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From Securities Regulation Daily, October 31, 2013

Gallagher discusses concerns about outsized influence of proxy advisory firms

By Jacquelyn Lumb

Commissioner Daniel Gallagher, in remarks to Georgetown University’s Center for Financial Markets and Policy, called for the SEC to withdraw two staff no-action letters which he said effectively gave a green light to investment advisers to vote the recommendations of proxy advisers without regard for potential conflicts of interest. Gallagher said he has grave concerns about whether investment advisers are fulfilling their fiduciary duties when they rely on the recommendations of proxy advisory firms. He also called for an examination of the thresholds for submitting shareholder proposals and the use of proxy votes as vehicles for social and political agendas.

Proxy advisers’ influence. Gallagher reviewed a number of studies which have documented the increasing influence of the two largest proxy advisory firms. He said the creation of this duopoly was a result of the two no-action letters that were issued after the SEC adopted new rules to require investment advisers that exercise voting authority over their clients’ proxies to adopt policies and procedures reasonably designed to ensure that the proxies are voted in the best interests of their clients.

Conflicts of interest. Gallagher explained that a key goal of the rule was to address potential conflicts of interest when voting a client’s securities on matters that affected an investment adviser’s own interests. The adopting release noted that an adviser could demonstrate that the vote was not in conflict with its own interests if the securities were voted in accordance with a pre-determined policy, based on the recommendation of an independent third party.

No-action letters. The proxy advisory firms sought guidance and clarity on the new rule and, in the first no-action letter, the staff said that an adviser that votes client proxies in accordance with a pre-determined policy based on the recommendations of an independent third party will not necessarily breach its fiduciary duty to its clients even though the recommendations may be consistent with the adviser’s own interests. The letter also advised that the fact that a proxy voting firm provided advice to an issuer and received compensation from the issuer for its services generally would not affect the firm’s independence from the investment adviser.

Rather than encouraging investment advisers to exercise their own judgment to address and minimize any potential conflicts of interest, the no-action letters enabled advisers to shift the responsibility to third parties that have their own conflicts of interest but none of the fiduciary duties and liability risks faced by advisers, Gallagher said. The two no-action letters unduly increased the role of proxy advisory firms in corporate governance, in Gallagher’s view.

Gallagher said the SEC should withdraw the two no-action letters and replace them with Commission-level guidance. The guidance should be designed to ensure that investment advisers comply with the original intent of the 2003 rule and are carrying out their fiduciary duties.

Gallagher said the SEC should review the role of proxy advisory firms and consider reform measures such as the adoption of universal codes of conduct, transparency about their methodologies, and assurance that conflicts of interest are addressed.

Proxy voting process. Gallagher also talked about the high costs of proxy voting and the use of the proxy process to further social, religious, or public policy purposes. He said the proxy process, including the thresholds for submitting shareholder proposals, would benefit from an economic analysis by the Division of Economic and Risk Analysis, particularly since the initial voting and resubmission thresholds were not subject to such a review.

Meanwhile, Gallagher encouraged investment advisers, including institutional investors, to focus on proxy advisers and whether their recommendations are designed to further their clients’ interests and goals.

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