Corporate managers have long complained about proxy advisory services, such as ISS, Egan-Jones, and Glass Lewis.  They argue that proxy advisors provide governance advice to companies – for a fee – and then make influential voting recommendations to client shareholders, functionally creating a kind of shakedown service (“Pay us and we’ll be able to recommend that shareholders vote in your favor; don’t, and who knows what we’ll do?”).  Corporations argue that shareholders don’t conduct their own analysis of issues anymore, and blindly vote with however proxy services recommend – giving them far too much power. 

There is plenty of reason to be skeptical of their complaints.  At least one study shows that most institutional investors take recommendations into account but ultimately make their own decisions.  And as John Coates recently testified before Congress on the issue, there is no evidence of a market failure necessitating congressional regulation, and regulation might make the industry more concentrated and less competitive, which is the exact opposite of what we should strive for.

I won’t deny that to the extent proxy advisory services potentially have conflicts, these should be known and their policies for cleansing should be clear.  But one cannot help but suspect that companies’ reasons for objecting to proxy advisors is the same as their objection to unions – it’s not conflicts or corruption, it’s that they overcome transactions costs of  a disaggregated constituency and facilitate coordination so as to create a countervailing power center.  Managers, in other words, just don’t want to be challenged – by anyone.

That said, corporate complaints have found a sympathetic ear among Republicans in Congress and now, apparently, in Jay Clayton at the SEC.  The SEC just announced that it was withdrawing two no-action letters from 2004 that have become the bete noire of corporate managers, in preparation for an upcoming Roundtable on the Proxy Process.  Clayton even went out of his way to issue a separate statement clarifying that staff guidance is non-binding, if we hadn’t gotten the message that anything done under previous administrations is now suspect.

You can’t read the letters online, because apparently withdrawing them means making them inaccessible unless you have access to a legal database – and that, by the way, is just terrible practice from a transparency point of view; I’d rather they just be clearly marked as withdrawn.

That said, I will summarize (and embed the letters in this post, if I can get the tech to cooperate).  But first, some background – and this is going to get long, so I’m putting the rest behind a cut.

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In 2003, the SEC issued Rule 206(4)-6 to address the problem of investment advisers who vote their clients’ proxies while operating under a conflict of interest.  For example, investment advisers may be associated with mutual funds who run 401(k) plans for issuers; as a result, they want to please issuers when they vote.

The SEC, newly attentive to this problem, required in the rule that investment advisers create policies to address conflicts and to ensure that votes are cast in the clients’ best interest.  The release associated with the rule mentioned that the adviser could develop policies to address conflicts, including the use of an independent third party to make voting decisions on the adviser’s behalf.

That’s, you know, a proxy advisor.

But of course, institutional investors don’t just use proxy advisors because of potential conflicts.  They also use them because it’s expensive to monitor every single proxy vote; reliance, at least in part, on a proxy advisory service smooths the way.

That practice, too, has been sanctioned – and indeed encouraged – by both the SEC and the Department of Labor (which administers ERISA).  Both agencies have made clear that it is the duty of investment managers to vote their clients’ shares if they can do so cost-effectively, and that they expect costs to be minimal in most cases because of the use of third-party services. (See, e.g., Interpretive Bulletin Relating to the Exercise of Shareholder Rights and Written Statements of Investment Policy, Including Proxy Voting Policies or Guidelines, 81 FR 95879-01, 2016 WL 7453352; see also extensive discussion in my essay – yes, this is a plug – Family Loyalty: Mutual Fund Voting and Fiduciary Obligation).

So the use of third-party advisors, and proxy advisory services, has been functionally folded into the regulatory framework.

That said, back in 2003 when the SEC first adopted its conflict rules, proxy advisory services sought clarity over whether they could provide voting guidance while simultaneously providing corporate governance counseling to issuers.  And that’s where the two (now-withdrawn) letters come in.

The first letter, issued to Egan-Jones in May 2004, said that if an investment adviser relies on a proxy advisory service, the adviser should consider all facts and circumstances to ensure that the proxy advisory service is capable of providing impartial voting advice, including a consideration of whether the proxy advisor’s relationship with the issuer will bias its recommendations.

The second letter, issued to ISS in September 2004, made clear that the investment adviser need not conduct a case by case assessment of whether the proxy advisor is conflicted in every specific voting recommendation (a likely expensive and possibly impossible task).  Instead, the investment adviser may rely on the proxy advisor’s own procedures for resolving conflicts, if the investment adviser investigates and concludes they are effective, and keeps abreast of changes, all facts and circumstances, etc etc.

And these are the two letters that were withdrawn.

I have so many questions.

First, only the two letters have been withdrawn – not the recommendations that investment advisers rely on third parties to address conflicts, not the releases that suggested that reliance on third-parties would solve the cost-benefit problem, not even SLB 20 – which apparently will be discussed at the Roundtable – and which also assumes that investment advisers will rely on proxy advisors, who themselves will use a set of general policies to resolve conflicts.  So, umm, how does the letter withdrawal change anything, exactly?  Spoiler alert: Commissioner Robert Jackson thinks the answer is not at all. Not at all has changed.  But to be fair, he is a Democrat.

Second, I note that the original letters are incredibly noncommittal.  All they say, basically, is that all facts and circumstances have to be considered – and they allow for the possibility that a proxy advisor’s standardized conflict policy might obviate the need for a case by case review of their conflicts in specific voting situations.

So is that … wrong?  Like, are investment advisers supposed to conduct a case by case review?  If so, doesn’t that defeat the whole purpose – which originally, was to cleanse the advisers’ conflicts?  If the investment adviser has a conflict, and it was supposed to cleanse via use of a third party, except it has to review the third party for every vote – and discretionarily decide if the third party is conflicted – isn’t that invitation for a tainted review, so that the third party will mysteriously be deemed “conflicted” if its recommendation goes against the adviser’s own interests?

Or is it just that proxy advisors are entirely off-limits, but other third parties are okay? Are proxy advisors subject to special rules?  Since, you know, the whole thing about relying on independent third parties is still part of the commentary on SEC Rule 206(4)-6?

If investment advisers themselves can address their own conflicts via a regular set of policies to address them, why can’t their own advisors do the same?

That said, here is where I get to the “be careful what you wish for” piece.  Because Delaware has responded to rising shareholder power – facilitated by proxy advisory services – by taking a more hands-off approach to review of management decisionmaking.  Corwin and MFW and Dell and DFC are predicated on the expectation that institutions are doing most of the voting, and they don’t need a judicial helicopter parent.  And part of the reason for that is the coordination enabled by proxy advisory services.  If those services are hobbled, I’d expect the pendulum to swing back the other way – and managers might not like the results.

Which brings me back around to my prior post on Zohar Goshen’s and Sharon Hannes’s article, The Death of Corporate Law.  As I said then, their argument is predicated on the idea that shareholders always hold the power within the corporate form that they do now – but that power is a function of legislative grace, and especially federal legislative grace.  If that grace is removed … all bets are off.