Legal Alert: SEC issues guidance regarding the proxy voting responsibilities of investment advisers

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Introduction

On August 21, 2019, in a 3-2 vote, the US Securities and Exchange Commission (SEC) voted in favor of publishing guidance (guidance) regarding the proxy voting responsibilities of investment advisers (IAs). The guidance, structured in a question-and-answer format, provides examples to help facilitate IAs’ compliance with their proxy voting responsibilities under the Investment Advisers Act of 1940, as amended (Advisers Act), and Rule 206(4)-6 thereunder. Importantly, the SEC encourages IAs and proxy advisory firms (PAFs) to review their policies and practices before next year’s proxy season to ensure they are consistent with the guidance. Further, to the extent that firms identify operational or other questions in the course of that review, the SEC encourages them to contact the staff of the SEC’s Division of Investment Management so that the SEC can evaluate whether any further guidance might be appropriate. The guidance will be effective upon publication in the Federal Register.

The guidance is divided into six questions and answers and illustrates how an IA’s proxy voting responsibilities would apply in two different contexts: first, where the IA has sole responsibility for voting proxies, and second, where the IA hires a PAF to vote them. In this Legal Alert, we review the six questions and answers and provide some compliance considerations for firms as they start the process of reviewing their policies and practices against the guidance. 

The Guidance

  1. How may an IA and its client, in establishing their relationship, agree upon the scope of the IA’s authority and responsibilities to vote proxies on behalf of that client?

As an initial matter—and consistent with the general concept that an IA’s fiduciary duty follows the contours of the relationship agreed to by the IA and its client (provided there is full and fair disclosure and informed consent)—the SEC makes clear that an IA is not required to accept the authority to vote client securities, and if it does accept the authority, the scope of any voting arrangements can vary. However, an IA that assumes proxy voting authority must make voting determinations consistent with its fiduciary duty and in compliance with Rule 206(4)-6. The guidance provides a non-exhaustive list of examples of possible voting arrangements an IA and client may agree to, subject to full and fair disclosure and informed consent:

  • Specific Parameters Designed to Serve the Client’s Best Interest. Absent instructions to the contrary or a determination by the IA that voting a particular proposal in a different way would be in the client’s best interest, the IA could agree with the client to uniformly vote: (1) in accordance with voting recommendations made by the issuer’s management; or (2) in favor of all proposals made by particular shareholder proponents. These arrangements could also be subject to conditions agreed to by the IA and the client.
  • Costs Imposed on the Client. An IA could abstain from voting in instances where voting would impose costs on the client.
  • Event-Driven Proposals. Subject to client preferences, an IA can agree to focus only on particular types of proposals, such as corporate events or contested elections.
  • Negative Cost / Benefit Analysis. An IA could refrain from exercising its voting authority when the cost of voting would be high, or the benefit to the client would be low.1
Compliance Consideration: The guidance stresses the overarching obligation to serve the client’s best interests, especially through the duty of care. Where an IA has multiple clients and assumes varied scopes of authority, it may want to consider whether the nature of each arrangement is properly documented from contractual and control perspectives for oversight purposes. An IA may also want to consider revisiting its processes around conducting and documenting a reasonable investigation and case-by-case determination before exercising or abstaining from a vote to support the IA’s best interest decision.

2. How can an IA demonstrate that determinations are being made in the client’s best interest and in accordance with proxy voting policies
and procedures?

The guidance suggests that IAs conduct a “reasonable investigation” into the matters that the IA may vote on behalf of its client to form a belief that its voting determinations are in the best interest of the client.2 In this regard, the SEC acknowledges that in most instances, IAs will have multiple clients who could own an array of different securities. The SEC explains in the guidance that a uniform voting policy may not be in accordance with the best interest of all clients (some of which may be institutional clients and others of which may be retail clients) and suggests that IAs consider whether to implement different voting policies for some of their clients, depending on the investment strategy and objectives of each client.3

In addition to suggesting client-specific voting policies as appropriate, the SEC suggests in the guidance that IAs consider whether a specific matter requires a “more detailed analysis than what may be entailed by application of [the IA’s] general voting guidelines,” and to “consider factors particular to the issuer or the voting matter under consideration.”4 The guidance explains that since an issuer- or event-specific analysis depends on the effect of the vote on the value of the client’s investments, a voting policy should include consideration of the factors used in making determinations. Additionally, for registered funds, disclosures in regulatory filings should describe whether the fund has different or multiple voting policies and procedures.

The SEC also encourages IAs to implement “reasonable measures” to determine that it is consistently casting votes on behalf of its clients in accordance with its policies and procedures. As an example, the SEC explains in the guidance that an IA could evaluate its compliance with Rule 206(4)-6 by sampling proxy votes as part of its annual review of compliance policies and procedures, including a sample of proxy votes that required an issuer- or event-specific analysis.5

Where an IA retains a PAF in any capacity, the SEC suggests that additional steps should be taken to evaluate whether the ultimate voting determinations are consistent with the IA’s voting policies and procedures and also in the client’s best interest before the vote is cast. The SEC explains that this hindsight-based compliance evaluation could consider: (1) reviewing periodic sampling of pre-populated votes on the PAF’s electronic voting platform; (2) implementing policies and procedures that provide for the consideration of additional information regarding a particular proposal; and (3) in instances where policies and procedures do not address how an IA should vote, whether a higher degree of analysis is necessary or appropriate to assess whether votes are cast in the client’s best interest.

Finally, the SEC reminds firms that as part of their ongoing compliance programs adopted pursuant to Rule 206(4)-7 under the Advisers Act, they must review and document, no less frequently than annually, the adequacy of their voting policies and procedures “to ensure that they have been formulated reasonably and implemented effectively, including whether the applicable policies and procedures continue to be reasonably designed to ensure that the adviser cast votes on behalf of its clients in the best interest of such clients.”6

Compliance Consideration: To demonstrate that voting determinations are being made in each client’s best interest, firms may want to consider reviewing current processes, and potentially implementing multiple proxy voting policies, to capture each client’s unique investment objectives and strategy, and conform those prerequisites to how proxies will be voted. Additionally, firms may want to consider drafting or enhancing policies and procedures to substantiate in the future that their decisions were and continue to be consistently made in the client’s best interest. Moreover, firms that use PAFs may want to consider enhancing their policies and procedures to oversee PAFs and ensure that their voting determinations are consistent with the firm’s voting policies and procedures and are in the client’s best interest.

3. What should an IA consider when looking to retain or continue to retain a PAF to assist in the proxy voting process?

The SEC states in the guidance that IAs should seek transparency from a PAF in making hiring decisions and on an ongoing basis once hired. In seeking such transparency, the SEC states that IAs should consider, among other things, whether a PAF has the “capacity and competency to adequately analyze the matters in which the [IA] is responsible for voting” as well as the “adequacy and quality of the PAF’s staffing, personnel, and/or technology.”7

Additionally, the SEC states that IAs should look into PAF processes related to proxy voting policies, methodologies and peer group constructions. When examining PAF methodologies, IAs should consider the disclosures made by the PAF so that IAs can “understand the factors underlying the PAF’s voting recommendations,” any third-party information used by the PAF, as well as when and how the PAF “would expect to engage with issuers and third parties.”8

The SEC also notes in the guidance that IAs will also need to consider how PAF policies and procedures identify and address conflicts of interest and provides examples of how IAs can conduct a review, including:

  • Whether the PAF has adequate policies and procedures to identify, disclose, and address actual and potential conflicts of interest;
  • Whether the PAF’s policies and procedures provide for adequate disclosure of actual and potential conflicts; and
  • Whether the PAF’s policies and procedures use technology in delivering conflicts disclosures that are readily accessible.
Compliance Consideration: Firms may want to consider whether they are sufficiently proactive in assessing the types of services a PAF provides. Firms may also want to consider whether they are gathering sufficient documentation from the PAF and properly documenting the review and consideration of such materials to demonstrate that the services the PAF provides align with the adviser’s fiduciary duty owed to clients. 

4. What should an IA do when it discovers that a factual error, incompleteness or methodological weakness may materially impact one or more of its voting recommendations?

The SEC states that IAs should implement policies and procedures that are “reasonably designed” to ensure that voting determinations are not based on materially inaccurate or incomplete information.9 For example, these policies and procedures could require a periodic review of a PAF’s research or voting recommendations, which could include an assessment of the extent to which potential factual errors, incompleteness or methodological weakness materially affected the PAF’s research or recommendations used by the IA. 

The SEC also states that IAs will also need to consider how effective the PAF’s policies and procedures are for obtaining “current and accurate” information used as part of its research and/or recommendations and enumerates factors that IAs should consider and potentially discuss with a PAF, including:

  • The PAF’s engagement with issuers;
  • The PAF’s efforts to correct any identified material deficiencies in the PAF’s analysis;
  • The PAF’s disclosure to the IA regarding the sources of information and methodologies used in formulating voting recommendations or executing voting instructions; and
  • The PAF’s consideration of factors unique to a specific issuer or proposal when evaluating a matter subject to a shareholder vote.
Compliance Consideration: To the extent they have not done so already, firms may want to consider adopting policies and procedures requiring a periodic review of PAF research or voting recommendations for factual errors, incompleteness or methodological weakness. Furthermore, when a potential error in the PAF’s analysis is confirmed through such a review, firms may want to consider whether they have sufficient processes around documenting the steps taken to remediate the error.

5. How should an IA evaluate the services of the PAF it retains? How should an IA evaluate material changes in services or operations by the PAF?

Under Rule 206(4)-6, IAs that retain third parties to assist in the proxy voting process must implement policies and procedures that are reasonably designed to ensure that proxies are voted in clients’ best interests. The guidance suggests that: (1) IA policies and procedures “identify and evaluate a PAF’s conflicts of interest that can arise on an ongoing basis”; (2) IAs consider requiring the PAF to update the IA regarding relevant business changes; and (3) IAs consider whether the PAF “appropriately updates its methodologies, guidelines and voting recommendations on an ongoing basis.”10

Compliance Consideration: IAs may want to consider whether they have a sufficiently frequent and substantive dialogue with PAFs that would allow them to meet their obligations under Rule 206(4)-6. Additionally, IAs may want to consider establishing guidelines with PAFs under which the PAFs must proactively update the IAs when a business change impacts the PAFs. Further, IAs may want to consider establishing communication channels with PAFs to receive updates when changes are made to methodologies, guidelines and voting recommendations.

6. If an IA has authority to vote proxies on its client’s behalf, does it always have to vote on behalf of its client?

No. The SEC describes two situations in the guidance in which an IA has the opportunity to vote a proxy on behalf of a client but may appropriately refrain from doing so:

  • When the IA and client have agreed in advance to limit the conditions under which the IA exercises voting authority, or
  • When refraining from voting is in the best interests of the client.

The SEC also notes that IAs cannot ignore or be negligent in fulfilling their proxy voting obligations, and will not fulfill their fiduciary duty by simply refraining from voting without demonstrating the rationale for its decision.

Compliance Consideration: Firms may want to consider whether their proxy voting policies or agreements with clients are sufficiently clear regarding the instances in which the firm may refrain from voting client proxies.  Moreover, firms may wish to consider whether they are appropriately documenting decisions to refrain from voting so that they can demonstrate that the decision not to vote was in the best interest of the client.

Conclusion

In adopting the guidance, the SEC intends only to clarify IAs’ fiduciary obligations under the Advisers Act and Rule 206(4)-6 thereunder. This was the first time we witnessed this entire Commission vote since Commissioner Lee joined this past July. Commissioner Lee joined Commissioner Jackson in dissent, expressing concerns with the guidance and pointing to the potential for increased costs and barriers to entry and a deterioration in the reliability and independence of PAFs’ recommendations. Commissioner Jackson viewed the guidance as inhibiting competition among PAFs and increasing small investor voting costs. After noting that smaller firms may be less able to bear the costs imposed by the guidance, he observed that if smaller investors respond to these costs simply by choosing to vote less, the result may be to give more influence to large institutions. Commissioner Lee doubted the guidance’s intent, explaining that it created a substantive requirement for issuers to get more involved in PAF processes, potentially undermining a PAF’s independence, and that “timely” input would increase costs associated with voting. Additionally, the dissenters noted the guidance was published without notice and comment, something that may, along with the split nature of the Commission’s vote, subject the Guidance to opposition in the future. However, since the guidance will be effective upon publication in the Federal Register, IAs would be well-served to evaluate their current practices, policies, and procedures to ensure that they are consistent with the guidance.

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1 SEC Guidance Regarding Proxy Voting Responsibilities of Investment Advisers, SEC Release No. IA-5325 (August 21, 2019), available at: https://www.sec.gov/rules/interp/2019/ia-5325.pdf (the “guidance”).

2 See the guidance at p.13.

3 Id. at 13.

4 Id. at 14.

Id. at 15.

6 Id. at 16.

7 Id. at 17.

8 Id. at 18.

9 Id. at 21.

10 Id. at 23.

Authors
Clifford E. Kirsch | +1 212 389 5052 | Email
Michael B. Koffler | +1 212 389 5014 | Email
John H. Walsh | +1 202 383 0818 | Email
Issa J. Hanna | +1 212 389 5034 | Email
Nicholas J. Rinaldi | +1 212 301 6586 | Email

If you have any questions about this legal alert, please feel free to contact any of the attorneys listed under ‘Related People/Contributors’ or the Eversheds Sutherland attorney with whom you regularly work.