Proxy advisors: A regulatory lacuna

Last week, I posted about the SEC’s Proxy Roundtable, and in particular, the panel regarding proxy advisors.

As I mentioned at the time, one of the big issuer complaints about proxy advisors is that their recommendations may be erroneous – though of course, the definition of “error” is somewhat expansive and may include differences of interpretation.  Issuer advocates have long sought some regulatory/statutory ability to review and, if possible, force revisions to proxy advisor reports before they are published, a proposal that – as I previously noted - apparently has found some sympathy with at least Commissioner Roisman.

From my perspective, though, the most interesting aspect to all of this is that if proxy advisors do, in fact, include false statements (however defined) in their recommendations, it is not entirely clear whether and to what extent they are subject to federal sanction.

The most obvious place to begin is Rule 14a-9, which prohibits false or misleading statements in proxy solicitations, and has generally been interpreted to apply to negligent, as well as intentional, false statements.

The problem here is that it is not entirely clear that the voting recommendations of proxy advisors are proxy solicitations.  Glass Lewis, in its letter to the Senate Banking Committee, functionally concedes that they are; but ISS’s letter disputes that interpretation, and argues that voting recommendations by proxy advisors are not proxy solicitations.

If ISS is right, is there any prohibition on false statements?

Well, ISS says yes, at least for its own recommendations, because ISS is a registered investment advisor.  As such, it is subject to the antifraud provisions of the Investment Advisers Act, and is subject under that Act to a duty of care, including a duty to ensure the accuracy of its recommendations.

That’s fine as far as it goes, but Glass Lewis is not a registered investment advisor, because it disputes that proxy advice counts as investment advice.

What if they’re both right: voting recommendations are neither proxy solicitations nor investment advice?  Then neither 14a-9, nor the Investment Advisers Act, would apply to false statements in recommendations.*

We might then look to general prohibitions on false statements, articulated in Section 10(b) of the Exchange Act and Section 17 of the Securities Act.  The problem is, both of these statutes only apply to statements made in connection with securities transactions.  Proxy advisors, by definition, only provide voting advice, not advice regarding purchases and sales.  Now, that may not matter: Section 10(b), for example, has been broadly extended to situations where the speaker might reasonably anticipate its statements would be used in connection with securities transactions, even if they weren’t specifically intended for that purpose.  But then any legal action would focus on buying and selling rather than voting behavior.  So it’s an unsettling gap: If proxy advisors are only providing voting advice, and their statements are not proxy solicitations, is there any clear legal prohibition on falsity? 

My point is this: There’s a real ambiguity about where, if it all, proxy advisors fit within the existing regulatory framework, and while I am not convinced there is a specific problem with how they operate or even necessarily a need for regulation, I think it can only be for the good if the SEC were to at least clarify the law, if for no other reason than that these entities play an important role in the securities ecosystem, and if we expect market pressure to discipline them, potential new entrants should have an idea of the regime to which they will be subject.

So this is where I do think some action by the SEC would be helpful.  Certainly, the SEC can decide whether proxy advisors’ voting recommendations qualify as proxy solicitations, and whether their conduct qualifies as investment advice (which might render unnecessary the proposed Senate Bill that would require proxy advisors to register as investment advisors).  And if neither of these categories applies, the SEC might weigh in on whether and to what extent proxy advisors may be liable privately or subject to regulatory sanction for distributing false information in advance of an upcoming vote.  And that alone, leaving aside other issuer complaints, would probably be useful going forward.

*Why the divergence in views as to whether proxy advice counts as investment advice?  I assume the default is no one wants to claim a regulated status if they don’t have to, but ISS is particularly vulnerable to charges of conflict due to its consulting business; it may therefore feel that RIA status lends it an air of legitimacy that its clients find reassuring and that staves off additional regulatory pressure.