Proxy advisory firms are supposed to help fund managers decide how to vote their shares in annual or other corporate meetings and even cast votes for them.
But that doesn’t mean fund managers should just let them do all the work and forget about it. Apparently that’s what the US Securities and Exchange Commission thinks they many have been doing and has just issued guidance for how they should monitor those proxy advisory firms, which has some buy-side firms anxious.
Rather than more rigorously monitor proxy advisors all by itself — which it can do in the case of proxy advisors registered as investment advisors or when issues of fraud or conflict of interest apply — the SEC wants fund managers to do their fair share of the work. Granted, proxy advisory firms are required to be more forthcoming about potential conflicts of interest, but fund managers must ensure the firms they hire won’t have their voting recommendations affected in any way. In addition, fund managers are expected to know that their votes were actually cast and voted the way they wanted. Even before it hires a proxy advisory firm, a fund manager is expected to verify it has the correct staff and procedures in place to do its job. (A full copy of the guidance can be found here).
Sounds great. To the regulator, that is. Fund managers tell FinOps Report they expect a lot more oversight work for compliance specialists with little certainty as to whether fund managers have fulfilled their fiduciary obligation. The guidepost: they have to ensure their votes are cast in the best interest of investors. It’s the same standard they always had to meet under the Investment Advisers Act of 1940. The newly issued guidance just clarifies what they should have been doing all along. The SEC apparently suspects they may have have been lax, and possibly with good reason.
Handling the Work Load
Only the largest fund management firms are able to spend the time and money to mount a corporate governance team to keep track of the proxy advisory’s activities. The manual labor involved, even if the work can be partially automated, is significant. That’s why so few fund management shops are taking the obvious steps to check if the advisory firm may have a conflicts of interest, such as buying research reports from multiple proxy advisory firms on the same company.
Smaller to mid-sized fund managers are likely delegating this oversight of the proxy advisors to an already overworked back-office operations staffer. Someone has to be responsible, because two separate no-action letters from the SEC made them think they had to cast their votes on all corporate agendas. Those letters also made them believe they could rely on proxy advisors to discharge their fiduciary duty.
As a result, proxy advisory firms have become a well-established fixture in the fund management world. With many fund management firms unable to spare the manpower to evaluate the hundreds if not thousands of proposals they receive each year and operationally place votes for their investors, they rely on the third-parties to do so. In some cases, the proxy advisories provide advice on how to vote, in others they cast the votes, and yet in others they do both.
But all is not smooth sailing. Because of their market dominance, the largest of these proxy advisory firms — namely Institutional Shareholder Services (ISS) and Glass-Lewis– have been wielding far too much power in shareholder votes, say corporate critics. Those critics claim the voting decisions chosen by the advisory firms are being unduly influenced by large activist investors at the expense of less vocal mutual funds and other institutions. There are also claims that the proxy advisory firms have serious conflicts of interest they aren’t clearly disclosing to fund managers.
Naturally proxy advisory firms dispute such allegations. ISS, which is registered as an investment advisor with the SEC, declined to comment for this article beyond the following statement: “As a matter of best practice and in fulfilling its regulatory obligations, ISS has for more than two decades effectively managed and disclosed potential conflicts of interest to its clients through robust policies, processes and procedures. We will review the SEC’s guidance with an eye toward further enhancing these disclosures, in keeping with an objective to provide our services with the higher level of transparency in the industry.”
Compliance Tasks
In monitoring the proxy advisory firm’s performance in casting votes, some of what the US securities watchdog wants can be handled electronically or through periodic “sampling” of votes, operations specialists tell FinOps. The SEC doesn’t define how frequent a “periodic” check would be, but the consensus among fund managers and other experts speaking with FinOps appears to be more than just annually.
“Verifying the vote count and determining that the proxy advisory firm voted the way the fund manager would have wanted can be addressed by the operations or compliance department through online reporting, telephone or onsite visits,” says Michael Sherman, a partner in the Washington DC office of Dechert, a law firm specializing in corporate and securities law. He recommends that fund managers with heavy voting loads consider even more frequent follow-ups with the proxy advisory firm during the proxy season.
Though a lot of work, checking the voting performance is relatively cut and dried. Much harder will be checking that the votes were in best interest of the investor. Doing this involves, for the fund manager, “reasonably” identifying potential conflicts interest on the part of the proxy advisory firm. The first and simplest step is that the find manager require the proxy advisory firm to update them of “relevant” business changes which would affect their ability to execute votes or of any conflicts of interest.
Checking voting completion and validating proxy advisors voting choices means that buy-side firms can expect to spend a lot more time managing their relationships with proxy advisory firms. This relationship management, which might previously have been delegated on a part-time basis to a back-office operations is going to be requiring more people and be more closely supervised by the fund manager’s compliance team.
In particular, the task of deciding whether a proxy advisory firm’s potential conflicts of interest is meaningful to investor interest at a specific fund management firm is going to require legal or compliance expertise. The evaluation must include whether conflicts actually exist, how serious they are and how they might affect the voting recommendations. No back-office operations specialist will want to tackle that responsibility and rightly so.
Raising regulatory stakes for fund managers, the SEC is also holding fund managers responsible for asking for the information. “If I were a fund manager I would make certain my proxy advisory firm discloses every single potential conflict in a public, proactively and in a timely manner, even if it [the proxy advisory firm] doesn’t believe it needs to,” says Kevin McManus, director of proxy advisory firm Egan-Jones Proxy Services in Haverford, Pennsylvania. “Ideally, conflicts should be disclosed on both the individual corporate report and on a central web page in plain text, of course, not a PDF or GIF.”
What to Look For
Just what are those conflicts? They can be pretty simple, requiring simple answers says McManus, who offers the following examples. Does the proxy advisory firm’s analyst own stock in the firm he or she is advising about or sell his or her own stock?. Does the analyst’s husband or wife work for the firm analyzed? Has the proxy advisory firm sold over US$100,000 in goods and services to the analyzed firm over the past twenty-four months? “I’m not saying [to a proxy advisory firm] don’t take any of these actions, but what I’m saying is if you are not comfortable with the public knowing about it, maybe you shouldn’t be doing it,” says McManus.
What happens if fund managers ask and the proxy advisory firm provides incorrect information? Will the SEC give the fund manager a free pass for at least trying? Fund managers appear uncertain. Two of the four fund managers contacted by FinOps thought the SEC would give them a pass, while the other two were worried the regulator wouldn’t. “As long as we can show paperwork proving that we asked, but the proxy advisory firm lied, we’re fine,” says one operations specialist at a New York fund management firm. His peer at a Boston fund management firm says: “We’re not counting on any forgiveness from the SEC. We’ll be asking our compliance unit to further investigate what the proxy advisory firm claims.”
What if a fund manager ultimately uncovers that the proxy advisory firm didn’t vote the shares correctly? If the error is purely operational — meaning the proxy advisory firm made an unintentional mistake — fund managers will clearly get mad, but not face any regulatory crackdown. All a fund manager has to do is try to make certain the proxy advisor is taking steps to avoid similar mistakes in the future, says the SEC.
Not so, if the mistake was due to a questionable thought process leading to the voting choice, or if the proxy advisory agency didn’t provide correct information to the fund manager. “If we don’t review the proxy advisory firm’s documentation on how they came up with their recommendation, the SEC may come down on us,” says the operations manager at the Boston-based fund management firm. His firm’s solution: a careful review of the documentation by the operations team and, if they find red flags, escalation up to the compliance unit for further action.
It’s clear that fund managers don’t want to take any chances when it comes to the SEC’s guidance. If they ever thought that proxy voting was just a mechanical process that could be confidently delegated to third parties, they certainly don’t any more. The regulatory buck will stop with the fund manager — and as usual its compliance staff will carry much of the load.
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