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Outreach Blog

Friday, April 23, 2021

Fund Advisers Brace for ESG Scrutiny

SEC to Mandate More Public Disclosure of Proxy Votes


Author: David Schwartz J.D. CPA

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. 
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The CSFME’s Regulatory Outreach Programs

Regulatory reform has become a collaborative process. Where once market supervisors promulgated rules without regard for input from practitioners, today’s reform process has evolved into a dialogue of mutual respect for the opinions of all stakeholders in the capital markets. The process of regulatory outreach has become embodied in virtually every developed markets in the world.

The CSFME has adopted a role of facilitating this collaborative dialogue at all stages of the professional contribution process. Starting with students’ contributions to published commentary letters, through panel presentation and webinars, right up to trade association initiatives, the CSFME provides assistance through education, data compilation, analysis and commentary for some of the most pressing issues in contemporary markets.

DLT and Preferred Securities Financing

We believe the widespread use of encrypted third-party ledgers, blockchains, and smart contracts (i.e., DLT) is inevitable in securities finance, and that those technologies will permit lending agents to offer new revenue opportunities to their clients. Among these, we believe that certain agents will use DLT to help their lenders expand their loan books by opening their lendable portfolios on a preferential basis to the hedge funds in which they've already invested, as well as to other trusted counterparties, a concept we have dubbed, “Preferred Securities Financing.”  

CSFME is openly soliciting participation in a research initiative to assess the potential benefits to securities lenders from the use of DLT and data sourced from new regulatory disclosures. Specifically, our research will focus on how DLT, blockchain, and smart contracts can facilitate Preferred Securities Financing.  Learn More about our DLT Securities Finance Initiative

Research and Analysis of the Effects of Financial Regulatory Reforms

Given the sweeping changes in financial market regulation following the financial crisis, CSFME has turned its focus to questions relating to to how these changes are affecting the risks and economics of bank activities. The purpose of the Center’s research in this area is to foster sound policymaking and effective regulation with minimal adverse and unintended consequences. CSFME studies supervision and regulation of global financial institutions, the effects of reregulation on the global financial industry, optimal roles and methods of regulation in securities markets, corporate governance at financial institutions, and the most effective metrics and methods of data collection for understanding and measuring the effects of regulations on the global financial landscape. 

Lately, in response to a call from the FDIC for research on financial sector policy and regulation, the Center submitted a paper modeling the indirect costs to markets of bank regulatory reform.  The paper critiques regulators’ models for assessing these costs, and provides empirically-based suggestions for a more complete dynamic model of the long-term effect of bank capital reform.  Mindful of the Basel Committee's ongoing reviews of modeling tools, i.e., May 2012 and March 2016, the Center's critique is intended as a constructive addition to the holistic conceptual base of the regulatory reforms.

The Center also continues to provide input on regulatory proposals.

In March of 2016, CSFME submitted a comment letter to the Bank for International Settlement's (BIS) December 2015 consultative document regarding step in risk.  While supporting generally the goals of the Basel Committee to minimize the potential systemic implications resulting from situations where banks may choose to provide financial support during periods of financial stress to entities beyond or in the absence of any contractual obligations, the Center expressed some concerns and offered some suggestions regarding the approach taken by the Consultation. Drawing on practical experience, the Center offered an example from the trade finance sector supporting its belief that the nature of step-in risk may be one example of an acceptable, non-diversifiable exposure, given the potential positives for the economy at large.

In February 2015, CSFME submitted a comment letter in response to the Financial Stability Board’s November 2014 consultative document, Standards and Processes for Global Securities Financing Data Collection and Aggregation. In its letter, the Center identified additional metrics that may be necessary to assess properly the risk of collateral fire sales associated with securities lending transactions.  In particular, CSFME asserted that FSB and sovereign regulators must expand the data initiative beyond position aggregates, to include risk mitigation resources as well as termination activity.

Students Learn to Evaluate and Contribute to the Reform Process

As the level of intensity surrounding the reform process continued to build in 2013, the CSFME began to bring a fresh perspective to the reform process. By working with finance students and the US regulatory agencies, CSFME hoped to challenge the settled views of stakeholder by introducing the views of those whose careers would be shaped by the outcome of the reforms.

In the spring of 2013, a select group of Fordham University economics students met in Washington with officials at the U.S. Treasury, Office of Management and Budget, Federal Reserve Board, and the Securities and Exchange Commission. The CSFME helped arrange the meetings and funded the logistics. By all accounts, the experience was very positive for students and regulators alike.

Buidling upon the success of the 2013 pilot program, in 2014, both Fordham and the CSFME decided to expand the outreach program and formalized the Regulatory Outreach for Student Education program as the ROSE program. Honor students in finance and economics were selected by the deans of four schools within the university: the Graduate School of Business Administration, Fordham College at Lincoln Center, the Gabelli School of Business, and Fordham College at Rose Hill. The students were organized into four teams representing their schools. The CSFME selected a contemporary issue of career significance, the Financial Stability Board’s Consultative Document on G-SIFI designation of non-bank, non-insurer financial institutions. Each team was charged with studying the issues in debate, then presenting their opinions in the manner of a formal comment letter to the FSB. Over four months, the students reviewed earlier opinion pieces, met with practitioners and regulators, and then submitted their opinions. Without influencing their opinions, the CSFME arranged access to research materials and opinion leaders, then reviewed their letters and, as appropriate, recommended submission on university letterhead. In April, 2014, the four teams’ letters were published by the FSB on its website. In recent memory, no university had ever had one letter, much less four, published on a regulatory website. To finalize the 2014 ROSE program, the CSFME arranged for all four teams to present their opinions to the key regulators at the Federal Reserve Board and the SEC in Washington, D.C. The day of meetings ended with regulators’ praise at the degree to which the students had understood the issues and presented their opinions clearly.

One student team even offered suggestions that regulators had not previously considered and praised for their creativity. “We always know what the trade groups will say, but you brought a fresh perspective.” That team, Fordham College at Lincoln Center, was awarded the 2014 ROSE Award for Analytic Excellence. In retrospect. each student completed the program with a credit that will not only endure on their resumes but also contribute to the evolution of the financial markets through the Twenty First Century.

In 2015 and 2016, Fordham formalized the ROSE Program as a for-credit course in their curriculum. The focus of the 2016 ROSE Program was the Bank for International Settlement's December 2015 consultative document proposing a preliminary framework for identifying, assessing and addressing step-in risk potentially embedded in banks' relationships with shadow banking entities.  Five teams of graduate and undergraduate students in economics, finance, accounting, management, and law researched and drafted comment letters on the consultation and submitted their letters to a panel of distinguished industry judges.  After reviewing each excellent submission, the judges then one winning letter to be presented at a visit to the Federal Reserve Bank on April 27, 2016. The winning team's letter was submitted in full to the BIS, along with a summary of the key ideas from the letters from each of the other four teams, and the submission was published on the organization's website with those of the consultation's other commenters.   All five teams of Fordham Scholars visited Washington, DC on April 27, 2016 and met with officials at the Fed, Treasury Department, and FINRA.  

Institutional Securities Lenders respond to Academic Criticisms

In 2006 the Center was created, initially for the purpose of testing academic criticisms of the securities lending markets. With funding and data support from the Risk Management Association, CSFME found “no strong evidence to conclude that securities lending programs have been used to any great extent to manipulate proxy votes or exercise undue influence on Corporate Governance issues.” Our study also found that “broker borrowbacks” had contributed to spikes in lending activity around record date – the same phenomenon that the academics had misinterpreted as evidence of hedge fund manipulation – due to the efforts of brokers to meet recall notices from securities lenders. In effect, the brokers were scrambling to acquire votes for their customers, not building positions to swing corporate elections. The academics had fatally misinterpreted their findings!

Ed Blount of CSFME testified at the SEC’s Roundtable on the results of the research in September, 2009. Then, the CSFME white paper, published in 2010, was submitted to the SEC as an attachment in response to a consultative document on the “Proxy Plumbing” process. As a result of the Center’s contribution to the collaborative process, the misguided call for reform of securities lending began to subside. Once again, securities borrowers were fairly recognized to be honest brokers in the corporate governance arena.

Securities Lenders consider new means to retain their Voting Rights

In a follow-up to the Empty Voting project (“Borrowed Proxy Abuse” as it came to be known), the CSFME responded in 2011 to requests by the participating securities lenders, by turning its attention to ways in which those lenders might be able to retain their corporate governance rights, while still benefiting from the income attributable to their securities loans. After all, as many studies have found, securities lending contributes significantly to the efficiency of market operations. Why should lenders be forced to choose between their loan fees and fiduciary duties to vote their shares, especially if they are contributing to market efficiency?? With independent funding, the CSFME retained attorneys from two prestigious Washington D.C. law firms, Stradley Ronon and Sidley Austin, to investigate the legal underpinnings to market practices which force pensions, mutual funds, insurers and other institutional securities lenders to give up their voting rights when they lend portfolio securities. In practice, margin customers of brokers also lend their securities, yet they usually retain voting rights -- and most of them aren’t even long-term beneficial owners. Both groups of beneficial owners retain dividend rights, so why, institutional investors asked, shouldn’t institutions also keep their voting rights? With the benefit of exhaustive legal research, CSFME filed a petition with the Securities & Exchange Commission to initiate a pilot program to test new market procedures by which recently-introduced efficiencies in market operations might permit lender to retain votes.  Learn more about Paradoxical Erosion of Corporate Governance

In 2013, the SEC approved that pilot program, largely in response to the encouraging recommendations of the International Corporate Governance Association, as well as the California State Teachers Retirement System and the Florida State Board of Administration.

That pilot was initiated in 2014. Simultaneously, the CSFME began to apply the results to new initiatives in Canada and Switzerland, where the pressure to meet fiduciary voting obligations was intensifying.  More about Full Entitlement Voting



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