Risk & Reward

SEC Proposals Would Modernize Investment Adviser Advertising Rule & Expand the Cash Solicitation Rule

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.

SEC Proposes More Changes to Proxy Voting Process

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.

Eligibility

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.

One-proposal limit

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.

Resubmission threshold

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.

A trap door of the 25% plan assets test

Many sponsors of private funds, particularly hedge funds, rely on the 25% or significant participant test in order to avoid holding plan assets under ERISA. Equity participation in an entity by benefit plan investors is “significant” on any date if, immediately after the most recent acquisition of any equity interest in the entity, 25 percent or more of the value of any class of equity interests in the entity is held by benefit plan investors. Investments by the fund’s investment manager and its affiliates are disregarded. There is little guidance in terms of what constitutes separate equity classes. Some ERISA attorneys will look to see how “class” is defined under the securities laws, such as the Exchange Ac or the ’40 Act. Yet others consider other factors, as well. Is it described in the offering materials as a class? Would the different features (e.g., different fees, liquidity terms, etc.) render it a different class under local law?

New investment managers as QPAMs?

One of the most versatile and popular ERISA exemptions used by discretionary investment managers is the QPAM Exemption. Embedded in the exemption are financial requirements (i.e., capital and assets under management requirements) applicable to the investment manager based on the manager’s prior fiscal year.

The DOL explained that the minimum capital and assets under management requirement are designed to ensure that the investment manager (i.e., the QPAM) is large enough to ward off undue influence over its decision-making by parties in interest. This can prove very challenging for brand new managers because the exemption requires the manager have a prior fiscal year under its belt. There can be work-arounds for new managers, but they should be carefully considered before sending out an investment manager agreement that includes a representation that the investment manager is a QPAM.

What is the FX Global Code?

Foreign exchange (FX) is one of the most obscure asset classes for ERISA and governmental plans (as well as other institutional investors). The FX Global Code is an important development. The FX Global Code is a set of good practice principles for both buy-side and sell-side participants. It is also voluntary in nature. So, why should plan fiduciaries be aware of it? First, plan fiduciaries that invest in international securities will most likely hedge their exposure to that local currency. So while FX is rarely used as a source of alpha for plans, it is often used defensively. Second, FX is the largest market but probably the least understood. It’s long been obscure, I think. So what are some of the key principles?

(A) a clear understanding of whether a market participant acts as a principal or agent in executing a transaction;

(B) a need to handle orders with fairness and transparency, which includes making clear whether the prices quoted are firm or indicative, time stamping policy, etc.;

(C) pre-hedging as a principal only and in a manner that does not disadvantage the customer;

(D) understanding how reference prices are established;

(E) whether a markup is fair and reasonable (e.g., how much is the spread?); and

(F) having an effective compliance framework governing FX activities, including processes designed to identify and eliminate abusive or manipulative practices, escalation procedures once issues are identified, etc.

Not all of the principles in the Code apply equally to participants, but they do reflect a consensus (for the most part). A plan investment committee may wish to ask its investment managers whether it’s a signatory to the FX Global Code and how they intend to comply with it, and whether those managers will engage dealers on applicable principles.

What the new Callan survey reveals about ESG adoption in US

Callan recently released its 2019 ESG Survey. I have previously written about their prior surveys. Here are the key takeaways (the findings are from the survey, the analysis and commentary are mine):

  • Respondents (89) were U.S.-based institutional investors, including governmental plans, ERISA plans, endowments and foundations. In other words, this is not an ERISA-specific survey, but nevertheless picks up trends in the DC plan space.
  • Rather strikingly, 62% of respondents that utilized ESG have been doing so for just the past 5 years. This translates to a 91% increase in respondents that have incorporated ESG factors into investment decisions since 2013.
  • Implementation is the most popular ESG approach. Here is my definition of this technique. I expect this trend to continue as the data linking ESG factors to investment performance continues to evolve.
  • Significant uptick in adoption by DB and DC plans (both governmental and ERISA), though their overall numbers continue to lag other investor types. 36% of DC plans offer an ESG option. Only 18% have added a themed fund into the lineup (meaning, DOL Field Assistance Bulletin 2018-01’s discussion around themed funds, particularly the questions raised over whether such funds could serve as QDIAs, may be muted).
  • Noticeable differences between early adopters (before 2015) and recent adopters (2015-2019) in how they have implemented ESG:
    • 64% of the earlies added language to an IPS vs. 39% for the recents (perhaps some of this reflects 2018 DOL guidance that ESG-specific language in an IPS is not necessary?)
    • 57% of the earlies communicated to investment managers that ESG is important vs. 35% of the recents
    • 21% of the earlies utilized shareholder engagement/proxy voting as a method to address ESG vs 13% for the recents (regulatory headwinds could have dented this number a bit, as well)
    • 14% of the earlies added an ESG option to the DC plan lineup vs. 9% of the recents
  • 68% of respondents do not have a distinct ESG allocation apart from its traditional portfolio (this make sense considering integration, which us “under the hood,” is gaining traction).
  • Of recent adopters, 22% use a screening process and 17% have divested.
  • Reasons for incorporating ESG include:
    • Fiduciary responsibility (50% earlies, 57% recents)
    • Improved risk profile (29% earlies vs. 43% recents)
    • To make an impact (29% earlies vs. 17% recents)
    • Higher long-term returns (29% earlies vs. 17% recents)
  • Reasons against ESG incorporation include:
    • Not considering factors that are “not purely financial” in investment decision-making
    • Limited participant interest
    • Perceived political activism
    • Fiduciary duty concerns
    • Perceived as pursuing a moral agenda
    • Not legally required
  • Respondents have interest in seeing greater ESG products for both private equity and real estate, among others.

Ticktock on potential new DOL guidance re. proxy voting

In just a few days, the Department of Labor will be set to satisfy its obligations under the President’s April Executive Order by “complet[ing] a review of existing Department of Labor guidance on the fiduciary responsibilities for proxy voting to determine whether any such guidance should be rescinded, replaced, or modified to ensure consistency with current law and policies that promote long-term growth and maximize return on ERISA plan assets.” In an op-ed I wrote for Pensions & Investments, I put the EO into context and highlighted some possible paths the DOL could take. As we await any guidance, I would like to highlight this point that I made several months ago:

“…it is possible the DOL could adhere to the executive order by issuing new guidance that raises the perceived costs of proxy voting and other forms of shareholder engagement and/or demands a more rigorous analysis on the part of fiduciaries that such engagement is “clearly connected to” shareholder value. Any new test could not be so onerous as to make divestment preferable to engagement, as that would seem to undermine the executive order’s very purpose.”

We will, of course, conduct a full analysis of new DOL guidance, which we will post to this blog.

A New Direction for DOL Fiduciary Rulemaking

Yesterday, the U.S. Senate confirmed Eugene Scalia to succeed Alex Acosta as the Secretary of Labor. Scalia was confirmed along party lines on a vote of 53-44. Last week, Scalia told lawmakers that he may have to recuse himself from the work involved in fiduciary rulemaking due to his involvement in litigation pertaining to the 2016 Fiduciary Rule. Scalia stated that he would seek guidance from the Department of Labor’s (DOL) designated agency ethics official with respect to his ability to participate in such work. However, if Scalia were to be required to recuse himself, political decisions regarding the final rule would likely fall to Patrick Pizzella, the deputy labor secretary who has been the acting head since Acosta stepped down earlier this year.

As early as this fall, we may see the DOL issue new guidance on rollovers (a significant and uncertain issue in the wake of the Fiduciary Rule’s demise) and, in all likelihood, a proposed class exemption applicable to broker-dealers, which, at its heart, could condition relief on adherence to new Regulation Best Interest. We do not anticipate the DOL to reformulate the ways in which one becomes an investment advice fiduciary under ERISA (i.e., expanding the ways in which one becomes a fiduciary).

Finally, we are keeping a close eye on new guidance from the DOL on proxy voting over the next few weeks. You may recall that the President issued an Executive Order in April that, in part, required the DOL to examine if new guidance in this area was necessary. The DOL could decline to issue new guidance, since Field Assistance Bulletin 2018-01 addressed proxy voting. We will provide an update as soon as any new guidance on these issues becomes available.

Why is there investor confusion over ESG products?

A recent Ignites article discusses an Allianz survey on ESG interest among retail investors. As we have seen for a while, interest in ESG across demographics has increased, leading manufacturers to offer more ESG products. This has occurred in the place space, too. Yet, 73% of respondents report difficult in assessing the funds for one or more E, S and/or G factors. One well-known reason for this gap between interest and understanding is the still nascent methods portfolio companies have to report ESG risks, thereby inhibiting a uniform approach by the funds and managers to synthesize that data, invest accordingly and report to investors the data is incorporated. Simply, there is not perfect information yet. Frustration by asset owners will persist until there is a consensus on reporting.