Introduction

In a move that underscores the importance of proxy voting today as a subject of securities regulation, the Securities and Exchange Commission on August 21, 2019 approved two separate releases (collectively, the “Guidance”) that will be effective upon publication in the Federal Register. The first release is a policy statement that provides reasonably comprehensive guidance and interpretive advice on the proxy voting responsibilities of investment advisers under Rule 206(4)-6, the proxy voting rule, under the Investment Advisers Act of 1940. In the second release, the Commission declared that the provision of proxy voting advice by proxy advisory firms is considered a solicitation under the federal proxy rules and provided new guidance about the availability of exemptions from the federal proxy rules as well as the applicability of the proxy anti-fraud rule to proxy voting advice.

Investment Advisers’ Proxy Voting Responsibilities

Issued in question and answer format, the Guidance relating to the Advisers Act addresses six questions relating to an investment adviser’s fiduciary duty to act in its clients’ best interest when discharging its proxy voting responsibilities under the Advisers Act.

Six Q&As: In three of these Q&As -- the first, the second, and the sixth -- the SEC considers questions concerning the application of an investment adviser’s fiduciary duty when it has accepted responsibility to vote securities held in a client’s account. In the remaining Q&As -- three, four, and five -- the Guidance contains a discussion of the exercise of this fiduciary duty when an investment adviser retains a proxy advisory firm to assist in handling its proxy voting responsibilities. Because many investment advisers use proxy advisory firms to perform various proxy voting functions and services, the guidance offered in these Q&As is particularly important to advisers.  

In the first Q&A, the SEC notes that an investment adviser is not obligated to accept responsibility to vote securities held in its clients’ accounts. The SEC recommends that if the investment adviser decides to accept this responsibility, however, it should establish the scope of this authority by agreement with its clients, including the types of matters for which proxy voting authority will be exercised. As the SEC has stated recently in other contexts, “[t]he fiduciary duty follows the contours of the relationship between the adviser and its client, and the adviser and its client may shape that relationship by agreement, provided that there is full and fair disclosure and informed consent.”

The SEC provides various examples in the first Q&A of voting arrangements that would satisfy the investment adviser’s fiduciary duty to act in its clients’ best interest. For example, the SEC discusses an arrangement in which the adviser and its client agree that the adviser will vote in accordance with the voting recommendations of management of the issuer, or an arrangement in which the adviser agrees to vote in favor of all proposals made by particular shareholder proponents, or an arrangement in which the investment adviser agrees not to exercise voting authority in circumstances in which voting would impose costs on the client (e.g., the opportunity cost to the client that results from restricting the lending of securities held in its portfolio in order to preserve the right to vote associated with holding these securities).

The second Q&A addresses the steps an investment adviser should take to demonstrate that it is making voting determinations in the client’s best interest and in accordance with the adviser’s proxy voting policies and procedures. In particular, this Q&A addresses how an investment adviser may satisfy its fiduciary duty and obligations under Rule 206(4)-6 when it has multiple clients. The SEC cautioned that an investment adviser in such case should consider whether a uniform voting policy would be in the best interest of each of its clients, or whether it would be more appropriate to fashion its voting policy in accordance with the particular investment strategy and objectives of each client. In this second Q&A, the SEC also advises that an investment adviser should consider whether certain types of matters may compel it to conduct a more detailed analysis than it would otherwise conduct under its general voting guidelines -- e.g., certain corporate events, such as mergers and acquisition transactions, conversions, dissolutions, contested elections for directors, etc. In this second Q&A, the SEC also advises that an investment adviser should consider developing reasonable measures to determine whether it is casting votes on behalf of its clients in a manner that is consistent with its voting policies and procedures -- e.g., evaluating a sample of proxy votes it has cast on behalf of its clients as part of its annual review of its compliance policies and procedures.    

In the third Q&A, the SEC discusses the factors an investment adviser should consider in deciding to retain a particular proxy advisory firm. The SEC advises that an investment adviser should consider whether the proxy advisory firm has the capacity and competency to adequately analyze matters for which the investment adviser is responsible for voting. This would include the adequacy and quality of the proxy advisory firm’s staffing, personnel, and/or technology. In addition, the investment adviser should consider whether the proxy advisory firm has an effective process for seeking timely input from issuers and clients of the advisory firm on matters such as proxy voting policies, methodologies, and peer group constructions, such as “say-on-pay” votes. The SEC recommends that investment advisers also consider whether a proxy advisory firm has adequately disclosed to the investment adviser its methodologies in formulating voting recommendations such that the investment adviser can understand the factors underlying the proxy advisory firm’s voting recommendations. Further, the SEC advises that an investment adviser should also review the proxy advisory firm’s policies and procedures regarding how it identifies and addresses conflicts of interest.

In the fourth Q&A, the SEC re-emphasizes the importance to advisers of evaluating the care and competency of a proxy advisory firm they have retained to provide research or voting recommendations as an input to the advisers’ voting determinations. The focus of this Q&A, however, is on the steps an adviser should take when it becomes aware of potential factual errors, potential incompleteness, or potential methodological weaknesses in the proxy advisory firm’s analysis that may materially affect one or more of the investment adviser’s voting determinations. The SEC advises that one step that an investment adviser may take is to reasonably design its policies and procedures to ensure that its voting determinations are not based on materially inaccurate or incomplete information. The adviser may include, for example, a procedure to periodically review its ongoing use of the proxy advisory firm’s research or voting recommendations, including an assessment of the extent to which potential factual errors, potential incompleteness, or potential methodological weaknesses in the proxy advisory firm’s analysis have materially affected the advisory firm’s research and voting recommendations provided to the investment adviser. The SEC has also recommended that in reviewing its use of the proxy advisory firm, the adviser should consider the effectiveness of the proxy advisory firm’s policies and procedures for obtaining current and accurate information relevant to matters included in its research and on which it makes voting recommendations.          

The fifth Q&A contains guidance on the procedures an investment adviser may take to evaluate a proxy advisory firm that it has retained, including evaluating any material changes in services or operations by the proxy advisory firm.

Finally, the SEC notes in the sixth Q&A that an investment adviser that has assumed voting authority on behalf of a client is not required to exercise every opportunity to vote a proxy for that client in two situations. First, the adviser is not required to cast a vote if the adviser and the client have agreed in advance to limit the conditions under which the adviser would not exercise voting authority. Second, an adviser may refrain from voting a proxy on behalf of a client if the adviser has determined that doing so would be in the client’s best interest. The SEC observes that this may be the case when the adviser determines that the cost to the client of voting the proxy exceeds the expected benefit to the client.

Application of the Proxy Rules to the Advice of Proxy Advisory Firms

Proxy Voting Advice Constitutes a Solicitation under the Federal Proxy Rules

As the use of proxy advisory firms by investment advisers and other institutional investors have become more widespread and the services offered by proxy advisory firms has broadened, the SEC has examined how proxy voting advice by proxy advisory firms may be considered to be solicitations under the federal proxy rules. The SEC and its staff has continually engaged with the public through various forums and statements relating to the voting process, most recently in a roundtable on the proxy process in November 2018 that included a panel on the role of proxy advisory firms and their use by investment advisers. Following this roundtable as well as the receipt of other feedback on these topics, the SEC released the Guidance. In the Guidance, the Commission affirmatively held that proxy advice given by a proxy advisory firm constitutes a solicitation under the federal proxy rules. Section 14(a) of the Securities Exchange Act applies to any solicitation for a proxy with respect to any security registered under the Section 12 of the Exchange Act. The Commission utilizes a broad-based definition of solicitation which includes any communication to security holders under circumstances reasonably calculated to result in the procurement, withholding or revocation of a proxy irrespective of whether the person itself is seeking authorization to act as a proxy or where the person making the solicitation is indifferent to the ultimate outcome. The Commission emphasized that proxy advisory firms provide their voting recommendations with the expectation that they will be used by their client in making voting decisions and since proxy advisory firms typically provide their voting recommendations shortly before a shareholder meeting, this enhances the likelihood that these recommendations are designed and expected to influence voting determinations. Accordingly, the Commission determined that advice from proxy advisory firms is not merely administrative or ministerial, but in fact influential, thus falling under the solicitation definition.

Notwithstanding the fact that proxy voting advice is deemed a solicitation and subject to the federal proxy rules, the Commission affirmed that proxy advisory firms are entitled to avail themselves of the exemptions under Rule 14a-2(b) of the Exchange Act from the information and filing requirements of the federal proxy rules under the Exchange Act. These exemptions provide relief from the requirement to file a proxy statement.

Proxy Voting Advice Remains Subject to the Anti-Fraud Rules under Rule 14a-9

The Guidance also affirmed that Rule 14a-9 of the Exchange Act applies to proxy voting advice. Rule 14a-9 prohibits solicitations from containing any false or misleading statements or omissions of any material fact. As such, proxy advisory firms must be careful not to make materially false or misleading statements or omit material facts that would be required to make the proxy voting advice not misleading when providing any proxy voting advice. For example, the SEC notes that the provider of proxy voting advice should consider whether it may need to disclose the following types of information in order to avoid a potential violation of Rule 14a-9: (i) an explanation of the methodology used to formulate its voting advice on a particular mater; (ii) to the extent that proxy voting advice is based on information other than the registrant’s public disclosures, such as third party sources, disclosure about such information sources; and (iii) disclosure about material conflicts of interest that arise in connection with providing the proxy voting advice in reasonably sufficient detail so that the client can assess the relevance of the conflicts.

Implications of the Guidance

The publication of this Guidance follows various actions the SEC and its staff have taken previously to address proxy voting issues. Rule 206(4)-6 was first adopted in 2003. In 2010, the SEC issued a concept release to solicit public comment on the role and legal status of proxy advisory firms, among other matters. In 2013, the SEC hosted a roundtable on the use of proxy advisory firm services by institutional investors and investment advisers. In 2014, the staff of the SEC’s Division of Corporation Finance and Division of Investment Management issued Staff Legal Bulletin No. 20 (“SLB 20”) that contains comprehensive guidance on the proxy voting responsibilities of investment advisers and the availability of exemptions from the proxy voting rules for proxy advisory firms. In 2015, the SEC’s Office of Compliance, Inspections and Examinations stated that compliance with the proxy voting rule was a priority item for the staff in examinations of investment advisers. And, as mentioned above, in November 2018, the SEC hosted another roundtable to address various issues relating to proxy voting.

The foregoing listing of actions taken by the SEC and its staff suggests that the SEC continues to view proxy voting as a high priority topic of securities regulation. Although the Guidance may appear to merely build on various questions considered in SLB 20, one should not overlook that the Guidance was published by the Commission, not its staff. The views expressed in the Guidance, therefore, are those of the Commission and may be considered to have full legal force and effect. By contrast, SLB 20, as the SEC has noted, is merely staff guidance that has no legal force or effect, does not alter or amend applicable law, and creates no new or additional obligations. See Guidance, Release No. IA-5325, n. 23 (August 21, 2019).

With the publication of the Guidance, against the spotlight placed on proxy voting issues in recent years, investment advisers will have to pay more attention to their compliance obligations under the proxy voting rule. The SEC notes in the Guidance that some public comment letters expressed concern about potential conflicts of interest by proxy advisory firms. Given the force of law that the Guidance presents, there is a reasonable likelihood that the SEC and its staff may be more vigilant on these issues in the course of conducting SEC examinations of investment advisers and pursuing enforcement actions and other administrative proceedings against investment advisers for violating Rule 206(4)-6. In addition, with the publication of the Guidance and the legal force it provides, investment advisers will have a more difficult time asserting, in the context of an enforcement or other administrative proceeding, that a particular course of action involving the exercise of their proxy voting responsibilities was reasonable in light of the unsettled law and lack of binding legal guidance that previously existed in this area of the law.

With the prospect of greater liability exposure to investment advisers for taking on the responsibility to vote securities held in their clients’ accounts, there is a question whether publication of the Guidance might have the unintended effect of causing advisers to avoid these arrangements altogether. The SEC has made clear that an adviser is not obligated to undertake the authority to vote securities in its client accounts, but that once it undertakes the responsibility to do so, it must conduct itself in a manner that is consistent with its fiduciary duty to act in its clients’ best interest and observe its other obligations under Rule 206(4)-6.

The possibility that publication of the Guidance might have this effect is more likely to occur among smaller advisers that have fewer resources to conduct themselves in a manner that is consistent with their fiduciary duty. This could mean less participation among advisory clients in the proxy voting process since these clients, which may not be the large institutions, are likely to participate with less frequency in the proxy process. A consequence of this type would significantly undermine a seemingly fundamental purpose of the SEC in publishing the Guidance -- i.e., to encourage investors, including advisory clients that invest through advisory arrangements with investment advisers, to participate more in the proxy process as a means to engage with public companies and their management.

In the case of large institutional investors, including advisory clients of large investment advisers, publication of the Guidance may have the effect of encouraging greater use of proxy advisory firms in the proxy process, due to the enhanced precision the Guidance may provide to a proxy advisory firm and its obligations vis-à-vis its relationship to its advisory client. With the added clarity the Guidance brings to advisers with respect to the steps they may take to satisfy their fiduciary duty when using proxy advisory firms, the larger advisers, in particular, might be inclined to increase their reliance on the services and voting recommendations of proxy advisory firms once the proxy advisory firms provide clients with the specific disclosures suggested by the Commission regarding (i) methodologies used to formulate voting advice, (ii) third party sources of information, and (iii) material conflicts of interest, as spelled out in the Guidance. This result would align well with the SEC’s fundamental objective in publishing the Guidance of encouraging greater participation by investors in the proxy process.

Managing associate Gregory DiBella contributed to this alert.