A Proxy Voting Primer for Uncertain Times
March 23, 2022
A proxy vote is a portfolio asset and an investment adviser that votes proxies on clients’ behalf must exercise care and loyalty in doing so. Where a private-sector employee benefit plan is involved, the adviser must satisfy additional obligations under the Employee Retirement Income Security Act of 1974 (ERISA).
In 2003, the SEC adopted Rule 206(4)-3 under the Advisers Act to address advisers’ obligations regarding proxy voting and companion rules and amendments under the Investment Company Act. In the years that followed, the Commission staff issued guidance regarding advisers’ use of proxy advisory firms to assist them in satisfying their fiduciary and regulatory obligations, while the staff of the DOL periodically issued its own proxy voting guidance under ERISA.
Starting in 2019, the SEC and DOL embarked on a course of action that sowed confusion in this area. In response to complaints from a segment of the issuer community about shareholder voting practices and the use of proxy advisory firms, the SEC issued two releases without notice and opportunity for comment. The first reclassified proxy advisers as “solicitors” for purposes of the federal proxy rules and subjected their advice, including “opinions, reasons, recommendations or beliefs” to potential liability under the proxy rules’ antifraud provision. The second (2019 Guidance) articulated proxy voting guidance for investment advisers, including a series of suggestions about the use of proxy advisers.[i]
The Commission followed these releases with formal rulemaking, codifying the reclassification of proxy advisers as solicitors and conditioning their exemption from the proxy rules’ information and filing requirements on their sharing their advice with issuers and facilitating the dissemination of issuers’ responses to clients. The Commission also issued supplemental guidance — again without notice and comment — addressing investment advisers’ duties around standing voting instructions and automated voting platforms in anticipation of increased issuer feedback about proxy advisers’ vote recommendations.[ii] Meanwhile, the DOL adopted a new proxy voting rule under ERISA, the text of which, coupled with statements in the preamble, gave the impression that even ordinary exercises of shareholder rights pose heightened risk for investment advisers.
Last year’s change of administration ushered in a new attitude toward proxy voting. Both the SEC and DOL instituted rulemakings to rescind portions of their 2020 rules and stayed enforcement of those rules in the interim. These proposals are pending, as is a lawsuit challenging the classification of proxy advisers as solicitors. A separate SEC proposal to enhance vote disclosure by funds and advisers is also pending.
This Compliance Corner explains various proxy voting requirements for investment advisers and suggests a practical approach to compliance for these uncertain times.
Requirements For Advisers and Investment Companies
Rule 206(4)-6 augments the fiduciary duties of care and loyalty with three requirements. First, an adviser that undertakes to vote client proxies must adopt written policies and procedures reasonably designed to ensure that proxies are voted in clients’ best interests. Second, the adviser must describe its proxy voting policies and procedures to clients and provide a copy of the same upon request. Finally, the adviser must tell clients how they can obtain information about how their individual shares were voted.
Registered investment companies have their own set of voting requirements. In addition to describing their proxy voting policies and procedures in their registration statements, funds are obliged to annually report on Form N-PX how they voted proxies relating to their portfolio securities.[iii]
Last year, the Commission proposed extensive revisions to Form N-PX to greatly expand the type of information funds report and alter the manner in which that information is displayed.[iv] In addition, the Commission proposed to require institutional investment managers subject to Exchange Act Section 13(f) to use Form N-PX to report their advisory say-on-pay votes, as authorized by the Dodd-Frank Act. These proposals are pending.
Requirements For ERISA Plans
An adviser that has the power to manage ERISA plan assets also has the exclusive authority to vote proxies appurtenant to those assets unless that authority has been expressly reserved to the named fiduciary or assigned elsewhere. In voting proxies for an ERISA plan, an adviser must act prudently and solely in the interests of the plan’s participants and beneficiaries. In 2020, the DOL codified these obligations in an amendment to ERISA Rule 404a-1 and adopted additional requirements obliging fiduciaries to vote proxies solely in the economic interest of the plan, participants and beneficiaries; not to subordinate the interests of participants and beneficiaries in their retirement income or financial benefits under the plan to non-pecuniary objectives; to consider the costs involved in proxy voting; and to exercise prudence and diligence in selecting and monitoring proxy advisers and related service providers.[v] As discussed below, the DOL has proposed to rescind other requirements imposed in the 2020 amendment that it deems hostile to plans’ exercise of their shareholder rights.
A Practical Approach to Compliance
Determining Whether to Vote
An investment adviser has no duty to vote proxies on clients’ behalf unless it has explicitly or implicitly agreed to do so. In the 2019 Guidance, the Commission suggested ways an adviser might limit the scope of its voting authority based on full and fair disclosure and informed consent. For example, the adviser and client could agree that the adviser will vote on only certain types of proposals, such as mergers, acquisitions, or contested director elections; that it will not recall securities out on loan for purposes of voting the loaned shares; or that it will not vote unless doing so is reasonably expected to have a material effect on the value of the client’s investment.
The 2020 amendments to ERISA Rule 404a-1 contain similar “safe harbors,” along with an explicit statement that fiduciary duty does not entail an absolute duty to vote every proxy.[vi] The DOL has proposed to eliminate all of these provisions out of concern that they might encourage plan fiduciaries to be indifferent to the exercise of shareholder rights.[vii] However, in doing so, the DOL confirms that proxies need not be voted if voting entails significant costs or if voting is otherwise not in the plan’s best interest. This principle applies under the Advisers Act as well.
While navigating this regulatory maze can be challenging, there are some steps you can take to minimize compliance risk. First, ensure that you understand the scope of your proxy voting authority for each client. Voting limits should be clearly documented and remember that you cannot waive voting responsibility for an ERISA client altogether unless another party has assumed it.
Second, ensure that your policies address how to determine whether the costs of voting outweigh the benefits in a particular situation. While you should generally be mindful of the costs of proxy voting, you are not obliged to conduct a cost-benefit analysis for each vote. Abstaining from voting is not a neutral act, so make sure to consider the costs of not voting, too. Public companies are more likely to adopt practices that maximize shareholder value when they know shareholders are watching and are willing to speak up.
Determining How to Vote
The duty to act in each client’s best interest may prevent you from taking a one-size-fits-all approach to proxy voting. Short-term investors and long-term investors have different voting interests, as do social values investors and investors who focus solely on maximizing their return. Proxy votes for ERISA plans cannot be used to promote benefits or goals unrelated to participants’ and beneficiaries’ financial interest, but the DOL has proposed to confirm that they may reflect environmental, social, and governance factors that constitute material economic considerations for a plan’s investment.[viii]
In addition to tailoring votes to clients’ various investment objectives and strategies, you must also take reasonable steps to ensure that you do not base voting decisions on materially inaccurate or incomplete information. Your proxy voting policies and procedures should address your sources of information and the level of analysis you use for various issues. Issues like mergers, acquisitions and contested director elections typically merit more scrutiny than routine matters do.
Your policies and procedures must also address how you handle material conflicts between your interests and those of your clients. Conflicts might arise, for example, where you have a business or personal relationship with a company whose management is soliciting proxies, participants in a proxy contest, or candidates for corporate directorships.
Satisfying these fiduciary and regulatory obligations can be daunting, especially for institutional investors who must analyze and vote thousands of ballot issues in a compressed proxy season. To ease the burden, you might engage a proxy advisory firm for research and analysis, vote recommendations, and/or assistance with the mechanics of voting, including vote execution and reporting. In some cases, proxy advisers analyze ballot issues based on an investor’s custom voting guidelines, while in other cases, vote recommendations are based on the proxy adviser’s benchmark or thematic voting guidelines, as the adviser selects.
Hiring and Monitoring Proxy Advisory Firms
Although a proxy adviser can help you fulfill your proxy voting obligations, you cannot outsource your fiduciary or regulatory duties. Thus, as is the case with any service provider, you must conduct reasonable due diligence on the proxy adviser and must monitor the proxy adviser’s activities on an ongoing basis.
In this regard, you should make a reasonable inquiry into the adequacy and quality of the proxy adviser’s staffing and technology, the manner in which it formulates its methodologies, its sources of information, its data integrity and error correction practices, and its mechanisms for alerting clients about changes in vote recommendations based on the receipt of additional information, including information from issuers.
The independence of proxy voting advice should also be assessed. You should have a thorough understanding of the proxy adviser’s business and the nature of the conflicts of interest that business presents and should assess whether the firm’s conflict procedures adequately address those conflicts. In addition, you should assess whether the proxy adviser provides context-specific disclosure of relationships with issuers, shareholder proponents and other interested parties, and if so, whether that disclosure is easily accessible.
Another area warranting attention is the proxy adviser’s treatment of material non-public information, including investors’ portfolio holdings and non-public information about how you intend to vote clients’ securities. This is particularly important if you use standing voting instructions that allow votes to be pre-populated into the proxy adviser’s voting platform.
If you do use standing instructions, address that fact in your policies and procedures and disclose it to clients. While this feature facilitates efficient voting and reduces cost, it is not an excuse to “robo-vote.” Review a sample of pre-populated votes on routine ballot issues to confirm that the votes align with the applicable guidelines and review particularly contentious matters more thoroughly.
Finally, because a proxy adviser’s business and/or conflicts could change over time, make sure to monitor the proxy adviser’s integrity and competence on an ongoing basis. This might include periodic certifications of compliance with applicable laws and the proxy adviser’s policies and procedures, periodic meetings with key personnel, and notification of material changes to information previously supplied.
Documentation and Testing
Like any other investment advisory function, proxy voting entails ancillary administrative duties, including recordkeeping and compliance testing. On the recordkeeping front, you must maintain: (i) proxy voting policies and procedures; (ii) all proxy statements regarding client securities; (iii) a record of each vote cast on clients’ behalf; (iv) any documents you create that either are material to making a voting decision or that memorialize the basis for that decision; and (v) all written client requests for information on how proxies were voted and all responses to requests for voting information.[ix] You may rely on third parties such as proxy advisers and the EDGAR system to store some of these records. Be sure to document your due diligence of any proxy adviser you engage, as well.
ERISA Rule 404a-1 has its own recordkeeping requirement, but the DOL proposes to eliminate this provision because the fiduciary duty of prudence already entails such an obligation.[x] The DOL believes that articulating this duty in the context of proxy voting gives the false impression that fiduciaries have heightened burdens in this area.
As for compliance testing, make sure you monitor every step of the process. In addition to confirming voting authority and the selection of voting guidelines that are in each client’s best interest, periodically ensure that you have adequately disclosed your proxy voting practices, including, where applicable, the use of proxy advisers and standing voting instructions.
Also confirm that you have not missed votes and that your voting decisions (including decisions not to vote) align with applicable voting guidelines unless you document a conscious decision to deviate from those guidelines. You do not have to review every vote; examining votes on any particularly consequential or contentious issue, and a meaningful sample of the rest, should suffice. If you utilize a proxy advisory firm, undertake the additional monitoring discussed above. Finally, confirm that you have responded to any client requests for voting information and have satisfied any applicable Form N-PX reporting requirements. Testing your proxy voting practices should be integrated into your annual compliance review and documented accordingly.
Conclusion
Although the SEC and DOL are still refining their respective proxy voting requirements, the compliance approach outlined above should serve you well, however the regulatory winds may blow.
*Mari-Anne Pisarri is a Partner at Pickard Djinis and Pisarri LLP, a Washington, D.C. boutique law firm that specializes in securities regulatory matters, including proxy voting. She can be reached at 202.223.4418 or mpisarri@pickdjin.com.
Note: The author represents a party in a pending lawsuit challenging the SEC’s recent proxy rules.
This article is for general information purposes and is not intended to be and should not be taken as legal or other advice.
[i] Commission Guidance Regarding Proxy Voting Responsibilities of Investment Advisers, SEC Rel. Nos. IA-5325 and IC-33605 (Aug. 21, 2019), 84 Fed. Reg. 47420 (Sep. 10, 2019).
[ii] Supplement to Commission Guidance Regarding Proxy Voting Responsibilities of Investment Advisers, SEC Rel. No. IA-5547 (July 22, 2020), 85 Fed. Reg. 55155 (Sep. 3, 2020).
[iii] Forms N-1A, N-2, N-3 and N-CSR [Referenced in 17 CFR 274.11A, 274.11a-1, 274.11b and 274.128, respectively], and Rule 30b1-4 under the Investment Company Act.
[iv] Enhanced Reporting of Proxy Votes by Registered Management Investment Companies; Reporting of Executive Compensation Votes by Institutional Investment Managers, SEC Rel. Nos. 34-93169 and IC-34389 (Sep. 29, 2021), 86 Fed. Reg. 57478 (Oct. 15, 2021).
[v] Fiduciary Duties Regarding Proxy Voting and Shareholder Rights, 29 CFR Part 2550, RIN 1210-AB91 (Dec. 11, 2020), 85 Fed. Reg. 81658 (Dec. 16, 2020).
[vi] Rule 404a-1(e)(2)(ii) and (e)(3)(i).
[vii] Prudence and Loyalty in Selecting Plan Investments and Exercising Shareholder Rights, 29 CFR Part 2550, RIN 1210-AC03 (Oct. 7, 2021), 86 Fed. Reg. 57272, 57282 (Oct. 14, 2021).
[viii] Proposed Rule 404a-1(d)(2)(ii)(A).
[ix] Advisers Act Rule 204-2(a)(c)(2).
[x] Rule 404a-1(e)(2)(ii)(E); 86 Fed. Reg. at 57281-82.