exchange Commission (SEC), disclose potential conflicts of interest and codes of ethics, and make publicly available their methodologies for formulating proxy recommendation and analyses.
Proxy advisory firms have seen significant growth recently. Proxy advisors advise investors on both the nature of matters up for vote and further on how to vote their shares on major corporate decisions, including mergers and acquisitions, elections of directors, executive compensation and important corporate governance policies. While proxy advisors were originally established as an impartial check-and-balance on institutional investor voting, two key players, Institutional Shareholder Services (ISS) and Glass Lewis, now claim 97% of the market share. Supporters of H.R. 4015, which is backed by a number of today’s companies and boards of directors, now argue that the proxy advisor pendulum of impartiality has swung too far in the opposite direction.
Background and Legislative History
H.R. 4015 was passed by the House of Representatives on December 20, 2017, by a vote of 238 -182. The vote was along party lines, with 226 Republicans and 12 Democrats voting Yea and six Republicans and 176 Democrats voting Nay. Eleven members did not vote. The Bill has been passed to the Senate for its consideration.
H.R. 4015 was introduced on October 11, 2017, and sponsored by Sean Duffy, Representative from Wisconsin’s 7th District. The Bill was originally introduced in the prior 114th Congress (as H.R. 5311) by Representative Duffy on May 24, 2016, but was not enacted during that term. The current Bill is co-sponsored by Lamar Smith (R-TX-21) and Gregory W. Meeks (D-NY-5).
H.R. 4015 was introduced as an addition to the existing Securities Exchange Act of 1934 as Section 15H. Registration of Proxy Advisory Firms. The House Financial Services Committee submitted its Report on the Bill on December 7, 2017, with both the majority and minority views.
In summarizing the need for the Bill, the majority provided the rationale for the Bill and raised several key points, including:
- When public companies hold annual shareholder meetings during which shareholders vote for directors and vote on significant corporate actions, the SEC requires that these companies provide a proxy statement to their shareholders prior to shareholder meetings. Such statements contain detailed information for voters about the matters to be voted on at a shareholder meeting in order that shareholders are well versed on information on board of director candidates, director and executive compensation, any related party transactions, the ownership of securities by certain beneficial owners and management, and other eligible shareholder proposals. This information is required to be filed with the SEC before soliciting a shareholder vote on each of these matters.
- In 2003, the SEC adopted a rule under the Investment Advisers Act of 1940 providing all investment advisers that exercise voting authority over the proxies of their clients to follow policies and procedures requiring that the investment advisers vote those proxies in the best interests of their clients. Significantly, the SEC rule covers institutional investors, including investment advisers to mutual funds and pension funds. These firms frequently hold shares in a large number of public companies, and the investment advisers for these funds vote “billions of shares on behalf of their clients on thousands of proxy ballot items.”
- In order to protect themselves from conflicts of interest and understandable scrutiny of votes, investment advisers instituted a process to demonstrate impartiality, i.e., to show that their votes were in the best interests of their clients and not influenced by a conflict of interest, by voting pursuant to a predetermined policy following from the recommendations of an independent third party – proxy advisory firms.
- According to the majority, as a result of the SEC’s regulations, “proxy advisory firms now wield outsized influence in the U.S. proxy system.” Additionally, the supporters of the Bill believe that the existing SEC regulations do not entirely eliminate potential conflicts. Market participants, academic observers and others have highlighted potential conflicts of interest inherent in the business models and activities of proxy advisory firms themselves. “For example, proxy advisory firms may feel pressured by their largest clients — many of whom are activist investors — to issue voting recommendations that reflect those clients’ specific agendas.”
- In its Report, the Committee noted that, “it is aware of numerous instances whereby the two largest proxy advisory firms have issued vote recommendations to public company shareholders that include errors, misstatements of fact, and incomplete analysis.” Additionally, Committee findings suggest that some proxy advisory firms have not contacted companies prior to a vote disclosing their recommendations. Also, some proxy advisory firms have attempted to encourage companies to join their service in order to gain the privilege to “influence” an advisory firm’s recommendations.
Key Provisions of H.R. 4015
The Bill defines a Proxy Advisory Firm as:
any person who is primarily engaged in the business of providing proxy voting research, analysis, ratings, or recommendations to clients, which conduct constitutes a solicitation within the meaning of section 14 and the Commission’s rules and regulations thereunder, except to the extent that the person is exempted by such rules and regulations from requirements otherwise applicable to persons engaged in a solicitation. 3(a) 81.
The key requirement of H.R. 4015 is registration:
- A proxy firm must file with the SEC “an application for registration” in a form determined by regulation, which must contain:
- Certification that the proxy advisory firm is consistently able to provide “proxy advice based on accurate information”;
- The “procedures and methodologies” the firm utilizes in making its recommendations and any information demonstrating “whether and how” the firm takes into consideration the size of the company when making its recommendations;
- The structure of the firm’s organization;
- Verification that the firm has a code of ethics and, if not, why not;
- Disclosure of any actual or potential conflicts of interest relating to the company for which it provides services and whether the firm provides any ancillary services for compensation with the company; and
- Practices and policies in place to manage conflicts.
- The Commission will render a decision within 90 days as to whether the application is approved. If denied, a process for a hearing is then available.
- Transparency is paramount and all registrations and related documents are made available on the SEC website.
- Ongoing updates of any changes within the proxy advisory firm’s processes or practices must be submitted to the Commission and “Each registered proxy advisory firm shall establish, maintain, and enforce written policies and procedures reasonably designed, taking into consideration the nature of the business of such registered proxy advisory firm and associated persons, to address and manage any conflicts of interest that can arise from such business.”
- Proxy advisory firms are required to develop and maintain procedures that will permit companies subject to proxy advisory firm recommendations three business days’ access to the firm’s draft recommendations, and to provide the companies an opportunity to comment on the recommendations and present details to the person responsible for developing the recommendation in person or telephonically.
Minority View and Opposition to H.R. 4015
Opposition to H.R. 4015 is perhaps best summed up by the comments of Committee member Maxine Waters, D-Calif., who stated that the bill would undermine good corporate governance and create an “untested and burdensome” regulatory framework that would defeat the purpose for proxy advisory firms and shareholders that rely on them for unbiased advice. The bill “would essentially fulfill the wishes of corporate management by regulating proxy advisory firms out of existence,” she said.
The Bill’s Report outlined other minority views:
- While the Bill’s purported goal is to promote ‘‘accountability, transparency, responsiveness, and competition in the proxy advisory firm industry,’’ the minority believes that the Bill will interfere with shareholders’ access to impartial analysis intended to inform proxy voting decisions, thus undermining shareholders’ ability to hold corporate management accountable. Additionally, H.R. 4015 “would stifle, rather than promote, competition in the industry by erecting significant barriers to entry for new proxy advisory firms.”
- The Bill is premised on a false belief that “shareholders are too powerful,” and that proxy advisory firms are coerced to serve ‘‘activist’’ shareholder interests. The minority view holds that the largest proxy advisory firm came down on the same side as company management on 88 out of every 100 executive pay proposals in 2017. When the proxy advisory firm recommended a ‘‘no’’ vote on these proposals, “a majority of shareholders agreed less than 2 percent of the time.”
- H.R. 4015 will tend to compromise proxy advisory firms’ independence by subjecting them to lobbying from companies before they can issue voting recommendations. This requirement would also “further reduce the already limited time shareholders have to develop independent and informed voting decisions.”
- Finally, written comments to the Committee have pointed out that H.R. 4015 would have the tendency to reduce the number of firms able to offer independent proxy advisory services, because the costs of registering with the Securities and Exchange Commission and “complying with the bill’s burdensome requirements would disproportionately impact new or smaller firms.”
It is too early to say how H.R. 4015 will fare in the Senate, though it is safe to say that it will be an uphill battle for proponents of the Bill in the current political environment, compounded by the number of matters on the Senate’s plate this term.
For today’s companies and boards of directors, H.R. 4015 offers protection against the potential harm caused by a proxy advisor’s negative vote recommendation based on an error of calculation in the middle of a busy proxy season.
Were the Act to pass, however, an entirely new set of challenges would be presented to both sides, as the implementation of H.R. 4015 would require significant coordination of proxy advisors, companies, boards and regulators, particularly if a third-party ombudsman solution were to be involved.