Friday, April 23, 2021

Fund Advisers Brace for ESG Scrutiny

SEC to Mandate More Public Disclosure of Proxy Votes

After nearly twenty years of study, the Securities and Exchange Commission seems poised to rewrite the rules on proxy disclosure for mutual funds. Two SEC commissioners predicted within days of each other that there will be radical revisions to how regulated investment companies will report their proxy voting behavior. Both Acting Chair Allison Herren Lee and Commissioner Caroline Crenshaw said in separate speeches last month that the SEC's current proxy reporting form is not meeting the needs of investors. Shareholders, they said, need more and better proxy voting information to evaluate whether fund managers are sticking to the fund's stated proxy policies, especially funds that have made commitments to ESG principles. 
The Current Form N-PX
Since 2003, mutual funds have been required to report their proxy voting data annually on Form N-PX.[1] Currently, Form N-PX requires disclosure of proxy voting information "for each matter relating to a portfolio security considered at any shareholder meeting held during the period covered by the report and for which the registrant was entitled to vote." However, the Form does not require disclosure of the number of shares for which proxies were voted, nor does it require disclosure of portfolio securities on loan when, as is generally the case, the fund is not entitled to vote proxies relating to those securities.[2]  The N-PX reporting period runs annually from July 1 to June 30 and is still filed on EDGAR in the same unstructured format as in 2003. 
  1. "enable fund shareholders to monitor their funds' involvement in the governance activities of portfolio companies." 
  2. "illuminate potential conflicts of interest and discourage voting that is inconsistent with fund shareholders' best interests." 
  3. enable shareholders to "evaluate how closely fund managers follow their state proxy voting policies, and to react adversely to fund managers who vote inconsistently with these policies."
As both Commissioners point out, the present content and format of N-PX fail to meet those goals. The scope of data provided on Form N-PX is entirely too limited for shareholders to get a complete picture of how fund managers have applied proxy voting policies. Without the number of shares voted or any information about how many shares were on loan and not voted, or recalled and voted, the Commissioners asked, 'How is there proper accountability?' [3]
For shareholders to be able to monitor their funds' proxy voting activities, reformers insist, the data needs to be tagged or presented in an understandable format. Exemplars such as Calvert funds have invested in proxy voting disclosure websites that present data in an accessible way. Both Acting Chair Lee and Commissioner Crenshaw said that the SEC's staff would be looking at ways to standardize, structure, tag the data submitted by mutual funds, and expand the requirement to disclose the number of shares voted versus shares available to vote. 
Proxy Voting and the SEC's ESG Agenda
These changes to proxy voting disclosure are not evolving in a vacuum, however. They are part of the Commission's overarching agenda to police ESG and environmental disclosuresActing Chair Lee and a recent academic study have raised questions about the proxy voting practices of index funds and funds with affiliate lending programs.[4] They posit that index funds face economic pressure to lend out their shares or not recall shares instead of voting, potentially standing in the way of the funds' stated ESG principles and the desires of shareholders.
"But a new landscape emerges as we consider these two trends together. That is, the rise of passive index funds, which has benefited retail investors in so many ways, may operate to the detriment of corporate accountability—and on ESG matters in particular—especially given that our rules have not kept up with these developments. We know investors are demanding ESG investment strategies and opportunities, but funds may not always reflect those investor preferences in their voting. Addressing this agency cost is at the heart of corporate governance today, and that is why it is critical that we at the SEC—along with all of you in this virtual room—focus more attention on fund and adviser voting duties and disclosure."
Making Form N-PX disclosures more complete, granular, and useful to shareholders is part of the SEC's greater focus on ensuring that funds and advisers live up to their fiduciary duties and their promises to investors deliver investment returns consistent with sustainable financial practices. 
Expanding the disclosures in Form N-PX would increase the burden on fund companies.  But, as some commenters pointed out in response to the 2003 proposal, advisers should already be keeping these kinds of records. The burden, however, may also be a boon to advisers. Making the number of shares voted versus eligible to vote and the number of shares out on loan versus recalls more transparent to shareholders would help validate the decisions made by advisers. As Acting Chair Lee said in her March address, "an updated and clearer Form N-PX can serve as a tool for funds to more readily distinguish their voting records from that of their competitors."
Armed with new NP-X data, investors will have a much clearer picture of funds' proxy voting behavior -- a picture that was previously only accessible for the fund's adviser. All this interest from the SEC in whether mutual funds are living up to their ESG commitments to shareholders is a red flag for future litigation brought by those who wish to hold funds and their advisers accountable for alleged breaches of their fiduciary duties.

[1] The Form arose from a 2002 proposal to require mutual funds to disclose proxy voting policies in their SAI's and their proxy voting records in their annual and semi-annual reports. However, in the final release, the SEC chose to create a new form, N-PX, and a standardized non-calendar annual cycle for proxy vote disclosure rather than in the fund's periodic reports (N-CSR). The 2002 proposal drew 8,000 public comments, a record at the time for any such rulemaking. 
[2]  Thus, for example, if a fund lends out 99% of its portfolio holdings of XYZ Corporation and therefore votes only 1% of its holdings of XYZ, Form N-PX would disclose that the fund voted proxies for shares of XYZ, but would not also disclose that the fund did not vote 99% of its holdings of XYZ because they were on loan or in a fail-to-receive status.
[3] Notably, the Commission included potential changes to Form N-PX in its July 2010 Proxy Concept Release soliciting comment on expanding the data funds must provide to include the number of shares voted and data on the number of shares out on loan.  Also, in November of 2010, the Commission proposed amendments to Form N-PX under Section 951 of the Dodd-Frank Wall Street Reform and Consumer Protection Act requiring certain institutional investment managers to report how they voted on executive compensation matters. The concept release resulted in no changes to the content of Form N-PX, and the SEC never finalized the rule proposal.
[4] Indeed, the original request for rulemaking asking for proxy voting disclosures filed by the AFL-CIO in 2000 and again in 2002 pointed out the need for proxy disclosure to police similar, if not the same, conflicts of interest.