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News June 21, 2004 Issue

SEC Staff Imposes New Due Diligence Burdens on Advisers That Vote Proxies

A recent SEC staff no-action letter has imposed new obligations on all SEC-registered advisers that use an outside proxy voting service, such as ISS, IRRC, Egan-Jones, or Glass Lewis, to help vote client proxies. The letter raises particularly vexing issues for advisers that rely on ISS, which provides corporate governance consulting services to issuers that it also evaluates on the proxy voting side.

Some background: the SEC, in its 2003 proxy voting adopting release, said that one way an adviser could cleanse itself of conflicts when voting proxies was by doing so “in accordance with a pre-determined policy based on the recommendations of an independent third party.” Egan-Jones Proxy Services, an ISS competitor that does not provide corporate governance consulting services, seized on the word “independent.” Egan-Jones asked the SEC’s Division of Investment Management whether a proxy voting service would be independent if it also provides corporate consulting services.

In a letter signed by Division chief counsel Douglas Scheidt, the staff explained that the test of a proxy voting firm’s independence is vis-à-vis the advisory firm, not vis-à-vis the issuer whose proxies are being voted on. To wit: “We believe that the mere fact that the proxy voting firm provides advice on corporate governance issues and receives compensation from the Issuer for these services generally would not affect the firm’s independence from an investment adviser.”

But the staff didn’t stop there. Going farther than the SEC’s proxy voting release, the letter went on to discuss an adviser’s general duties when selecting an outside proxy voting service. The staff said an adviser must verify that the service:

  • is independent from the adviser (more on this later);
  • has the “capacity and competency” to adequately analyze proxy issues; and
  • can make proxy voting recommendations in an impartial manner and in the best interests of the adviser’s clients.
The staff warned that if a proxy voting service makes a voting recommendation to further its corporate governance consulting relationship with the issuer, and the adviser follows that recommendation, the adviser “could breach its fiduciary duty of care to its clients.”

Scary, eh?

To address conflicts at the proxy voting service level, the staff said that an adviser should obtain information from a “prospective” proxy voting service to allow it to determine whether the service is in fact independent and impartial. The staff also said that an adviser’s proxy voting procedures “should” address the use of any independent proxy voting service if the use of such a service “is a material part of the adviser’s proxy voting policies.”

It’s not a one-time deal. The staff also said that an adviser should establish and implement procedures to “identify and address conflicts that can arise on an ongoing basis” concerning the proxy service. To do this, suggested the staff, an adviser could have the proxy service represent, each time it makes a voting recommendation, that it faces no conflict of interest with respect to the vote.

And then, the staff dropped the following bombshell: “For instance,” said the staff, when an adviser is dealing with a proxy voting firm that makes recommendations about the same issuers from which it receives compensation for corporate governance consulting (read: ISS), “the procedures should require” the proxy voting firm “to disclose to the adviser any relevant facts concerning the firm’s relationship with an Issuer, such as the amount of the compensation that the firm has received or will receive from an Issuer.” That information, said the staff, would allow an adviser to decide whether the proxy voting service really is impartial, or whether the service is conflicted (in which case the adviser needs to figure out another way to decide how to vote the proxies).

Depending on who you ask, this is a big deal, or no deal at all. Focusing on the “an Issuer” language, some are interpreting the staff’s letter as requiring advisers to obtain information about the corporate governance consulting fees their proxy voting service receives from each issuer. “You have to determine on an issuer-by-issuer basis that the advice you’re getting isn’t tainted,” Glass Lewis CEO Greg Taxin told IM Insight. Sean Egan of Egan-Jones agreed with Taxin’s assessment.

Mari-Anne Pisarri of Pickard and Djinis, who is outside legal counsel to ISS, however, comes out the other way. She said that if an adviser makes a front-end determination that a proxy voting service has taken steps to ensure that potential conflicts do not become actual conflicts, the adviser need not obtain issuer-by-issuer disclosure.

Why does it matter?

ISS, of course, is the proxy voting service used by most advisers. It also seems to be the only major proxy voting service that provides corporate governance consulting services to the same issuers on which it makes proxy voting recommendations. To its credit, ISS has recognized the conflict that the two lines of business present and has established policies and procedures to address it. Among other things, ISS has imposed a firewall with physical and technological separation of its research and consulting staffs.

Therein lies the rub. To maintain the sanctity of its firewall, ISS doesn’t put information about its corporate governance consulting services on the face of its proxy reports. It will, however, provide that information, including the dollar amount of corporate consulting services provided to any issuer, to any of its proxy clients that ask. In fact, ISS has received an increased “velocity of requests” about its corporate governance relationships following the release of the Egan-Jones letter, according to ISS special counsel Patrick McGurn.

During a June 14 conference call with its clients, ISS was asked whether it would put together a due diligence package for advisers. “We’re going to be very responsive to what our clients would like to see,” replied ISS chief legal officer Steven Friedman. “We’re getting some of these requests already and responding to them,” he added, noting that ISS is putting together customized due diligence packages that contain “exactly what different clients need for their own purposes and that match up with their own internal policies and procedures.” Added Friedman: “We’re acting very proactively and quickly to give our institutional clients what they need to comply.” He said advisers were free to e-mail ISS to obtain the information they needed.

ISS’s competitors have a different take on the matter.

“What ISS is asking their money manager clients to do ought to be wholly unacceptable,” said Glass Lewis’s Taxin. “If you have a thousand stocks in your portfolio you need to make a thousand determinations.” He said that his firm has received “a flood of inbound calls” from current ISS clients who “either have not appreciated up until now the extent of ISS’s corporate relationships or have not regarded it as a concern from a fiduciary perspective.” ISS’s firewall procedures, said Taxin, have resulted in a Byzantine structure that ultimately imposes burdens on advisory clients. “Doing business in a conflicted way is always difficult and no one should give them any sympathy for it,” he added.

According to ISS’s McGurn, however, the new requirements in the letter don’t impose significant new burdens on advisers. “I think in a lot of cases it’s really documenting what they’re already doing,” he said. “We talk with compliance officers . . . all the time about these issues,” he said. “If people want to come in for site visits or bring us into their offices to talk about these issues, we’re happy to do so.” McGurn noted that all of ISS’s recommendations already carry a legend to the effect that the issuer had nothing to do with the final proxy voting recommendation.

So, who’s right?

IM Insight has spoken with an SEC staffer who thinks that obtaining issuer-by-issuer corporate governance compensation disclosure isn’t necessarily the only way to comply with the obligations spelled out in the Egan-Jones letter. While obtaining issuer-specific compensation disclosure is one approach, said the staffer, there may be “other ways to work that out.” The staffer pointed out that in the SEC’s proxy voting releases, the Commission said that disclosure of a material conflict and obtaining client consent is not the exclusive way of dealing with proxy voting conflicts. “Disclosure is one way,” said the staffer, “but there may be others.”

The betting money is that the staff will be contacted formally about the issue, so there may be some official guidance coming down the road.

Let’s Talk About Our Relationship . . . Turning back to the “independent” prong of the SEC’s letter, advisers should consider whether they have corporate or business relationships that tie them too closely to their proxy voting service. The staff said that an adviser should take “reasonable steps” to make sure that any proxy voting firm it uses “is in fact independent of the adviser.”

That “reasonable steps” language is a gift to the thousands of small, stand-alone advisers who can look around and say “Us? Affiliated with one of these proxy voting services? Having a ‘material business relationship’ with one of these guys? You’ve got to be kidding.”

Also greatly simplifying matters: none of the four major proxy voting services — ISS, IRRC, Egan-Jones, and Glass Lewis — are publicly-held companies, so it’s unlikely that smaller advisers have voting power over 5 percent or more of their shares (one of the tests for affiliation).

However, for larger advisers, particularly those that are publicly-held or that are part of a larger corporate organization, the independence question might not be so cut and dried. The determination of a proxy voting service’s independence, said the staff, should be “based on all of the relevant facts and circumstances.”

They weren’t kidding.

The staff took the unusual step of tying the independence analysis to the Investment Company Act’s “affiliated person” definition. This will require advisers to sit down and map out their direct and indirect ownership and control relationships. And not only does the staff want advisers to consider their own material business, professional, or other relationships with their proxy voting services, they want advisers to consider the business relationships that their affiliated persons have with the adviser’s proxy voting service.

Before you think the web of affiliation can’t reach too far, consider that U.K. adviser Hermes Pensions Management holds an 18 percent stake in ISS and has a representative on the ISS board. Warburg Pincus also owns a chunk of ISS and has two representatives on the ISS board. You can take it from there.

Lastly, Fund Lawyers, Take Note . . . The Egan-Jones letter imposes new disclosure obligations for funds. The staff said that, if applicable, a fund must disclose in its registration statement that an independent third party makes voting recommendations, or otherwise votes the fund’s proxies, and must disclose the policies and procedures used by the third party to vote the fund’s proxies.