Risk & Reward

SEC Updates Regulation Best Interest FAQs – Our Initial Take

On February 11, 2020, the staff of the Securities and Exchange Commission (SEC) updated its Frequently Asked Questions on Regulation Best Interest.  The update added a new “Retail Customer” section with four new Q&As.

  • The first Q&A reminds firms to carefully consider the extent to which associated persons can make recommendations to prospective retail customers in compliance with Regulation Best Interest, should the prospective retail customer use the recommendation.
  • The second Q&A clarifies that Regulation Best Interest applies to recommendations by a limited purpose broker-dealer of private offerings to accredited investors that are retail customers, and that the application of Regulation Best Interest is not dependent on whether the broker-dealer engages in limited activity.
  • The third Q&A seeks to clarify that the term “legal representative” of a retail customer would not cover regulated financial services industry professionals, which include registered investment advisers and broker-dealers, corporate fiduciaries and insurance companies, and the employees or other regulated representatives of such entities.
  • The final Q&A states that a retail customer, or a non-professional legal representative of such retail customer, cannot waive or agree to waive the protections afforded under Regulation Best Interest.

The update also adds a new Q&A in the Recommendations section that a recommendation of a securities account (e.g., a self-directed brokerage account) is covered by Regulation Best Interest even if the broker-dealer does not intend to provide subsequent recommendations subject to Regulation Best Interest in the new account.

Finally, the update added a new Q&A in the Disclosure section that confirms that while a standalone broker-dealer will generally be able to satisfy the requirement to disclose, in writing, all material facts about the scope and terms of its relationship with the retail customer, by delivering the relationship summary, a dually registered, broker-dealer or its associated persons, will not be able to satisfy the requirement with the relationship summary alone but must also disclose the capacity in which they are acting with respect to the retail customer.

Proposed Amendments to Issuer Disclosure: To ESG or Not to ESG

Proposed Amendments to Issuer Disclosure: to ESG or not to ESG

In connection with the SEC’s January 30 proposed amendments to certain of the financial disclosure requirements applicable to public companies under Regulation S-K, as well as accompanying guidance thereon, the separate public statements of Chairman Jay Clayton, Commissioner Hester Peirce, and Commissioner Allison Herren Lee underscore the continuing divide over the role of the SEC in disclosure related to ESG factors–and particularly climate-related disclosure–and its materiality to investors.

John P. Hamilton

Commissioner Peirce applauds the proposed amendments and guidance for “not bow[ing] to demands for a new [ESG-related] disclosure framework, but instead support[ing] the principles-based approach that has served us well for decades.” Citing the lack of sustainability-focused metrics disclosed in a recent sample of public disclosure filings, Peirce suggests that, “[t]here is reason to question the materiality of ESG and sustainability disclosure based on existing practices.” Further, Peirce highlights her skepticism of “calls to expand our disclosure framework to require ESG and sustainability disclosures regardless of materiality.”

Commissioner Lee, on the other hand, notes that she cannot support the proposal because the Commission has chosen to “ignore the challenge of disclosure around climate change risk rather than to begin the difficult process of confronting it.” Lee posits that investors have “overwhelmingly” made clear to the SEC, “through comment letters and petitions for rulemaking, that they need consistent, reliable, and comparable disclosures of the risks and opportunities related to sustainability measures, particularly climate risk …[and] that this information is material to their decision-making process, and a growing body of research confirms that.”  In Lee’s view, the “principles-based ‘materiality’ standard has not produced sufficient disclosure to ensure that investors are getting the information they need—that is, disclosures that are consistent, reliable, and comparable.”

Chairman Clayton, in his comments, took the opportunity to summarize steps that the SEC has taken over the last several years involving climate-related disclosure, framing the SEC’s commitment as “rooted in materiality,” and citing efforts such as the Commission’s 2010 guidance on climate change disclosure, as well as continuing engagement, both formally and informally, with market participants and non-U.S. regulators. In addition, Chairman Clayton noted certain of the challenges involved, including the “complex, uncertain, multi-national/jurisdictional and dynamic” landscape as well as the forward-looking nature of much of such disclosure, which “likely involve[s] estimates and assumptions regarding, again, complex and uncertain matters that are both issuer- and industry-specific…”

Looking ahead, Chairman Clayton highlighted two “avenues of engagement that currently are of particular interest” to him:

  1. Discussing with issuers, such as property and casualty insurers, the extent to which they use, and their experience with, environmental and climate-related models and metrics in their operations and planning, including price, risk and capital allocation decisions; and,
  2. Discussing with asset managers that have been using environmental and climate-related models and metrics to allocate capital on an industry or issuer specific basis their experience with that process.  

 De Facto Materiality – A Proposal in the ESG Disclosure Simplification Act

While several ESG-related bills have been filtering through Congress, and each will likely continue to face an uphill battle, one such bill, the ESG Disclosure Simplification Act of 2019 would address the materiality question raised in the Commissioners’ public comments referenced above by deeming ESG metrics “de facto material.” As such, the draft law would task public companies with mandatory reporting, while the SEC would be responsible for defining the relevant ESG metrics based on recommendations from the permanent Sustainable Finance Advisory Committee to be established pursuant to the law.

It’s true, ESG is a ‘compliance minefield’

Sometimes, our friends in the press come up with a headline that simply cannot be topped. Yesterday, Ignites published an article called, “Going Green: Shops Work to Navigate ESG Compliance Minefield.” The article opens appropriately, noting that while ESG funds “may be all the rage with investors […] shops that fail to think carefully about their investment methodologies and related disclosures could end up in the SEC’s hot seat.” Indeed, though, the SEC is certainly not the only regulator to keep a close eye on ESG products and mandates. In the United States, the Department of Labor also has ESG on its radar. ESG is also a hot topic for numerous regulators and legislatures globally. What are some of they important compliance challenges?

  1. Are fund descriptions, registration statements and disclosures accurate? If ESG factors are considered as part of the fund’s strategy, do such documents reflect that reality correctly?
  2. If the firm has publicly committed to engage in certain conduct (e.g., shareholder engagement, etc.) by reason of membership in a particular group or alliance (e.g., UN PRI, Climate Action 100+, etc.), is the firm following through on its promises?
  3. Are global legal developments considered, recognizing that Europe, North America and Asia are at different stages of ESG statutory and regulatory promulgation?
  4. Have proxy voting policies been considered in light of SEC and DOL guidance?
  5. Does the investment management agreement explicitly require (or prohibit) the investment manager to vote proxies or exercise other shareholder rights on behalf of an ERISA plan?
  6. Are the investment manager and asset owner on the same page in terms of which ESG strategy will be pursued?
  7. Does the investment policy statement or investment guidelines specify which E, S or G factor is part of the investment mandate?
  8. Has the investment manager considered potential conflicts of interest of proxy adviser firms?
  9. If the client is a governmental plan, has the investment manager diligenced the applicable state statutes and constitutional provisions to confirm that implementation of the mandate complies with applicable law?
  10. Is disclosure in due diligence questionnaires accurate and factually supportable?


A key implication for financial services firms under the SECURE Act

The passage of the Setting Every Community Up for Retirement Enhancement Act (SECURE Act) includes provisions on pooled individual account plans whose participating employers lack a common nexus (PEPs). PEPs should be particularly appealing to small employers who were previously daunted by the cost and complexity of sponsoring, and the fiduciary duty risk from managing, their own retirement plan. A pooled plan provider (PPP) would serve as plan administrator and “named fiduciary” under ERISA of the PEP. In this capacity, a financial services firm operating as a PPP would have various fiduciary responsibilities, including all administrative functions and the selection of investment options in the plan lineup. A PPP must also ensure that all persons/firms handling plan assets are properly bonded under ERISA. The DOL will issue regulations over the coming months on the exact contours of a PPP’s duties. Financial services firms looking to gain market share of the plan market may wish to watch these developments closely, particularly as we gauge interest in these types of plans by small employers.

ERISA fiduciaries, take note of new ISS study on ESG

Brian Croce of Pensions & Investments recently reported on a new ISS study. As reported, the study establishes a link between a high/favorable ISS ESG rating and profitability. Similarly, companies with higher ESG ratings are less volatile.  The Department of Labor, rather rightly, in Field Assistance Bulletin 2018-01, cautioned fiduciaries against making too many assumptions or wishful thinking in establishing a nexus between an ESG risk factor and investment performance. The ISS study is worthwhile because it helps build a case for fiduciaries that use integration as an ESG strategy. As a reminder, integration is when one “incorporates ESG-related data and/or information in respect of an ESG factor into the usual process when making an investment decision where such data or information is material to investment performance and where the exclusive purpose is to enhance portfolio return or reduce portfolio risk.” See this glossary for more information and context.

SEC Proposes Expanded ‘Accredited Investor’ Definition

On December 18, 2019, a divided SEC proposed amendments (the Proposal) to the definition of “accredited investor” under Rule 501(a) of Regulation Dby 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.”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”
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.

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).

See Amending the “Accredited Investor” Definition, (proposed Dec. 18, 2019) (to be codified at 17 C.F.R. pts. 230, 240).

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).

Jay Clayton, Chairman, U.S. Sec. & Exch. Comm’n, “Modernizing the Accredited Investor Definition” (Dec. 18, 2019), (Clayton’s Remarks).


Concept Release on Harmonization of Securities Offering Exemptions, 84 Fed. Reg. 30,460 (proposed June 18, 2019) (to be codified at 17 C.F.R. pts. 210, 227, 230, 239, 240, 249, 270, 274, 275).

Clayton’s Remarks, supra note 4.

Proposal, supra note 2, at 27.

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).

13 Robert J. Jackson Jr., Comm’r, U.S. Sec. & Exch. Comm’n, “Statement on Reducing Investor Protections around Private Markets” (Dec. 18, 2019).

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.

20 Id.

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.

Copyright © 2020 Stradley Ronon Stevens & Young, LLP. All rights reserved.

ESG, Proxy Voting & ERISA Today

As we prepare for upcoming proxy voting rules from the Department of Labor (DOL), it is important to consider their context. A registered investment adviser (RIA) can indeed satisfy its fiduciary duties under the Employee Retirement Income Security Act of 1974 (ERISA) to plan clients when taking environmental, social and governance (ESG) risks into account as part of investment decisions and voting proxies. Some will cheer the preceding sentence, while others remain skeptical. The fact is, with proper structuring, a fiduciary to an ERISA plan, or a governmental plan, for that matter, can favorably respond to client requests for ESG issues to be part of the investment mandate without losing much sleep over fiduciary duty risk.

For all the headline-grabbing that ESG garners, there remains considerable uncertainty over what exactly it means. This is unfortunate, not least because it is hard to comply with fiduciary duties if the conduct at issue is a moving target. ESG issues are various environmental (e.g., climate change), social (e.g., child labor) and governance (e.g., board structure) risk areas. RIAs can zoom in slightly and focus just on environmental, social or governance risks. Zoom in even further and focus on a single risk area, such as climate change.

From here, there are four primary techniques for addressing ESG risk. First, one can screen out from investment consideration those portfolio companies that fail to satisfy one more ESG risk-related criteria, known as negative screening. For convenience, divestment, can be included in this category because it is effectively screening out existing holdings. The second technique is to limit the investible universe to those best-in-class portfolio companies that satisfy ESG risk-related criteria, known as positive screening. Third, treating an ESG risk like any other material risk to investment performance, no more and no less. This is known as integration. The fourth technique is to address ESG risk through proxy voting and other forms of shareholder engagement.

At this stage, we now recognize that ESG is an umbrella term that encompasses myriad environmental, social and governance risks. We appreciate that ESG can be boiled down to discrete risk areas, such as cybersecurity or board diversity, and that RIAs can focus on only one of these risks as part of their mandate with a plan client. We also understand that there are basically four main ways of taking these risks into account in a similar plug-and-play fashion. Our final threshold question for fully appreciating ESG investing, and, ultimately, how an RIA can satisfy its fiduciary duties under ERISA, is the reason for addressing the ESG risk.

ERISA’s fiduciary duties can most directly be satisfied if the reason for addressing an ESG risk is to mitigate material investment risk or seek material investment return (i.e., alpha). At least for now, a less direct, though entirely attainable, path toward satisfying ERISA’s fiduciary duties exist when investment risk/return is at most a secondary reason for taking ESG into account.

An RIA’s motivation for treating one or more E, S or G issues as material is possible because, depending on the issue, there is now data linking that issue with portfolio return. Climate change modeling, for example, can predict the sectors, industries and asset classes most vulnerable to climate change, whether it is because their source materials dry up, they face high regulatory uncertainty, or some of their key assets become stranded. The DOL, in Interpretive Bulletin 2015-01, acknowledged that ESG can present material risks and opportunities for a fiduciary. By doing so, the DOL put ESG risk on equal footing with more traditional material market risks.

The significance of the DOL’s acknowledgment that ESG issues may in fact present material risks to portfolio performance cannot be overstated. An RIA, acting as an ERISA fiduciary, effectively treats the ESG risk as if it were any other material risk factor. Historically, though, a fiduciary considering an ESG investment had to satisfy the “tie-breaker” test, a set of conditions fraught with risk and more understandable in the abstract than in practice. This test, which remains in effect for ESG investments that do not treat ESG as being material to investment performance, demands that an ERISA fiduciary serve up the potential ESG investment opportunity and a non-ESG investment alternative with similar risk and return characteristics; only when the RIA determines that the ESG opportunity does not create more risk relative to return (and vice versa) than the non-ESG opportunity, may the ESG investment be pursued.

It is worth noting at this point that the DOL’s most recent guidance on ESG, Field Assistance Bulletin 2018-01, expressly reaffirmed the notion that ESG issues can present material risks (and opportunities) for plans, and, consequently, could be treated the same way as any other factors a fiduciary would consider as part of a prudent process. The DOL cautioned fiduciaries against making too many assumptions and against not relying on the evolving data linking one or more ESG issues with investment performance. This makes sense and should not present too much of an operational nuisance, considering that more fine-tuned data is available reportedly showing one or more ESG issues as being material to performance.

Proxy voting and other forms of shareholder engagement (which usually precede voting decisions) are one of the most popular techniques used to account for ESG risks. The exercise of shareholder rights is a fiduciary function under ERISA. It is critical that an investment management agreement be crystal clear as to whether the RIA is responsible for proxy voting, and that the RIA review the plan’s proxy voting policies when managing a separate account. Commingled funds may develop their own proxy voting/shareholder engagement policies, to which the subscribing plans would be subject.

Indeed, proxy voting and engagement rarely cost much, and proxy advisor firms are often used to reduce costs even more. Where, however, the exercise of shareholder rights would be expensive, such as in cases where it would be unusually expensive to partake in a shareholder vote, or where the time and preparation to meet with a company board is more involved, RIAs, as ERISA fiduciaries, should analyze and document the cost of that activity and weigh it against the expected gain. This is easier said than done. If anything, costs should be monitored and recorded in the RIA’s files, and there should be some estimate or calculation of what benefits will flow back to the plan investor over the short, medium and long term resulting from one or more votes or engagements.

Proxy voting and shareholder engagement have become a flashpoint and is under scrutiny by the Securities and Exchange Commission, the DOL and even the White House. Just this past April, the President issued an Executive Order that required the DOL, in part, to determine whether additional guidance on proxy voting was necessary. The Executive Order’s aim was on energy independence, so it is fair to assume that the White House is interested in whether more onerous requirements are necessary for ERISA fiduciaries to vote proxies on ESG issues.

Whether the DOL will impose on fiduciaries a more exacting and granular cost-benefit analysis for proxy voting and shareholder engagement remains to be seen. With that said, the DOL must walk the tight rope: if new guidance contains so many trap doors, thereby introducing significantly greater fiduciary risk for voting proxies and engaging the boards of energy companies, for example, then RIAs may feel compelled to purge fossil fuel companies altogether from the portfolio to satisfy their fiduciary duties under an ESG mandate. A tilt toward divesting or negative screening, and away from engagement and voting, arguably undermines the very purpose of the Executive Order. The DOL could update this guidance any day now.

Finally, several influential individuals and institutions have publicly stated that one or more ESG issues are in fact material risks. While there is by no means a consensus on whether ESG is material to investment performance, ERISA fiduciaries, at a minimum, would be expected to kick the tires on these claims. A prudent process necessarily involves some knowledge of what others are fiduciaries are considering. An RIA could take the position that these materials are already reflected in the share price; ERISA fiduciaries, after all, are not required to second-guess the market price of a security absent extraordinary circumstances. A fiduciary could alternatively believe that the markets do not (yet) fully appreciate these risks, thereby presenting meaningful opportunities from a risk/return standpoint for the RIA. Following this latter path, the RIA has various techniques at its disposal to addressing one or more ESG risks and, as described above, can satisfy its fiduciary duties under ERISA in doing so.

SEC Proposes to Modernize the Advertising and Cash Solicitation Fee Rules for Investment Advisers

On November 4, 2019, the Securities and Exchange Commission (the “SEC”) proposed amendments to its investment adviser advertising and cash solicitation fee rules under the Investment Advisers Act of 1940 (the “Advisers Act”), as well as related amendments to its investment adviser books and records rule and registration form (collectively, the “Proposals”).1  Specifically, the Proposals seek to amend Rule 206(4)-1, which governs how a registered investment adviser can market its products and services (the “Advertising Rule”); Rule 206(4)-3, which regulates an adviser’s cash solicitation fee arrangements (the “Solicitor Rule”); Rule 204-2, which sets forth an adviser’s books and records and obligations (the “Books and Records Rule”); and Form ADV, the adviser registration and disclosure form.

The current Advertising Rule and Solicitor Rule have remained largely unchanged since their adoption in 1961 and 1979, respectively. The SEC states in its release containing the Proposals (the “Proposing Release”) that they are principally designed to bring the rules and disclosure form up to speed with current industry practices and technological advancements.

This alert provides an overview of the Proposals and discusses how an investment adviser’s existing regulatory obligations pertaining to advertising and the payment of cash solicitation fees would be altered if the Proposals are adopted. Part I discusses the proposed amendments to the Advertising Rule, and Part II discusses the proposed amendments to the Solicitor Rule.

The proposed amendments relating to the Advertising Rule are numerous and substantive, and go well beyond mere updates. They would include the following:

  • Significantly expand the definition of “advertisement” to include online communications, third-party communications disseminated “by or on behalf of” an adviser, and private fund marketing materials.
  • Permit the use of client testimonials, non-client endorsements and third-party ratings, subject to certain enumerated conditions.
  • Impose substantive conditions on advertisements that present actual or hypothetical investment performance (including model, target and projected performance).
  • In certain instances, such as the presentation of gross-of-fee investment performance, impose regulatory conditions on advertisements distributed to retail investors that are more extensive than those provided solely to non-retail investors.
  • Require a designated employee of an adviser to review and approve each advertisement, other than certain excluded communications, prior to distribution.

The proposed amendments to the Solicitor Rule are also significant, and would include the following:

  • Encompass non-cash compensation arrangements.
  • Apply to private fund investor solicitation arrangements.
  • Eliminate the current requirement that the solicitor provide a copy of the adviser’s Form ADV Part 2A to solicited prospects.
  • Ease the solicitor’s brochure delivery requirement in connection with certain mass solicitations.
  • Revise and expand the list of disciplinary events that disqualify a solicitor from receiving compensation.

Part I – Proposed Amendments to the Advertising Rule

The Advertising Rule currently prohibits all investment advisers registered, or required to be registered, with the SEC from distributing, directly or indirectly, advertisements that contain any of the following:

  1. Testimonials of any kind concerning the adviser’s advisory services;
  2. Past specific recommendations of an investment adviser that were or would have been profitable;
  3. Charts and graphs to help investors decide which securities to buy or sell, without prominently disclosing the limitations of such material;
  4. Offers to provide reports or services free of charge unless such reports or services are actually free; and
  5. Untrue statements of material fact, or otherwise false or misleading statements of material fact.

The proposed amendments would restructure and expand the Advertising Rule to five main subsections: (1) definitions; (2) general prohibitions; (3) testimonials, endorsements and third-party ratings; (4) performance information; and (5) review and approval. A brief overview of each subsection follows.


The definitions subsection would define key terms used throughout the Advertising Rule. Without a doubt, the most important of these terms is “advertisement.” The proposed amendments would substantially expand the scope of this defined term to include the following types of communications that promote an adviser’s investment advisory services to prospective and existing customers: oral communications; online communications; communications to a single person; communications to private fund investors; and communications by or on behalf of an adviser. By focusing this definition on the goal of the communication, not the method of delivery, the SEC expects the proposed definition to be flexible enough to keep pace with advancing technology and evolving industry practices.

The Proposing Release indicates that the inclusion of private fund communications was intended to supplement and enhance the prohibitions from making misleading statements to private fund investors under Rule 206(4)-8.2 Thus, private fund communications would be subject to both the Advertising Rule and Rule 206(4)-8.

The expanded definition of advertisement would include not only communications that an adviser disseminates, but also communications that some other party distributes “by or on behalf” of the adviser. The Advertising Rule would not expressly define this phrase, but the Proposing Release indicates that it would encompass adviser-authorized communications made by intermediaries, such as consultants and solicitors, as well as adviser affiliates. The Proposing Release also discusses in some detail the circumstances under which communications by unaffiliated third-parties could be considered by or on behalf of an adviser.3

The proposed amendments to the Advertising Rule would expressly exclude the following four types of communications from the definition of advertisement: (1) non-broadcast live oral communications; (2) communications responding to unsolicited requests for information about the adviser or its services, other than communications to retail persons, including performance results or communications to anyone that include hypothetical performance; (3) an advertisement about a registered investment company or public business development company that is within the scope of Rule 482 or Rule 156 under the Securities Act of 1933; and (4) any information required to be contained in a regulatory notice, filing or other communication.

General Prohibitions

The proposed general prohibitions subsection of the Advertising Rule contains an expanded and enhanced list of general advertising prohibitions. Violations of these provisions can rest on a finding of mere negligence; proof of scienter would still not be required. This subsection includes the following new prohibitions:

  1. Unsubstantiated claims. Unsubstantiated material claims or statements, such as exaggerated statements about an adviser’s skill or experience. This prohibition is designed to prohibit the same conduct currently prohibited regarding the use of charts and graphs in advertisements, but is broader in scope to prevent other misleading advertisements, such as guaranteed returns and unsubstantiated statements about an adviser’s skill or experience.
  2. Untrue or misleading implications or inferences. This prohibition is aimed at advertisements that are likely to cause misleading inferences to be drawn by an investor regarding some material fact about the adviser. The Proposing Release notes examples of advertisements that could present a true statement of fact in materially misleading ways.4  For instance, it would be misleading for an advertisement to include a single investor testimonial stating that an investor’s account was profitable, which may be factually true, if the investor’s results were atypical among all the adviser’s investors.
  3. Failing to disclose risks and limitations. Failing to clearly and prominently disclose any material risks or other limitations when advertising the benefits of an adviser’s services. The proposed amendments to the Advertising Rule do not specifically address the circumstances under which disclosures will be deemed “clear and prominent” for purposes of this prohibition. The SEC does state in the Proposing Release, however, that what is considered clear and prominent may vary by type of advertising medium. However, merely including a hyperlink to risks within an online advertisement would not be sufficient.
  4. Cherry-picking. Referencing specific investment advice that is not presented in a fair and balanced manner. This provision is principally concerned with an adviser “cherry-picking” and presenting in a misleading manner favorable aspects of its investment advice, including but not limited to past and current profitable securities recommendations. The SEC states in the Proposing Release that what is “fair and balanced” will depend on the specific facts and circumstances.

It is important to note that these general prohibitions are in addition to the proposed amendments, discussed below, relating to testimonials, endorsements, third-party ratings and performance results. Thus, for example, an advertisement containing a testimonial satisfying the proposed testimonial-related provisions of the Advertising Rule would still violate the Advertising Rule if it violated one or more of the general prohibitions discussed above.

Testimonials, Endorsements and Third-Party Ratings in Advertisements

The proposed amendments to the Advertising Rule would permit the use of testimonials, which are currently prohibited, and permit non-client endorsements and third-party ratings, which are not addressed by the current rule. The proposed definitions of “testimonials” and “endorsements” are broad and capture all advertisements containing any direct or indirect approval, support, recommendation or experience by clients or investors in connection with an adviser’s advisory services. Third-party ratings are defined in the proposed Advertising Rule as ratings provided by a non-related person who provides such ratings in the ordinary course of business. The Proposing Release states that the ordinary course of business requirement is intended to relate to persons with experience developing and promoting ratings, and would distinguish third-party ratings from testimonials and endorsements.5

Under the proposed amendments, advertisements containing testimonials, endorsements or third-party ratings must satisfy certain disclosure and other conditions intended to alert recipients to any relationship with the adviser, compensation received by the author and related conflicts of interest. As a result, for testimonials and endorsements, a disclosure must be provided as to who provided the recommendation and whether such person was compensated for the recommendation (including non-cash compensation). Third-party ratings must be accompanied by prominent disclosure of the date the rating was made, the period of time the rating is based upon, and the party who is providing the rating. Although the Proposing Release indicates that third-party statements or ratings hosted on third-party platforms generally will fall outside the scope of the Advertising Rule, the Proposing Release cautions that such a determination requires an analysis of the facts and circumstances.6  To use third-party ratings, the adviser must also reasonably believe that the questionnaire used to generate the rating makes it equally easy to provide positive and negative ratings and was not prepared to solicit certain results.

Testimonials, endorsements and third-party ratings that are not themselves “advertisements” or appear within an advertisement will not be subject to the Advertising Rule. However, if the adviser takes steps to influence reviewers or commentary, such as preparing, editing, prioritizing or paying for the content, then this would bring the materials under the scope of the Advertising Rule because such content would be “by or on behalf of” the adviser.

Performance Information 

The performance information subsection identifies six types of performance information that advisers may include in their advertisements: (1) net performance; (2) gross performance; (3) related performance; (4) extracted performance and (5) hypothetical performance. It also sets forth the specific conditions that must be met depending on the type of performance that is presented and the nature of the audience. In this connection, the subsection distinguishes between non-retail advertisements and retail advertisements. A “non-retail advertisement” is defined, essentially, as any advertisement that is disseminated solely to a “qualified purchaser,” as defined in Section 2(a)(51) of the Investment Company Act of 1940 (the “1940 Act”), or a “knowledgeable employee,” as defined in Rule 3c-5 under the 1940 Act. A “retail advertisement” is any advertisement that is not a non-retail advertisement. An adviser that seeks to publish a “non-retail advertisement” will be required to adopt and implement policies and procedures reasonably designed to ensure dissemination only to qualified purchasers and knowledgeable employees. The adviser must also periodically review the adequacy of this policy.

Each type of performance information that advisers would be permitted to include in their advertisements, and the applicable conditions that must be met, are briefly discussed below.

  1. Net Performance. “Net performance” would be defined as the performance results of an account or portfolio after the deduction of all fees and expenses that a client or investor has paid or would have paid an adviser for its investment advisory services. While no particular methodology is prescribed for calculating net performance, the proposed rule contains a list of recommended fees and expenses to be considered, such as direct advisory fees, advisory fees paid to underlying investment vehicles, and payments by the investment adviser for which the client or investor reimburses the investment adviser.The proposed amendments to the Advertising Rule would, effectively, require all retail advertisements containing performance information to include net performance. The net performance would have to be presented for one-, five- and ten-year periods, each with equal prominence and ending on the most recent practicable date. This net performance presentation requirement essentially codifies the SEC staff’s long-standing position in Clover Capital Management, Inc. (Oct. 28, 1986). Significantly, this requirement would not apply to non-retail advertisements, including those for private funds excluded under Section 3(c)(7) of the 1940 Act.
  2. Gross Performance. “Gross performance” is defined as the performance results of an account or portfolio that is presented before the deduction of all fees and expenses charged for the provision of investment advisory services. The proposed amendments to the Advertising Rule would require all advertisements containing gross performance to provide or offer to provide promptly a schedule of the specific fees and expenses (presented in percentage terms) deducted to calculate net performance. Retail advertisements could not include gross performance unless equally prominent net performance accompanies it. The accompanying gross performance must be calculated over the same time period as the net performance using the same methodology.
  3. Related Performance. “Related performance” would be defined as the performance results of one or more portfolios with substantially similar investment policies, objectives and strategies as those of the services being offered or promoted in the advertisement. The proposed amendments to the Advertising Rule would prohibit the presentation of related performance in an advertisement without including all portfolios with substantially similar investment policies, objectives and strategies, unless the advertised performance is no higher than if all related portfolios had been included. Such requirements seek to prevent an adviser from selectively excluding poor performing portfolios that are similarly managed. The adviser also cannot exclude performance information if such exclusion would alter the Proposals’ prescribed time periods. The adviser would be permitted to present related performance information on a portfolio-by-portfolio basis or as composites. It should be noted that the Financial Industry Regulatory Authority (“FINRA”) does not currently allow related performance to be included in advertisements to retail investors.
  4. Extracted Performance. “Extracted performance,” which is also often referred to as carveout performance, would be defined as the performance results of a subset of investments extracted from a portfolio. The proposed amendments to the Advertising Rule would prohibit the presentation of extracted performance, unless the advertisement provides or offers to provide promptly the performance results of all investments in the portfolio from which the performance was extracted.
  5. Hypothetical Performance. Finally, “hypothetical performance” would be defined as performance results that were not actually achieved by any portfolio of any client of the investment adviser. This defined term would include, but not be limited to, the following: (1) performance derived from representative model portfolios that are managed contemporaneously alongside portfolios managed for actual clients; (2) backtested performance; and (3) targeted or projected performance. Since hypothetical performance is perceived as carrying a higher risk of being misleading, if an adviser decides to provide hypothetical performance, it must adopt policies and procedures reasonably designed to ensure that such information is disseminated only to persons for which it is relevant to their financial situation and investment objectives. Sufficient information must also be provided so that the recipient can understand the criteria and assumptions in calculating the performance, as well as the risks and limitations of such performance information (although only an offer to provide such information promptly is required in the case of a non-retail investor). Note that FINRA currently prohibits hypothetical backtested performance in “retail communications,” as that term is defined in Conduct Rule 2210.

The Proposals also provide guidance with regard to the portability of performance. For instance, where an adviser wishes to use the performance results in its advertisement from a predecessor firm or from personnel that have joined the adviser from a different firm, it must disclose that the predecessor performance was achieved by a different firm or by personnel from a different firm to make the advertisement not misleading. In addition, an advertisement may be misleading if the personnel that joined the adviser were not primarily responsible for the predecessor performance. While an adviser must maintain books and records required to substantiate performance, the SEC recognized that documentation related to predecessor performance may be unavailable to an adviser, and asked for comment as to whether the rule should permit other forms of verification (e.g., using publicly available contemporaneous information).

Review and Approval of Advertisements

Except as noted below, the proposed amendments to the Advertising Rule would require that an advertisement be reviewed, approved and determined to be in compliance with the Advertising Rule by a designated employee of the adviser before the advertisement could be disseminated. The Proposing Release indicates that the designated reviewer should be competent and knowledgeable, and the SEC expects that the designated employee should generally include legal or compliance personnel of the adviser. The proposed Advertising Rule would not permit the designated reviewer to be an outside third-party, such as a compliance consultant or law firm, but the Proposing Release asks for comment on this limitation.

Preapproval would not be required, however, for the following two types of communications:

  • Communications to individual persons. Communications to a single person, household or private fund investor would not require preapproval. However, an adviser cannot seek to utilize this exemption by customizing a template presentation or mass mailing and then simply filling in different investor names or other basic client details; and
  • Live oral communications. Live oral communications that are broadcast over television, the internet or other similar media would not require preapproval. However, if a live communication is recorded, then approval would be required prior to a distribution.

Books and Records

The Proposals would amend the Books and Records Rule in light of the proposed amendments to the Advertising Rule. Thus, among other things, the Books and Records Rule would be amended to require an adviser to make and keep copies of all communications sent to one or more persons. Currently, this requirement applies only to communications sent to 10 or more persons. In addition, it would require an adviser to maintain copies off all third-party questionnaires and surveys used to create third-party ratings. Finally, an adviser would be required to keep and maintain those records necessary to demonstrate the calculations of the various types of performance information discussed above, such as hypothetical performance.

Amendment to Form ADV

The Proposals would amend Form ADV to require an adviser to report additional information about its advertising activities. Specifically, five new “yes/no” questions would be added to Part 1A of Form ADV, which would request information about an adviser’s use of advertisements that contain performance results, testimonials, endorsements, third-party ratings and its previous investment advice. The SEC would use this information to help prepare for examinations of advisers.

Advertising Rule’s Harmonization With Other Regulators

While the proposed amendments would bring investment advisers closer in line with the principles-based advertising regime of other regulators, such as the Commodity Futures Trading Commission (the “CFTC”) and the National Futures Association (the “NFA”), an adviser that is also registered as a commodity pool operator and/or commodity trading advisor should note that compliance with the amended adviser advertising rule, as proposed, may not satisfy its obligations under similar CFTC and NFA rules. The proposed Advertising Rule is also different from the obligations imposed on broker dealers by FINRA, which may create compliance challenges for dual-registrants and broker dealers seeking to advertise pooled investment vehicles.

Part II – Proposed Amendments to the Solicitor Rule

The existing Solicitor Rule sets forth the conditions under which a registered investment adviser may compensate related and unrelated third-party solicitors for prospective client referrals. The rule prohibits cash payments to persons subject to certain specified legal and disciplinary actions (“Disqualifying Events”). The term “solicitor” is defined broadly to include “any person who, directly or indirectly, solicits any client for, or refers any client to, an investment adviser.”

All solicitor arrangements currently must be memorialized in a written agreement between the adviser and solicitor (the “Solicitor Agreement”). The Solicitor Agreement must obligate any solicitor, other than one who is an officer, director, employee or control affiliate of the adviser, to provide each client prospect, at the time of solicitation, with a copy of the adviser’s Form ADV, Part 2A (the “Adviser Brochure”) and a separate written disclosure document concerning the solicitor arrangement (the “Solicitor Disclosure”). The Solicitor Disclosure must contain specified types of information about the arrangement, including the name of the solicitor, the name of the adviser, the nature of the relationship between the parties and the terms of compensation. Finally, the adviser must receive from the client prospect, prior to, or at the time of, entering into any advisory contract, a signed and dated acknowledgment of receipt of the Adviser Brochure and Solicitor Disclosure.

The Proposals would amend the Solicitor Rule in several important areas, briefly discussed below.

Definition of Solicitor 

The proposed amendments to the Solicitor Rule would expand the definition of “solicitor” to also include any person who solicits prospective or existing private fund investors, as opposed to only advisory clients. Although not addressed directly in the proposed amendments, the Proposing Release also discusses the circumstances under which a person receiving compensation for providing testimonials or endorsements in an adviser’s advertisements would be deemed a solicitor. The Proposing Release further notes that, depending on the facts and circumstances, a solicitor may also meet the Advisers Act’s definition of “investment adviser,” and, therefore, have to register with the SEC under the Advisers Act, absent an available exemption from registration.

Permissible Compensation 

The Solicitor Rule would be expanded to cover solicitation arrangements involving all forms of compensation rather than only cash compensation. Non-cash compensation would include, but not be limited to, directed brokerage; sales awards or other prizes; training or education meetings; outings, tours or other forms of entertainment; and free or discounted advisory services. The Proposing Release states that compensation “could also include the adviser providing investment advice that directly or indirectly benefits the solicitor.” For example, if the solicitor is a broker-dealer or affiliated with a broker-dealer, an adviser’s payment for solicitation could be the adviser’s recommendation that its investors purchase the solicitor’s proprietary investment products or products that the adviser knows have revenue sharing or other pecuniary arrangements with the solicitor or its affiliates.

Solicitor Agreement

The proposed amendments to the Solicitor Rule would alter the requirements relating to the Solicitor Agreement in certain key respects. Specifically, an adviser would no longer be required to enter into a Solicitor Agreement with its officers, directors, employees and control affiliates (“Solicitor Affiliates”), provided that (1) the Solicitor Affiliate’s affiliation with the adviser is readily apparent and (2) the adviser documents the Solicitor Affiliate’s status at the time it enters into the solicitation arrangement (“Solicitor Affiliate Conditions”).

In addition, the solicitor would no longer be required to deliver the Adviser Brochure under the terms of the Solicitor Agreement. The Solicitor Disclosure would still need to be delivered at the time of solicitation, except in connection with solicitations made through mass communications, where delivery must be made as soon as reasonably practicable. Either the adviser or the solicitor could agree to deliver the Solicitor Disclosure under the terms of the Solicitor Agreement.

The information that must be contained in the Solicitor Disclosure would largely remain the same, with two exceptions. First, the Solicitor Disclosure would have to disclose any potential material conflicts of interest on the part of the solicitor resulting from the investment adviser’s relationship with the solicitor and/or the compensation arrangement. Second, it would have to disclose the amount of any additional cost to the investor as a result of solicitation.

Adviser Oversight of Solicitor 

An adviser would be required to have a reasonable basis for believing that the solicitor has complied with the terms of the Solicitor Agreement. Whether an adviser satisfies this “reasonable basis” requirement would depend on the circumstances. The SEC states in the Proposing Release, however, that “a reasonable basis generally should involve periodically making inquiries of a sample of investors referred by the solicitor in order to ascertain whether the solicitor has made improper representations or has otherwise violated” the Solicitor Agreement. The proposed amendments would omit Solicitor Affiliates from this solicitor oversight requirement, provided that the Solicitor Affiliate Conditions are met.

Disqualifying Events

The proposed amendments to the Solicitor Rule would revise the provisions relating to Disqualifying Events. Specifically, they would reorganize the list of Disqualifying Events and add certain new legal and disciplinary proceedings to this list. In addition, an adviser would be required to exercise reasonable care in determining that a solicitor is not subject to a Disqualifying Event and thus prohibited from receiving compensation. This reasonable care standard would continue to apply throughout the term of the solicitation arrangement. It is important to note that the Disqualifying Event provisions would continue to apply to Solicitor Affiliates. Moreover, the proposed amendments would provide a conditional exemption from the Disqualifying Event provisions for certain SEC administrative actions, including proceedings under Section 9(c) of the 1940 Act and those proceedings that are not, themselves, Disqualifying Events.


The proposed amendments would exempt from the Solicitor Rule certain charitable programs and arrangements under which a solicitor has received $100 or less in compensation over the preceding 12 months.

Books and Records

The proposed amendments to the Solicitation Rule would be accompanied by corresponding amendments to the Books and Records Rule to require investment advisers to make and keep records of (1) copies of the Solicitor Disclosure delivered to investors, (2) any communication or other document related to the investment adviser’s determination that it has reasonable basis for believing that any solicitor it compensates under the Solicitor Rule has complied with the Solicitor Agreement, and that such solicitor is not an ineligible solicitor and (3) a record of the names of all solicitors who are an adviser’s partners, officers, directors or employees, or other affiliates.

Existing SEC Staff Guidance

The Proposing Release notes that various no-action letters and other guidance addressing the application of the advertising and solicitation rules issued by the staff of the SEC’s Division of Investment Management (the “Division”) are under review for withdrawal (or for withdrawal with respect to a certain topic) in connection with the potential adoption of the amendments. More than 180 letters have been identified for review (including almost 100 “bad actor” letters issued under the Solicitor Rule). A number of notable letters are also specifically discussed in the Proposing Release.7  The SEC has requested that interested parties identify additional letters for potential withdraw.

Public Comment Period

The public comment period will remain open for 60 days following publication of the Proposing Release in the Federal Register. The Division has recently been focused on expanding the views considered in the rulemaking comment process, and asset managers and industry participants of all sizes are encouraged to comment on the Proposal.8 The SEC is also soliciting information from investors about the Proposals via Appendix B of the Proposing Release, titled “Investor Feedback.”

The SEC indicated that, should the Proposals be adopted, advisers and their solicitors would have one year to comply with the new rules.


1 Investment Adviser Advertisements; Compensation for Solicitations, Investment Advisers Act Release No. IA-5407 (Nov. 4, 2019).
2 See Proposing Release, p. 35 (noting there may be some overlap between the prohibition in Rule 206(4)-8 and the proposed Advertising Rule).
3 See Proposing Release, pp. 24-28.
4 See Proposing Release, pp. 57-59.
5 See Proposing Release, pp. 80-81.
6 See Proposing Release, p. 81.
7 See, e.g., Investment Adviser Association, SEC No-Action Letter (Dec. 2, 2005); TCW Group, SEC No-Action Letter (Nov. 7, 2008); Investment Counsel Association of America, Inc., SEC No-Action Letter (Mar. 1, 2004); Horizon Asset Management, LLC, SEC No-Action Letter (Sept. 13, 1996); Munder Capital Management, SEC No-Action Letter (May 17, 1996); Clover Capital Mgmt., Inc., SEC No-Action Letter (Oct. 28, 1986).
8 Comments can be submitted via the SEC’s internet comment form (available at http://www.sec.gov/rules/proposed.shtml) or by sending an email to rule-comments@sec.govwith “File Number S7-21-19” in the subject line.

New SEC Proposal May Complicate Proxy Voting & Engagement by Advisers

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.

III. Conclusion

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


1 Amendments to Exemptions from the Proxy Rules for Proxy Voting Advice, Release No. 38-87457 (Nov. 5, 2019); Procedural Requirements and Resubmission Thresholds under Exchange Act Rule 14a-8, Release No. 34-87458 (Nov. 5, 2019).

2 Robert J. Jackson Jr., Commissioner, SEC, Statement on Proposals to Restrict Shareholder Voting (Nov. 5, 2019); Allison Herren Lee, Commissioner, SEC, Statement on Shareholder Rights (Nov. 5, 2019).

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.

4 The SEC’s proposed amendment would codify the definition from its recent proxy interpretation. Commission Interpretation and Guidance Regarding the Applicability of the Proxy Rules to Proxy Voting Advice, Release No. 34-8671 (Aug. 21, 2019). The interpretation is subject to a lawsuit by Institutional Shareholder Services (“ISS”), which argued that proxy voting advice is not a solicitation. In addition, ISS challenged the interpretation on procedural grounds. Complaint, Institutional S’holder Servs. Inc. v. SEC, No. 1:19-cv-03275 (D.D.C. Oct. 31, 2019).

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.”

9 Jay Clayton, Chairman, SEC, Statement of Chairman Jay Clayton on Proposals to Enhance the Accuracy, Transparency and Effectiveness of Our Proxy Voting System (Nov. 5, 2019).

10 See supra note 2.

Revealing insights from SSgA report on ESG adoption – ERISA perspective

State Street Global Advisors (SSgA) recently released a research report entitled, Into the Mainstream – ESG at the Tipping Point. It begins with a salient point: “ESG may well be becoming a mainstream trend, but every institutional investor – from pension funds to endowments to sovereign wealth funds – faces a unique mix of forces pushing them towards, or pulling them away from, ESG investing.” Indeed, asset owners and their managers are in fact subject to distinct standards of care, with ERISA’s fiduciary duties being the ultimate. In reviewing this report of global institutional investors’ reasons for addressing environmental, social and/or governance (ESG) factors in their investment decisions, and their reasons for not doing so, I considered the implications for ERISA fiduciaries, as “pension funds” were one of the institutional investors surveyed (along with endowments, charities, sovereign wealth funds and others). Consider also some of my prior analysis on the interplay of fiduciary duties under ERISA and ESG issues.

Here are the key takeaways:

  1. Fiduciary Duty: A Hurdle or Affirmative Duty to Incorporate ESG? A longstanding, significant obstacle to adoption of ESG by ERISA plans was whether it could be done in a manner consistent with ERISA’s fiduciary duties. The duty of prudence (Section 404(a)(1)(B)) has been the primary area of concern under an ERISA/ESG analysis, but duty of loyalty (Section 404(a)(1)(A)) and diversification (Section 404(a)(1)(C)) issues may also arise depending on the circumstances. Interestingly, the SSgA findings indicate that 46% of those surveyed viewed fiduciary duty as a push factor – i.e., an affirmative duty. If we drill down, the % of respondents who cited fiduciary duty as a lead push factor was highest in North America. If we drill down further, we see that, 41% of pension funds view ESG as a fiduciary duty. So, while pension funds seem less likely to view ESG as an affirmative fiduciary duty relative to other institutional investors, the fact that 41% do is notable. Again, this picks up pension funds globally and appears to cover private (i.e., ERISA) and public (i.e., governmental) plans.
  2. Risk Mitigation or Opportunity? The results also show that ESG risk mitigation is, at this point, (much) more of a basis/push factor to incorporate ESG factors into an investment decision than outperformance reasons (in North America, 42% (of all respondents – not just plans) cited risk mitigation vs. 1% who cited ESG as a way to generate higher returns). Various other studies make the point that ESG can present both mitigation and return opportunities, so it is interesting that institutional investors have gravitated toward mitigation rather than return. Perhaps lack of standardized disclosures and metrics is a reason, but it would seem that would affect both downside risk and return on any given investment. Perhaps another reason is that the outperformance takes longer to materialize. The DOL has reiterated that integration is examined under the regular prudence test and not the heightened tie-breaker test.
  3. Obstacles: A continuing theme, now picked up by this new SSgA report, is that the lack of standardized and transparent ESG data remains a primary obstacle to adoption (e.g., inconsistent scoring across the various providers). SSgA, in this report and over time, has helpfully examined the correlations of the major data providers in terms of a specific company’s ESG coverage. In one example, the ratings of companies by two prominent providers had a correlation of (only) .53. The lack of expertise in ESG was also cited as a top reason for not incorporating ESG factors – a valid reason for not making a particular investment under ERISA (fiduciaries are not expected to be all-knowing, but are expected to seek outside expertise when doing so would be prudent). Perhaps this explains why more and more ESG-related questions are showing up on questionnaires sent to investment managers.
  4. Governance: Respondents reported better measurement of governance (G) factors than environmental (E) or social (S) factors. For ERISA fiduciaries using integration, an analysis/documentation of how the respective E, S and/or G factor affects performance is important under DOL guidance. It is also important for investment managers and appointing fiduciaries to be clear on whether one or more E,S or G factors will be incorporated for any particular mandate, and to confirm that doing so would be in accordance with plan documents.