The federal government is not now and has never been in the business of telling you how you should vote your proxies. But it seems that through regulatory creep, the government may have indirectly given the power to tell investors how to vote their proxies to someone else entirely. Regulating disclosures and mechanics by which we vote proxies is plainly within the scope of the Securities and Exchange Commission's mission. However, the federalization of proxy regulation may be driving institutional investors and investment advisers, to view their responsibility to vote on proxy matters with more of a compliance mindset than a fiduciary mindset. This compliance mindset has had the effect of entrenching proxy advisory firms solidly in the voting process and given them an outsized say in the way most proxy shares are voted. The federal government may not be dictating how institutional investors vote their proxies, but in a presumably unintended consequence, by regulation have given this power to proxy advisory firms.
The power of proxy advisory firms bothers SEC Commissioner Daniel Gallagher. As he said in a July 11, 2013 address
before the Society of Corporate Secretaries and Governance Professionals"
I am very concerned [about] the role of proxy advisory firms in corporate governance. I also have grave concerns as to whether investment advisers are indeed truly fulfilling their fiduciary duties when they rely on and follow recommendations from proxy advisory firms.
In Gallagher's view, compliance with the letter of regulation has led institutional investors away from their fiduciary duty to their shareholders and beneficiaries. As he explains, in order to avert conflicts of interest when investment advisors and other institutional fiduciaries vote the proxies in the portfolios they manage, proxy rules
require them to adopt proxy voting policies reasonably designed to ensure they vote the proxies in the best interests of their clients or beneficiaries. Interpretations of these rules create somewhat of a safe harbor: “an 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 recommendations of an independent third party.” The safe harbor is further buttressed by SEC no action letters stating that:
. . . an investment adviser that votes client proxies in accordance with a pre-determined policy based on the recommendations of an independent third party will not necessarily breach its fiduciary duty of loyalty to its clients even though the recommendations may be consistent with the adviser’s own interests. In essence, the recommendations of a third party that is in fact independent of an investment adviser may cleanse the vote of the adviser’s conflict.
This safe harbor is where the proxy advisory firms have gained most of their outsized influence. The safe harbor has led fiduciaries to rely on the recommendations of proxy advisory firms, rather than researching proxy issues, and voting them in accordance with their proxy voting policies. In effect, in order to comply with proxy voting regulations and defend against potential liability, many, if not most, institutional investors are ceding proxy voting decisions to advisory firms. This mindset of voting for compliance rather than giving proxy issues the rigorous case-by-case attention they need has outsourced voting responsibility to proxy advisory firms who have no duty to those who ultimately own the votes.
It is troubling to think that institutional investors, particularly investment advisers, are treating their responsibility akin to a compliance function carried out through rote reliance on proxy advisory firm advice rather than actively researching the proposals before them and ensuring that their votes further their clients’ interests. The last thing we should want is for investment advisers to adopt a mindset that leads to them blindly casting their votes in line with a proxy advisor’s recommendations, especially given the fact that such recommendations are often not tailored to a fund’s unique strategy or investment goals.
Gallagher proposes that the SEC "issue 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." In his opinion, this step "would go a long way toward mitigating the concerns arising from the outsized and potentially conflicted role of proxy advisory firms." In addition, Commissioner Gallagher calls for an overhaul of the regulation of proxy voting firms themselves, subjecting them to a strict code of conduct.
In addition, as I have stated in the past, I believe that the Commission should fundamentally review the role and regulation of proxy advisory firms and explore possible reforms, including, but not limited to, requiring them to follow a universal code of conduct, ensuring that their recommendations are designed to increase shareholder value, increasing the transparency of their methods, ensuring that conflicts of interest are dealt with appropriately, and increasing their overall accountability.
Commissioner Gallagher is not alone in his concerns about proxy voting firms' outsized influence on corporate governance decisions. The matter has been taken up in the EU by the European Securities and Markets Authority, and Congressman Scott Garrett (R-NJ)
has taken up the issue in Congressional hearings.