Risk & Reward

What the new Executive Order on proxy voting may mean for fiduciaries

The White House announced on April 10 that the President had signed an Executive Order on “Promoting Energy Infrastructure and Economic Growth.” Section 5 of the Executive Order imposes two requirements on the Department of Labor (DOL), each of which must be completed within 6 months:

  1. “[C]omplete a review of available data filed with the Department of Labor by retirement plans subject to the Employee Retirement Income Security Act of 1974 (ERISA) in order to identify whether there are discernible trends with respect to such plans’ investments in the energy sector,” and “provide an update to the Assistant to the President for Economic Policy on any discernable trends in energy investments by such plans;” and,
  2. “complete 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of Labor guidance on the fiduciary responsibilities for proxy voting to determine whether any such guidance should be rescinded, replaced, or modified to ensure consistency with current law and policies that promote long-term growth and maximize return on ERISA plan assets.”

Less than one year ago, the DOL released Field Assistance Bulletin 2018-1, in which the DOL clarified its views on how shareholder engagement could be conducted in a manner consistent with ERISA’s fiduciary duties. Proxy voting and other forms of engagement are fiduciary functions under ERISA. The application of ERISA’s fiduciary duties in this context is ultimately a function of materiality and cost, each positively related to the other, so that as the perceived materiality of an issue on investment performance that is the subject of engagement increases, a fiduciary has more rope to incur costs on its meetings with the board, etc. The converse is also true. A possible result of a narrower interpretation by the DOL and/or the courts of what (ESG) risks are material to a company’s performance: less engagement on those risks broadly. A more probable result, however, is that fiduciaries already evaluating ESG risks will continue parsing whatever ad hoc disclosures are volunteered by the companies, and may point to statements made by prominent individuals and institutions on the materiality of these risks.

Fund Proxy Voting: Looking Back to Look Forward

Sara Crovitz

In recent years, the frequency of proxy contests at public companies has increased, focusing more attention on the way institutional investors decide how to vote their proxies. Issuer dissatisfaction with the role of proxy advisory firms in this decision-making process has been a steady drumbeat for decades. In part, public company issuers are understandably unhappy that there is not more competition; Institutional Shareholder Services Inc. (“ISS”) and Glass Lewis dominate the market for providing proxy advisory services. The Securities and Exchange Commission (“SEC”), however, cannot regulate its way to requiring that additional players enter the market. Absent legislation, the question becomes what, if anything, the SEC can achieve under its current rulemaking authority or through SEC staff guidance. What action could help address public company issuer concerns without raising barriers to entry or otherwise negatively impacting competition for proxy advisory firms by increasing regulatory costs, which would undoubtedly be passed on to institutional investor clients? It is a complicated path strewn with the potential for unintended consequences.

This article describes the history of the issues around fund and asset manager use of proxy advisory firms in connection with fund proxy voting, highlighting how we got to where we are today. It then discusses some of the difficulties the SEC faces in moving forward with any additional regulation. Finally, it provides some practical considerations to fund directors and asset managers with regard to fund proxy voting in this uncertain time.

Looking Back

SEC Proxy Voting Regulation and Staff Guidance
On March 19, 2002, shareholders narrowly approved a hotly contested shareholder vote on the merger between Hewlett-Packard and Compaq. Merger opponents alleged that a fund asset manager had switched its vote at the last minute to favor the merger after Hewlett-Packard executives threatened to lock its parent company out of future Hewlett-Packard investment banking business if it voted against the merger. A dissident director of Hewlett-Packard filed suit to block the merger, alleging Hewlett-Packard executives used corporate assets “to entice and coerce” the fund asset manager.1 The SEC eventually settled an enforcement action against the asset manager, alleging that it had failed to disclose to its clients the existence of a material conflict in connection with its proxy vote.2

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On the heels of this controversy, the SEC, under the leadership of then-Chairman Harvey Pitt, finalized proxy voting rules for both funds and advisers.3 On the one hand, the rules were typical to the regulatory regime under the Investment Company Act of 1940 (“Investment Company Act”) and the Investment Advisers Act of 1940 (“Advisers Act”) in that the rules were disclosure-based and operated mainly through policies and procedures that could be adapted to a fund’s or asset manager’s particular circumstances. Funds were required to disclose the policies and procedures they used to vote proxies and to disclose to shareholders the specific proxy votes the funds cast.4 Advisers were required to maintain policies and procedures reasonably designed to ensure that the adviser voted proxies in the best interest of clients, including how the adviser addressed material conflicts.5

On the other hand, the Adviser Rule Release indicated that voting proxies was an explicit fiduciary duty of care: “The duty of care requires an adviser with proxy voting authority to monitor corporate events and to vote the proxies.”6 While the SEC stated in the Adviser Rule Release that “we do not suggest that an adviser that fails to vote every proxy would necessarily violate its fiduciary obligations,” it provided only one very limited exception to an adviser’s duty to vote every proxy, namely voting on a foreign security as that could involve costs such as hiring a translator or traveling to a foreign country to vote in person.7 The SEC also noted in the Adviser Rule Release that if an investment adviser had a conflict with regard to voting, one way to address that conflict would be to have a third party assist in determining how to vote: “[A]n adviser could demonstrate that the vote was not a product of a conflict of interest if it voted client securities, in accordance with a pre-determined policy, based upon the recommendation of an independent third party.”8

A year or so later, certain proxy advisory firms asked the SEC staff to clarify how investment advisers could determine that a third party, like a proxy advisory firm, was, in fact, independent for purposes of Advisers Act rule 206(4)-6. The SEC staff issued two interpretive letters outlining that an investment adviser could use a proxy advisory firm that itself had a conflict if the adviser determined that the proxy advisory firm “has the capacity and competency to adequately analyze proxy issues and can make such recommendations in an impartial manner and in the best interests of the adviser’s clients.”9 In particular, the letters indicated that advisers should obtain information from the proxy advisory firm to make this determination and suggested that an adviser require the proxy advisory firm to disclose relevant facts relating to the conflict, whether that be on a case-by-case basis or on the basis of the proxy advisory firm’s conflict procedures.

Within a couple of years, public company issuers began questioning proxy advisory firm’s potential conflicts, particularly with regard to ISS, which had two services: providing reports about issuers and consulting services to corporations seeking to improve their corporate governance. Critics contended that issuers could feel obligated to retain ISS’s consulting services in order to obtain favorable vote recommendations when ISS issued reports about that particular issuer.10 Responding to requests from the House Committee on Financial Services, the Government Accountability Office (“GAO”) issued a report in 2007 generally finding that, while ISS may have conflicts of interest, it discloses such conflicts, and, as a registered investment adviser, it has been subject to examination by the SEC staff, which had not identified any major issues.11

SEC Concept Release
In 2010, the SEC issued a concept release on the proxy voting system, noting that it had been almost 30 years since the SEC last conducted a comprehensive review of proxy voting issues and pointing to corporate and investor interest in promoting greater efficiency and transparency in the system.12 The concept release sought comments as to whether the proxy system as a whole operated with the accuracy, reliability, transparency, accountability and integrity that investors and issuers should expect, and focused on issues such as over- and under-voting, vote confirmation, proxy voting in the context of securities lending, proxy distribution fees and issuers’ ability to communicate with beneficial owners. As part of that release, the SEC suggested that proxy advisory firms may be investment advisers because part of their service is issuing reports about securities.13 The SEC noted that, as fiduciaries, proxy advisory firms that were registered as advisers would have to disclose conflicts of interest to the institutional investors they advised.

Over the next few years, public companies and certain academics increasingly criticized proxy advisory firms, focusing on a perceived lack of sufficient resources, which led to errors in issuer reports, as well as reiterating prior criticism that certain proxy advisory firms suffered from misaligned incentives and conflicts. Critics also began to attack asset manager use of proxy advisory firms, including claims that, because of perverse incentives created by Advisers Act rule 206(4)-6 and the related interpretive letters, asset managers and funds outsourced decision making and blindly relied on proxy advisory firms.14 For example, these critics pointed to data indicating that shortly after ISS would release a report on a public company issuer, a significant number of shares would be voted in a lock-step manner.15 The real concern, however, seemed to be the influence that proxy advisory firms have on shaping corporate policy.16

First SEC Roundtable and Staff Guidance
The SEC held a roundtable in 2013 that focused, in part, on the factors that had contributed to the use of proxy advisory firm services and the purposes such firms serve; conflicts of interest that may exist for proxy advisory firms and users of their services; the transparency and accuracy of the recommendations made by proxy advisory firms; and what the nature and extent of reliance by investors on proxy advisor recommendations was and should be. Not surprisingly, vastly different views were expressed by public companies, institutional investors and proxy advisory firms themselves.17

Following the roundtable, the SEC’s Chairman and Commissioners continued to speak to issues around corporate governance.18 In mid-2014, SEC staff from both the Division of Investment Management (“IM”) and the Division of Corporation Finance (“CF”) issued a staff legal bulletin that provided guidance about investment adviser responsibilities in voting client proxies and retaining proxy advisory firms (“SLB 20”).19 SLB 20 also provided guidance on the availability and requirements of two exemptions to the federal proxy rules that are often relied upon by proxy advisory firms. In particular, IM staff reiterated positions from the interpretive letters that investment advisers, in determining whether to retain or continue using a proxy advisory firm, should conduct due diligence to ensure that the adviser, acting through the proxy advisory firm, continued to vote in the best interests of its clients. In addition, IM staff clarified that an investment adviser and its clients may agree to arrangements whereby the adviser would not vote every proxy. In addition, CF staff made clear that, if a proxy advisory firm relied on certain exemptions from the federal proxy rules and therefore was required to disclose a significant relationship or material interest, that disclosure must be sufficient for the recipient to understand the nature and scope of the relationship or interest, including the steps taken to mitigate the conflict of interest, such that the recipient could make an assessment about the objectivity of the recommendation. In other words, the proxy advisory firm must make more than a boilerplate disclosure regarding the conflict of interest.

In 2016, in response to issues raised by some members of Congress, industry associations and academics, the GAO issued another report that examined proxy advisory firms’ influence on voting and corporate governance, the level of transparency in their methods and the level of regulatory oversight with regard to such methods.20 The GAO interviewed various stakeholders, including public company issuers, institutional investors and proxy advisory firms. The GAO report reflected varying views, but it contained no recommendations.

In the last couple of years, there have been legislative efforts to address issues raised about proxy advisory firms. In 2017, the House of Representatives passed H.R. 4015, but it was not taken up by the Senate.21 H.R. 4015, which was in many ways similar to the Credit Rating Agency Reform Act of 2006, would have, among other things, required proxy advisory firms to register under the Securities Exchange Act of 1934, disclose potential conflicts of interest and codes of ethics and make public their methodologies for formulating recommendations. Most importantly, H.R. 4015 would have required proxy advisory firms to provide access, in a reasonable amount of time, to a draft report on a public company issuer, including data, analysis and the proposed recommendation, to the public company issuer before sending the report to their institutional investor clients; if the public company issuer objected to the analysis and the objection could not be resolved, H.R. 4015 would have required that the public company issuer’s objection and rebuttal be included in the report.22 More recently, a bipartisan bill was introduced by six Senators in November 2018, which would have required that all proxy advisory firms register as investment advisers, that the SEC conduct periodic inspections of proxy advisory firms, that the SEC submit periodic reports to Congress evaluating the policies and procedures at proxy advisory firms and that the SEC continue to examine whether additional investor protection regulation is necessary.23

Second SEC Roundtable
In November 2018, the SEC held a second roundtable. In advance of that roundtable and “to facilitate the discussion,” IM staff withdrew the two interpretive letters.24 The staff did not withdraw SLB 20, which, as discussed earlier, reiterated positions in the interpretive letters. While there was little discussion of the interpretive letters at the roundtable, it is noteworthy that no one at the roundtable strongly supported additional regulation for proxy advisory firms.25

Although not directly related to fund use of proxy advisory firms, another important conversation taking place around fund voting relates to the “common ownership” theory expounded by certain academics. This theory posits that index funds and index ETFs have perverse incentives because they seek only to match the performance of an index (rather than over-perform) and will use their vote to induce portfolio company management to reduce intra-industry competition, thereby harming the portfolio company’s other shareholders. Some academics that subscribe to this theory have argued that passive funds should not be permitted to vote or should have to pass voting to fund shareholders.26 While the asset management industry and certain other academics have criticized the common ownership theory,27 it has caught the attention of regulators globally,28 and its potential impact on fund voting cannot be ignored in the debate around fund voting and the use of proxy advisory firms.

Looking Forward

On December 6, 2018, SEC Chairman Clayton gave a speech during which he discussed significant initiatives for 2019, including SEC action to improve the proxy process.29 The Chairman recognized the consensus view that proxy “plumbing” (i.e., issues raised by the 2010 Concept Release around proxy voting mechanics such as over- and under-voting, accuracy and transparency in voting and issuer communication with beneficial owners) needs a major overhaul, and he appeared to endorse consideration of changes to the ownership and resubmission thresholds for shareholder proposals. Specifically with respect to proxy advisory firms, he also indicated that the SEC should consider: (1) “the division of labor, responsibility and authority between proxy advisors and the investment advisers they serve”; (2) “clarity regarding the analytical and decision-making processes advisers employ, including the extent to which those analytics are company- or industry-specific”; (3) “the framework for addressing conflicts of interest at proxy advisory firms”; and (4) “ensuring that investors have effective access to issuer responses to information in proxy advisory firm reports.” Subsequently, the Chairman asked SEC Commissioner Roisman to lead efforts to improve the proxy voting process and infrastructure.30

While there is general agreement that improvements are needed with regard to the proxy voting process, there is no consensus around issues related to fund adviser and other institutional investor use of proxy advisory firms. While these issues have been discussed and debated for years, and while the SEC staff has made efforts to address at least some aspects of these issues, the SEC’s efforts have not stopped the criticism. Public company issuers believe ISS and Glass Lewis have too much power over public company governance. Asset managers believe that their use of proxy advisory firms, whether for administrative processing of votes, research reports, assistance with custom guidelines, or otherwise, is appropriate.

The SEC faces significant hurdles to moving forward with any rules or regulations. First is the issue of bandwidth. Issues specifically related to proxy voting are on the long-term actions (as opposed to active list) on the recent Regulatory Flexibility Agenda, and the Chairman has spoken publicly, including in his December 6, 2018 speech, about his intent to focus the agenda on rulemakings that the Commission can reasonably complete. Moreover, in addition to issues around proxy advisory firms, there are a number of other proxy-related issues (e.g., proxy voting mechanics and issues around shareholder proposals). All of these issues have the potential to be complicated and controversial, and stakeholders with strongly held views will likely challenge any rules or regulation from different perspectives. In addition, the SEC is subject to significant regulatory requirements to justify regulation on cost-benefit grounds.31 For all of these reasons, the SEC faces a difficult road ahead in taking action to significantly improve the situation for all interested parties in 2019.

Practical Considerations

Funds and their advisers cast a large number of votes on public company proxies in a short proxy season.32 This section highlights some background on proxy voting, including common proxy voting structures and processes and practical considerations for fund boards and advisers.

Fund Boards
As the SEC stated in the adopting release to the Fund Rule Release in 2003, a fund’s board of directors or trustees (the “board”) has the right to vote proxies for the fund.33 The SEC recognized, however, that most boards delegate responsibility to the fund’s investment adviser subject to board oversight.34 The board retains responsibility for overseeing the processes put in place by the adviser.35

The board also must approve and annually review the adequacy of a fund’s policies and procedures as part of the fund’s compliance program. Some boards adopt a separate fund policy while others determine to rely on the fund adviser’s policy.36 If relying on the fund adviser’s policy, the board should understand the process the adviser uses to determine when it has a conflict, how the adviser’s process addresses conflicts (e.g., use of committees, firewalls or third-party service providers) and how the adviser will disclose conflicts to the board or otherwise provide appropriate reporting to the board.

Fund Advisers
Advisers that have been delegated authority for the administrative process of voting or delegated voting authority may engage in different practices with regard to the use of proxy advisory services. Larger asset managers may have sufficient in-house resources and staff to conduct research on proxy votes and address conflicts (i.e., by having separate governance staff), such that they do not rely on proxy advisory firms’ recommendations at all. Most advisers, however, use proxy advisory firms for at least some of the following services:

  • Administrative services. An adviser could be responsible for thousands of votes per year for registered investment companies. Advisers may engage proxy advisory firms to assist in the mechanical processing of proxy votes, similar to how advisers engage other service providers for operational functions. This might include data tracking and administration as well as workflow management processes. For example, an adviser could use a proxy advisory firm to provide notifications and reminders of upcoming proxy votes; provide coverage and translation services with respect to foreign issuers; communicate voting recommendations and rationales; execute voting instructions; record and report proxy voting records; and prepare and/or file Form N-PX for funds.
  • Research and analytics. An adviser may receive research from proxy advisory firms to use as an input to the adviser’s own decision making. Advisers may choose to receive information based on standard benchmark policies or more specific policies.
  • Using proxy advisory firm recommendations. Proxy advisory firms may offer vote recommendations based on their own guidelines that the adviser takes into account in its own decision-making process. Smaller asset managers may vote proxies in line with a proxy advisory firm’s recommendations subject to the asset manager’s override.
  • Using a proxy advisory firm to help draft guidelines. Some advisers use a proxy advisory firm to help draft or update their own voting guidelines, especially in areas where the adviser lacks expertise.

As a fiduciary to the funds it advises, an adviser must address conflicts consistent with Advisers Act rule 206(4)-6. A fund adviser with voting authority must adopt and implement policies and procedures reasonably designed to ensure that it votes proxies in the best interest of the funds it advises, and those policies and procedures must address material conflicts that may arise between the interests of the adviser and the funds it advises.

To address these fiduciary responsibilities, there are a number of methods that advisers use, some of which involve proxy advisory firms:

  • Creating a predetermined voting policy. This effectively limits the adviser’s own voting discretion on individual votes. A predetermined policy may not always be sufficient as the adviser may have valid (i.e., non-conflict related) reasons to deviate from the policy, or the policy may not cover every possible situation. An adviser therefore may wish to consider appointing a committee or designating particular personnel who otherwise are not involved in the proxy voting process to help determine how such matters should be voted.
  • Use of a proxy advisory firm. Just as it would for any service provider, an adviser should conduct due diligence before retaining a proxy advisory firm and continue to monitor the proxy advisory firm’s services.37

Given the current focus on adviser use of proxy advisory firms, advisers should review their policies and procedures relating to proxy voting, including how they evaluate and use proxy advisory firms’ services, and particularly in circumstances where a proxy vote relates to more controversial proposals.38

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1 Chris Gaither, Hewlett Heir Files Lawsuit to Overturn Merger Vote, NY Times (March 29, 2002).

2 Deutsche Asset Management, Inc., Advisers Act Release No. 2160 (Aug. 19, 2003) (SEC alleged that the asset manager failed to disclose a material conflict, namely that its parent was working for Hewlett-Packard on the merger and had intervened in the asset manager’s proxy voting process on behalf of Hewlett Packard). See also U.S. Gov’t Accountability Office, GAO-04-749, Additional Transparency and Other Actions Needed in Connection with Proxy Voting (2004) (recommending changes to ERISA and DOL action).

3 See Disclosure of Proxy Voting Policies and Proxy Voting Records by Registered Management Investment Companies, Investment Company Act Release No. 25922 (Jan. 31, 2003) (the “Fund Rule Release”), and Proxy Voting by Investment Advisers, Advisers Act Release No. 2106 (Jan. 31, 2003) (the “Adviser Rule Release”).

4 See Investment Company Act rule 30b1-4 and form N-PX.

5 See Advisers Act rule 206(4)-6. In addition, Advisers Act rule 206(4)-6 requires an adviser to disclose to its clients information about the policies and procedures and to disclose to clients how they may obtain information on how the adviser has voted proxies.

6 See Adviser Rule Release, supra note 3.

7 Id.

8 Id.

9 Egan-Jones Proxy Services (pub. avail. May 27, 2004); Institutional Shareholder Services, Inc. (pub. avail. Sept. 15, 2004).

10 Some also have contended that Glass Lewis’s ownership by the Ontario Teachers’ Pension Plan Board raises conflicts. See, e.g., Chamber of Commerce Comment Letter to the SEC (May 30, 2012) (alleging that its activist owner influenced Glass Lewis’s recommendation to oppose the board of directors for a Canadian railway in a proxy battle with an activist hedge fund). Both ISS and Glass Lewis publicly disclose information about their respective conflicts of interest.

11 U.S. Gov’t Accountability Office, GAO-07-765, Issues Relating to Firms that Advise Institutional Investors on Proxy Voting (2007). The GAO report contained no recommendations.

12 Concept Release on the U.S. Proxy System, Investment Company Act Release No. 29340 at 109 (Jul. 14, 2010) (“Concept Release”). See also, Mary L. Schapiro, Chairman, Remarks at the National Conference of the Society of Corporate Secretaries and Governance Professionals (Jul. 9, 2010).

13 As indicated, ISS already had been registered as an investment adviser, but certain other proxy advisory firms, such as Glass Lewis, had not registered.

14 See, e.g., James K. Glassman & J. W. Verret, How to Fix our Broken Proxy Advisory System, Mercatus Ctr. at George Mason Univ. (April 16, 2013) (“How to Fix our Broken Proxy Advisory System”), (“Unfortunately, the rule became a classic case of unintended consequences. Many institutional investors largely outsourced their shareholder voting policies to a proxy advisory industry that relies on precisely the type of ‘one-size-fits-all’ policies that were intentionally excluded from the original regulation because of objections by commissioners. The SEC staff interpretation of the rules on proxy voting have led to the opposite result of what many of its supporters intended.”). See also, Daniel M. Gallagher, Commissioner, Remarks at Society of Corporate Secretaries & Governance Professionals,” (July 11, 2013), (“Given the sheer volume of votes, institutional shareholders, particularly investment advisers, may view their responsibility to vote on proxy matters with more of a compliance mindset than a fiduciary mindset. Sadly, the Commission may have been a significant enabler of this [through rule 206(4)-6 and the interpretive letters]”). But see Stephen Choi, Jill Fisch & Marcel Kahan, Who Calls the Shots? How Mutual Funds Vote on Director Elections, 3 Harv Bus L. Rev. 35 (2013) (finding a substantial degree of divergence in fund voting from ISS recommendations).

15 See IBM Comment Letter on the Concept Release (Oct. 15, 2010), (institutional investors vote in a lock-step manner (i.e., 100% in accordance) with the ISS recommendation). See also Morris Mitler, Sean Collins & Dorothy Donohue, Funds and Proxy Voting: Funds Vote Thoughtfully and Independently (Nov. 7, 2018), (in 2017, while funds voted in lock-step with ISS recommendations on proposals submitted by management, which tend to be routine business matters, that correlation breaks down when funds vote on shareholder proposals, which tend to be much more debated).

16 “To a large degree, corporate directors and executives are now subject to decision making on critical issues by organizations that have no direct stake in corporate performance and make poor decisions as a result. Conscientious shareholders, who do have such a stake, also suffer because their votes are usurped or overwhelmed by these same organizations. The SEC’s proxy policy rules have led to results unimagined by their original advocates.” How to Fix our Broken Proxy Advisory System, supra note 14.

17 The Commissioners themselves disagreed on the extent of any problems. For example, Commissioner Gallagher strongly sided with corporate interests, arguing for the need for “Commission guidance clarifying to institutional investors that they need to take responsibility for their voting decisions rather than engaging in rote reliance on proxy advisory firm recommendations would go a long way toward mitigating the concerns arising from the outsized and potentially conflicted role of proxy advisory firms” supra note 14. Chair White indicated that proxy advisory firms play an important role in assisting institutional investors and stated that she was “particularly interested in the discussion of conflicts of interest that may or may not arise in connection with the participation of proxy advisors in our system.” Mary J. White, Chairman, Welcoming Remarks at Proxy Advisory Services Roundtable (Dec. 5, 2013).

18 See, e.g., Mary Jo White, Chairman, Completing the Journey: Women as Directors of Public Companies (Sept. 16, 2014), (encouraging greater diversity in public company boards); Kara M. Stein, Commissioner, Remarks to the Council of Institutional Investors (May 8, 2014), (SEC should consider permitting, if not mandating, universal proxy ballots and clarifying process for evaluating issuer no-action requests to exclude shareholder proposals); Luis A. Aguilar, Commissioner, Looking at Corporate Governance from the Investor’s Perspective (Apr. 21, 2014), (examining three fundamental principles of an effective corporate governance regime – accountability, transparency and engagement – in the context of the executive compensation process); Michael S. Piwowar, Commissioner, Advancing and Defending the SEC’s Core Mission (Jan. 27, 2014), (the SEC should “move forward with initiatives to curb the unhealthy over-reliance on proxy advisory firm recommendations”); and Daniel M. Gallagher, Commissioner, Remarks to the Forum for Corporate Directors (Jan. 24, 2014), (“Proxy advisory firms have gained an outsized role in corporate governance, both in the United States and abroad.”).

19 SEC Staff Legal Bulletin No. 20 (June 30, 2014).

20 U.S. Gov’t Accountability Office, GAO-17-47, Proxy Advisory Firms’ Role in Voting and Corporate Governance Practices (2016).

21 See H.R. 4015, 115th Cong. (2017)

22 Id. While the legislation defined a “reasonable time” to be one that did not interfere with the proxy advisory firm’s ability to provide the report to its institutional investor client, it is not clear how this process would be possible given the tight timelines during the proxy season.

23 S. 3614, 115th Cong. (2018) The legislation appears to have been intended to deny Glass Lewis the ability to rely on the publisher’s exclusion from registration as an investment adviser as it specifically states that a proxy advisory firm may not rely on section 202(a)(11)(D) of the Advisers Act.

24 See Statement Regarding Proxy Advisory Letters (Sept. 13, 2018).

25 See, e.g., Adam Kokas, Exec. Vice President, General Counsel and Sec’y, Atlas Air Worldwide, Remarks at U.S. SEC Roundtable on the Proxy Process (Nov. 15, 2018).

26 See, e.g., Dorothy Shapiro Lund, The Case Against Passive Shareholder Voting, Coase-Sandor Working Paper Series in Law and Economics 846 (2017); and José Azar, Martin C. Schmalz & Isabel Tecu, Anticompetitive Effects of Common Ownership (Jan. 30, 2015).

27 See, e.g., BlackRock Index Investing and Common Ownership Theories (Mar. 2017); Daniel P. O’Brien & Keith Waehrer, The Competitive Effects of Common Ownership: We Know Less Than We Think, 81 Antitrust L. J.l No. 3 (Feb. 2017); Pauline Kennedy, Daniel P. O’Brien, Minjae Song & Keith Waehrer, The Competitive Effects of Common Ownership: Economic Foundations and Empirical Evidence (July 2017).

28 The Federal Trade Commission held a hearing addressing common ownership in December 2018. A European Parliament member recently told the Financial Times that “[t]he effects of [large passive funds] have to be taken into account and regulated,” and the European Competition Commissioner has been looking into issues since December 2018. See Siobhan Riding, Brussels targets large index fund managers on “common ownership” (Jan. 21, 2019). The OECD held a hearing on common ownership in December 2017.

29 Jay Clayton, Chairman, SEC Rulemaking Over the Past Year, the Road Ahead and Challenges Posed by Brexit, LIBOR Transition and Cybersecurity Risks (Dec. 6, 2018).

30 Elad L. Roisman, Commissioner, Brief Statement on Proxy Voting Process: Call with the SEC Investor Advisory Committee (Feb. 6, 2019).

31 See, e.g., Division of Risk, Strategy and Financial Innovation and the Office of the General Counsel, Current Guidance on Economic Analysis in SEC Rulemakings (March 16, 2012).

32 Recent data published by the Investment Company Institute indicates that during the 2017 proxy season, funds cast more than 7.6 million votes for proxy proposals. See Mitler, Collins & Donohue, supra note 15.

33 “Because a mutual fund is the beneficial owner of its portfolio securities, the fund’s board of directors, acting on the fund’s behalf, has the right and the obligation to vote proxies relating to the fund’s portfolio securities.” See Fund Rule Release, supra note 3.

34 “As a practical matter, however, the board typically delegates this function to the fund’s investment adviser as part of the adviser’s general management of fund assets, subject to the board’s continuing oversight.” Id.

35 A board’s oversight is subject to its general fiduciary duty, and the “business judgment” rule should apply so long as the board has exercised reasonable judgment and not put its interests above those of the fund and its shareholders.

36 Fund boards that rely on the adviser’s policy and procedures should conduct a periodical review to determine the continued appropriateness of such policy and procedures.

37 The SEC staff in SLB 20 suggested good practices for an adviser to consider with regard to retaining the services of a proxy advisory firm and in determining whether to maintain such services. With regard to initial retention, the SEC staff suggested an adviser diligence the adequacy and quality of the proxy advisory firm’s staffing and resources and examine the robustness of its policies and procedures with regard to, for example, conflicts. With regard to maintaining such services, the SEC staff suggested, for example, periodically sampling proxy votes to determine if they are consistent with the adviser’s policy and procedures and having a process to investigate any material factual errors identified that formed the basis of a recommendation.

38 For example, many advisers include in their proxy voting guidelines that the adviser will make a case-by-case determination for more controversial proposals rather than having a proxy advisory firm vote according to a pre-determined guideline.

Governmental/public plans – fiduciary due diligence considerations

A common question we field is how investment managers and others can provide services to governmental plans and state entities without running afoul of applicable law. “Governmental plans” refer to employee benefit plans offered to state, county or municipal employees. Texas Teachers and CalPERS are two examples. State treasury assets may also be subject to myriad restrictions. These plans/entities, though not subject to ERISA, present numerous due diligence considerations for service providers.

An immediate challenge is determining what rules apply to a particular plan. Fiduciary duties, prohibited transactions, investment restrictions and other important provisions may be found in the state constitution, numerous statutes, administrative regulations, local ordinances, case law and attorney general advisory letters. Each state, of course, differs in terms of (1) where these rules can be found and (2) how detailed and restrictive they are.

Various (but certainly not all) governmental plans are subject to laws that impose fiduciary duties that are quite similar to those found under ERISA. A minority have ERISA-like prohibited transaction rules, and of those, a scant few seem to offer any apparent analog to ERISA’s prohibited transaction exemptions.

In stark contrast to ERISA, a number of legislatures and regulators have formulated detailed investment restrictions, such as prohibitions on derivatives, investments prohibitions in certain countries, concentration caps, and ESG-related rules. It can be challenging to ensure that a term in draft investment guidelines does not conflict with these nuanced rules.

A number of governmental plans have very detailed disclosure requirements. While this is rarely a deal-breaker for a service provider, these disclosure rules entail special consideration to manage the administrative burden.

There are several other considerations, too, such as whether compliance with the procurement rules are necessary, the extent to which sovereign immunity applies, and ensuring that the applicable pay-to-play rules are satisfied.

Nevada fiduciary proposal’s potential effect on private fund managers

The recent Nevada fiduciary proposal has its sights set on broker-dealers. But private fund managers, and other investment advisers, are covered, as well. Discretionary management of a client’s assets is fiduciary conduct. However, communications by fund managers with prospective and current investors regarding their interests in the fund may also amount to fiduciary investment advice under the proposal. Similarly, communications regarding the features of the fund may amount to fiduciary investment advice. Thus, the Nevada proposal seems to raise similar issues as the 2016 DOL Fiduciary Rule for private fund managers.

The proposal seeks to address these concerns by providing that information about a security that is specifically contained in the security’s “offering documents” is presumptively not investment advice unless, as part of the discussion, there is (A) a recommendation of one product over another, (B) a recommendation to buy, hold, or sell a security, or (C) advice on the purchase, hold, sale, or value of a security, to a client or limited group of clients.

It is unclear what, beyond an offering memorandum, constitutes “offering documents” for purposes of this presumption. Would a pitch book suffice? Would the materials necessarily have to be in written form and would they have to be shared with all prospective/current investors?

It is also worth mentioning that information about a fund that is not “specifically” described in an offering memorandum or other material that is an “offering document” seems to be considered investment advice. Consider whether communications with a prospective investor regarding the attributes of two or more funds would give rise to “investment advice” under the proposed definition.

The proposal raises a number of interpretive issues, including those described above. The comment period closes on March 1.

Maryland’s General Assembly Proposes Broad Fiduciary Legislation That Would Cover Broker-Dealers And Insurance Producers

On February 4, 2019, the Financial Consumer Protection Act of 2019 was introduced in the Maryland Senate as bill MD SB 786.  An analog bill for the same proposed legislation has been introduced before the Maryland House as MD HB 1127.  Included in the proposed legislation is a section that would make broker-dealers, broker-dealer agents, and insurance producers fiduciaries.

Specifically, the proposed legislation would amend Maryland’s Corporations and Associations Article to create a fiduciary duty for any individual covered by the statute “to act in the best interests of the customer without regard to the financial or other interest of the person or firm providing the advice.”  The legislation also vests broad powers in the hands of the Commissioner of Financial Regulation by authorizing the Commissioner to “adopt regulations to carry out the fiduciary duty required under this section,” including regulations that (1) define, require, prohibit, or exclude an act, practice, or course of business of a person subject to the statute; and (2) prevent a person from engaging in acts, practices, and courses of business in violation of the statute.

The proposed legislation comes on the heels of a report the Maryland Financial Consumer Protection Commission (the “Commission”) issued in January 2019, recommending changes to Maryland law.  In that report, the Commission recommended that the “ General Assembly pass legislation that provides that broker-dealers, broker-dealer agents, insurance producers, investment advisers, or investment adviser representatives who offer advisory services or hold themselves out as advisors, consultants, or as providing advice, would be held to a fiduciary duty to act in the best interest of the customer without regard to the financial or other interest of the person or firm providing the advice.”  The Commission also suggested that, “[i]n addition to broadening the fiduciary duty standard in Maryland to broker-dealers and insurance agents, the fiduciary duty standard currently imposed on investment advisers in Maryland needs to be strengthened, as it is currently weaker than the national fiduciary duty standard.”

The legislation proposed in Maryland’s General Assembly is sweeping in scope and, if passed in its current form, would have a profound impact on the financial services and insurance industries in the state.  Among other things, the proposed legislation is very broad as applied to insurance producers, making them fiduciaries in the context of a wide range of transactions.  Given its scope, the proposed legislation is likely to meet fierce opposition from industry groups and other organizations who are concerned about the detrimental impact the proposed legislation could have on the cost and availability of insurance and other investment products in the marketplace for Maryland consumers.

It is difficult to predict if the proposed legislation will succeed.  Just last year, Maryland’s General Assembly declined to pass similar a provision that would have made broker-dealers and insurance producers fiduciaries.  The current proposed legislation, however, comes against a different backdrop.  After declining to pass the legislation proposed in 2018, the General Assembly directed the Commission to study the outcome of federal efforts on fiduciary duty and determine whether Maryland should enact its own fiduciary law.  The Commission has completed that work and determined, among other things, that because “[the] SEC and the state insurance regulators have proposed standards that largely preserve the status quo, individual states may need to provide greater protections that investors expect from financial professionals who provide investment advice.”  Additionally, other states, such as New York, New Jersey, and Nevada are pressing forward with their own approach to implementing a fiduciary duty standard through legislation or regulation.

We continue to view state level activity through the same lens as we have through the past year, which is that most states will likely wait to see the SEC’s final Regulation Best Interest and the National Association of Insurance Commissioner’s revisions to it Suitability in Annuity Transactions Model Regulation before determining whether they should take any action on their own.  But as demonstrated by the regulations adopted by New York’s Department of Financial Services in 2018, and the recent activity in Maryland and New Jersey, states that have historically been aggressive in addressing consumer protection may be less apt to wait for a national standard.

NY Senate considering companion bill to Dinowitz’s proposed Investment Transparency Act

The draft legislation, which has been introduced in the New York State Assembly and Senate, is identical to last year’s proposed Investment Transparency Act.  As is the case with last year’s legislation, it would apply to: (1) investment advisers and other financial intermediaries that, essentially, hold themselves out as financial planners, financial consultants, retirement planners or as engaged in comparable types of businesses; and (2) which are not fiduciaries under federal law, state law, or the terms of their own internal policies (collectively, “Non-Fiduciary Financial Advisors”).  It would require Non-Financial Advisors to provide certain disclosures to existing and prospective customers about the non-fiduciary nature of their relationship and the surrounding limitations.  In essence, the legislation would serve as a sort of “truth in labelling” consumer protective mechanism.  It would not apply to federally registered advisers, broker-dealers who are fiduciaries under state law, or broker-dealers who are not Non-Fiduciary Financial Advisors.  Consequently, its scope and application would be far narrower than the Nevada’s proposed regulations or even the SEC’s proposed Regulation Best Interest, for that matter.

Nevada Proposes Sweeping Fiduciary Regulation

On July 1, 2017, Nevada broker-dealers and investment advisers became subject to the state’s financial planner statute (NRS 628A), making them fiduciaries to their clients and requiring them to submit to a rigorous disclosure regime. This legislation removed existing exemptions for broker-dealers, investment advisers and their respective representatives from the definition of a “financial planner.” As a result, broker-dealers, investment advisers and their respective representatives are “financial planners” under Nevada law if they advise others for compensation upon the investment of money or upon provision for income to be needed in the future, or if they hold themselves out as qualified to perform either of these functions. As financial planners, they will now be subject to Nevada’s statutory fiduciary duty with respect to advice that they provide to Nevada clients. Under NRS 628A.010, a “client” is a “person” who receives advice from a financial planner.

The statutory fiduciary duty specifically requires financial planners to “disclose to a client, at the time advice is given, any gain the financial planner may receive, such as profit or commission, if the advice is followed.” The statutory fiduciary duty also requires financial planners, through a “diligent inquiry of each client,” to make an initial determination of suitability of the advice to be given to each client as well as to evaluate such suitability on an ongoing basis. In making such determinations of suitability, the financial planner should consider “the client’s financial circumstances and obligations and the client’s present and anticipated obligations to and goals for his or her family.” A violation of the statutory fiduciary duty by these regulated persons and entities will be a violation of the Nevada Uniform Securities Act.

Clients of financial planners have a statutory right of action if the financial planner (1) violates any element of the fiduciary duty, (2) is grossly negligent in the provision of advice to the client, in light of all of the client’s financial circumstances known to the financial planner or (3) violated any state law in the provision of investment advice. If any of the above violations occur, the client is entitled to recover, in a civil action, the amount of any economic loss resulting from the advice and all costs of litigation and attorney’s fees.

Since July 2017, the Nevada Securities Division has been working to further define the statutory fiduciary duty, as applicable to broker-dealers, investment advisers and their respective representatives, through the inclusion or exclusion of certain actions as violations and to prescribe means reasonably designed to prevent violations of the fiduciary duty.

The Proposed Draft Regulation

On January 18, the Nevada Securities Division released its long-awaited proposed draft regulation (“Proposal”). The Proposal begins by stating that a broker-dealer or its sales representatives will owe a fiduciary duty to its clients if it: (1) provides “investment advice” (as defined below) to the clients; (2) manages the clients’ assets1; (3) performs discretionary trading2 of client assets; (4) who otherwise establishes a fiduciary relationship with clients,3 or (5) uses the following titles and terms in their title, name, biographical description, or otherwise holds themselves out as having such role: (a) advisor/adviser, (b) financial planner/financial consultant, (c) retirement consultant/retirement planner, (d) wealth manager, (e) counselor, or (f) “other titles that the Administrator may by order deem appropriate.”4 A broker-dealer and sales representative are presumed to owe a fiduciary duty to the client.

Preemption

The Securities Division opted to have the Proposal be read “in harmony” with the Securities Exchange Act of 1934, as amended by the National Securities Market Improvement Act of 1996’s recordkeeping requirements, thereby attempting to address some of the preemption concerns.

Key Definitions

The Proposal provides a detail definition of “investment advice.” Specifically, “investment advice” includes, but not limited to:

  1. providing advice or a recommendation regarding the buy, hold, or sale of a security to a client,
  2. providing advice or a recommendation regarding the value of a security to a client,
  3. providing analyses or reports regarding a security to a client,
  4. providing account monitoring for the purpose of potentially recommending a buy, hold, or sale of a security,
  5. providing advice or a recommendation regarding the type of account a client should open,
  6. providing advice or a recommendation regarding the fee options available for the services provided by the investment adviser, representative of an investment adviser, broker-dealer, or sales representative,
  7. providing information on a personalized investment strategy,
  8. providing a financial plan that includes consideration of buying, holding, or selling a security,
  9. providing a limited list of securities for consideration by a client or by a limited group of clients that is tailored to the client or group of clients,
  10. providing information about a security that is not provided in the offering documents or is an opinion regarding the security or its potential performance,
  11. recommending a broker dealer, sales representative, investment adviser, representative of an investment adviser, or financial planner, and
  12. providing advice or a recommendation regarding an insurance product or an investment by comparison to a security, or that includes the buy, sale, or hold of a security.

The Proposal notes that “providing information about a security that is specifically contained in the security’s offering documents is presumptively not investment advice unless, as part of the discussion, the investment adviser, representative of an investment adviser, sales representative, or broker-dealer recommends one product over another, recommends a buy, hold, or sale, or advises on the purchase, hold, sale, or value of a security to a client or limited group of clients.” Moreover, communications regarding a general investment strategy that applies to the general public, or is publishing an investment company ranking or a bond mutual fund volatility rating ranking consistent with FINRA rules, are not investment advice, provided they are “not targeted to any particular group or individual clients.”

Investment Advisers and their Representatives

The fiduciary duty also applies to investment advisers and their representatives. Notably, the Proposal provides that dual-registered entities and individuals who are both investment adviser representatives and “sales representatives” (presumably, registered representatives) will be presumed to be acting as investment advisers.

Scope

The fiduciary duty imposed on both broker-dealers and investment advisers generally includes the time period during which it provides investment advice, performs discretionary trading, maintains assets under management, acts in a fiduciary capacity towards the client, discloses fees or gains, through the completion of any contract, and through the term of engagement of services. Broker-dealers, but not investment advisers, may qualify for the Episodic Fiduciary Duty Exemption, which would limit the fiduciary duty to the specific investment advice provided, but not, unless otherwise required by law, have an ongoing fiduciary duty towards the client. This means that, under the Episodic Fiduciary Duty Exemption, the broker-dealer or sales representative would not have an ongoing duty to keep informed about the client’s financial circumstances and obligations.

The conditions of the Episodic Fiduciary Duty Exemption are:

  1. The broker-dealer or sales representative does not manage the client’s assets or perform discretionary trading for the client;
  2. The broker-dealer or sales representative does not create periodic financial plans for the client, provide ongoing investment advice, or enter into a contract to provide investment advice;
  3. The broker-dealer or sales representative has not otherwise developed a fiduciary relationship with the client from previous or concurrent services undertaken on behalf of the client;
  4. The broker-dealer and sales representative do not the use terms/titles, described above.
  5. The “facts and circumstances surrounding the transaction do not indicate that additional or ongoing investment advice is reasonably expected by the client relative to that transaction, type of product or advice,” and,
  6. The client solicited any investment advice.

The Standard of Care

The Proposal provides that the fiduciary duty is breached if the broker-dealer, investment adviser or their representatives, inter alia:

  1. Fails to perform adequate and reasonable due diligence on a product or investment strategy prior to transacting sale or providing investment advice;
  2. Recommends to a client a security or an investment strategy that is not in the client’s best interest, or the recommendation or sale deviates from firm policies, offering limitations, or other law;
  3. Provides investment advice on a product or investment strategy without understanding or conveying all risks or features of the product or investment strategy;
  4. Puts their own interest, other client’s interests, or the firm’s interest ahead of the client;
  5. Fails to provide current offering documents on the product prior to execution of the transaction;
  6. Fails to disclose that a recommended product was a proprietary product or that the advice was based upon a limited pool of products, or fails to convey all material risks or features of the product;
  7. Fails to adequately disclose all information regarding a potential conflict of interest;
  8. Fails to comply with best execution rules;
  9. Recommends or sells a security without disclosure of a bad actor disqualification as defined in Regulation D, Rule 506;
  10. Recommends or charges a fee that is unreasonable;
  11. Violates an applicable FINRA rule or other applicable self-regulatory organization rule that relates to client communications or disclosure;
  12. Engages in conduct prohibited by NAC 90.321, 90.327, or 90.328 (relating to fraudulent and unethical practices); or
  13. Limits the availability of securities to certain clients unless based upon a client’s investment goals, a client’s investment strategy, a firm’s limitation of quantity or type of investment that can be sold to a client, or the security’s own sale limitations.

Conduct that is Not a Per Se Violation of the Fiduciary Duty

The Proposal sets forth three instances of conduct that do not amount to a per se violation of the fiduciary duty:

  1. The sale of a proprietary product by a broker-dealer or sales representative alone is not a breach of the fiduciary duty, provided:
    1. The broker-dealer’s and sales representative’s conduct does not otherwise violate the law;
    2. The broker-dealer’s and sales representative’s conduct does not otherwise violate an applicable self-regulatory organization rule; and,
    3. They advised the client that the product is proprietary and advised the client of all risks associated with the product.
  1. A broker-dealer, investment adviser and their representatives who hold or manage a client’s position in cash does not breach the fiduciary duty based on that cash position alone if:
    1. They advise the client of all risks associated with the cash position;
    2. The conduct does not otherwise violate the law; and
    3. All applicable self-regulatory organization, custody, and conduct rules are followed regarding the cash position.
  1. A broker-dealer or sales representative’s receipt of commissions does not breach the fiduciary duty provided the commission is both reasonable and in the client’s best interest as opposed to other types of fees.

Exemptions

The Proposal sets forth three exemptions to the fiduciary duty standard:

  1. A broker-dealer or sales representative who executes an unsolicited transaction for a client whose assets are not managed by the broker-dealer or sales representative, and has otherwise complied with all applicable rules, firm policies and procedures, unless the client receives investment advice (impliedly or explicitly), discretionary trading services, ongoing contractual services or a financial plan.
  2. A broker-dealer who executes a trade in good faith that was recommended to a client by a registered or licensed investment adviser or representative, and has otherwise complied with applicable laws, rules, firm policies and procedures, provided the broker-dealer does not provide investment advice, asset management, discretionary trading or provide a financial plan to the client.
  3. A clearing firm that receives a direct instruction for the execution of a transaction from a properly registered or licensed broker-dealer, provided the clearing firm has acted in good faith, otherwise complied with all applicable laws, self-regulatory rules and firm policies and procedures.

Disclosure Requirement

As a general rule, if a broker-dealer, investment adviser or their representatives receives certain types of fees or “gains” “as a result of a client following their advice,” then such compensation need to be disclosed to the client no later than at the time the advice is given. The types of compensation included are: (a) percentage of managed assets fee, (b) commissions, (c) mark ups or mark downs commissions, (d) market-maker commissions (electronic communication network rebates or credits), (e) discounts based upon number of transactions or clients, (f) management fees, (g) deferred or trailed fees or commissions, (h) front end load or back end loads, (i) service fees or (j) payment for order flow. The Proposal explains that “gain” excludes “the profit or gain [that] may accrue as a result of all business activities.”

The Proposal contains a number of caveats:

  1. Where the actual amount of the gain is not known at the time of the advice, the firm and representative would need to disclose to the client that a gain will be received and the manner by which the gain is calculated, and the amount actually received, is provided to the client within a reasonable time period (i.e., within a time period permitted under applicable law or SRO rules).
  2. A firm or its representatives that charge the client a fee based upon a specific percentage of assets under management, and where those charges are “regularly” provided consistent with “other firm documents and law” need not disclose such fees at the time of the advice.
  3. The receipt and amount of finder’s fees, referral fees and “other benefit” for referrals to firms (brokerage and advisory), their representatives and/or a “financial planner,” must be disclosed to the client at the time of the referral, along with any applicable contracts relating to the referral.

Our Initial Impressions

Some of our impressions of the Proposal are:

  1. The Proposal, if adopted, would impose new and additional requirements on both broker-dealers and investment advisers.
  2. It remains unclear whether investment advice to plan participants, fiduciaries, investment managers or entities would fall within the scope of the Proposal.
  3. For all intents and purposes, broker-dealers and registered representatives are foreclosed from using the following titles, or otherwise holding themselves out as, (a) advisor/adviser, (b) financial planner/financial consultant, (c) retirement consultant/retirement planner, (d) wealth manager, or (e) counselor, because doing so would disqualify them from relying upon the Episodic Fiduciary Duty Exemption. Use of such titles would mean that broker-dealers and their representatives would owe a continuing fiduciary duty to their client even after the transaction at issue was consummated.
  4. The Securities Division reserves the right to add to the list of terms and titles that connotate fiduciary status, creating an uncertain business environment for firms. Commenters may wish to have a final regulation confirm that any additional titles will not have retroactive effect.
  5. Dual-registrants and their affiliates should pay particular attention to the Proposal.
  6. The definition of “investment advice” appears to go well beyond existing definitions and interpretations under federal law. For example, the definition refers to both “advice” and “recommendations,” without explaining how the terms differ and how a recommendation can amount to advice. Moreover, seemingly any information about a specific security to a specific client could be deemed to constitute investment advice, even such general information as price and historical performance. Though the Proposal indicates that the provision of information about a security “that is specifically contained in the security’s offering documents is presumptively not investment advice,” it leaves open-ended whether providing general information not contained in such documents would give rise to investment advice. The Proposal does not unequivocally state that general information about a specific security to a specific client is not advice.
  7. There is uncertainty over the scope and application of the Episodic Fiduciary Duty Exemption.
  8. The Proposal is silent on whether and how the fiduciary status (or inability to rely on an exemption) of a representative applies to the entire firm (and its other representatives).
  9. The Proposal helpfully indicates that the sale of proprietary products is not a per se violation of the fiduciary duty, but the firm or the representative would need to inform the client that the product is proprietary and advise the client “of all risks associated with the product.” The Proposal does not define the term “risks” or the level of materiality triggering risk disclosure. Broker-dealers may wish to have this condition clarified to provide that disclosure in a manner consistent with federal law would satisfy this condition.
  10. Firms should carefully review the proposed disclosure requirements regarding fees and gains, which may create substantial operational burdens.
  11. The Proposal suggests that the mere holding of client cash could create a fiduciary obligation under certain circumstances. The Proposal curiously provides that a firm (broker-dealer or investment adviser) could, under certain circumstances, be subject to a fiduciary duty simply by holding or managing the client’s position in cash.
  12. The Proposal says that the fiduciary duty standard of care extends to the time during which a broker-dealer “maintains assets under management,” even though the fiduciary duty is only supposed to apply, in pertinent part, when broker-dealers “manage” assets or perform “discretionary” trading. This could potentially ensnare custodial functions after investment advice was given. We don’t necessarily think this conclusion is the Securities Division’s intent, but it may make sense to seek clarification.
  13. Commissions are seemingly preserved as a method of compensation, but the Proposal imposes “best interest” and “reasonable compensation” requirements. Unfortunately, the Proposal fails to define “best interest” or otherwise provide any guidance on how a firm could demonstrate satisfaction of such requirements.
  14. Clearing firms are potentially ensnared by the Proposal, as they are covered by an exemption that contains a number of conditions. This seems to assume that clearing firms could otherwise be subject to the fiduciary duty.
  15. Brokerage firms may be deemed to be exercising trading discretion, and, therefore, subject to the fiduciary duty, for selecting the trading venue from which to buy or sell a security on behalf of a client.
  16. A breach of fiduciary duty would occur if a firm or representative provides investment advice on a product or investment strategy “without understanding” all of the risks and features of the product or strategy. It leaves to the imagination how a firm could ensure that its representatives understand risks and features of a product or strategy.
  17. The Proposal bars putting one client’s interest ahead of another client’s interest.
  18. The Proposal acknowledges the Securities and Exchange Commission’s (“SEC”) preemptive authority under the Exchange Act with respect to broker-dealer books and records requirements, but is silent with regard to federal preemption of state authority under the Investment Advisers Act of 1940, as amended (“Advisers Act”), and ERISA; therefore, it appears the Securities Division is of the view that the Proposal, if adopted, would not be preempted under the Advisers Act and ERISA.
  19. The Proposal authorizes the Securities Division to adopt any rule, form or exemption approved by the SEC for application to broker-dealers, investment advisers and their representatives so long as the adoption does not materially diminish the fiduciary duty under applicable Nevada law. This appears to give them the flexibility to adopt SEC’s best interest proposals (including Regulation Best Interest, if adopted). As a practical matter, we think this is unlikely given that the Securities Division opted to propose the Proposal seemingly mere months away from the SEC’s adoption of its own rulemaking package and the numerous differences between the Proposal and the SEC’s proposals.

Next Steps

Those interested in submitting a comment letter on the Proposal may do so by March 1, 2019. Written comments should be sent to: Diana Foley, Nevada Secretary of State’s Office Securities Division, 2250 Las Vegas Boulevard North, Suite 400, North Las Vegas, Nevada 89030.

We expect that the Securities Division will hold a second workshop (open to the public) at some point, and, prior to a final rulemaking, a public hearing. It is unclear if the Proposal has been blessed by the Nevada Legislative Counsel Bureau at this point.


1 We note that “assets” may not necessarily be limited to securities.

2 The Proposal defines “discretionary trading” by what it’s not, namely, that it does not encompass the “limited conduct of exercising discretion as to time and price of buying or selling a security that is based upon a client’s direction, or transactions executed to satisfy customer margin obligations.

3 It is unclear whether a fiduciary relationship established under federal law (e.g., Employee Retirement Income Security Act of 1974, as amended (“ERISA”)) would trigger fiduciary status here.

4 A broker-dealer and sales representative will be presumed to owe a fiduciary duty to their client. This means that they would have the burden of showing that an exemption applies.

A Fiduciary’s 2018 Retrospective (and Predictions for 2019)

Our inaugural 2019 Risk & Reward will both get you up to speed on 2018 fiduciary-related developments that affected financial institutions, as well as preview the 2019 landscape. We’ll refrain from screaming predictions, that, while attention-grabbing, are unlikely to materialize. Instead, we will provide context and nuance that anchors our predictions. We take this role very seriously, considering that the Fiduciary Governance Group’s very genesis was in the heady days between the Department of Labor’s (DOL) fiduciary rule demise and the Securities and Exchange Commission’s (SEC) standard of conduct proposal. While standards of conduct will dominate our discussion and predictions, many other fiduciary issues also manifested themselves in 2018, including proxy voting and environmental, social and governance (ESG) investing, and those will be addressed, too.

DOL Fiduciary Rule

The DOL fiduciary rule was already in purgatory when we rung in 2018. While it was clear the rule was unlikely to survive in its Obama-era form, the question was more over whether a scalpel or wrecking ball would be the preferred instrument and whether it would be at the hands of Trump’s DOL or a court.

The administrative complaint filed against Scottrade by the Massachusetts Securities Division in February 2018 was the first salvo of the year. Here, William Galvin, Massachusetts’ Secretary of State, alleged that Scottrade violated the DOL fiduciary rule’s “impartial conduct standards,” and, therefore, violated state law. As we noted, “Massachusetts was effectively seeking to enforce the DOL rule.” The worry, of course, was that the complaint against Scottrade would be the first of many lodged by Massachusetts and others against firms who may have been working off policies and procedures put in place due to the DOL fiduciary rule but by then no longer strictly required. For now, however, no other such actions have been filed.

The second salvo occurred on March 15, 2018, when the Fifth Circuit Court of Appeals flatly rejected the fiduciary rule’s expansive scope of investment advice fiduciary status under the Employee Retirement Income Security Act of 1974 (ERISA), and with it, the prohibited transaction exemptive relief the DOL bundled together with the 2016 rule. Efforts by the states of California, New York and Oregon, along with the American Association of Retired Persons, to have the Fifth Circuit reconsider its judgment were unsuccessful. The DOL, unsurprisingly, declined to appeal the decision to the U.S. Supreme Court. Some wondered whether the ruling had nationwide effect; we believed it did. Our very own Bill Mandia said:

“I don’t see there being any question about the nationwide impact. The Fifth Circuit determined that the DOL’s actions were not a proper exercise of its statutory authority. That ruling should, under the Administrative Procedures Act, vacate the rule nationwide. The mandate is drafted in that manner because it provides that the Fifth Circuit ‘vacat[ed] the Fiduciary Rule in toto.’”1

(Click on image to enlarge.)

At first glance, the Court’s decision to toss out both the fiduciary rule and the related exemptions (e.g., Best Interest Contract Exemption) may seem like throwing out the baby with the bathwater. You will recall, however, that by the time of the Court’s ruling, most of the more complicated and expensive conditions of those exemptions had already been relaxed. As we cheerily noted in November 2017, “[a]n early holiday gift to many, the [DOL] on November 27 formalized an extension of the transition period of the Best Interest Contract (BIC) Exemption, the Principal Transactions Exemption, and certain conditions of Prohibited Transaction Exemption 84-24. The transition period will now end on July 1, 2019 rather than January 1, 2018.” The transition period was, by definition, transitory, and ultimately the DOL would have to find a final fix. In this sense, the Fifth Circuit saved the DOL from having to iron out enough of the 2016 rule’s wrinkles to make the rule (more) workable.

On May 7, 2018, the DOL issued Field Assistance Bulletin (FAB) 2018-02, which states that the DOL and Internal Revenue Service (IRS) will not bring an enforcement action against firms for non-exempt prohibited transactions that arise from providing fiduciary investment advice to plans and IRA holders when they exercise reasonable diligence and act in good faith in complying with the impartial conduct standards. This non-enforcement policy binds only the DOL and IRS; state regulators and private plaintiffs could potentially seek to bring an action for alleged non-compliance with the impartial conduct standards. The industry was already familiar with the impartial conduct standards because they were originally set forth in the Best Interest Contract Exemption.

The original five-part test now determines whether one is an investment advice fiduciary under ERISA. We expect that the DOL will issue interpretive guidance, and propose exemptive relief, in the summer or fall of 2019. The interpretive guidance will most likely address the circumstances under which rollover recommendations constitute fiduciary investment advice. The proposed DOL exemption will probably apply to services and products that the DOL views as presenting fewer conflicts of interest, one of the conditions being adherence to the final form of Regulation Best Interest (more on that, below). While we cannot completely predict whether multiple exemptions will be proposed, we can say, with some level of confidence, that the DOL is quite unlikely to modify the five-part test for when one becomes an investment advice fiduciary. We do not think the DOL has the appetite or bandwidth to do that.

SEC Best Interest Rulemaking Initiatives

SEC Chairman Jay Clayton

Without question, the big fiduciary news of 2018 was the SEC’s April 18 release of its rulemaking proposals on the standards of conduct and required disclosures for broker-dealers and investment advisers who provide services to retail investors.2 Though SEC Chairman Jay Clayton garnered four votes to secure the release of the proposal (Stein dissenting), the commissioners had enough misgivings to give the impression that a final rulemaking could look quite different from the proposal.​ By way of background, the Dodd-Frank Act authorized the SEC to adopt rules on the standards of care for broker-dealers, investment advisers and their associated persons.3 The SEC staff, in 2011, issued a study recommending that the SEC engage in rulemaking to adopt and implement a uniform fiduciary standard of conduct for broker-dealers and investment advisers when providing personalized investment advice about securities to retail customers.

Last April, the SEC acted. The SEC did not, however, propose a uniform fiduciary standard. Rather, it proposed a best interest standard for broker-dealers that it characterized as an enhancement to existing standards (but separate and distinct from the fiduciary duty applicable to investment advisers). The SEC also proposed a new requirement for both broker-dealers and investment advisers to provide a brief relationship summary to retail investors, and it published for comment a proposed interpretation of the standard of conduct for investment advisers.

Proposed Regulation Best Interest would require broker-dealers and registered representatives to act in the “best interest” of a “retail customer”4 at the time a “recommendation”5 of a securities transaction or investment strategy involving securities is made to that customer, without placing the financial or other interest of the broker-dealer or associated person ahead of the interest of the customer.6

The SEC release states that the proposed best interest obligation both draws from principles applying to investment advice in other contexts where conflicts of interests exist, and builds upon the existing regulatory obligations in light of the unique structure of broker-dealer relationships with retail customers. The proposed best interest release reflects the underlying intent of many of the recommendations of the 2011 staff report, and also generally draws from the principles underlying the DOL’s 2016 fiduciary rulemaking.

Crucially, the SEC opted not to define “best interest,” and this omission has largely dominated the discussion over the entire proposed package. The proposed best interest standard is, in fact, not a fiduciary standard, such as the one imposed on investment advisers under the Investment Advisers Act of 1940 (Advisers Act). Rather, it’s a suitability-plus standard with enhanced disclosures and a requirement to mitigate or eliminate certain conflicts of interest. For example, the broker-dealer must establish, maintain, and enforce written policies and procedures reasonably designed to identify and then to, at a minimum, (1) disclose, or eliminate, material conflicts of interest associated with the recommendation; and (2) disclose and mitigate, or eliminate, material conflicts of interest arising from financial incentives associated with the recommendation.

We think that, most likely, Regulation Best Interest will be finalized this spring (in the fall at the latest) largely intact. We would not be surprised if the SEC opted to provide examples of how firms can meet their best interest duties, while still avoiding the rhetorical exercise of trying to define them.

The SEC also included title reforms for broker-dealers and investment advisers which include (1) a requirement of broker-dealers and investment-advisers to prominently disclose their registration status and (2) a prohibition against standalone broker-dealers and their financial professionals from using the terms “adviser” and “advisor” as part of their name or title.

We believe that the SEC is unlikely to adopt the proposed title reform changes given their limited application to just a few terms out of a possible universe of many, and the fact that this initiative was championed by Michael Piwowar, who has since left the SEC. If the SEC does not adopt title reform, we would not be surprised to continue to see state legislatures and regulators view this as an area of focus.

The SEC also proposed requiring that both broker-dealers and investment advisers provide retail investors7 with information intended to clarify the relationship via the proposed Form CRS Relationship Summary. Form CRS would be limited to four pages, with a mix of tabular and narrative information, and contain sections covering (1) the relationships and services the firm offers to retail investors; (2) the standard of conduct applicable to those services; (3) the fees and costs that retail investors will pay; (4) comparisons of brokerage and investment advisory services (for standalone broker-dealers and standalone investment advisers); (5) conflicts of interest; (6) where to find additional information, including whether the firm and its financial professionals currently have reportable legal or disciplinary events and who to contact about complaints; and (7) key questions for retail investors to ask the firm’s financial professional. Form CRS would be provided to investors, filed with the SEC, and available online.8

Form CRS has also proven to be a controversial component of the SEC proposal. If Form CRS was supposed to allay investor confusion over a broker-dealer standard of care and an investment adviser standard of care, the jury still appears to be out. While testing of the Form confirmed investors’ desire for clarity on standards of care, it is still an open question whether investors understand the Form or the concepts addressed in it. As a result, industry comments criticized Form CRS for adding to the confusion. We believe that the SEC will move forward with Form CRS, making some adjustments to address industry concerns and perhaps incorporating some of the models industry submitted.

One other aspect of the SEC standards of conduct package proposal is also worth watching. The SEC published for comment a proposed interpretation of the existing fiduciary duty owed by investment advisers under the Advisers Act. The proposed interpretation is intended to summarize the SEC’s understanding of that fiduciary duty and put the market on notice of the SEC’s views. This has been somewhat controversial within the adviser industry because some believe it goes beyond existing precedents, guidance and interpretations to impose new obligations on advisers. Most notably, the proposed release suggests that certain conflicts of interest may no longer be addressed through disclosure and informed client consent.

In light of the controversy surrounding the release, we predict that the SEC will either choose not to move forward with the interpretation at this time or modify it to delete the more controversial interpretations for which there is no existing strong precedent.

The public had until August 7, 2018 to submit comment letters regarding the proposal. There was general support amongst commenters that the SEC’s proposals were well-intentioned and that the SEC should continue to take a lead on formulating a best interest standard for broker-dealers. However, many commenters felt the SEC’s proposal was vague and went far beyond current broker-dealer obligations. Many commenters hoped the final rules would show significant improvements over the proposals.

William F. Galvin,
Secretary of the
Commonwealth of
Massachusetts

William Galvin submitted a comment letter to the SEC criticizing the proposed Regulation Best Interest and suggested that, absent the SEC’s withdrawal of the proposal, “Massachusetts is prepared to adopt a fiduciary standard for broker-dealers.” Meanwhile, the attorneys general of New York, California, Connecticut, Delaware, Hawaii, Illinois, Maine, Maryland, Massachusetts, Minnesota, New Mexico, Oregon, Pennsylvania, Rhode Island, Vermont, Washington and the District of Columbia submitted a comment letter calling for a uniform fiduciary standardand, inter alia, for Regulation Best Interest to “require the elimination of certain conflicted compensation incentives that cannot be sufficiently mitigated and to base any differential compensation to individuals on neutral factors.”

State Developments

As we noted early in the year, 2018 promised to be very eventful at the state level driven in large measure by a perception that regulatory rollback was well afoot at the federal level. It did not fail to deliver. Regulators and legislators in New Jersey, New York, Nevada and Maryland, among others, raced to fill a perceived void created by federal deregulation. The National Association of Insurance Commissioners (NAIC) also was hard at work in an attempt to form a model standard of conduct for states to follow in connection with the sale of life insurance products.

On October 15, the New Jersey Bureau of Securities (Bureau) issued a notice of pre-proposal to solicit comments on whether to adopt rule amendments that would require broker-dealers, agents, investment advisers and investment adviser representatives to be subject to an express fiduciary duty. The notice highlighted concerns that investors are often unaware of whether and to what extent those they trust to make financial recommendations are receiving undisclosed financial benefits in exchange for steering their clients to certain products.9 The pre-proposal did not include any specific language, but the Bureau did indicate it was considering “making it a dishonest or unethical business practice for failing to act in accordance with a fiduciary duty when recommending to a customer, an investment strategy, or the purchase, sale, or exchange of any security or securities, or providing investment advisory services to a customer.”10 The Bureau held two public hearings last November; the comment period closed on December 14. The Bureau currently expects to release a formal proposal in the first quarter of 2019, followed again by another comment period. This timeline could be extended, depending on when the SEC finalizes its standards of conduct rulemaking. The Bureau could also shelve its proposal if the final Regulation Best Interest is modified in such a way as to assuage state legislatures and regulators.

Early in 2018, the New Jersey Senate reintroduced a bill that would have required non-fiduciary investment advisers to make a plain language disclosure stating that they are not required to act in the client’s best interest, that they are allowed to recommend investments that earn them higher fees, and also keep records of the client’s acknowledgement of those disclosures. The bill stalled. With that said, we understand that the sponsor of the bill has not lost faith and is open to re-introducing the bill this session. It may simply be a matter of politics if legislation is introduced while the Bureau works through its regulatory process.

New Jersey has certainly not been alone. Early last year, New York Assemblyman Jeffrey Dinowitz introduced the Investment Transparency Act, which would have required brokers, dealers, investment advisers and other financial planners that are not otherwise subject to a fiduciary standard under existing state or federal law to make a “plain language disclosure to clients orally and in writing” at the outset of the relationship that states:

I am not a fiduciary. Therefore, I am not required to act in your best interests, and am allowed to recommend investments that may earn higher fees for me or my firm, even if those investments may not have the best combination of fees, risks, and expected returns for you.11

The bill’s language is virtually identical to the New Jersey bill we noted above. While the Investment Transparency Act did not advance to a floor vote following a third reading before the State Assembly in May 2018, Dinowitz has indicated that he plans to re-propose legislation.

One of the most significant state developments over the past year occurred on July 18, 2018 when New York’s Department of Financial Services (NYDFS) approved an amendment to its insurance regulation to impose a “best interest” standard on the sale of life insurance and annuity contracts.12 Specifically, the regulation requires insurers and “producers” to establish standards and procedures for recommendations to consumers with respect to annuity contracts or insurance policies delivered or issued for delivery in the state, so that any transaction with respect to those policies is in the best interest of the consumer and appropriately addresses the insurance needs and financial objectives of the consumer at the time of the transaction. The amendment is to take effect on August 1, 2019 for annuity contracts and February 1, 2020 for life insurance policies.

The New York regulation marked a sea change and raised concerns about what might happen with the NAIC model drafting process as well as in other jurisdictions. The regulation not only heightened the standard of care owed by the sellers of life insurance products, but also vastly expanded the breadth of the products covered from annuities to all life insurance products, including term life insurance. Some industry groups quickly challenged the NYDFS regulation.13 Does this regulation presage how other states respond to the rollback of regulations at the federal level?

On that point, the outcome of the NAIC’s model rulemaking process is of particular note. The NAIC committee tasked with revising the NAIC’s model suitability rule for the sale of annuity products was hard at work in 2018 seeking to revise its current “suitability” standard for the sale of annuity products with a rule that would apply a “best interest” standard. The committee faced great debate among NAIC members regarding among the future of the model rule. With states like New York and California leading the charge, the NAIC was pressured to adopt a rule that, like New York’s regulation, would impose a best interest standard for the sale of both annuity and life insurance products. Other states have pushed back, arguing that such an approach goes too far and would be unlikely to pass in many state legislatures. Because the NAIC is working to harmonize its advice standards with those of the SEC, it is unlikely that NAIC will have its final model rule promulgated until after the SEC finalizes its rule. The future of the NAIC’s model regulation will continue to be a hot topic of debate in 2019.

Maryland is also worth watching. Last May, legislation passed in the House and Senate as part of a larger financial reform bill (titled the Financial Consumer Protection Act of 2018), which instructed the Maryland Financial Consumer Protection Commission (the MFCPC) to study the DOL’s 2016 fiduciary rule and SEC’s proposed Regulation Best Interest, to determine whether it would be in the best interest of the state to adopt its own fiduciary rule. The MFCPC has since held two public hearings where it has heard testimony from interested parties. Last we heard, the MFCPC hopes to issue a final report and draft fiduciary rule to Maryland’s General Assembly and to the Governor any day now. Although there seems to be some support for such a rule in the Maryland legislature, Chair Gary Gensler has recognized that adopting a new fiduciary standard will be a “tough lift” for the General Assembly.

Though the passage of a Nevada bill in 2017, which imposed a statutory fiduciary duty on broker-dealers, sales representatives, and investment advisers14 was met with great fanfare and surprise, it left financial services firms that were subject to the new law in limbo because its scope and core requirements were left to the Nevada Securities Division to decide. While repeatedly promised, a regulation explaining how this uniform fiduciary standard was to work in practice, and whether firms registered with the SEC would be exempted, has yet to materialize. The Nevada Securities Division has been made aware of the preemption concerns by reason of The National Securities Markets Improvement Act of 1996 (NSMIA) and other federal law, which may be the holdup.

Last April, we noted, “Nevada Democratic Senate Majority Leader Aaron Ford, the sponsor of the legislation (who subsequently announced his intention to run for state attorney general), said in an interview that he is ‘confident’ the law will ‘comport with what the federal government may do,’ specifically referencing the DOL Fiduciary Rule.” We also mentioned that, “Ford intimated that he and others would not hesitate to send the Securities Division back to the drawing board if the regulation does not reflect (enough) of their legislative intent. He also vowed, ‘We’ll be back again in 2019’ should the law be struck down by a court on preemption grounds.” Since then, Ford has won his race for state attorney general. We wonder if this means Nevada pursues its agenda of imposing a uniform fiduciary standard through the courts (e.g., filing suit against a final SEC rulemaking) rather than through the legislature.

Also on the legislative front, Illinois took a preliminary step toward promulgating a standard of care for investment advisers. On February 13, 2018, Illinois introduced the Investment Advisor Disclosure Act. While the bill does not yet provide any text, it appears to target disclosure-related standards and mimics the approach taken by New York in its proposed Investment Transparency Act. It also has yet to advance.

With the states’ legislative approach to addressing the standards of conduct issue largely unsuccessful, we expect most states will await final rulemaking from the SEC and the NAIC, and only then propose and promulgate regulations directly or indirectly imposing uniform standards of care. We do not expect many other states, besides the ones already mentioned, to be involved (with one or two exceptions). While regulations may face better odds than legislation, they also remain vulnerable to court challenge that the regulator acted beyond its powers. This means that litigation both by, and against, the states involved, such as New York and potentially New Jersey, will likely characterize state activity regarding broker-dealer and investment adviser standards of conduct in 2019.

Proxy Voting

On September 13, 2018, Clayton announced a review of all SEC staff guidance to determine if prior positions “should be modified, rescinded or supplemented in light of market or other developments.”15 In conjunction with the Chairman’s statement, IM staff withdrew two interpretive letters that gave guidance to investment advisers seeking to comply with the proxy voting requirements of rule 206(4)-6 under the Advisers Act, which, among other things, requires investment advisers to vote client securities in the best interest of clients and to describe how they address material conflicts of interest between themselves and the clients on whose behalf they are voting.16 While rule 206(4)-6 does not dictate how an investment adviser must address conflicts, the adopting release discusses options, including engaging a third party to vote a proxy involving a material conflict or voting in accordance with a pre-determined policy based on recommendations of an independent party. The letters addressed how investment advisers that have a material conflict can determine that a proxy advisory firm is capable of making impartial recommendations in the best interests of the adviser’s clients. The SEC left in place 2014 staff guidance that enshrines the principles of the two interpretive letters.17

IM staff indicated in its statement that its withdrawal of the letters was designed to “facilitate discussions” at the Roundtable on the Proxy Process,18 which was held in November, and that staff was seeking views on the 2014 staff guidance. The U.S. Chamber of Commerce and some corporate secretaries have criticized proxy advisory firms for years, claiming proxy advisory firms lack transparency and accountability, and as part of these efforts, the corporate community has lobbied to withdraw the letters.19 Legislative efforts to directly regulate proxy advisory firms also have been proposed.20

John Baker and Michael Wallace attended the Staff Roundtable on the proxy process on November 15, 2018. The Roundtable consisted of three panels on each of the following topics: (1) proxy voting mechanics and technology; (2) shareholder proposals; and (3) the role of proxy advisory firms. Clayton opened the discussion by expressing his personal goal to improve the quality of the voting process for long term investors, such that they can make more informed, company-specific voting decisions. He requested that the panel continue to work on and present recommendations for change to the SEC. Notably, Clayton did not make the same request after the other two panel discussions. Also notable was the absence of any discussion at all about the two interpretive letters from 2004, which were recently withdrawn by the SEC. Much of the panel’s time was spent discussing how proxy advisory firms operated, what services they provide, and how those services are used by asset managers, investment advisers, and issuers.

In December, Clayton gave a speech that included priorities for the SEC in 2019.21 Among other things, he indicated that improving the proxy process is a significant initiative. With regard to proxy advisory firms, Clayton indicated that “there should be greater clarity regarding the division of labor, responsibility and authority between proxy advisors and the investment advisers they serve.” Additionally, Clayton pointed to the need for “clarity regarding the analytical and decision-making processes advisers employ,” and indicated that “it is clear to me that some matters put to a shareholder vote can only be analyzed effectively on a company-specific basis, as opposed to applying a more general market or industry-wide policy.” Clayton indicated that he intended to move forward with staff recommendations.

ESG

Environmental, social and/or governance issues are a fact of life. Cybersecurity and climate change are two examples. Some investment funds that incorporate ESG factors, for instance, scrutinized their holdings in Facebook because they viewed the recent privacy scandals “as the digital equivalent of a toxic waste spill,”22 while other funds and managers focus on the myriad other environmental (E), social (S) and/or governance (G) issues and risks when making investment decisions. ESG continues to proliferate at breakneck speed across asset classes. In fact, we’re helping both our registered and private fund clients incorporate various ESG strategies, and advising fiduciaries on the fiduciary implications, such as how integration, shareholder engagement and divestment can be conducted in a manner consistent with ERISA. We simply don’t see ESG going away anytime soon.

We also appreciate that there is widespread confusion over what ESG actually means. How does “ESG investing” differ from “impact investing,” “socially responsible investing,” “economically targeted investing,” and “sustainable investing”? It is also helpful to remember that gone are the days when ESG investing consisted primarily of either screening out, or divesting, of certain issuers/sectors because they did not meet some moral or other non-economic test. Today’s ESG is much more driven by data linking one or more ESG factors and investment performance – i.e., an ESG factor can now be a material risk. On an even more fundamental level, there is not unanimity on what constitutes an E, S or G factor. ESG is an umbrella term capturing as many as 40 different topics. To better align fiduciary duty nuance and industry practice, George Michael Gerstein, in An ESG Proposal for You, proposed this glossary:

ENGAGEMENT: Exercising one or more rights of a holder of interests in an ISSUER, such as proxy voting, introducing resolutions or participating in formal or informal meetings with the ISSUER board, in respect of an ESG FACTOR where (A) the exclusive purpose is to enhance portfolio return or reduce portfolio risk, (B) the primary purpose is for non-investment performance reasons, such as the promotion of an ESG policy, and a secondary purpose is to enhance portfolio return or reduce portfolio risk or (C) the exclusive purpose is for one or more non-investment performance reasons, such as the promotion of an ESG policy.

ENVIRONMENTAL: Issues or facts related to the natural environment, such as climate change, carbon emissions, waste management, recycling, energy, biodiversity, pollution, and conservation.

ESG (FACTOR): ENVIRONMENTAL, SOCIAL and/or GOVERNANCE-related issues or facts.

ESG INVESTING: Employing NEGATIVE SCREENING, POSITIVE SCREENING, THEMATIC INVESTING, INTEGRATION, ENGAGEMENT, IMPACT INVESTING, SOCIALLY RESPONSIBLE INVESTING, RESPONSIBLE INVESTING AND/OR SUSTAINABLE INVESTING.

EXCLUSIONARY SCREENING: See NEGATIVE SCREENING.

GOVERNANCE: Issues or facts related to the governance of an ISSUER, such as executive compensation, board structure, shareholder rights, bribery and corruption, and cybersecurity.

IMPACT INVESTING: Selecting investments in respect of an ESG FACTOR where the primary purpose is for non-investment performance reasons, such as the promotion of an ESG public policy, and a secondary purpose is to enhance portfolio return or reduce portfolio risk.

INTEGRATION: Incorporating 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.

ISSUER: Any issuer, such as a corporation or country, whether in the public or private markets, that issue investible holdings, whether a security or not, in which an investment can be made.

NEGATIVE SCREENING: Avoiding the purchase of prospective investments, or DIVESTING from existing investments, on the basis of such investments not meeting a designated ESG standard, rating or requirement where (A) the exclusive purpose is to enhance portfolio return or reduce portfolio risk, (B) the primary purpose is for non-investment performance reasons, such as the promotion of an ESG public policy, and a secondary purpose is to enhance portfolio return or reduce portfolio risk or (C) the exclusive purpose is for one or more non-investment performance reasons, such as the promotion of an ESG public policy. Also called EXCLUSIONARY SCREENING.

POSITIVE SCREENING: Selecting investments on the basis of meeting a designated ESG standard, rating or requirement where (A) the exclusive purpose is to enhance portfolio return or reduce portfolio risk, (B) the primary purpose is for non-investment performance reasons, such as the promotion of an ESG public policy, and a secondary purpose is to enhance portfolio return or reduce portfolio risk or (C) the exclusive purpose is for one or more non-investment performance reasons, such as the promotion of an ESG public policy.

RESPONSIBLE INVESTING: Selecting investments where (A) the primary purpose is for non-investment performance reasons, namely the promotion of a GOVERNANCE ESG FACTOR, and a secondary purpose is to enhance portfolio return or reduce portfolio risk or (B) the exclusive purpose is for one or more non-investment performance reasons, namely the promotion of a GOVERNANCE ESG FACTOR.

SOCIAL: Issues or facts related to human relations of an ISSUER, such as employee relations, community relations, board diversity, human rights, demography, food security, poverty/inequality, child labor and health and safety.

SOCIALLY RESPONSIBLE INVESTING: Selecting investments where (A) the primary purpose is for non-investment performance reasons, namely the promotion of a SOCIAL ESG FACTOR, and a secondary purpose is to enhance portfolio return or reduce portfolio risk or (B) the exclusive purpose is for one or more non-investment performance reasons, namely the promotion of a SOCIAL ESG FACTOR.

SUSTAINABLE INVESTING: Selecting investments where (A) the primary purpose is for non-investment performance reasons, namely the promotion of an ENVIRONMENTAL ESG FACTOR, and a secondary purpose is to enhance portfolio return or reduce portfolio risk or (B) the exclusive purpose is for one or more non-investment performance reasons, namely the promotion of an ENVIRONMENTAL ESG FACTOR.

THEMATIC INVESTING: Utilizing NEGATIVE SCREENING, POSITIVE SCREENING, INTEGRATION and/or ENGAGEMENT to invest in ISSUERS that share a common ESG purpose, industry or product.

On April 23, 2018, the DOL issued Field Assistance Bulletin 2018-01. At the time of its publication, we noted that it, “reflects an unease by the DOL over certain ESG practices and largely clarifies existing fiduciary obligations in this space.” Specifically, FAB 2018-01 preserved integration as an ESG approach. As defined above, integration is where the fiduciary thinks that one or more ESG factors will have a material impact on investment performance. There is a good amount of data coming out that links investment performance with various (but not all, yet) ESG factors.

We think the DOL might prefer integration as an ESG approach over strategies that make investment decisions for moral reasons or to otherwise promote a public policy. The DOL stressed the importance of documenting why the fiduciary believes the respective ESG factor will have a material effect on performance, without having to make a series of wishful assumptions to reach that conclusion. We suggested that, “fiduciaries will want to build a record in support of the view that a particular factor bears a relationship with investment performance, and carefully consider how much weight to put on that specific factor.”

FAB 2018-01 also warned plan fiduciaries against selecting an ESG-themed fund as a qualified default investment alternative (QDIA) for purposes of section 404(c) of ERISA. However, we thought the DOL left open the possibility of selecting a QDIA that integrates ESG factors, again, seemingly demonstrating a preference for that approach.

We also noted in April that the DOL “zeroed-in on shareholder engagement in respect of ESG issues that have a connection to the value of the plan’s investment in the company, where the plan may be paying significant expenses for the engagement or development of proxy resolutions.” If anything, this aspect of FAB 2018-01 has the most significant ramifications. If plans are viewed as paying indirectly for engagement through the management fee, which view we think the DOL takes, then proxy voting and other forms of shareholder engagement need to be monitored for both costs and benefits, particularly as the time spent on the engagement increases.

On May 22, 2018, the Government Accountability Office (GAO) released a report on ERISA fiduciaries’ incorporation of ESG factors into its investment process. Though the report provides a really helpful overview of ESG’s evolution, we noted the following:

Rather unfortunately, the report was largely completed prior to the DOL’s issuance of Field Assistance Bulletin (FAB) 2018-01, which we discussed here. The principal recommendation by the GAO is for the DOL to issue guidance on whether a fiduciary can incorporate ESG factors into the management of a default investment option in a defined contribution plan. As you may know, FAB 2018-01 seemed to do just that, though not in an entirely clear manner. Nevertheless, the GAO addressed FAB 2018-01 at the end of the report and narrowed its initial recommendation, namely, that the DOL better explain how fiduciaries can utilize the integration strategy in a QDIA. In the DOL’s defense, FAB 2018-01 seems to address (to some extent) whether a QDIA can utilize the integration strategy; the DOL instead hit the brakes on offering a themed ESG product as a QDIA.

In our view, ESG will continue to evolve and proliferate, while also garnering the attention of both the DOL and SEC on a number of levels. ESG is, in essence, entirely fluid and will continue to present business opportunities and compliance challenges. We will likely have more to say on this in the coming weeks.

_________

1 Citing Chamber of Commerce of the U.S.A. v. U.S. Dep’t of Labor, No. 17-10238, slip op. 46 (5th Cir. Mar 15, 2018).

2 See Regulation Best Interest, SEC Rel. No. 34-83062 (April 18, 2018); Form CRS Relationship Summary; Amendments to Form ADV; Required Disclosures in Retail Communications and Restrictions on the use of Certain Names or Titles, SEC Rel. Nos. 34-83063; IA- 4888 (April 18, 2018); Proposed Commission Interpretation Regarding Standard of Conduct for Investment Advisers; Request for Comment on Enhancing Investment Adviser Regulation, SEC Rel. No. IA-4889 (April 18, 2018).

3 Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, § 913, 124 Stat. 1376, 1824-30 (2010).

4 A “retail customer” is proposed to be defined under Regulation Best Interest as a person who receives a recommendation and uses it primarily for personal, family or household purposes.

5 “Recommendation” is not defined but is proposed to be interpreted consistent with existing FINRA rules, under which factors that have historically been considered in the context of broker-dealer suitability obligations include whether the communication “reasonably could be viewed as a ‘call to action’” and “reasonably would influence an investor to trade a particular security or group of securities.”

6 Regulation Best Interest, Release No. 34-83062 (April 18, 2018), available at https://www.sec.gov/rules/proposed/2018/34-83062.pdf.

7 For purposes of the Form CRS delivery requirement, a “retail investor” is proposed to be defined as a prospective or existing client or customer who is a natural person, including a trust or other similar entity that represents natural persons.

8 The form would not supersede the Form ADV Part 2 brochure, which investment advisers would continue to prepare and provide to clients.

9 Both New Jersey and FINRA rules require securities recommendations to meet a suitability standard. See N.J. Admin. Code § 13:47A-6.3(a)(3); FINRA Rule 2111.

10 50 N.J.R. 2142(a) (Oct. 15, 2018).

11 An Act to Amend the General Obligations Law, in Relation to Mandating Greater Levels of Disclosure by Non-Fiduciaries that Provide Investment Advice, New York State Assembly, A02464A (N.Y. 2017), available here.

12 Suitability and Best Interests in Life Insurance and Annuity Transactions, New York State Department of Financial Services, First Amendment to 11 NYCRR 224, available at https://www.dfs.ny.gov/insurance/r_finala/2018/rf187a1txt.pdf.

13 For example, the National Association of Insurance and Financial Advisors of New York filed a lawsuit in November 2018 against the NYDFS in New York’s Supreme Court alleging various claims regarding the regulation’s constitutionality. To view the complaint, please visit: https://www.investmentnews.com/assets/docs/CI1180381126.PDF.

14 Assembly Amendment to S.B. 383, 79th Sess. (Nev. 2017), available at https://www.leg.state.nv.us/App/NELIS/REL/79th2017/Bill/5440/Text#.

15 Statement Regarding SEC Staff Views, available at https://www.sec.gov/news/public-statement/statement-clayton-091318. The Chairman noted that other federal financial agencies had instituted similar reviews of staff guidance.

16 Statement Regarding Staff Proxy Advisory Letters, available at https://www.sec.gov/news/public-statement/statement-regarding-staff-proxy-advisory-letters. Commissioner Jackson issued a statement in conjunction with the Investor Advisory Committee meeting critical of IM staff’s withdrawal of the letters. Statement on Shareholder Voting, available at https://www.sec.gov/news/public-statement/statement-jackson-091418.

17 Staff Legal Bulletin No. 20 (June 30, 2014), available at https://www.sec.gov/interps/legal/cfslb20.htm.

18 Statement Announcing SEC Staff Roundtable on the Proxy Process, available at https://www.sec.gov/news/public-statement/statement-announcing-sec-staff-roundtable-proxy-process.

19 See, e.g., Statement of the U.S. Chamber of Commerce on the Market Power and Impact of Proxy Advisory Firms (June 5, 2013) (“For a number of years, the Chamber has expressed its long-standing concerns with . . . proxy advisory firms”), available at https://www.centerforcapitalmarkets.com/wp-content/uploads/2010/04/2013-6.3-Pitt-Testimony-FINAL.pdf; James K. Glassman and J.W. Verret, “How to Fix our Broken Proxy Advisory System,” (2013) (recommending that the letters be rescinded to “[e]nd the preferential regulatory treatment that proxy advisors currently enjoy in the law”). Both the corporate community and the asset management industry discussed their views on the letters and proxy advisory firms generally in a prior SEC roundtable in 2013. See Transcript of the Proxy Advisory Firms Roundtable (Dec. 5, 2013), available at https://www.sec.gov/spotlight/proxy-advisory-services/proxy-advisory-services-transcript.txt

20 For example, HR 5311 was introduced in May 2016 and later folded into the Financial CHOICE Act. More recently, in October 2017, HR 4015, which is mostly a resubmission of HR 5311 was introduced. These bills generally require registration of proxy advisory firms with the SEC, and require firms to meet extensive disclosure requirements relating to methodologies and conflicts of interest, require firms to hire an ombudsperson to handle complaints, and give corporate issuers the ability to vet proxy advisory firms’ recommendations before the recommendations are released.

21 SEC Rulemaking Over the Past Year, the Road Ahead and Challenges Posed by Brexit, LIBOR Transition and Cybersecurity Risks, available at https://www.sec.gov/news/speech/speech-clayton-120618.

22 Emily Chasan, Facebook Turns Toxic for Some ESG Funds, Bloomberg, March 26, 2018.

Impressions on SEC Roundtable

The Securities and Exchange Commission held a Staff Roundtable on the proxy process on November 15, 2018, which John Baker and I attended. The Roundtable consisted of three panels on each of the following topics: 1. Proxy Voting Mechanics and Technology; 2. Shareholder Proposals; 3. The Role of Proxy Advisory Firms. Panelists consisted of corporate issuers, asset managers, institutional investors, academics, interest groups and proxy advisory firm representatives. The following is a summary of the third panel’s discussion on proxy advisory firms.

Chairman Clayton opened the discussion by expressing his personal goal to improve the quality of the voting process for long term investors, such that they can make more informed, company specific voting decisions. The Chairman requested that the panel continue to work on and present recommendations for change to the SEC. Notably, the Chairman did not make the same request after the other two panel discussions. Also notable was the absence of any discussion at all about the two no-action letters from 2004 which were recently withdrawn by the SEC.

Much of the panel’s time was spent discussing how proxy advisory firms operated, what services they provide, and how those services are used by asset managers, investment advisers, and issuers. The asset managers and institutional investors emphasized their fiduciary obligations owed to shareholders when voting proxies and they all spoke to the large operational efficiencies they realize by using proxy advisory firms. The asset managers were of the opinion that they likely could not meet their fiduciary obligations with regard to proxy voting without the information provided by proxy advisory firms, because they do not have the resources to perform the vast amounts of research and data aggregation entailed in the process.

Some discussion was spent questioning the potential conflicts of interest which may arise when proxy advisory firms advise both issuers and investment advisers. The investment advisers expressed little concern over such conflicts of interest, commenting that they make their own voting determinations based upon their own internal guidelines, not the guidelines of the advisory firm, and that information provided by proxy advisory firms is merely one factor among many factors used in consideration of how to vote. One issuer recommended that issuers be given the opportunity to review proxy advisory firm’s recommendations in advance of their dissemination, however this recommendation received a negative reception from the proxy advisory firms and investment advisers.

One of the last questions asked by the moderator was whether anyone saw a need for any SEC regulations to improve the process of how proxy advisory firms are used. No panelist expressed any desire for increased regulation over how proxy advisory firms are used, with the exception of one panelist, a CEO of a small proxy services firm, who thought there should be regulation to allow easier market access for new companies to compete in the proxy advisory business. Likewise, panelists expressed no desire to see Staff Legal Bulletin No. 20 changed. Chairman Clayton closed the panel with a remark where he again emphasized the importance of investors being able to make informed, company specific voting decisions and invited comments from interested parties.

An ESG proposal for you

I routinely speak on Environmental, Social & Governance (ESG) issues. Time and again, I hear that there is widespread confusion over ESG terminology. This lack of clarity vexes many institutional investors, including fiduciaries. A number of great glossaries are out there (those of SSgA and Mercer immediately come to mind). But the US Department of Labor has its own understanding of ESG, as most recently reflected in Field Assistance Bulletin 2018-01. To better align the fiduciary duty nuance with industry practice, I am proposing definitions to certain key terms. As you will see, most of the definitions allow for a plug-and-play approach to ensure that a plan sponsor and investment manager, for instance, are on the same page when it comes to utilizing a particular ESG strategy. I certainly welcome any feedback.

ENGAGEMENT: Exercising one or more rights of a holder of interests in an ISSUER, such as proxy voting, introducing resolutions or participating in formal or informal meetings with the ISSUER board, in respect of an ESG FACTOR where (A) the exclusive purpose is to enhance portfolio return or reduce portfolio risk, (B) the primary purpose is for non-investment performance reasons, such as the promotion of an ESG policy, and a secondary purpose is to enhance portfolio return or reduce portfolio risk or (C) the exclusive purpose is for one or more non-investment performance reasons, such as the promotion of an ESG policy.

ENVIRONMENTAL: Issues or facts related to the natural environment, such as climate change, carbon emissions, waste management, recycling, energy, biodiversity, pollution, and conservation.

ESG (FACTOR): ENVIRONMENTAL, SOCIAL and/or GOVERNANCE-related issues or facts.

ESG INVESTING: Employing NEGATIVE SCREENING, POSITIVE SCREENING, THEMATIC INVESTING, INTEGRATION, ENGAGEMENT, IMPACT INVESTING, SOCIALLY RESPONSIBLE INVESTING, RESPONSIBLE INVESTING AND/OR SUSTAINABLE INVESTING.

EXCLUSIONARY SCREENING: See NEGATIVE SCREENING.

GOVERNANCE: Issues or facts related to the governance of an ISSUER, such as executive compensation, board structure, shareholder rights, bribery and corruption, and cybersecurity.

IMPACT INVESTING: Selecting investments in respect of an ESG FACTOR where the primary purpose is for non-investment performance reasons, such as the promotion of an ESG public policy, and a secondary purpose is to enhance portfolio return or reduce portfolio risk.

INTEGRATION: Incorporating 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.

ISSUER: Any issuer, such as a corporation or country, whether in the public or private markets, that issue investible holdings, whether a security or not, in which an investment can be made.

NEGATIVE SCREENING: Avoiding the purchase of prospective investments, or DIVESTING from existing investments, on the basis of such investments not meeting a designated ESG standard, rating or requirement where (A) the exclusive purpose is to enhance portfolio return or reduce portfolio risk, (B) the primary purpose is for non-investment performance reasons, such as the promotion of an ESG public policy, and a secondary purpose is to enhance portfolio return or reduce portfolio risk or (C) the exclusive purpose is for one or more non-investment performance reasons, such as the promotion of an ESG public policy. Also called EXCLUSIONARY SCREENING.

POSITIVE SCREENING: Selecting investments on the basis of meeting a designated ESG standard, rating or requirement where (A) the exclusive purpose is to enhance portfolio return or reduce portfolio risk, (B) the primary purpose is for non-investment performance reasons, such as the promotion of an ESG public policy, and a secondary purpose is to enhance portfolio return or reduce portfolio risk or (C) the exclusive purpose is for one or more non-investment performance reasons, such as the promotion of an ESG public policy.

RESPONSIBLE INVESTING: Selecting investments where (A) the primary purpose is for non-investment performance reasons, namely the promotion of a GOVERNANCE ESG FACTOR, and a secondary purpose is to enhance portfolio return or reduce portfolio risk or (B) the exclusive purpose is for one or more non-investment performance reasons, namely the promotion of a GOVERNANCE ESG FACTOR.

SOCIAL: Issues or facts related to human relations of an ISSUER, such as employee relations, community relations, board diversity, human rights, demography, food security, poverty/inequality, child labor and health and safety.

SOCIALLY RESPONSIBLE INVESTING: Selecting investments where (A) the primary purpose is for non-investment performance reasons, namely the promotion of a SOCIAL ESG FACTOR, and a secondary purpose is to enhance portfolio return or reduce portfolio risk or (B) the exclusive purpose is for one or more non-investment performance reasons, namely the promotion of a SOCIAL ESG FACTOR.

SUSTAINABLE INVESTING: Selecting investments where (A) the primary purpose is for non-investment performance reasons, namely the promotion of an ENVIRONMENTAL ESG FACTOR, and a secondary purpose is to enhance portfolio return or reduce portfolio risk or (B) the exclusive purpose is for one or more non-investment performance reasons, namely the promotion of an ENVIRONMENTAL ESG FACTOR.

THEMATIC INVESTING: Utilizing NEGATIVE SCREENING, POSITIVE SCREENING, INTEGRATION and/or ENGAGEMENT to invest in ISSUERS that share a common ESG purpose, industry or product.