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SEC Releases Guidance to Clarify Investment Advisers’ Proxy Voting Responsibilities and Interpretation of Proxy Rules to Voting Advice

At an open meeting held on August 21, 2019 (the “Meeting”), the Commissioners of the Securities and Exchange Commission (SEC) issued guidance (the “Guidance”), by a 3-2 vote, to assist investment advisers when conducting proxy votes on behalf of clients. Among other matters, the Guidance explained how investment advisers can establish a variety of different voting arrangements with clients, including determining matters advisers should consider when using a proxy advisory firm. The Guidance emphasized, however, that proxy voting advisers must act consistently with their fiduciary duties and best interest obligations under the Investment Advisers Act Rule 206(4)-6 (“Rule 206(4)-6”), especially when using a proxy advisory firm. In addition, the SEC issued an interpretation explaining, among other things, that proxy voting advice provided by proxy advisory firms generally constitutes a “solicitation” under the federal proxy rules (the “Interpretation”). The Guidance and Interpretation are effective immediately. We therefore recommend that advisers take steps promptly to conform their policies and procedures accordingly.

In question and answer format, the Guidance responded to the following six topics:

  1. the scope of the investment adviser’s authority and proxy voting responsibilities;
  2. the steps to take to demonstrate voting determinations are made in a client’s best interest and in accordance with proxy voting policies and procedures;
  3. considerations to take into account when retaining a proxy advisory firm;
  4. the steps to take in response to potential factual errors, incompleteness, or methodological weaknesses in the proxy advisory firm’s analysis;
  5. the considerations to evaluate a proxy advisory firm’s subsequent material changes in services or operations; and
  6. how to determine whether an investment adviser must vote every proxy. 

The Guidance and Interpretation will impose significant new responsibilities and administrative burdens on investment advisers. They include, at a minimum, a comprehensive review of the adviser’s current compliance policies and procedures regarding proxy voting, including with respect to the adviser’s use of a proxy advisory firm and associated oversight, diligence and reporting/notification processes and procedures.

Proxy Voting Responsibilities of Investment Advisers

The SEC reiterated that when assuming voting authority on behalf of clients, investment advisers owe each client a duty of care and loyalty and must adhere to Rule 206(4)-6. Rule 206(4)-6 requires an investment adviser exercising voting authority to adopt and implement written policies and procedures that are reasonably designed to ensure that the investment adviser votes proxies in the best interest of its clients. The Guidance highlighted how investment advisers can fulfill these responsibilities, particularly when using a proxy advisory firm’s services. The questions and responses provided in the Guidance are discussed below.

Question 1: What is the Scope of the Investment Adviser’s Authority and Responsibilities to Vote Proxies on Behalf of a Client?

According to the Guidance, an investment adviser is not required to accept the authority to vote on a client’s behalf. If an investment adviser does accept voting authority, it may enter an agreement outlining the scope of the adviser’s authority and responsibilities to vote proxies on the client’s behalf. Each adviser’s arrangement may vary in scope, but the adviser’s relationship with the client, in all cases, remains that of a fiduciary. The Guidance lists several non-exhaustive examples of possible voting arrangements:

  • Vote within specific parameters designed to serve the client’s best interest, such as

    • voting in accordance with the voting recommendations of management of the issuer, or

    • voting in favor of all proposals made by particular shareholder proponents;

  • Refrain from voting when voting imposes costs on the client, such as

    • opportunity costs from restricting the use of securities for lending to preserve the right to vote;

  • Vote resources on particular proposals based on specific client preferences, such as

    • proposals relating to corporate events (e.g., mergers and acquisition transactions, dissolutions, conversions, or consolidations), or

    • contested elections for directors; or

  • Refrain from voting when the cost of voting would be high, or the benefit to the client would be low, such as

    • voting on a foreign security that could involve the costs of hiring a translator or traveling to a foreign country, or

    • voting when it would not reasonably be expected to have a material effect on the value of the client’s investment. 

Question 2: What Steps Could an Investment Adviser Take to Show It Is Making Voting Determinations in a Client’s Best Interest and in Accordance with Proxy Voting Policies and Procedures?

An investment adviser could take the following steps, among other things, including considering:

  • how its fiduciary duty and its obligations under Rule 206(4)-6 apply when it has multiple clients, and whether having one uniform voting policy or different voting policies for some or all of its clients would be in the best interest of each;

  • whether certain matters may require a more detailed analysis than what the application of general voting guidelines would require, particularly regarding matters such as merger and acquisition transactions, dissolutions, conversions, consolidations or contested elections for directors;

  • reasonable measures taken to determine that the investment adviser’s voting is consistent with its voting policies and procedures and in the client’s best interest, including sampling proxy votes as part of an annual review of compliance policies and procedures. Additional steps that could be taken when retaining a proxy advisory firm to evaluate its compliance include:

    • Sampling Pre-Populated Votes: assessing “pre-populated” votes on a proxy advisory firm’s electronic voting platform before such votes are cast;

    • Consideration of Additional Information: considering additional information that may become available, which may include an issuer’s or a shareholder proponent’s subsequently filed additional definitive proxy materials or other information conveyed by an issuer or shareholder proponent to the investment adviser that would reasonably be expected to affect the investment adviser’s voting determination; and

    • A Higher Degree of Analysis: considering whether a higher degree of analysis may be necessary or appropriate for matters where the investment adviser’s voting policies and procedures do not address how it should vote on a particular issue or where the matter is highly contested or controversial. 

An adviser must review and document, no less frequently than annually, the adequacy of its voting policies and procedures to ensure that they have been reasonably designed for the adviser to cast votes in the best interest of its clients.

Question 3: What Should an Investment Adviser Consider When Retaining a Proxy Advisory Firm?

Generally and in accordance with the SEC Guidance, when retaining a proxy advisory firm, an investment adviser should consider, among other things, whether the proxy advisory firm has the “capacity and competency to adequately analyze” the applicable voting matters, which includes considering a proxy advisory firm’s staffing, personnel and technology. Although the level of the adviser’s review would depend on the particular arrangement with the proxy advisory firm, other considerations to take into account include:

  • The proxy advisory firm’s process for seeking timely input from its issuers and its clients regarding the firm’s proxy voting policies, methodologies, and peer group constructions, including for “say-on-pay” votes;
  • The information the proxy advisory firm considers in constructing peer groups, including the unique characteristics of the issuer, such as its size, governance structure, industry group, history and financial performance; and
  • The proxy advisory firm’s policies and procedures for recognizing and addressing conflicts of interest. 

Question 4: What Should an Investment Adviser Consider after Becoming Aware of Potential Factual Errors, Incompleteness or Methodological Weaknesses in a Proxy Advisory Firm’s Analysis?

An investment adviser’s policies and procedures should be reasonably designed to ensure that its voting determinations are not based on materially inaccurate or incomplete information. According to the SEC Guidance, an adviser could consider including an evaluation of the extent to which potential factual errors, incompleteness or methodological weaknesses in the proxy advisory firm’s analysis could materially affect the proxy advisory firm’s research or recommendations. An investment adviser could also consider, among other things, the proxy advisory firm’s:

  • engagement with issuers, including the firm’s process for ensuring that it has complete and accurate information regarding the issuer and each particular matter;

  • efforts to correct any identified material deficiencies in the proxy advisory firm’s analysis;

  • disclosure of the sources of information and methodologies used in formulating voting recommendations or executing voting instructions; and

  • consideration of factors unique to a specific issuer or proposal for a matter subject to a shareholder vote.

Question 5: How Can an Investment Adviser Subsequently Evaluate the Services of a Proxy Advisory Firm? 

Since a proxy advisory firm’s business and policies and procedures could change after an investment adviser’s initial assessment, the Guidance suggests advisers could consider performing assessments of the firm on an ongoing basis. As part of this assessment, investment advisers could consider requiring updates regarding relevant business changes, methodology changes, changes in guidelines, changes in voting recommendations, and other changes made in response to feedback from issuers and their shareholders.

Question 6: Must an Investment Adviser Exercise Every Opportunity to Vote a Proxy for a Client? 

According to the SEC Guidance, an adviser is not required to vote every client proxy if:

  • an adviser and client have agreed in advance to limit the conditions under which the investment adviser would exercise voting authority; or
  • an investment adviser has determined that refraining from voting is in the best interest of the client, as long as this is consistent with the adviser’s duty of care.

Applicability of the Federal Proxy Rules to Proxy Voting Advice

The SEC Interpretation (i) clarified that proxy voting advice constitutes a “solicitation” under the federal proxy rules and (ii) applied Rule 14a-9 under the Securities and Exchange Act of 1934, as amended (the “Exchange Act”) to the services and activities of proxy advisory firms. The SEC Interpretation determined that proxy voting advice is a “communication to security holders under circumstances reasonably calculated to result in the procurement, withholding or revocation of a proxy.” The Interpretation, however, does not change the ability of proxy advisory firms to rely on the exemptions under Rule 14a-2(b) from the proxy rules’ information and filing requirements.

The Interpretation also noted that any person engaged in a solicitation through proxy voting advice must not make materially false or misleading statements or omit material facts in order to avoid the potential violation of Rule 14a-9.

Practice Points and Tips

According to the SEC Guidance and Interpretation, the questions, answers and associated examples were provided to help facilitate investment advisers’ compliance with their proxy voting responsibilities. The SEC cautioned, however, that these examples were not exhaustive nor were they the only way by which investment advisers could comply with their fiduciary duties of care and loyalty imposed by the Investment Advisers Act. Investment advisers and proxy advisory firms will be required under the Guidance to perform a comprehensive review of their policies, procedures and practices on a client-by-client basis in light of the newly released Guidance and Interpretation in advance of the upcoming proxy season.

Investment Advisers. We believe that the Guidance and Interpretation are likely to have significant ramifications for advisers and, potentially, their clients. At a minimum, advisers will need to perform a documented review of their proxy voting policies for each client. For funds, this means that each fund’s investment objective and strategies must be considered. It is therefore possible that funds’ proxy voting policies could differ as between funds with equity, fixed-income, indexed, environmental, social and governance (ESG) and other kinds of strategies. Many advisers currently have one set of proxy voting policies that apply to multiple types of clients. It is possible under the Guidance for an adviser to maintain one uniform set of policies; however, in that case, advisers would need to document why the policies are in the best interests of each client.

Advisers that rely on proxy advisory firms for advice and recommendations will need to reevaluate their processes with respect to these firms. They will need to develop fairly extensive procedures for investigation of the firms’ policies and processes and rationale for their recommendations. The review should address the firm’s source of information for its recommendations and the firm’s potential conflict of interest. In addition, advisers will need to perform more extensive oversight of the firms. With respect to some particularly controversial issues, a “higher degree of analysis” may be necessary by the adviser to assess the best interests of clients.

Advisers will also need to examine particular situations in which they should either refrain from or limit voting. These situations should be carefully documented in the adviser’s records. Funds are required to disclose in their statements of additional information or on Form N-CSR, as applicable, proxy voting policies and procedures. In addition, if an adviser accepts authority to vote client securities, an adviser must explain in its Form ADV how a client can obtain a copy of its proxy voting policies and procedures upon request.

Proxy Advisory Firms. The Interpretation will place new material obligations on proxy advisory firms. Specifically, proxy advisory firms will need to establish detailed policies and procedures to ensure that their recommendations are accurate and complete in all material respects. Application of the anti-fraud provisions of Rule 14a-9 to proxy advisory firms’ operations could have a significant impact on how proxy advisory firms operate going forward and the kinds of recommendations they make. Application of the solicitation rules under Regulation 14a of the Exchange Act may likewise impact proxy advisory firms’ operations. In addition, the solicitation requirements of Schedule 14A may subject the proxy advisory firms to certain disclosure requirements unless they can qualify for certain existing exemptions.

Compliance. We believe that fund and adviser compliance officers will play a significant role in implementing and overseeing updated proxy voting policies and procedures and in the diligence and continued oversight of the use of proxy voting firms.

Fund Boards. Fund boards already are responsible for reviewing proxy voting reports and fund proxy voting policies and procedures, which in most cases are delegated to the adviser. The board will need to oversee the development of the adviser’s new policies and procedures to comply with the Guidance, including making determinations with respect to each fund.

©2019 Drinker Biddle & Reath LLP. All Rights Reserved

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About this Author

Dianne McCarthy, investments attorney, Drinker Biddle
Partner

Diana E. McCarthy focuses on representations of registered investment companies, including exchange-traded funds, and their independent boards of directors, investment advisers and other financial services companies. She has counseled with respect to multiple class funds, funds of funds, multi-manager funds and funds serving as underlying investment vehicles for variable insurance products. Diana is a partner in the firm’s Investment Management Group.

Diana regularly advises investment advisers on their day-to-day operations,...

215-988-1146
Joshua B. Deringer, Investment Management, Attorney, Drinker Biddle, Law firm
Partner

Joshua B. Deringer counsels a wide range of national and international financial service companies involved in all aspects of the investment management industry, including registered investment companies, hedge funds and other alternative investment vehicles, as well as investment advisers. He is chair of the Investment Management Practice Group and a managing partner of the firm.

Josh has extensive experience in organizing, counseling and reorganizing open- and closed-end investment companies. His clients include multi-series and multi-class mutual funds, registered fund of funds, multi-manager funds and exchange-traded funds. Josh also has substantial experience counseling boards of directors and related parties on: fund governance; fiduciary duties; best practices; compliance policies and procedures; and regulatory investigations and inspections. He has worked closely with regulators on a broad range of issues and products.

Josh’s practice also focuses on advising domestic and offshore hedge funds and private equity funds in planning, funding and structuring strategies (including documentation and agreements) and their day-to-day operations. He also has experience with the organization, day-to-day operations and mergers and acquisitions of investment advisers. Josh counsels them on a wide range of matters, including investment, regulatory and compliance issues such as SEC investigations and inspections, compliance policies and procedures, contract reviews, advertising, soft dollars, trade allocation and valuation of securities.

Josh speaks at securities law conferences and is a widely published author; he has written many articles on investment management industry topics, and regularly comments on developments in financial services and investment management for industry and business publications.

215-988-2959
Gloria Liu,Investment attorney, Drinker Biddle
Associate

Gloria Y. Liu counsels clients in the investment management industry, including investment companies and investment advisers. She has prepared registration statements and has handled securities filings and other compliance matters.

During law school, Gloria interned with the Enforcement Division of the SEC. She was also a summer associate with Drinker Biddle in 2017 and served as a judicial intern through the Sonia and Celina Sotomayor Judicial Internship Program in Brooklyn, NY. Prior to law school, she was a corporate accountant with a...

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