Sara Crovitz, most recently Deputy Chief Counsel and Associate Director of the U.S. Securities and Exchange Commission’s Division of Investment Management, provides counsel on all aspects of investment company and investment adviser regulation. She worked at the SEC for 21 years, including 17 years in the Division of Investment Management focusing on issues under the Investment Company and Investment Advisers Acts of 1940. While in the Division, Sara supervised the provision of significant legal guidance to the investment management industry through no-action and interpretive letters, exemptive applications, IM guidance updates and other written and oral means.
Introduction On December 18, 2019, a divided SEC proposed amendments (the Proposal) to the definition of “accredited investor” under Rule 501(a) of Regulation D1 by modestly expanding the categories of individuals and institutions that would qualify as accredited investors and, therefore, have access to the private markets.2 While such amendments, if adopted, would likely require most private fund managers to update their funds’ subscription agreements to reflect these new categories, the Proposal would be unlikely to expand significantly the pool of available investors for most private funds.3 In his public statement4 in connection with the Proposal, however, Chairman Jay Clayton framed the Proposal as “an important step . . . [with] more to come in this space in the coming months . . . .”5 Further, echoing language from the SEC’s June 2019 Concept Release,6 Chairman Clayton specifically referred to “examining whether appropriately structured funds can facilitate greater Main Street investor access to private investments . . . .”7
Below, please find a discussion of certain changes addressed in the Proposal that may be relevant to private fund managers.
Natural Persons with Professional Certifications In the Proposal, a majority of the SEC stated its belief that “relying solely upon financial thresholds may unduly restrict access to investment opportunities for individuals whose knowledge and experience render them capable of evaluating the merits and risks of a prospective investment . . . in a private offering, irrespective of their personal wealth.”8 As such, the proposed rule set forth in the Proposal (the Proposed Rule) would allow individuals with specified certifications, designations, or other credentials to qualify as accredited investors even if they do not meet the wealth or income tests currently in place. The SEC expects this category would initially include natural persons who hold either a Series 7 or Series 82 license or those who have taken and passed a Series 65 exam. Details, however, would be contained in a separate SEC order, which would provide the flexibility to add or delete particular qualifying certifications without additional rulemaking (i.e., without notice and comment or economic analysis).
Natural Persons Who Are Knowledgeable Employees of Private Funds
In addition, the Proposed Rule would expand the definition of accredited investor to include “knowledgeable employees”9 of private funds.10 This amendment would provide that knowledgeable employees would be eligible to invest in their employers’ funds even if they do not otherwise qualify as accredited investors under the financial threshold tests.
Financial Thresholds Unchanged In addition to requests for comment on the various proposed amendments, the Proposal also requests comment on whether the financial thresholds within the definition should be adjusted. As drafted, the Proposed Rule would not modify the current levels of $200,000, $1 million, and $5 million, which have been largely unchanged since 1982. Specifically, the Proposal requests comment on, among other things, whether indexing for inflation would be an appropriate benchmark. During the open meeting, Commissioner Allison H. Lee voiced her concern that, by not increasing the financial thresholds or adjusting them to reflect inflation, the Proposed Rule would “codify the toll that 37 years of inflation has already taken.”11
Clients of Registered Investment Advisers or Broker-Dealers as Accredited Investors Similarly, although not included in the Proposed Rule, the Proposal seeks comment on whether investors should be considered accredited if they are advised by a registered investment adviser or broker-dealer but do not otherwise meet the financial thresholds. Commissioner Robert J. Jackson, Jr. voiced his concern that such an approach would have a detrimental effect on investors, pointing to evidence that “brokers who put investors in private securities are unusually likely to be the subject of both customer complaints related to sales practices and regulatory inquiries about misconduct.”12 In response to Commissioner Jackson’s concern, Chairman Clayton noted that he views such an approach “with skepticism due to the lack of alignment of interests and sophistication.”13
Additional Proposed Changes The Proposed Rule also includes other additions and clarifications to Rule 501 as well as corresponding changes to other securities laws, certain of which are highlighted below:
Rule 501(a)(1) would be expanded to include registered investment advisers as well as any Rural Business Investment Company.14
Rule 501(a)(3) would be expanded to include limited liability companies, not formed for the specific purpose of acquiring the securities offered, with total assets in excess of $5 million.
Rule 501(a)(5) and (6) would be expanded to include “spousal equivalents”15 under the net worth and income tests.16
Rule 501(a)(9) would be added as a “catch-all” to include any entity, not formed for the specific purpose of acquiring the securities offered, that owns investments17 in excess of $5 million.
Rule 501(a)(12) would be added to include any family office18 that, among other requirements, has at least $5 million in assets under management and whose prospective investment is directed by a person with certain financial sophistication.
Finally, in addition to the changes outlined above with respect to the definition of accredited investor for purposes of Regulation D, the Proposed Rule would make corresponding changes to applicable definitions within Rules 215, 163B and 144A under the Securities Act as well as Rule 15g-1 of the Securities and Exchange Act of 1934, as amended.
Conclusion While the Proposed Rule would likely have a minimal impact on the fundraising audience available to most private fund managers, Chairman Clayton’s remarks make clear that the SEC will continue to focus on greater access for retail investors to private markets, “particularly as a component of an investment portfolio that is analogous to the portfolio of a well-managed pension fund.”19 Further, the Chairman went on to highlight his belief that:
“it is important to focus on solutions that provide access to investment opportunities on substantially the same terms as those that would be available to institutional investors with protections – including alignment of interest between individuals and institutions, and transparency – that are akin to the protections in our public market. This alignment of interest is extremely important to me and I ask that commenters please recognize that I and many of my colleagues are skeptical of approaches that do not have either (1) demonstrated financial sophistication of the individual investor or (2) clear, ongoing alignment of interest with the sponsor.”20
As such, if viewed in the broader context of the various topics explored in the Concept Release, which included, among other things registered feeder funds into private funds, modifications to the interval fund structure, and the ability to charge performance fees to registered funds, the Chairman’s remarks and the Proposal itself imply there could, indeed, potentially be “more to come.”
The comment period will close 60 days after the Proposal is published in the Federal Register.
1 Many private securities, including most private funds, are offered pursuant to an exemption from registration under Regulation D of the Securities Act of 1933, as amended (the Securities Act).
2 See Amending the “Accredited Investor” Definition, (proposed Dec. 18, 2019) (to be codified at 17 C.F.R. pts. 230, 240).
3 For example, the Proposal would not change the definition of “qualified client” under
Rule 205-3 of the Investment Advisers Act of 1940 (the Advisers Act), nor would it change the definition of “qualified purchaser” under Section 2(a)(51)(A) of the Investment Company Act of 1940 (the Investment Company Act).
9 Under the Proposal, “knowledgeable employee” would be defined as it is under Investment Company Act Rule 3c-5(a)(4).
10 Funds excepted from the definition of investment company under Sections 3(c)(1) and 3(c)(7) of the Investment Company Act.
11 Allison H. Lee, Comm’r, U.S. Sec. & Exch. Comm’n, “Statement on the Proposed Expansion of the Accredited Investor Definition” (Dec. 18, 2019) (noting that the failure to increase the thresholds to account for 37 years of inflation reflects a 550% increase in the number of qualifying households and that, if not adjusted in the future, in 30 years, 57.3% of U.S. households would qualify).
12 Jay Clayton, Chairman, U.S. Sec. & Exch. Comm’n, Remarks During Open Meeting (Dec. 18, 2019), webcast available here(2:05:05–2:05:10).
14 As defined pursuant to the Consolidated Farm and Rural Development Act.
15 Defined as “a cohabitant occupying a relationship generally equivalent to that of a spouse.” Proposal, supra note 2, at 152.
16 The staff also proposed adding a note to Rule 501(a)(5) to clarify that the calculation of “joint net worth” can be the aggregate net worth of an investor and his or her spouse or spousal equivalent and that the securities being purchased by an investor relying on the joint net worth test need not be purchased jointly.
17 As defined in Investment Company Act Rule 2a51-1(b).
18 As defined under Advisers Act Rule 202(a)(11)(G)-1. Note that Rule 501(a)(13) would also be added to include any “family client,” as defined under the same Advisers Act rule. Proposal, supranote 2, at 152.
19 Clayton’s Remarks, supra note 4.
Information contained in this publication should not be construed as legal advice or opinion or as a substitute for the advice of counsel. The articles by these authors may have first appeared in other publications. The content provided is for educational and informational purposes for the use of clients and others who may be interested in the subject matter. We recommend that readers seek specific advice from counsel about particular matters of interest.
At an open meeting on November 5, 2019, a majority of the Securities and Exchange Commission (“SEC”) voted to recommend two proposals amending the federal proxy rules.1Commissioners Robert Jackson Jr. and Allison Herren Lee opposed these proposals.2 The first proposal conditions reliance on certain existing exemptions under the proxy rules by proxy voting advice businesses such as Institutional Shareholder Services (“ISS”) and Glass Lewis, upon compliance with additional conflicts disclosure and procedural requirements, including permitting issuers to review and provide responses to proxy businesses’ reports.3 The second proposal would amend the proxy rules applicable to the submission of shareholder proposals, including enhanced eligibility requirements and more onerous resubmission limits. The components of each of these two proposals are summarized below. Comments on the proposals are due 60 days after publication in the Federal Register.
I. Amendments to Exemptions From the Proxy Rules for Proxy Voting Advice
The first proposal would amend the proxy rules applicable to companies that regularly provide proxy voting advice to asset managers and others (“proxy businesses”), such as ISS and Glass Lewis. The proposed amendments would (1) clarify that proxy businesses’ voting advice constitutes a solicitation, (2) require additional conflict disclosure in voting advice, (3) provide issuers up to two opportunities to review the proxy advice before it is delivered to clients, (4) provide issuers the opportunity to require in the advice that is delivered to clients a hyperlink to the issuer’s views on that advice and (5) enumerate specific examples of what may constitute misleading statements by proxy businesses. The proposed amendments would increase costs for proxy businesses and may shorten the amount of time asset manager clients have to review proxy advice prior to the vote.
Definition of “Solicitation.” The SEC’s proposal would amend the definition of “solicitation” under Rule 14a-1(l) and Section 14(a) to 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 such advice separately from other forms of investment advice and sells such advice for a fee.4 This definition encompasses voting recommendations promulgated under proxy businesses’ benchmark voting policies or sets of guidelines. The SEC emphasized that the definition of solicitation should continue to be construed broadly. However, the SEC clarified that it intended that proxy voting advice furnished by a person such as a broker-dealer or an investment adviser made only in response to unprompted client requests would continue to be excluded under the definition.
Conflicts of interest disclosures. Proposed Rule 14a-2(b)(9)(i) requires that persons who provide proxy voting advice and rely on the solicitation exemptions in Rules 14a-2(b)(1) or 14a-2(b)(3) provide additional written disclosures about material conflicts of interest in their proxy voting advice to clients.5
Timely review and feedback period. Proposed Rule 14a-2(b)(ii), as a condition of relying on exemptive Rules 14a-2(b)(1) and 14a-2(b)(3), would require a standardized opportunity for timely review and feedback by issuers and certain other soliciting persons of proxy voting advice before the advice is disseminated to the proxy business’ clients. This would be required regardless of whether the advice on the matter is adverse to an issuer’s own recommendation, subject to certain conditions.6 The proxy business can condition this receipt of proxy voting advice on the issuer agreeing to keep the contents of the proxy voting advice confidential. The length of time for review and feedback varies depending on how far in advance of the shareholder meeting the issuer has filed a proxy statement (see table below). The proxy business would not be required to accept any suggested revisions. However, in accepting or rejecting any revisions, the proxy business would be subject to Rule 14a-9, which prohibits any materially misleading misstatements or omissions.
Final notice of voting advice. In addition to the review and feedback period and as a condition of relying on the exemptions in Rules 14a-2(b)(1) and 14a-2(b)(3), proxy businesses would be required to provide a final notice of voting advice to issuers at least two business days prior to the delivery of the proxy voting advice to their clients. This is required regardless of whether the issuer commented on the version it received during the review and feedback period. This final notice should contain a copy of the proxy voting advice that the proxy business will deliver to its clients, including any revisions to the advice as a result of the review and feedback period. As in the review and feedback period, proxy businesses can condition an issuer’s receipt of the proxy voting advice on the issuer keeping the contents of the proxy voting advice confidential.
Hyperlink to issuer’s statement. Under proposed Rule 14a-2(b)(9)(iii), as a condition of relying on the exemptions in Rules 14a-2(b)(1) and 14a-2(b)(3), a proxy business must, upon request, include in its proxy voting advice and in any electronic medium used to deliver the advice a hyperlink (or other analogous electronic medium) that leads to a written statement by the issuer about its views of the proxy business’s voting advice, regardless of whether the advice is consistent with the issuer’s recommendation. Thus, asset managers relying on proxy voting advice could be confronted with conflicting views of facts or analysis in such advice with very little time to evaluate and determine whether such disagreements should impact the asset manager’s decision on how to vote. Notably, the SEC requested comments on whether proxy businesses should be required to disable the automatic submission of votes unless a client clicks on the hyperlink and/or accesses the issuer’s response or otherwise confirms any prepopulated voting choices before the proxy business submits the votes to be counted. Moreover, an asset manager’s determination to vote in accordance with a proxy business recommendation when such recommendation is subject to an issuer written statement could be subject to increased scrutiny.7
Anti-fraud provisions. Currently, Rule 14a-9 prohibits any proxy solicitation from containing false or misleading statements or omissions with respect to any material fact. Proposed Rule 14a-9 would elaborate on the current examples of what might constitute misleading information by including failure to disclose information such as the proxy business’s methodology, sources of information and conflicts of interest.
II. Procedural Requirements and Resubmission Thresholds Under Rule 14a-8
The second proposal would amend the shareholder proposal process to (1) provide a tiered approach for eligibility, (2) require certain documents when a proposal is submitted by a shareholder representative, (3) require shareholder-proponents to state when they would be able to meet with the issuer with respect to the proposal and (4) clarify that each shareholder may submit one proposal to an issuer for a particular shareholder meeting.
Ownership Eligibility Requirements. Currently, Rule 14a-8 requires a shareholder to have continuously held at least $2,000 in market value or 1% of the issuer’s securities for at least one year by the date the proposal is submitted. Under the proposed amendments, a shareholder would be able to submit a Rule 14a-8 proposal if the shareholder satisfies one of the three following continuous ownership requirements.
Shareholders would not be allowed to aggregate their securities with other shareholders’ securities to meet the minimum ownership thresholds. This tiered approach reflects the SEC majority’s understanding that a shareholder’s long-term investment in an issuer’s securities makes it more likely that a shareholder’s proposal is meaningful to the issuer and not for personal gain.
Co-filing/co-sponsoring shareholder proposals. Under the proposed rules, shareholders would be able to continue to co-file or co-sponsor shareholder proposals as a group if each shareholder in the group meets the eligibility requirements.
Use of a representative to submit a shareholder proposal. To address issuers’ concerns about whether a shareholder truly supports the proposal submitted on his/her behalf, proposed amendments to Rule 14a-8 would require shareholders who use representatives to submit their proposals or otherwise act on their behalf in connection with the proposal to provide the issuer with written documentation confirming the representative has authority to act on behalf of the shareholder.
Shareholder engagement with the issuer. The SEC proposal also would require a statement from each shareholder-proponent that he/she is able to meet with the issuer in person or via teleconference no fewer than 10 calendar days nor more than 30 calendar days after submission of the shareholder proposal. The shareholder would also be required to include contact information, business days and specific times that he/she is available to discuss the proposal with the issuer.
One-proposal limit. Rule 14a-8(c) currently provides that each shareholder may submit no more than one proposal to an issuer for a shareholders’ meeting. The SEC proposed amendments to address issuer concerns that proponents try to evade the one-proposal limitation, for example, by a shareholder submitting a shareholder proposal in its own name and simultaneously serving as a representative to submit a different proposal on another shareholder’s behalf for consideration at the same meeting.
Resubmissions. Currently, under Rule 14a-8(i)(12), an issuer can exclude a proposal if the matter was voted on at least once in the past three years and did not receive at least (i) 3% of the vote if previously voted on once, (ii) 6% of the vote if previously voted on twice or (iii) 10% of the vote if previously voted on three or more times. The proposed amendments to the resubmission thresholds would raise the current resubmission thresholds from 3%, 6% and 10% to 5%, 15% and 25%.8 Shareholders would be allowed to resubmit substantially similar proposals after a three-year “cooling-off” period.
“Momentum” requirements. In addition to the proposed amendments to the resubmission thresholds, the SEC proposed to amend Rule 14a-8(i)(12) to allow issuers to exclude proposals dealing with substantially the same subject matter as proposals previously voted on by shareholders three or more times in the preceding five calendar years that would not otherwise be excludable under the proposed 25% threshold if (i) the most recently voted-on proposal received less than a majority of the vote cast and (ii) support declined by 10% or more compared to the immediately preceding shareholder vote on the matter. The proposal stated that the purpose of the amendment is to relieve management and shareholders from repeatedly considering proposals in which shareholder interest has declined.
With regard to the first proposal, the SEC would permit a one-year transition period after publication of the final rule in the Federal Register. Issuers receiving shareholder proposals for 2020 annual meetings should continue analyzing proposals under existing rules. Interested parties are encouraged to express their views during the 60-day comment period.
The two proposals are part of the SEC’s ongoing work to “enhance the accuracy, transparency and effectiveness of our proxy voting system.”9 The split vote on the proposals, however, reflects the ongoing debate over shareholder engagement. In particular, Commissioners Jackson and Lee expressed concerns that the proposals “shift power away from shareholders and toward management” and limit investors’ ability to “hold corporate insiders accountable.”10
3 Rule 14a-2(b)(1) exempts solicitations by persons who do not seek the power to act as proxy for a shareholder and do not have a substantial interest in the subject matter of the communication beyond their interest as a shareholder. Rule 14a-2(b)(3) exempts proxy voting advice furnished by an adviser to any other person with whom the adviser has a business relationship.
5 Currently, proxy businesses relying on the exemption under Rule 14a-2(b)(3) provide conflicts of interest disclosures, for example, on their websites. However, in its proposal, the SEC asserted these disclosures may be inadequate because they are often vague or boilerplate.
6 Proxy businesses would not be required to extend the timely review and feedback period or provide the final notice to persons conducting solicitations that are exempt pursuant to Rule 14a-2 or to shareholder-proponents who submit proposals pursuant to Rule 14a-8 and whose proposal will be voted upon at the issuer’s upcoming meeting.
7 In particular, the SEC’s recent guidance regarding proxy voting responsibilities of investment advisers includes a statement that for an investment adviser to form a reasonable belief that its voting determinations are in the best interest of the client, it should conduct a reasonable investigation into potential factual errors. Commission Guidance Regarding Proxy Voting Responsibilities of Investment Advisers, Release No. IA-5325 (Aug. 21, 2019).
8 Specifically, Rule 14a-8(i)(12) would provide that a shareholder proposal may be excluded from an issuer’s proxy material if “the proposal addresses substantially the same subject matter as a proposal previously included in the issuer’s proxy materials within the preceding five calendar years, and if the most recent vote occurred within the preceding three calendar years and was: (i) less than 5 percent of the votes cast if previously voted on once; (ii) less than 15 percent of the votes if previously voted on twice; and (iii) less than 25 percent of the votes if previously voted on three times or more.”
On November 4, 2019, the Securities and Exchange Commission (Commission) voted seriatim to issue proposed amendments to the rules under the Investment Advisers Act that prohibit certain investment adviser advertisements offering a more flexible principles-based approach, permitting, notably, testimonials and endorsements under certain circumstances. The proposed amendments, if adopted, would likely be welcomed relief to the industry, which has clamored for modernization of the advertising rules for years. The Commission also proposed amendments that would broaden the current cash solicitation rule to apply regardless of whether an adviser pays a solicitor cash or non-cash compensation and would apply to the solicitation of current and prospective investors in private funds.
Investment adviser advertisements
The proposed advertising rule: (i) modifies the definition of “advertisement,” including adding to the types of communications to cover broadcasts that are not live (e.g. webinars); (ii) replaces the current four per se prohibitions with a set of principles that are reasonably designed to prevent fraudulent or misleading conduct and practices; (iii) provides certain additional restrictions and conditions on testimonials, endorsements, and third-party ratings; and (iv) includes tailored requirements for the presentation of performance results, based on the sophistication of the intended audience (i.e. includes a new category of “non-retail” investors comprised of qualified purchasers and knowledgeable employees). The proposed rule also would require internal review and approval of most advertisements by a “designated employee.” It also would require each adviser to report additional information regarding its advertising practices in its Form ADV, which appears largely designed to assist examination staff.
Replacing the current strict prohibitions with a more flexible principles-based approach will be gratifying to the industry, which has requested such modernization for years. Under the proposal, for example, testimonials and endorsements would be permitted so long as the advertisement meets general anti-fraud type prohibitions, subject to certain disclosures about the person giving the testimonial or endorsement and any cash or non-cash compensation paid by or on behalf of the adviser. Similarly, the proposed rule replaces the prohibition on past specific recommendations with a “fair and balanced” approach, which also incorporates the sophistication of the intended audience. This should be welcomed by private fund advisers, particularly in the private equity context, where case studies are particularly helpful in explaining the adviser’s investing approach. Less welcomed for private fund advisers is that the proposal would specifically include private fund adviser advertising in scope despite the acknowledged “overlap” with current rule 206(4)-8.
Payments to solicitors
The proposed amendments would broaden the current cash solicitation rule to apply regardless of whether an adviser pays a solicitor cash or non-cash compensation (including free or discounted services, directed brokerage and awards or other prizes) and would apply to the solicitation of current and prospective investors in private funds. The Commission recognized that the broader rule could have unintended consequences. For example, to avoid capturing investors who participate in “refer-a-friend” programs, the proposed rule would add an exemption for certain de minimis compensation (i.e. $100 or the equivalent in non-cash compensation in a 12-month rolling period). The proposed amendments eliminate certain process and disclosure requirements but include additional disclosure about a solicitor’s conflict of interest.
Yesterday, the Securities and Exchange Commission (Commission ) voted 3-2 (Commissioners Jackson and Lee dissenting) to propose amendments to rules under the Exchange Act in connection with the ongoing review of the proxy process. The proposed amendments would impose additional requirements on proxy advisory firms that provide recommendations on votes and would raise the eligibility and resubmission thresholds for shareholder proposals:
Amendments to exemptions from the proxy rules
Among others, the proposed amendments would condition the availability of certain existing exemptions from the information and filing requirements of the federal proxy rules for proxy advisory firms on compliance with certain additional disclosure, including disclosure of material conflicts of interest in voting advice (not just to their clients). The proposed amendments also would provide registrants opportunities to review and provide feedback on reports before a proxy advisory firm disseminates its votes to institutional investor clients, regardless of whether the advice is adverse to the voting recommendation of the registrant. The Chairman asserted at the open meeting that the proposal is intended to incentivize the registrant to file its definitive proxy statement earlier, thereby allowing more time for the proxy advisory firm and its clients to formulate and consider voting recommendations, because registrants who file earlier (45 days or more in advance of shareholder meeting) have more time to review the proxy voting advice than those who file later (25-45 days in advance). In addition, the proxy advisory firm would be required to provide a final notice of voting advice no later than two business days prior to delivery of the advice to clients. The registrant thereafter would be permitted to include a hyperlink to its views on the voting advice in the report delivered to clients. This proposal also would add examples of when the failure to disclose certain information in proxy voting advice could be considered misleading under the proxy rules.
Procedural requirements and resubmission thresholds
These amendments would update the shareholder proposal rule, which requires issuers subject to the federal proxy rules to include shareholder proposals in their proxy statements, subject to certain procedural and substantive requirements. The amendments would revise the current eligibility requirements, the one-proposal limit and the resubmission thresholds.
To initially submit a shareholder proposal, a shareholder would need to hold at least $2000 or 1% of an issuer’s securities for at least three years, rather than the current one year holding period. Those with larger ownership stake could satisfy the eligibility standard in less time. In addition, shareholder proponents would be required to be available to meet with the company to discuss the proposal.
The proposed amendments would apply the one-proposal rule such that a shareholder proponent would not be permitted to submit a proposal in her own name and simultaneously serve as a representative to submit a different proposal on another shareholder’s behalf for consideration at the same meeting (and similarly, a representative could only submit one proposal at a given meeting, even if the representative submits each proposal on behalf of different shareholders). Commissioner Roisman alleged at the open meeting that this process had been “misused” in the past by proponents wishing to submit multiple proposals at the same shareholder meeting.
The proposed amendments would raise the current resubmission thresholds of 3%, 6% and 10% for matters voted on once, twice or three or more times in the past five years to 5%, 15% and 25% respectively. In addition, the proposal would allow an issuer to exclude a proposal that previously has been voted on three or more times in the past five years, even if the proposal received 25% in its most recent resubmission if the proposal: (1) received less than 50% of the votes cast and (2) experienced a decline in shareholder support of 10% or more. Commissioner Lee’s dissenting statement asserted that the amendments would “suppress” the exercise of shareholding rights with regard to ESG issues, including in particular climate-related proposals which made up more than half of shareholder proposals in recent years.
All of the proposals are subject to a 60-day public comment period. We will be following up in the near future with more detailed analysis of the proposals.
The Securities and Exchange Commission recently adopted a package of new rules and interpretations, including Regulation Best Interest (Reg BI), the Form CRS Relationship Summary (Form CRS) and guidance1 on the Investment Advisers Act of 1940 (the Advisers Act Guidance or Release). This Client Alert will focus on the Advisers Act Guidance, which is applicable to both advisers fully registered with the SEC and exempt reporting advisers who manage only private funds.2 The following is a brief discussion of certain aspects that may be relevant to private fund managers.
More information on Reg BI, which is applicable only to broker-dealers, and Form CRS, which is applicable only to broker-dealers and investment advisers3 that enter into advisory contracts with “retail” investors, can be found in separate Client Alerts [Risk&Reward-June Edition and Risk&Reward-July Edition].
With the Advisers Act Guidance, the SEC aims to “reaffirm – and in some cases clarify – certain aspects of” an adviser’s fiduciary duty under the Advisers Act, namely the duty of care and duty of loyalty all advisers owe their clients. Of particular importance to private fund managers are the SEC’s general focus on the duty of loyalty as it relates to disclosure of material facts about conflicts of interest, and the SEC’s specific discussion of conflicts associated with allocation of investment opportunities among clients, including co-investments, each of which we cover below. In addition, we highlight a recent enforcement case involving a U.K.-based hedge fund manager that underscores certain of the themes from the Advisers Act Guidance.
Duty of Loyalty The Release lays out the SEC’s view that “[u]nder its duty of loyalty, an investment adviser must eliminate or make full and fair disclosure of all conflicts of interest … such that a client can provide informed consent to the conflict.”
Disclosure and Informed Consent The Release is not prescriptive with respect to how an adviser must disclose any conflicts and obtain informed consent from clients, but it does note that consent need not be in a written agreement. Rather, an adviser’s “client could implicitly consent by entering into or continuing the investment advisory relationship,” after receiving “a combination of Form ADV and other disclosure.” Although offering memoranda are not specifically referenced in the Advisers Act Guidance, SEC staff has suggested in the past4 that such disclosure may include a private fund’s offering memorandum.
Nor is the Release prescriptive in terms of the format and content of the disclosure, although the SEC clearly differentiated between an adviser’s obligations with respect to institutional clients (e.g., a private fund) and “retail” clients, noting that what constitutes full and fair disclosure “can differ, in some cases, significantly” between the two audiences.5 The key, however, is that “regardless of the nature of the client, the disclosure must be clear and detailed enough for the client to make an informed decision to consent to the conflict of interest or reject it.”
Specificity of Disclosure and Appropriateness of Use of ‘May’ The Release does, however, provide examples of disclosure practices that the SEC considers inadequate or inappropriate, with a particular focus on use of the word “may.” Citing past enforcement actions, the SEC points out that “disclosure that an adviser ‘may’ have a particular conflict, without more, is not adequate when the conflict actually exists…. In addition, the use of ‘may’ would be inappropriate if it simply precedes a list of all possible or potential conflicts regardless of likelihood and obfuscates actual conflicts to the point that a client cannot provide informed consent.” In terms of level of detail, the guidance notes that it would be insufficient simply to disclose that an adviser “has ‘other clients’ without describing how the adviser will manage conflicts between clients if and when they arise or to disclose that the adviser has ‘conflicts’ without further description.” Managers should take note of the above and review their firm’s disclosure for appropriate use of the word “may.”
Allocation of Investment Opportunities Including Co-Investments One specific area of potential conflicts of interest that the Release discussed is an adviser’s allocation policies and the obligation to describe “how the adviser will allocate investment opportunities, such that a client can provide informed consent.” In this way, the Release echoed in part the SEC’s Office of Compliance and Inspections (OCIE) 2019 Examination Priorities,6 which noted that OCIE plans to “review firms’ practices for … fairly allocating investment opportunities among clients,” and for “disclosing critical information to clients….”
For private fund managers, such allocation conflicts could arise in various contexts, for example, trade allocations among client accounts that have overlapping investment mandates, including a managed account run pari passu to a flagship fund, or a long-only fund that has been “carved out” from a flagship long/short fund. In addition, conflicts of interest could arise in the allocation of co-investment opportunities among clients, as suggested by the acting director of OCIE in a 2015 speech: “Co-investment opportunities have a very real and tangible economic value but also can be a source of various conflicts of interest,” and given that, “all investors deserve to know where they stand in the co-investment priority stack.”7 While on the enforcement front the SEC’s recent focus has primarily been on private equity managers’ practices with regard to allocation of fees and expenses associated with co-investments among clients,8 managers should take note of this increasing focus on co-investments more broadly, and should review their practices with respect to allocation of opportunities and relevant disclosure.
In terms of the content of allocation policies, the SEC clearly states that opportunities need not be allocated pro rata, noting further that “[a]n adviser and a client may even agree that certain investment opportunities or categories of investment opportunities will not be allocated or offered to a client” (emphasis added). The SEC’s use of the word “agree” in this context is a reminder of its expectation that an adviser’s “fiduciary duty follows the contours of the relationship … and the adviser and its client may shape that relationship by agreement, provided that there is full and fair disclosure and informed consent.”
Enforcement In 2016, the SEC brought an enforcement proceeding9 against a U.K.-based hedge fund manager that highlights certain of the themes discussed above. In that case, the SEC alleged that the manager failed to inform investors in its existing flagship fund of the “significant overlap” in trade allocations between that flagship fund and a newer vehicle, which was marketed as having a divergent investment strategy. The SEC cited, among other things, the fact that the manager “never updated” the offering documents of the flagship fund, which disclosed that the manager “may manage additional funds in the future that may invest in the same markets as [the flagship fund] and certain conflicts of interest could result.” Further, the SEC alleged that the manager and its founder “should have, but did not, update the [due diligence questionnaire] response they provided to many existing and prospective [flagship fund] investors about [the new vehicle],” which continued to position the two funds as having separate strategies despite the “high degree of overlap” between their investments.
Duty of Care In addition to its discussion of advisers’ duty of loyalty, the Release also describes advisers’ duty of care, including the duty to seek best execution and the newly described “duty to provide advice and monitoring.” With respect to best execution, the Release is consistent with prior SEC guidance and serves as a reminder of advisers’ obligations not only to seek best execution in selecting counterparties to execute trades on behalf of clients, but also to “periodically and systematically” evaluate such providers. Further, the Release lays out a newly described obligation to “monitor” client accounts, which should be “at a frequency that is in the best interest of the client, taking into account the scope of the agreed relationship.” While the SEC provides no specific guidance in terms of expectations with respect to private fund clients, all advisers may want to consider how best to document satisfaction of their duty to monitor client accounts. The Release further suggests that registered investment advisers “may consider whether written policies and procedures relating to monitoring would be appropriate.”
Given that the Release is immediately effective, below are certain questions that private fund managers may wish to consider in light of the SEC’s focus on these issues:
Have you reviewed the Conflicts of Interest disclosure in your fund offering documents and/or Form ADV, Part 2A, for appropriate use of the word “may”?
Do you have a written investment allocation policy, and are you following it and documenting any deviations therefrom?
Does your firm participate in co-investments, and if so, have you disclosed your policy (and any updates) to investors?
Do you have a process and documentation in place to substantiate your firm’s “duty to monitor” client accounts?
2 The Advisers Act Guidance also applies to any managers relying on the “foreign private adviser” exemption of Section 202(a)(30) of the Advisers Act (Foreign Private Advisers), generally those with fewer than 15 U.S. clients and 15 U.S. investors in private funds as well as less than $25 million attributable to such U.S. clients and investors.
3 Note that Form CRS is also applicable to Foreign Private Advisers, but only to the extent of any advisory contracts with U.S. “retail” investors. A “retail” investor for purposes of Form CRS includes any natural person, without regard to net worth or sophistication. Note, however, that Form CRS does not “look through” to underlying investors in pooled investment vehicles such as hedge funds or mutual funds, such that it will not impact managers of only such vehicles, or those who advise institutional clients, such as separately managed accounts with endowments or pension funds.
On Aug. 21, 2019, the Securities and Exchange Commission (the Commission) voted 3-2 to approve two interpretive guidance proposals related to proxy voting and proxy advisory firms.1 The first guidance discusses, among other matters, the ability of investment advisers to establish a variety of voting arrangements with their clients, as well as matters they should consider when they use the services of a proxy advisory firm. In addition, the Commission issued guidance that proxy voting advice provided by proxy advisory firms generally constitutes a “solicitation” under the federal proxy rules and provided related guidance about the application of the proxy antifraud rule to proxy voting advice.
Overall, the guidance reiterates positions taken by the Commission staff in 2014.2 However, certain aspects of the guidance are new, and we offer practical suggestions to investment advisers and funds as they review proxy voting policies and procedures and disclosure and consider whether amendments are appropriate.
Commission Guidance Regarding Proxy Voting Responsibilities of Investment Advisers3 The Commission issued guidance designed to assist investment advisers in fulfilling their proxy voting responsibilities, particularly where they use the services of a proxy advisory firm. Rule 206(4)-6 under the Investment Advisers Act of 1940 (Advisers Act) requires an investment adviser who exercises voting authority with respect to client securities to adopt and implement written policies and procedures that are reasonably designed to ensure that the investment adviser votes proxies in the best interest of its clients.
The guidance clarifies how an investment adviser’s fiduciary duty and Rule 206(4)-6 under the Advisers Act relate to an adviser’s proxy voting on behalf of clients, particularly if the investment adviser retains a proxy advisory firm. The guidance discusses, among other things:
How an investment adviser and its client, in establishing their relationship, may agree upon the scope of the investment adviser’s authority and responsibilities to vote proxies on behalf of that client.
What steps an investment adviser who has assumed voting authority on behalf of clients could take to demonstrate it is making voting determinations in a client’s best interest and in accordance with the investment adviser’s proxy voting policies and procedures.
Considerations for an investment adviser if it retains a proxy advisory firm to assist it in discharging its proxy voting duties.
Steps for an investment adviser to consider if it becomes aware of potential factual errors, incompleteness or methodological weaknesses in the proxy advisory firm’s analysis that may materially affect one or more of the investment adviser’s voting determinations.
How an investment adviser could evaluate the services of a proxy advisory firm that it retains, along with any material changes in services or operations by the proxy advisory firm.
Whether an investment adviser who has assumed voting authority on behalf of a client is required to exercise every opportunity to vote a proxy for that client.
The guidance is presented in a question-and-answer format and states that the examples it provides are not the only way for investment advisers to comply with the fiduciary duty imposed on them. Nonetheless, given the ongoing review of issues around proxy voting, advisers should expect the Commission’s Office of Compliance Inspections and Examinations to review compliance with the guidance.
Many investment advisers, including fund advisers, reviewed and updated their proxy voting policies and procedures and client disclosure following the issuance of SLB 20 in 2014. Advisers should consider whether such policies and procedures and disclosure adequately address, among others, the following issues raised in the Commission guidance:
Retaining or continuing to use a proxy advisory firm for research or voting recommendations. The Commission guidance includes considerations beyond those identified in SLB 20. In particular, advisers should consider how a proxy advisory firm seeks and utilizes issuer input with regard to the proxy advisory firm’s proxy voting policies, methodologies and peer group constructions. In addition, advisers should conduct a “reasonable investigation” of “potential factual errors, potential incompleteness, or potential methodological weaknesses” that may materially affect a voting determination. In this context, the Commission guidance indicates that an investment adviser should consider the proxy advisory firm’s “engagement with issuers,” including the process for the adviser to access the issuer’s views about the firm’s voting recommendations “in a timely and efficient manner.”4
At least annual review of policies and procedures. The Commission guidance indicates advisers should review votes cast to ensure consistency with voting policies and procedures. Advisers should consider whether the annual review of its policies and procedures adequately addresses sampling or testing of votes cast. Advisers, particularly fund advisers, should consider whether to identify in policies or procedures factors to consider as to whether to conduct a more detailed analysis with regard to an issuer or voting matter (e.g., with regard to corporate events or contested director elections).
Fund disclosure. The Commission guidance indicates that investment advisers to multiple funds or other clients should consider whether voting policies should be different depending on the investment strategies and objectives of each client. Registered funds should ensure that any such different voting policies are appropriately reflected in relevant disclosures.
Refraining from voting. The Commission guidance reiterates that investment advisers are not required to accept the authority to vote client securities. If an investment adviser accepts voting authority:
The investment adviser and client can agree on the scope of voting arrangements, including voting on only certain types of matters or always voting in favor of certain types of proposals.5 Such agreements should be subject to full disclosure and informed consent and should thus be clearly documented with the client.6
Absent specific agreement with a client, the investment adviser may determine that it is in the client’s best interest to refrain from voting if, for instance, the cost to the client of voting the proxy exceeds the expected benefit to the client. However, an investment adviser “may not ignore or be negligent in fulfilling the obligation it has assumed to vote client proxies and cannot fulfill its fiduciary responsibilities to its clients by merely refraining from voting the proxies.” Thus, an adviser should consider whether its procedures should identify factors that would be relevant to a determination to refrain from voting.
Commission Interpretation and Guidance Regarding the Applicability of the Proxy Rules7 The Commission also issued an interpretation of Rule 14a-1(l) under the Securities Exchange Act of 1934 (Exchange Act) that proxy voting advice generally constitutes a solicitation under the federal proxy rules and related guidance regarding the application of the antifraud provisions in Exchange Act Rule 14a-9 to proxy voting advice.8
The Commission’s interpretation that proxy voting advice generally constitutes a solicitation does not affect the ability of proxy advisory firms to continue to rely on the exemptions from the federal proxy rules’ filing requirements.9
While much of this guidance reiterates staff positions in SLB 20, the Commission guidance also explains what a person providing proxy voting advice should consider with respect to the information it may need to disclose in order to avoid a potential violation of Rule 14a-9 where the failure to disclose such information would render the advice materially false or misleading.
In particular, the guidance highlights that a proxy advisory firm should consider whether it may need to disclose “an explanation of the methodology used to formulate its voting advice on a particular matter (including any material deviations from the provider’s publicly-announced guidelines, policies, or standard methodologies for analyzing such matters).” If the voting advice is materially based on a methodology using a peer group comparison, the proxy advisory firm may need to include the identities of the peer group members and the reasons for selecting them. In addition, the proxy advisory firm may need to disclose third-party sources of information included in its reports and underlying its recommendations, particularly if the information deviates from the issuer’s publicly provided information.
The guidance appears to be designed to address issuer concerns that proxy advisory firms have relied on peer group comparisons that are poorly constructed (e.g., include peers from unrelated industries or differ from peers used for an issuer’s direct competitor) or on performance data or other issuer assessments that deviate from the issuer’s publicly released information. It is not clear yet what the impact of this guidance will be on proxy advisory firms and their relationships with asset management clients.
What’s Next? The guidance and interpretation will be effective upon publication in the Federal Register, as there is no associated notice and comment period. As indicated in the Regulatory Flexibility Agenda, the Commission in the near future expects to engage in rulemaking with regard to submission and resubmission thresholds for shareholder proposals under Exchange Act Rule 14a-8 as well as proxy advisory firms’ reliance on the proxy solicitation exemptions in Exchange Act Rule 14a-2(b).
1 Commissioners Robert Jackson and Allison Lee dissented.
2 Proxy Voting: Proxy Voting Responsibilities of Investment Advisers and Availability of Exemptions from the Proxy Rules for Proxy Advisory Firms, Staff Legal Bulletin No. 20 (IM/CF) (June 30, 2014) (SLB 20), available at https://www.sec.gov/interps/legal/cfslb20.htm.
4 Two proxy advisory firms, ISS and Glass-Lewis, dominate the market for services. Both currently offer certain fact-checking and error correction processes. The Commission guidance does not clarify whether those processes are sufficient to address an investment adviser’s fiduciary duty.
5 In this regard, the Commission guidance helpfully notes that a client and its investment adviser could agree not to restrict the use of securities for lending to preserve the right to vote in circumstances where such voting would impose opportunity costs on the client.
6 Commission Interpretation Regarding Standard of Conduct for Investment Advisers, Securities and Exchange Commission, Investment Advisers Act Rel. No. 5248 (June 5, 2019), available at https://www.sec.gov/rules/interp/2019/ia-5248.pdf (“Whether the disclosure is full and fair will depend upon, among other things, the nature of the client, the scope of the services, and the material fact or conflict. Full and fair disclosure for an institutional client (including the specificity, level of detail, and explanation of terminology) can differ, in some cases significantly, from full and fair disclosure for a retail client because institutional clients generally have a greater capacity and more resources than retail clients to analyze and understand complex conflicts and their ramifications.” (internal citations omitted)).
7 Commission Interpretation and Guidance Regarding the Applicability of the Proxy Rules to Proxy Voting Advice, Securities and Exchange Commission, Exchange Act Rel. No. 34-86721 (Aug. 21, 2019), available at https://www.sec.gov/rules/interp/2019/34-86721.pdf.
8 The federal proxy rules apply to any solicitation for a proxy with respect to any security registered under Exchange Act Section 12. Under Exchange Act Rule 14a-1(l), a solicitation includes, among other things, a “communication to security holders under circumstances reasonably calculated to result in the procurement, withholding or revocation of a proxy,” and includes communications by a person seeking to influence the voting of proxies by shareholders, regardless of whether the person itself is seeking authorization to act as a proxy.
9 These exemptions, found in Rule 14a-2(b), among other things, provide relief from the obligation to file a proxy statement, as long as the advisory firm complies with the exemption’s conditions.
As part of its package of new rules, forms and interpretations under both the Investment Advisers Act of 1940 and the Securities Exchange Act of 1934, the Securities and Exchange Commission has adopted a requirement that registered investment advisers and registered broker-dealers provide a brief relationship summary to retail investors on Form CRS.
This Client Alert focuses on the practical process of drafting, filing, updating and delivering Form CRS as well as legal implications for advisers and broker-dealers subject to this new requirement.
The overarching purpose of the relationship summary is “to reduce retail investor confusion in the marketplace for brokerage and investment advisory services and to assist retail investors with the process of deciding whether to engage, or to continue to engage, a particular firm or financial professional and whether to establish, or to continue to maintain, an investment advisory or brokerage relationship.”1
Following the proposal of Form CRS in April 2018, the SEC’s Office of the Investor Advocate engaged the RAND Corporation to conduct investor testing on the proposed relationship summary through the administration of surveys and qualitative interviews of individual participants.2 Many commenters on the proposal expressed dissatisfaction with the scope and design of the study. For instance, one commenter stated that “the RAND Testing was not sufficiently rigorous to appropriately assess the effectiveness of Form CRS, and we strongly believe that it does not provide a reasonable basis upon which to adopt Form CRS as proposed.”3 As a result, commenters urged the SEC to delay its finalization of the proposed form until it could be determined that the disclosure in Form CRS and its utility to dispel investor confusion work as intended.
Despite these concerns, the SEC adopted the final rule without delay for further testing. In its release, the SEC noted that while it “considered this input” from commenters and used it to inform certain policy choices, “feedback we have received from or on behalf of retail investors through the RAND 2018 report, surveys and studies submitted by commenters, and input received at roundtables and on Feedback Forms, demonstrate that the proposed relationship summary would be useful for retail investors and provide information, e.g., about services, fees and costs, and standard of care, that would help investors to make more informed choices when deciding among firms and account options.”4
In the adopting release, the SEC provides for a review of the effectiveness of Form CRS to help ensure that it “fulfills its intended purpose.”5 In particular, the SEC directs the staff to review a sample of relationship summaries and provide the SEC with results of this review. There are no further details regarding the scope or timing of the review, or what the SEC will do with the staff’s report once it is provided.
Time will tell whether Form CRS will ultimately be effective to assist retail investors in understanding the scope of their engagement with an investment adviser, broker-dealer or dual registrant.
II. Presentation and Format
In response to several commenters arguing that the proposed Form CRS was too long and incomprehensible, the SEC resolved to streamline its presentation and format of Form CRS in adopting the final rule.
Instead of the four-page relationship summary that was proposed, the summary will now be limited to two pages (or four pages for dual registrants). Unlike the proposed instructions, the final instructions do not prescribe paper size, font size and margin width, but say only that they must be “reasonable.”6 The instructions also indicate that registrants should include white space and implement other design features to make the relationship summary easy to read.
Some commenters to the proposed Form CRS argued that the use of prescribed language in the instructions and the “one size fits all” approach would not appropriately address the various accounts, services and models of investment advisory and brokerage firms and therefore could be misleading to retail investors. Commenters urged the SEC to allow firms to craft their own relationship summary so that it can be tailored to the different types retail investors they service. In its adopting release, the SEC explained that, while firms will still be required to respond to a list of required topics in a prescribed order, firms will now have the flexibility to generally use their own wording to respond to the items on Form CRS.7
Several commenters to the proposed Form CRS also called for “layered” disclosure in the relationship summaries, whereby additional information could be found through cross-references, embedded URLs and QR codes. Commenters argued that “layered” disclosure would shorten and simplify the form, as well as help to alleviate the burden of having to disclose complex information that retail investors are unlikely to read. In its adopting release, the SEC states that the instructions now permit, and in some instances require, layered disclosures and otherwise encourage the use of charts, graphs, tables and other graphics to help retail investors easily digest the information.8
Additionally, in response to commenters, roundtable participants and the RAND study, which suggested that retail investors were confused with industry jargon, the final release states that in crafting their responses on Form CRS, firms will not be permitted to use legal jargon or highly technical business terms – such as “asset-based fee” and “load” – unless firms clearly explain them in plain English, even if the firm believes a reasonable retail investor would understand those terms.9
While the scope of the information required within the relationship summary has been modified in light of commenter concerns, firms are still obligated to provide accurate information and may not omit any material facts necessary to make the required disclosures, in light of the circumstances under which they were made, not misleading.10 According to the SEC, the phrase, “in light of the circumstances under which they were made,” was added to the final instructions in order to clarify that the disclosure is intended to be a summary, that firms must still adhere to the page limit, and that the instructions encourage firms to reference or link to additional information.11 Form CRS is “not intended to create a private right of action.”12
As a practical matter, firms may find it difficult to adhere to these requirements in a paper-based relationship summary. In such a format, firms must ensure that all material facts and disclosures are provided, that all technical terms are fully explained, and charts, tables or other graphics intended to help investors understand the information all fit within the confines of the two or four-page summary limit. It is unclear whether it is practical, or even possible, to disclose such information in a paper-based format within these page constraints. While the SEC permits hyperlinks and QR codes to be embedded in the text of a paper-based summary, questions remain as to the likelihood that retail investors would separately access the links provided.
III. Standards of Conduct
The RAND 2018 Report and other surveys found that retail investors struggled to understand the standard of care for broker-dealers and investment advisers after reading the proposed Form CRS, and RAND reported that survey participants especially had difficulty reconciling the information provided in the “Obligations to You” section and the “Conflicts of Interest” section. In addition, commenters noted that retail investors did not understand the differences between a “best interest” and “fiduciary” standard, with at least one commenter noting that the confusion is likely attributable to a lack of clarity regarding the standards themselves. Yet as shown in the final release for Regulation Best Interest, broker-dealers and investment advisers will continue to be subject to different standards of conduct despite the SEC’s efforts to harmonize the obligations.
In the final release, firms will remain subject to the requirement to describe their legal standard of conduct using prescribed wording, but the standard of conduct disclosure is provided in the conflicts of interest section.13 The modified standard of conduct disclosure now eliminates legal jargon, such as “fiduciary,” and instead uses the term “best interest” across the board, to describe how broker-dealers, investment advisers, and dual registrants must act regarding their retail customers or clients when providing recommendations as a broker-dealer or when acting as an investment adviser.
This decision is notable, considering that the final form of Regulation Best Interest still does not place a “fiduciary standard” on broker-dealers, and thus one could argue that the standards of conduct are inherently different. The harmonizing of the standard of care under Form CRS, however, appears to imply that the broker-dealer standard is as high as a fiduciary standard, even though it is not defined as such. In this regard, the SEC noted that, “we believe that requiring firms – whether broker-dealers, investment advisers, or dual registrants – to use the term ‘best interest’ to describe their applicable standard of conduct will clarify for retail investors their firm’s legal obligation in this respect, regardless of whether that obligation arises from Regulation Best Interest or an investment adviser’s fiduciary duty under the Investment Advisers Act.”14
The SEC states in the adopting release that the prescribed language describing the standard of conduct broker-dealers and investment advisers owe to their customers and clients is not intended to create a private right of action.15 The SEC did not address the possibility that such disclosures might support claims under existing private rights of action, such as that under rule 10b-5 under the Exchange Act.
IV. Contents of the Relationship Summary
The final instructions for the relationship summary require a question-and-answer format, with standardized questions serving as the headings in a prescribed order to promote consistency and comparability. The headings will be structured and machine-readable. Under the standardized headings, firms will generally use their own wording to address the required topics, although some specific disclosures are prescribed. Firms will also be required to link to additional information, which for investment advisers will be to their Form ADV Part 2A brochures or equivalent information and for broker-dealers will be to their Regulation Best Interest disclosures.
In particular, the required headings address: (i) identifying information about the firm and a link to the SEC’s website; (ii) the types of client and customer relationships and services each firm offers; (iii) the fees, costs, conflicts of interest, and required standard of conduct associated with those relationships and services; (iv) whether the firm and its financial professionals currently have reportable legal or disciplinary history; and (v) how to obtain additional information about the firm.
Some of the “Key Questions to Ask” from the proposal have been integrated into the relationship summary sections as required “conversation starters.” The SEC intends that retail investors can use these questions to engage in dialogue with their financial professionals about their individual circumstances.
V. Delivery, Filing, Updating and Recordkeeping Requirements
Under the final rule, investment advisers and broker-dealers will be obligated to deliver a relationship summary to retail investors at a certain time before or during the engagement, file copies of their relationship summaries with the SEC, update the disclosures when the information becomes materially inaccurate, and communicate any changes to retail investors who are existing clients or customers.
The relationship summary requirement applies to investment advisers and broker-dealers with retail investors. If a firm does not have any retail investors, it is not required to prepare or file a relationship summary. In particular, it appears that investment advisers to institutional separate accounts, private funds and registered funds will not be required to deliver Form CRS. In addition, the adopting release states that the SEC would not consider a broker-dealer that is serving solely as a principal underwriter to a mutual fund or variable annuity or variable life insurance contract issuer to be offering services to a retail investor for this purpose, when acting in such capacity.16
a. Retail Investor
The SEC’s final rule defines a retail investor as a natural person, or the legal representative of a natural person, who seeks to receive or receives services primarily for personal, family or household purposes. The SEC interprets a “legal representative” of a natural person to cover only non-professional legal representatives (e.g., a non-professional trustee that represents the assets of a natural person and similar representatives such as executors, conservators, and persons holding a power of attorney for a natural person).17 The definition excludes natural persons seeking services for commercial or business purposes (though a relationship summary is required to be delivered to those persons who might be seeking services for a mix of personal and commercial or other non-personal purposes).18 The definition does not distinguish based on a net worth or other asset threshold.19 In addition, in response to commenter concerns regarding whether the definition includes plan participants, the SEC clarified that the definition will include a natural person seeking to select and retain a firm to provide brokerage or advisory services for his or her own retirement account, including but not limited to IRAs and individual accounts in workplace retirement plans, such as 401(k) plans and other tax-favored retirement plans.20
In its adopting release, the SEC stated that while the final instructions adopt a definition of “retail investor” that is consistent with the definition of “retail customer,” it differs to reflect differences between the relationship summary delivery requirements and the obligations of broker-dealers under Regulation Best Interest, including “that the relationship summary is required whether or not there is a recommendation and covers any prospective and existing clients and customers (i.e., a person who ‘seeks to receive or receives services’) of both investment advisers and broker-dealers.”21
For investment advisers, the SEC requires delivery of a relationship summary before or at the time the firm enters into an investment advisory contract and is intended to generally track the initial delivery requirement for Form ADV Part 2A. However, in a change from the proposal, broker-dealers must deliver the relationship summary to each new or prospective customer who is a retail investor before or at the earliest of one of three triggers: (i) a recommendation of an account type, a securities transaction, or an investment strategy involving securities; (ii) placing an order for the retail investor; or (iii) the opening of a brokerage account for the retail investor. Dual registrants, and affiliated broker-dealers and investment advisers that jointly offer their services, must deliver at the earlier of the initial delivery triggers for an investment adviser or a broker-dealer.
In response to commenters’ concerns, the SEC also adopted rules for delivery when changes are made to an existing account that would “materially change the nature and scope” of the firm’s relationship with the retail investor. For example, firms will be required to deliver the relationship summary to existing retail investors: (i) before or at the time firms open a new account that is different from the retail investor’s existing account; (ii) when they recommend that the retail investor roll over assets from a retirement account; or (iii) when they recommend or provide a new service or investment outside of a formal account (e.g., variable annuities or a first-time purchase of a direct-sold mutual fund through a “check and application” process).
To facilitate retail investors receiving the relationship summary as early as possible, a firm may deliver the initial relationship summary to a new or prospective client or customer in a manner that is consistent with how the retail investor requested information about the firm or financial professional (e.g., by email if information requested by email).22 The SEC is not requiring that firms make the initial relationship summary available in paper format and believes that retail investors that prefer paper communications will have the opportunity to establish relationships with firms that accommodate paper delivery.23 With respect to existing clients or customers, firms must comply with the SEC’s electronic delivery guidance, which provides that a person who has a right to receive a document under the federal securities laws and chooses to receive it electronically, should be provided with the information in paper form whenever specifically requesting paper.24
Relationship summaries will be filed by broker-dealers on Form CRS through Web CRD and by investment advisers as Form ADV Part 3 (Form CRS) through IARD, using a text-searchable format. Dual registrants will file using both IARD and Web CRD. The use of Web CRD instead of EDGAR, as proposed, is to allow broker-dealers to use a platform which, according to commenters, is more accessible and familiar to them. The summaries will be accessible via the SEC’s public website, Investor.gov, in addition to each firm’s website.25
Broker-dealers and investment advisers must update the relationship summary and file it within 30 days whenever any information in it becomes materially inaccurate, and any changes must be communicated to existing clients or customers within 60 days (instead of 30 days as proposed). In a change from the proposal, the SEC also added a requirement that firms delivering updated relationship summaries to existing clients or customers must highlight the most recent changes by, for example, marking the revised text or including a summary of material changes.26 This additional disclosure must be filed as an exhibit to the unmarked amended relationship summary (but would not be counted toward the two-page or four-page limit, as applicable).
The SEC is adopting amendments to the recordkeeping and record retention requirements under Advisers Act rule 204-2 and Exchange Act rules 17a-3 and 17a-4. Pursuant to paragraph (a)(14)(i) of Advisers Act rule 204-2 as amended, investment advisers will be required to make and preserve a record of the dates that each relationship summary was given to any client or prospective client who subsequently becomes a client. New paragraph (a)(24) of Exchange Act rule 17a-3, as adopted, will require broker-dealers to create a record of the date on which each relationship summary was provided to each retail investor, including any relationship summary provided before such retail investor opens an account. In addition, paragraph (a)(14)(i) of Advisers Act rule 204-2, as amended, will require investment advisers to retain copies of each relationship summary and each amendment or revision thereto while paragraph (e)(10) of Exchange Act rule 17a-4, as amended, will require broker-dealers to maintain and preserve a copy of each version of the relationship summary as well as the records required to be made pursuant to new paragraph (a)(24) of Exchange Act rule 17a-3. The amended rules also set forth the manner in which and the period of time for which these records must be retained.
The recordkeeping requirements were adopted as proposed, despite concerns from commenters that the requirements as written would be burdensome, especially with regard to maintaining records of prospective clients and customers who do not become clients or customers. The SEC indicated that the collection of information will be used in its examination and oversight program.27
VI. Compliance Date
In the final rule, the SEC extended the time to comply with the relationship summary requirements. In the adopting release, the SEC noted that firms that are registered, or investment advisers who have an application for registration pending, with the Commission prior to June 30, 2020, will have a period of time beginning on May 1, 2020 until June 30, 2020 to file their initial relationship summaries with the SEC. On and after June 30, 2020, newly registered broker-dealers will be required to file their relationship summary with the SEC by the date on which their registration with the SEC becomes effective, and the SEC will not accept any initial application for registration as an investment adviser that does not include a relationship summary that satisfies the requirements of Form ADV, Part 3: Form CRS.28 It is not clear what the review process will be at the SEC for relationship summaries and whether that process could slow down effectiveness of newly registering investment advisers, or whether existing broker-dealers and investment advisers should anticipate comments on their relationship summaries.
Firms will be required to deliver their relationship summary to new and prospective clients and customers who are retail investors as of the date by which they are first required to electronically file their relationship summary with the SEC. In addition, firms will be required, as part of the transition, to deliver their relationship summaries to all existing clients and customers who are retail investors on an initial one-time basis within 30 days after the date the firm is first required to file its relationship summary with the SEC.
2Form CRS Relationship Summary, supra Note 1,at 9.
3 Investment Adviser Association, Investor Testing of Form CRS Relationship Summary, at 2 (Dec. 4, 2018). Seealso Consumer Federation of America, File No. S7-08-18, Form CRS Relationship Summary, at 1 (Dec. 7, 2018) (the “inescapable conclusion” from the study is that the disclosures in the proposed Form CRS do not, as currently conceived, “actually support informed investor decision-making” and that many investors still fail to understand “key information that would help them determine whether a brokerage or advisory account would best suit their needs.”).
4Form CRS Relationship Summary, supra Note 1, at 11 – 12.
5Id. at 28 – 29.
6 The adopting release indicates that 8½” x 11” paper size, at least an 11 point font size, and a minimum of 0.75” margins on all sides could be considered reasonable, but other parameters could also be reasonable. Id. at 48.
7Id. at 21, 37.
8Id. at 21 – 22.
9Id. at 33.
10 Instructions to Form CRS, supra Note 1, General Instruction 2.B.
11Form CRS Relationship Summary, supra Note 1, at 42 (emphasis in original).
12Id. at 43.
13Id. at 143 – 44.
14Id. at 153 – 54.
15Id. at 145.
16Id. at 224 – 25.
17Id. at 195. In other words, delivery of the relationship summary to regulated financial services professionals acting as representatives of a natural person is not required.
18Id. at 193.
19Id. at 193 – 94.
20Id. at 197. In addition, the SEC noted that participants in 401(k) plans and other workplace retirement plans will not be retail investors for purposes of the Form CRS delivery obligation when making certain ordinary plan elections that do not involve selecting or retaining a firm to provide brokerage or advisory services. Id. at 198.
In recent years, the frequency of proxy contests at public companies has increased, focusing more attention on the way institutional investors decide how to vote their proxies. Issuer dissatisfaction with the role of proxy advisory firms in this decision-making process has been a steady drumbeat for decades. In part, public company issuers are understandably unhappy that there is not more competition; Institutional Shareholder Services Inc. (“ISS”) and Glass Lewis dominate the market for providing proxy advisory services. The Securities and Exchange Commission (“SEC”), however, cannot regulate its way to requiring that additional players enter the market. Absent legislation, the question becomes what, if anything, the SEC can achieve under its current rulemaking authority or through SEC staff guidance. What action could help address public company issuer concerns without raising barriers to entry or otherwise negatively impacting competition for proxy advisory firms by increasing regulatory costs, which would undoubtedly be passed on to institutional investor clients? It is a complicated path strewn with the potential for unintended consequences.
This article describes the history of the issues around fund and asset manager use of proxy advisory firms in connection with fund proxy voting, highlighting how we got to where we are today. It then discusses some of the difficulties the SEC faces in moving forward with any additional regulation. Finally, it provides some practical considerations to fund directors and asset managers with regard to fund proxy voting in this uncertain time.
SEC Proxy Voting Regulation and Staff Guidance On March 19, 2002, shareholders narrowly approved a hotly contested shareholder vote on the merger between Hewlett-Packard and Compaq. Merger opponents alleged that a fund asset manager had switched its vote at the last minute to favor the merger after Hewlett-Packard executives threatened to lock its parent company out of future Hewlett-Packard investment banking business if it voted against the merger. A dissident director of Hewlett-Packard filed suit to block the merger, alleging Hewlett-Packard executives used corporate assets “to entice and coerce” the fund asset manager.1 The SEC eventually settled an enforcement action against the asset manager, alleging that it had failed to disclose to its clients the existence of a material conflict in connection with its proxy vote.2
On the heels of this controversy, the SEC, under the leadership of then-Chairman Harvey Pitt, finalized proxy voting rules for both funds and advisers.3 On the one hand, the rules were typical to the regulatory regime under the Investment Company Act of 1940 (“Investment Company Act”) and the Investment Advisers Act of 1940 (“Advisers Act”) in that the rules were disclosure-based and operated mainly through policies and procedures that could be adapted to a fund’s or asset manager’s particular circumstances. Funds were required to disclose the policies and procedures they used to vote proxies and to disclose to shareholders the specific proxy votes the funds cast.4 Advisers were required to maintain policies and procedures reasonably designed to ensure that the adviser voted proxies in the best interest of clients, including how the adviser addressed material conflicts.5
On the other hand, the Adviser Rule Release indicated that voting proxies was an explicit fiduciary duty of care: “The duty of care requires an adviser with proxy voting authority to monitor corporate events and to vote the proxies.”6 While the SEC stated in the Adviser Rule Release that “we do not suggest that an adviser that fails to vote every proxy would necessarily violate its fiduciary obligations,” it provided only one very limited exception to an adviser’s duty to vote every proxy, namely voting on a foreign security as that could involve costs such as hiring a translator or traveling to a foreign country to vote in person.7 The SEC also noted in the Adviser Rule Release that if an investment adviser had a conflict with regard to voting, one way to address that conflict would be to have a third party assist in determining how to vote: “[A]n adviser could demonstrate that the vote was not a product of a conflict of interest if it voted client securities, in accordance with a pre-determined policy, based upon the recommendation of an independent third party.”8
A year or so later, certain proxy advisory firms asked the SEC staff to clarify how investment advisers could determine that a third party, like a proxy advisory firm, was, in fact, independent for purposes of Advisers Act rule 206(4)-6. The SEC staff issued two interpretive letters outlining that an investment adviser could use a proxy advisory firm that itself had a conflict if the adviser determined that the proxy advisory firm “has the capacity and competency to adequately analyze proxy issues and can make such recommendations in an impartial manner and in the best interests of the adviser’s clients.”9 In particular, the letters indicated that advisers should obtain information from the proxy advisory firm to make this determination and suggested that an adviser require the proxy advisory firm to disclose relevant facts relating to the conflict, whether that be on a case-by-case basis or on the basis of the proxy advisory firm’s conflict procedures.
Within a couple of years, public company issuers began questioning proxy advisory firm’s potential conflicts, particularly with regard to ISS, which had two services: providing reports about issuers and consulting services to corporations seeking to improve their corporate governance. Critics contended that issuers could feel obligated to retain ISS’s consulting services in order to obtain favorable vote recommendations when ISS issued reports about that particular issuer.10 Responding to requests from the House Committee on Financial Services, the Government Accountability Office (“GAO”) issued a report in 2007 generally finding that, while ISS may have conflicts of interest, it discloses such conflicts, and, as a registered investment adviser, it has been subject to examination by the SEC staff, which had not identified any major issues.11
SEC Concept Release In 2010, the SEC issued a concept release on the proxy voting system, noting that it had been almost 30 years since the SEC last conducted a comprehensive review of proxy voting issues and pointing to corporate and investor interest in promoting greater efficiency and transparency in the system.12 The concept release sought comments as to whether the proxy system as a whole operated with the accuracy, reliability, transparency, accountability and integrity that investors and issuers should expect, and focused on issues such as over- and under-voting, vote confirmation, proxy voting in the context of securities lending, proxy distribution fees and issuers’ ability to communicate with beneficial owners. As part of that release, the SEC suggested that proxy advisory firms may be investment advisers because part of their service is issuing reports about securities.13 The SEC noted that, as fiduciaries, proxy advisory firms that were registered as advisers would have to disclose conflicts of interest to the institutional investors they advised.
Over the next few years, public companies and certain academics increasingly criticized proxy advisory firms, focusing on a perceived lack of sufficient resources, which led to errors in issuer reports, as well as reiterating prior criticism that certain proxy advisory firms suffered from misaligned incentives and conflicts. Critics also began to attack asset manager use of proxy advisory firms, including claims that, because of perverse incentives created by Advisers Act rule 206(4)-6 and the related interpretive letters, asset managers and funds outsourced decision making and blindly relied on proxy advisory firms.14 For example, these critics pointed to data indicating that shortly after ISS would release a report on a public company issuer, a significant number of shares would be voted in a lock-step manner.15 The real concern, however, seemed to be the influence that proxy advisory firms have on shaping corporate policy.16
First SEC Roundtable and Staff Guidance
The SEC held a roundtable in 2013 that focused, in part, on the factors that had contributed to the use of proxy advisory firm services and the purposes such firms serve; conflicts of interest that may exist for proxy advisory firms and users of their services; the transparency and accuracy of the recommendations made by proxy advisory firms; and what the nature and extent of reliance by investors on proxy advisor recommendations was and should be. Not surprisingly, vastly different views were expressed by public companies, institutional investors and proxy advisory firms themselves.17
Following the roundtable, the SEC’s Chairman and Commissioners continued to speak to issues around corporate governance.18 In mid-2014, SEC staff from both the Division of Investment Management (“IM”) and the Division of Corporation Finance (“CF”) issued a staff legal bulletin that provided guidance about investment adviser responsibilities in voting client proxies and retaining proxy advisory firms (“SLB 20”).19 SLB 20 also provided guidance on the availability and requirements of two exemptions to the federal proxy rules that are often relied upon by proxy advisory firms. In particular, IM staff reiterated positions from the interpretive letters that investment advisers, in determining whether to retain or continue using a proxy advisory firm, should conduct due diligence to ensure that the adviser, acting through the proxy advisory firm, continued to vote in the best interests of its clients. In addition, IM staff clarified that an investment adviser and its clients may agree to arrangements whereby the adviser would not vote every proxy. In addition, CF staff made clear that, if a proxy advisory firm relied on certain exemptions from the federal proxy rules and therefore was required to disclose a significant relationship or material interest, that disclosure must be sufficient for the recipient to understand the nature and scope of the relationship or interest, including the steps taken to mitigate the conflict of interest, such that the recipient could make an assessment about the objectivity of the recommendation. In other words, the proxy advisory firm must make more than a boilerplate disclosure regarding the conflict of interest.
In 2016, in response to issues raised by some members of Congress, industry associations and academics, the GAO issued another report that examined proxy advisory firms’ influence on voting and corporate governance, the level of transparency in their methods and the level of regulatory oversight with regard to such methods.20 The GAO interviewed various stakeholders, including public company issuers, institutional investors and proxy advisory firms. The GAO report reflected varying views, but it contained no recommendations.
In the last couple of years, there have been legislative efforts to address issues raised about proxy advisory firms. In 2017, the House of Representatives passed H.R. 4015, but it was not taken up by the Senate.21 H.R. 4015, which was in many ways similar to the Credit Rating Agency Reform Act of 2006, would have, among other things, required proxy advisory firms to register under the Securities Exchange Act of 1934, disclose potential conflicts of interest and codes of ethics and make public their methodologies for formulating recommendations. Most importantly, H.R. 4015 would have required proxy advisory firms to provide access, in a reasonable amount of time, to a draft report on a public company issuer, including data, analysis and the proposed recommendation, to the public company issuer before sending the report to their institutional investor clients; if the public company issuer objected to the analysis and the objection could not be resolved, H.R. 4015 would have required that the public company issuer’s objection and rebuttal be included in the report.22 More recently, a bipartisan bill was introduced by six Senators in November 2018, which would have required that all proxy advisory firms register as investment advisers, that the SEC conduct periodic inspections of proxy advisory firms, that the SEC submit periodic reports to Congress evaluating the policies and procedures at proxy advisory firms and that the SEC continue to examine whether additional investor protection regulation is necessary.23
Second SEC Roundtable In November 2018, the SEC held a second roundtable. In advance of that roundtable and “to facilitate the discussion,” IM staff withdrew the two interpretive letters.24 The staff did not withdraw SLB 20, which, as discussed earlier, reiterated positions in the interpretive letters. While there was little discussion of the interpretive letters at the roundtable, it is noteworthy that no one at the roundtable strongly supported additional regulation for proxy advisory firms.25
Although not directly related to fund use of proxy advisory firms, another important conversation taking place around fund voting relates to the “common ownership” theory expounded by certain academics. This theory posits that index funds and index ETFs have perverse incentives because they seek only to match the performance of an index (rather than over-perform) and will use their vote to induce portfolio company management to reduce intra-industry competition, thereby harming the portfolio company’s other shareholders. Some academics that subscribe to this theory have argued that passive funds should not be permitted to vote or should have to pass voting to fund shareholders.26 While the asset management industry and certain other academics have criticized the common ownership theory,27 it has caught the attention of regulators globally,28 and its potential impact on fund voting cannot be ignored in the debate around fund voting and the use of proxy advisory firms.
On December 6, 2018, SEC Chairman Clayton gave a speech during which he discussed significant initiatives for 2019, including SEC action to improve the proxy process.29 The Chairman recognized the consensus view that proxy “plumbing” (i.e., issues raised by the 2010 Concept Release around proxy voting mechanics such as over- and under-voting, accuracy and transparency in voting and issuer communication with beneficial owners) needs a major overhaul, and he appeared to endorse consideration of changes to the ownership and resubmission thresholds for shareholder proposals. Specifically with respect to proxy advisory firms, he also indicated that the SEC should consider: (1) “the division of labor, responsibility and authority between proxy advisors and the investment advisers they serve”; (2) “clarity regarding the analytical and decision-making processes advisers employ, including the extent to which those analytics are company- or industry-specific”; (3) “the framework for addressing conflicts of interest at proxy advisory firms”; and (4) “ensuring that investors have effective access to issuer responses to information in proxy advisory firm reports.” Subsequently, the Chairman asked SEC Commissioner Roisman to lead efforts to improve the proxy voting process and infrastructure.30
While there is general agreement that improvements are needed with regard to the proxy voting process, there is no consensus around issues related to fund adviser and other institutional investor use of proxy advisory firms. While these issues have been discussed and debated for years, and while the SEC staff has made efforts to address at least some aspects of these issues, the SEC’s efforts have not stopped the criticism. Public company issuers believe ISS and Glass Lewis have too much power over public company governance. Asset managers believe that their use of proxy advisory firms, whether for administrative processing of votes, research reports, assistance with custom guidelines, or otherwise, is appropriate.
The SEC faces significant hurdles to moving forward with any rules or regulations. First is the issue of bandwidth. Issues specifically related to proxy voting are on the long-term actions (as opposed to active list) on the recent Regulatory Flexibility Agenda, and the Chairman has spoken publicly, including in his December 6, 2018 speech, about his intent to focus the agenda on rulemakings that the Commission can reasonably complete. Moreover, in addition to issues around proxy advisory firms, there are a number of other proxy-related issues (e.g., proxy voting mechanics and issues around shareholder proposals). All of these issues have the potential to be complicated and controversial, and stakeholders with strongly held views will likely challenge any rules or regulation from different perspectives. In addition, the SEC is subject to significant regulatory requirements to justify regulation on cost-benefit grounds.31 For all of these reasons, the SEC faces a difficult road ahead in taking action to significantly improve the situation for all interested parties in 2019.
Funds and their advisers cast a large number of votes on public company proxies in a short proxy season.32 This section highlights some background on proxy voting, including common proxy voting structures and processes and practical considerations for fund boards and advisers.
Fund Boards As the SEC stated in the adopting release to the Fund Rule Release in 2003, a fund’s board of directors or trustees (the “board”) has the right to vote proxies for the fund.33 The SEC recognized, however, that most boards delegate responsibility to the fund’s investment adviser subject to board oversight.34 The board retains responsibility for overseeing the processes put in place by the adviser.35
The board also must approve and annually review the adequacy of a fund’s policies and procedures as part of the fund’s compliance program. Some boards adopt a separate fund policy while others determine to rely on the fund adviser’s policy.36 If relying on the fund adviser’s policy, the board should understand the process the adviser uses to determine when it has a conflict, how the adviser’s process addresses conflicts (e.g., use of committees, firewalls or third-party service providers) and how the adviser will disclose conflicts to the board or otherwise provide appropriate reporting to the board.
Fund Advisers Advisers that have been delegated authority for the administrative process of voting or delegated voting authority may engage in different practices with regard to the use of proxy advisory services. Larger asset managers may have sufficient in-house resources and staff to conduct research on proxy votes and address conflicts (i.e., by having separate governance staff), such that they do not rely on proxy advisory firms’ recommendations at all. Most advisers, however, use proxy advisory firms for at least some of the following services:
Administrative services. An adviser could be responsible for thousands of votes per year for registered investment companies. Advisers may engage proxy advisory firms to assist in the mechanical processing of proxy votes, similar to how advisers engage other service providers for operational functions. This might include data tracking and administration as well as workflow management processes. For example, an adviser could use a proxy advisory firm to provide notifications and reminders of upcoming proxy votes; provide coverage and translation services with respect to foreign issuers; communicate voting recommendations and rationales; execute voting instructions; record and report proxy voting records; and prepare and/or file Form N-PX for funds.
Research and analytics. An adviser may receive research from proxy advisory firms to use as an input to the adviser’s own decision making. Advisers may choose to receive information based on standard benchmark policies or more specific policies.
Using proxy advisory firm recommendations. Proxy advisory firms may offer vote recommendations based on their own guidelines that the adviser takes into account in its own decision-making process. Smaller asset managers may vote proxies in line with a proxy advisory firm’s recommendations subject to the asset manager’s override.
Using a proxy advisory firm to help draft guidelines. Some advisers use a proxy advisory firm to help draft or update their own voting guidelines, especially in areas where the adviser lacks expertise.
As a fiduciary to the funds it advises, an adviser must address conflicts consistent with Advisers Act rule 206(4)-6. A fund adviser with voting authority must adopt and implement policies and procedures reasonably designed to ensure that it votes proxies in the best interest of the funds it advises, and those policies and procedures must address material conflicts that may arise between the interests of the adviser and the funds it advises.
To address these fiduciary responsibilities, there are a number of methods that advisers use, some of which involve proxy advisory firms:
Creating a predetermined voting policy. This effectively limits the adviser’s own voting discretion on individual votes. A predetermined policy may not always be sufficient as the adviser may have valid (i.e., non-conflict related) reasons to deviate from the policy, or the policy may not cover every possible situation. An adviser therefore may wish to consider appointing a committee or designating particular personnel who otherwise are not involved in the proxy voting process to help determine how such matters should be voted.
Use of a proxy advisory firm. Just as it would for any service provider, an adviser should conduct due diligence before retaining a proxy advisory firm and continue to monitor the proxy advisory firm’s services.37
Given the current focus on adviser use of proxy advisory firms, advisers should review their policies and procedures relating to proxy voting, including how they evaluate and use proxy advisory firms’ services, and particularly in circumstances where a proxy vote relates to more controversial proposals.38
4See Investment Company Act rule 30b1-4 and form N-PX.
5See Advisers Act rule 206(4)-6. In addition, Advisers Act rule 206(4)-6 requires an adviser to disclose to its clients information about the policies and procedures and to disclose to clients how they may obtain information on how the adviser has voted proxies.
6See Adviser Rule Release, supra note 3.
9 Egan-Jones Proxy Services (pub. avail. May 27, 2004); Institutional Shareholder Services, Inc. (pub. avail. Sept. 15, 2004).
10 Some also have contended that Glass Lewis’s ownership by the Ontario Teachers’ Pension Plan Board raises conflicts. See, e.g., Chamber of Commerce Comment Letter to the SEC (May 30, 2012) (alleging that its activist owner influenced Glass Lewis’s recommendation to oppose the board of directors for a Canadian railway in a proxy battle with an activist hedge fund). Both ISS and Glass Lewis publicly disclose information about their respective conflicts of interest.
12 Concept Release on the U.S. Proxy System, Investment Company Act Release No. 29340 at 109 (Jul. 14, 2010) (“Concept Release”). Seealso, Mary L. Schapiro, Chairman, Remarks at the National Conference of the Society of Corporate Secretaries and Governance Professionals (Jul. 9, 2010).
13 As indicated, ISS already had been registered as an investment adviser, but certain other proxy advisory firms, such as Glass Lewis, had not registered.
14See, e.g., James K. Glassman & J. W. Verret, How to Fix our Broken Proxy Advisory System, Mercatus Ctr. at George Mason Univ. (April 16, 2013) (“How to Fix our Broken Proxy Advisory System”), (“Unfortunately, the rule became a classic case of unintended consequences. Many institutional investors largely outsourced their shareholder voting policies to a proxy advisory industry that relies on precisely the type of ‘one-size-fits-all’ policies that were intentionally excluded from the original regulation because of objections by commissioners. The SEC staff interpretation of the rules on proxy voting have led to the opposite result of what many of its supporters intended.”). Seealso, Daniel M. Gallagher, Commissioner, Remarks at Society of Corporate Secretaries & Governance Professionals,” (July 11, 2013), (“Given the sheer volume of votes, institutional shareholders, particularly investment advisers, may view their responsibility to vote on proxy matters with more of a compliance mindset than a fiduciary mindset. Sadly, the Commission may have been a significant enabler of this [through rule 206(4)-6 and the interpretive letters]”). Butsee Stephen Choi, Jill Fisch & Marcel Kahan, Who Calls the Shots? How Mutual Funds Vote on Director Elections, 3 Harv Bus L. Rev. 35 (2013) (finding a substantial degree of divergence in fund voting from ISS recommendations).
15SeeIBM Comment Letter on the Concept Release (Oct. 15, 2010), (institutional investors vote in a lock-step manner (i.e., 100% in accordance) with the ISS recommendation). Seealso Morris Mitler, Sean Collins & Dorothy Donohue, Funds and Proxy Voting: Funds Vote Thoughtfully and Independently (Nov. 7, 2018), (in 2017, while funds voted in lock-step with ISS recommendations on proposals submitted by management, which tend to be routine business matters, that correlation breaks down when funds vote on shareholder proposals, which tend to be much more debated).
16 “To a large degree, corporate directors and executives are now subject to decision making on critical issues by organizations that have no direct stake in corporate performance and make poor decisions as a result. Conscientious shareholders, who do have such a stake, also suffer because their votes are usurped or overwhelmed by these same organizations. The SEC’s proxy policy rules have led to results unimagined by their original advocates.” How to Fix our Broken Proxy Advisory System, supra note 14.
17 The Commissioners themselves disagreed on the extent of any problems. For example, Commissioner Gallagher strongly sided with corporate interests, arguing for the need for “Commission guidance clarifying to institutional investors that they need to take responsibility for their voting decisions rather than engaging in rote reliance on proxy advisory firm recommendations would go a long way toward mitigating the concerns arising from the outsized and potentially conflicted role of proxy advisory firms” supra note 14. Chair White indicated that proxy advisory firms play an important role in assisting institutional investors and stated that she was “particularly interested in the discussion of conflicts of interest that may or may not arise in connection with the participation of proxy advisors in our system.” Mary J. White, Chairman, Welcoming Remarks at Proxy Advisory Services Roundtable (Dec. 5, 2013).
22Id. While the legislation defined a “reasonable time” to be one that did not interfere with the proxy advisory firm’s ability to provide the report to its institutional investor client, it is not clear how this process would be possible given the tight timelines during the proxy season.
23S. 3614, 115th Cong. (2018) The legislation appears to have been intended to deny Glass Lewis the ability to rely on the publisher’s exclusion from registration as an investment adviser as it specifically states that a proxy advisory firm may not rely on section 202(a)(11)(D) of the Advisers Act.
28 The Federal Trade Commission held a hearing addressing common ownership in December 2018. A European Parliament member recently told the Financial Times that “[t]he effects of [large passive funds] have to be taken into account and regulated,” and the European Competition Commissioner has been looking into issues since December 2018. SeeSiobhan Riding, Brussels targets large index fund managers on “common ownership” (Jan. 21, 2019). The OECD held a hearing on common ownership in December 2017.
32 Recent data published by the Investment Company Institute indicates that during the 2017 proxy season, funds cast more than 7.6 million votes for proxy proposals. See Mitler, Collins & Donohue, supra note 15.
33 “Because a mutual fund is the beneficial owner of its portfolio securities, the fund’s board of directors, acting on the fund’s behalf, has the right and the obligation to vote proxies relating to the fund’s portfolio securities.” See Fund Rule Release, supra note 3.
34 “As a practical matter, however, the board typically delegates this function to the fund’s investment adviser as part of the adviser’s general management of fund assets, subject to the board’s continuing oversight.” Id.
35 A board’s oversight is subject to its general fiduciary duty, and the “business judgment” rule should apply so long as the board has exercised reasonable judgment and not put its interests above those of the fund and its shareholders.
36 Fund boards that rely on the adviser’s policy and procedures should conduct a periodical review to determine the continued appropriateness of such policy and procedures.
37 The SEC staff in SLB 20 suggested good practices for an adviser to consider with regard to retaining the services of a proxy advisory firm and in determining whether to maintain such services. With regard to initial retention, the SEC staff suggested an adviser diligence the adequacy and quality of the proxy advisory firm’s staffing and resources and examine the robustness of its policies and procedures with regard to, for example, conflicts. With regard to maintaining such services, the SEC staff suggested, for example, periodically sampling proxy votes to determine if they are consistent with the adviser’s policy and procedures and having a process to investigate any material factual errors identified that formed the basis of a recommendation.
38 For example, many advisers include in their proxy voting guidelines that the adviser will make a case-by-case determination for more controversial proposals rather than having a proxy advisory firm vote according to a pre-determined guideline.
Both Commissioner Roisman and IM Division Director Blass spoke at this week’s Investment Company Institute Mutual Funds and Investment Management Conference about fund and investment adviser use of proxy advisory firms. Commissioner Roisman raised a number of questions and sought input from the industry, particularly from smaller asset managers, on the use of proxy advisory firms. Director Blass indicated that updates to the current guidance to clarify how investment advisers should fulfill their fiduciary duties in this area are anticipated around the end of proxy season this year, which is only a couple of months away. Additional information and context can be found here.
On September 13, 2018, the Chairman announced a review of staff guidance to determine if prior positions “should be modified, rescinded or supplemented in light of market or other developments.”1 In conjunction with the Chairman’s statement, IM staff withdrew two interpretive letters that gave guidance to investment advisers seeking to comply with the proxy voting requirements of rule 206(4)-6 under the Investment Advisers Act of 1940, which, among other things, requires investment advisers to vote client securities in the best interest of clients and to describe how they address material conflicts of interest between themselves and the clients on whose behalf they are voting.2 While rule 206(4)-6 does not dictate how an investment adviser must address conflicts, the adopting release discusses options, including engaging a third party to vote a proxy involving a material conflict or voting in accordance with a pre-determined policy based on recommendations of an independent party. The letters addressed how investment advisers that have a material conflict can determine that a proxy advisory firm is capable of making impartial recommendations in the best interests of the adviser’s clients. The SEC left in place 2014 staff guidance that enshrines the principles of the two interpretive letters.3
IM staff indicated in its statement that its withdrawal of the letters was designed to “facilitate discussions” at the Roundtable on the Proxy Process,4 which is expected to be held in November, and that staff was seeking views on the 2014 staff guidance. The U.S. Chamber of Commerce and some corporate secretaries have criticized proxy advisory firms for years, claiming proxy advisory firms lack transparency and accountability, and as part of these efforts, the corporate community has lobbied to withdraw the letters.5 Legislative efforts to directly regulate proxy advisory firms also have been proposed.6 For further information on the impact of the current and potential future SEC and staff actions, and advice on how to respond, please contact us at Stradley.
6 For example, HR 5311 was introduced in May 2016 and later folded into the Financial CHOICE Act. More recently, in October 2017, HR 4015, which is mostly a resubmission of HR 5311 was introduced. These bills generally require registration of proxy advisory firms with the SEC, and require firms to meet extensive disclosure requirements relating to methodologies and conflicts of interest, require firms to hire an ombudsperson to handle complaints, and give corporate issuers the ability to vet proxy advisory firms’ recommendations before the recommendations are released.