Tuesday, February 15, 2011

Corporate Secretaries Society Says Proxy Advisory Firms Are ERISA Fiduciaries and Should Also Register with the SEC as Advisers

While the Society of Corporate Secretaries and Governance Professionals does not support the DOL’s proposed definition of fiduciaries for those providing investment advice to an employee benefit plan or a plan’s participant, the Society does believe that proxy advisory firms should be considered fiduciaries under the definition. In a separate letter to the SEC, which was also attached to the DOL letter, the Society said that proxy advisory firms should register with the Commission as investment advisers. The Society believes that the fact that investment managers with fiduciary duties can rely on proxy advisory firms with no fiduciary duties to make voting recommendations is a disconnect in the current system that needs to be remedied.

The DOL proposes to redefine the term fiduciary under section 3(21) of ERISA and section 4975(e) of the Internal Revenue Code. Generally, the Society does not support what he calls a broadly expanded definition of fiduciary. The Society is concerned that the proposed regulation could significantly expand the circumstances under which numerous persons supporting the management of plan assets, but not
exercising discretion over fiduciary decisions, would be deemed to be fiduciaries. This result would significantly increase plan costs and harm plan participants, fiduciaries, and sponsors.

However, noting that many investment managers delegate their voting responsibility to proxy advisory firms without appropriate oversight, the Society believes that proxy advisory firms that effectively exercise discretion over proxy voting decisions should be considered fiduciaries. More broadly, the Society urged the Department to undertake a comprehensive review of the practices of proxy advisory firms as set forth in its letter to the SEC.

In the SEC letter, the Society said that the voting influence exercised by proxy advisory firms undermines the integrity of the proxy voting system because firms are subject to conflicts of interest and make factual mistakes in their analysis, with the effect that their voting guidelines are erroneously applied to the company’s proposal and the voting recommendation is inaccurate. Further, proxy advisory firms lack an economic interest in the shares they vote and thus have no responsibility to ensure their recommendations achieve the best economic outcome for shareholders.

In the Society’s view, proxy advisory firms are subject to three types of conflicts of interest. The first occurs as a result of selling their services to both institutional clients and issuers. The second conflict arises when firms make recommendations on proposals submitted by their own investor clients. The third conflict stems from proxy advisory firms’ interest in recommending proposals and adopting policies that are likely to expand their influence and future market.

Society members believe proxy advisory firms often do not take into account the specific circumstances of the company, but instead follow a one-size-fits-all approach to their voting recommendations. Society members have reported situations where the proxy advisory firm recommended against a governance practice that had been approved in a prior vote by the shareholders. In addition, leading proxy advisory firms often use largely formulaic models in recommending approval for equity compensation plans, with little attempt to take into account the particular circumstances faced by a company at a given point of time.

Further, the Society noted that the delegation by investment advisors of their vote to proxy advisory firms has resulted in a divorce between the persons who make the investment decision and the persons who exercise the vote. The result of this gap is that voting recommendations may bear no relation to the economic performance of the company and, therefore, such voting recommendations may not improve the performance of a company.

Because proxy advisory firms do not need to take into consideration the
economic consequences of their recommendations, noted the Society, they do not feel compelled to specifically tailor their recommendations to the particular facts and circumstances of each issuer For example, in some companies, having a lead director may make sense, but not in all.

The Society urged the SEC to require proxy advisory firms to establish procedures to manage conflicts of interest and disclose in their reports any conflicts of interest with the subject of their recommendation. The firms should also disclose the methodologies, guidelines, or assumptions they used in making their recommendations, including a discussion on whether the methodology is a generic methodology applied to all issuers.

The SEC should also require the disclosure of the processes the firms employed to gather their information, including the number of companies each analyst reviews within a given time frame and whether the recommendations are reviewed by a more senior manager. Firms should also disclose their executive compensation models and standards so that companies do not need to purchase consulting services from a proxy advisory firm in order to determine if it will get a favorable recommendation on a stock plan.

Firms should be required to report to the SEC at the end of each proxy season the number of incidents where companies took exception to the factual statements contained in the proxy advisors’ reports or appealed the recommendation of the proxy advisory firm. Also, companies should be given at least five business days to review draft reports prior to their release.

Finally, the Society recommends that proxy advisory firms be required to register as investment advisers and become subject to SEC examinations that would provide additional discipline and accountability to the system. Once registered, proxy advisory firms would need to establish an oversight authority that they are following their procedures and would need to provide factual support for the bases of their disclosures. In addition to the registration of proxy advisory firms, the Society believes the Commission should require any investment adviser or other fiduciary that uses a proxy advisory firm to exercise appropriate oversight of the proxy advisory firm and its
recommendations.

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