Who Watches the Watchers? SEC Issues Guidance on Proxy Advisory Firms

Written By Brent Kraus, Jon Truswell, Nick Fader and Zach Johnson

The United States Securities and Exchange Commission (SEC) recently issued guidance on the applicability of certain U.S. proxy rules to voting advice given by proxy advisory firms, such as ISS and Glass Lewis. This initiative should be of interest to Canadian public issuers, as the SEC's guidance may prompt a further examination in Canada of these very influential, but largely unregulated, organizations and their role in Canadian capital markets.

The Role of Proxy Advisory Firms

Proxy advisory firms occupy an influential role in Canada's capital markets. Among other things, they advance self-developed policies on best practices for corporate governance. In addition, some proxy advisory firms develop proprietary models for evaluating executive compensation. These policies and models are generally applied to Canadian public issuers and result in proxy advisory firms issuing voting recommendations on various matters, including director elections, executive compensation, significant transactions and other corporate governance matters placed before shareholders. Many institutional investors base their voting decisions in whole or in part upon such recommendations.

Although proxy advisory firm policies are publicly disclosed, not all formulae and detail are published. As a result, it is not always possible for issuers to arrive at a predictive conclusion on the voting recommendation a proxy advisory firm may publish on a particular matter. Certain proxy firms do, however, offer proxy evaluation services for a fee, which allow issuers to engage the proxy advisory firm to review proposed executive compensation or governance matters.

U.S. Guidance

The SEC guidance specifically addresses whether the voting recommendations issued by proxy advisory firms constitute a "solicitation" under Section 12 of the U.S. Securities Exchange Act of 1934 (Exchange Act).

The SEC has stated that the U.S. federal proxy rules apply to any person seeking to influence the voting of proxies by shareholders, regardless of whether the person itself is seeking authorization to act as a proxy. Building on this concept, proxy advisory firms may become subject to the proxy rules, because these firms provide recommendations likely to result in the procurement, withholding, or revocation of a proxy. 

As a result, the SEC guidance clarifies that proxy advisory firm advice is subject to Exchange Act Rule 14a-9 (anti-fraud provision), which prohibits any solicitation from containing false or misleading statements of a material fact. Further, any material fact necessary to make the statements therein not false or misleading must also be disclosed. As a result, the SEC guidance provides that a proxy advisory firm may need to disclose the following to avoid being offside Rule 14-a9: 

• an explanation of the methodology used to formulate its voting advice, where the omission would otherwise render the advice materially false or misleading; 
• any information sources relied on other than an issuer's public disclosures, if the proxy voting advice is based on this information;
• material differences between the information that the proxy advisor has relied on and the issuer's public disclosures, if the differences are material and failing to do so would again render the advice false or misleading; and
• any material conflicts of interest (so the client can determine if such conflicts are relevant).

The SEC also provided guidance in relation to the responsibilities of investment advisors (Advisors) when they retain and rely on a proxy advisory firm. Among other things, Advisors should consider how proxy advisory firms take into account the unique characteristics of the issuer, its industry, history and financial performance, recognizing that a "one size fits all" approach to complex matters that are subject to a shareholder vote is concerning. The SEC also identified concerns relating to issuer engagement and the need to ensure that proxy advisory firms have complete and accurate information and take steps to correct any identified material deficiencies in a firm's analysis.

Implications for Canada

The SEC guidance is notable in that it could, in relation to U.S. issuers, increase the transparency of proxy advisory firms vis-à-vis their methodologies and analyses. It could also encourage those firms to engage with issuers and reduce their reliance upon "one size fits all" policies that fail to consider the unique characteristics of the issuer or transaction.

To date, Canadian securities regulators have published only non-prescriptive guidance and recommended practices for proxy advisory firms. It remains to be seen whether Canadian securities regulators will follow suit with the SEC. Having regard to the increasing influence that these for-profit, privately-owned entities have in Canada's capital markets, there is some rationale for an updated consideration of market participant views about policy formulation by proxy advisory firms and related issues. Market participants subject to proxy advisory firm policies may welcome an opportunity to offer further input regarding the governance of proxy advisory firms, their policy formulation activities and the desirability of enhanced issuer engagement.

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