January 12, 2011

SEC Issues Concept Release on the U.S. Proxy System

Holland & Knight Alert
Patrick C. Emans

In an effort to conduct a broad review of the U.S. proxy system, the SEC issued a Concept Release on the U.S. Proxy System on July 14, 2010.1 The SEC, through the concept release, sought comments to help it review “whether the U.S. proxy system as a whole operates with the accuracy, reliability, transparency, accountability, and integrity that shareholders and issuers should rightfully expect.”

The SEC cited the following reasons for reviewing the U.S proxy system:

  • technological advances
  • commentators’ complaints about the administration of the proxy system
  • changes in the NYSE voting rules
  • changes in the nature of stock ownership in the U.S.
  • increased third-party participation in the proxy system

The SEC sought comments that address the entire U.S. proxy system, but the SEC specifically identified the following three main concerns in the concept release:

  1. accuracy, transparency and efficiency of the proxy voting process
  2. communications and investor participation in the proxy voting process
  3. relationship between voting power and economic interest

Background

The U.S. proxy system is the framework that enables investors to vote over 600 billion shares per year. The process of issuers distributing proxy materials to investors, voting by investors and tabulation of the votes seems straightforward, but the use of third parties by both investors and issuers complicates the process.

Today, the process to send an issuer’s proxy materials to a registered owner is fairly simple because the issuer or its transfer agent maintains records of investors’ names and addresses. However, if the issuer is attempting to distribute proxy materials to a beneficial owner, the process is complicated by the use of third-party securities intermediaries that are positioned between the issuer and the beneficial owner. Many issuers (and some large investors) utilize the services of the following third-party securities intermediaries to aid in the proxy process:

  • brokers
  • banks
  • securities depositories
  • transfer agents
  • proxy solicitors
  • proxy service providers
  • proxy advisory firms
  • vote tabulators

While third parties may aid issuers and investors in the proxy process, the SEC is concerned that the proxy system is not as accurate and transparent as it should be. Accordingly, the SEC sought comments in order to improve the entire proxy system.

Accuracy, Transparency and Efficiency of the Voting Process

Over-Voting and Under-Voting of Securities

Securities intermediaries’ current clearance and settlement systems are unable to attribute securities held by an intermediary to a particular investor. This inability to attribute securities may lead to over-voting or under-voting when a securities intermediary loans an investor’s securities or credits an investor’s account with securities purchased before the intermediary actually possesses the securities. To prevent over- voting or under-voting, securities intermediaries utilize different reconciliation and allocation methodologies to balance the number of securities the intermediary actually possesses with the number of securities credited to the investors’ accounts. As a result, investors may not be able to vote every security they own. The SEC sought comments that address:

  • whether over-voting or under-voting is a major problem
  • whether the SEC should require securities intermediaries to disclose its reconciliation or allocation method to investors
  • whether the SEC should require securities intermediaries to use a particular reconciliation or allocation method
  • whether the current clearance and settlement system creates inefficiencies or problems in the proxy system

Vote Confirmation

The release discusses the SEC’s concerns regarding the inability of investors and issuers to confirm that their securities have been properly voted. This problem is caused by the lack of information sharing among third-party securities intermediaries, which results in no single entity possessing all of the required information for an investor or issuer to confirm that their shares have been properly voted. Accordingly, the SEC sought comments on whether or not to require third-party securities intermediaries to share information with each other for the limited purpose of allowing investors and issuers to confirm their shares were properly voted.

Proxy Voting by Institutional Securities Lenders

Institutional investors frequently lend their securities in order to receive additional income instead of allowing the securities to sit idle in their portfolios. When an institutional investor lends its securities, it transfers all incidents of ownership, including its voting interests, to the borrower. As a result, the institutional investor loses its voting interests in the securities unless the institutional investor cancels the loan and recalls the securities before the record date. However, institutional investors rarely can determine what issues are being voted on before the record date. Accordingly, institutional investors must rely on informal means to determine whether they should cancel the loan and recall their securities before the record date. As a result, the SEC sought comments addressing possible methods of disseminating meeting information to investors in advance of the record date in order to provide investors who have loaned their securities with enough time to recall their securities.

In addition, the release addresses the disclosure of voting history by mutual funds. In 2003, the SEC began requiring mutual funds to disclose how they voted. But when mutual funds loan their securities (“loaned securities”), they also loan the voting interests associated with those securities. As a result, mutual funds may not be providing an accurate report of how they voted if the mutual fund has a large number of loaned securities because the mutual fund does not have to disclose how loaned securities voted. Accordingly, the SEC sought comments as to whether mutual funds should be required to disclose the number of securities it voted, ignoring loaned securities, along with how the mutual fund voted.

Proxy Distribution Fees

Exchange rules require broker-dealers and banks to provide proxy materials received from an issuer to the beneficial owners. However, the broker-dealers’ or banks’ obligation to supply the proxy materials is contingent upon the issuer providing “reimbursement of the broker’s or dealer’s reasonable expenses.” Currently, the reimbursement amount is based on guidance from the broker’s or intermediary’s self-regulatory organization. Oftentimes the reimbursement amount is equal to the NYSE fee structure rates because most brokers or intermediaries are members of the NYSE. Although there are regulations addressing fees, issuers frequently complain about the fee structure. In response to these complaints, the SEC sought comments that address:

  • whether current fees are reasonable
  • whether fees prevent issuers from communicating with beneficial owners
  • whether fees should be deregulated
  • whether current proxy service providers are efficient

Communications and Investor Participation

Issuer Communications With Investors

Today, issuers struggle with determining the identity of their security holders because beneficial owners hold securities in “street name” only and may object to having their name disclosed (“objecting beneficial owner”) to an issuer. However, issuers believe that they need more direct communication with their investors and want to be able to access their beneficial owners’ information. In order to evaluate this conflict between objecting beneficial owners and issuers, the SEC sought comments that address:

  • whether the SEC should eliminate the objecting beneficial owner status
  • whether beneficial owners have a legitimate privacy interest with respect to the disclosure of their ownership positions
    • f beneficial owners do have a legitimate privacy interest, how the investor’s privacy right should be balanced against an issuer’s interest in identifying and communicating with its investors
  • whether there are technological solutions that could facilitate communication without revealing the investor’s identity

Means to Facilitate Retail Investor Participation

Historically, retail investors have low participation levels in the proxy voting process. For this reason, the SEC is reviewing methods to increase retail investor participation in the proxy voting process. The release contemplates the use of brokers’ and issuers’ websites to provide proxy information to retail investors. Additionally, the release addresses the benefits and drawbacks of allowing retail investors to provide advance voting instructions to their brokers. For example, a retail investor could instruct his or her broker to always vote the securities in accordance with the board’s recommendations. In addition, the release addresses whether the “notice and access” model adopted by the SEC in 2007 is contributing to the reduction in retail investor participation. To help formulate methods that will help increase retail investor participation, the SEC sought comments that address:

  • what steps should be taken to encourage retail investor participation
  • whether increased investor education would be helpful
  • whether issuers or brokers should enhance their websites to provide more information to investors
  • whether advance voting instructions should be allowed
  • whether the “notice and access” model is contributing to the reduction in retail investor participation
  • what changes should be made to the “notice and access” model

Data-Tagging Proxy-Related Materials

Although the SEC requires many filings to be translated into interactive data, the SEC neither requires nor permits proxy statements and voting information to be in interactive data format. For a document to be interactive, it must be tagged using computer language that can be processed by software for analysis. In order to increase investors’ ability to analyze proxy statements and voting information, the SEC sought comments as to whether it should require issuers to provide proxy statements and voting information in interactive data format.

Relationship Between Voting Power and Economic Interest

Proxy Advisory Firms

By providing recommendations to investors and consulting services to issuers, proxy advisory firms have a great deal of influence over the U.S. proxy system. Because of this influence, the SEC has the following concerns:

  • Proxy advisory firms may have too much power over investor voting because these firms are able to control or influence voting without an economic interest in the issuer.
  • Investors may be misled by the proxy advisory firms’ failure to disclose its potential conflicts of interests that may arise because the proxy advisory firm provides services to both investors and issuers.
  • Proxy advisory firms may use inaccurate or incomplete data when making voting recommendations.

As a result, the SEC sought comments on whether it should change the disclosure requirements of potential conflicts of interest by proxy advisory firms and whether the SEC should require proxy advisory firms to disclose what research the firm has conducted in regards to a particular voting recommendation.

Dual Record Dates

Since the record date is days before the voting date, voting and economic interest may not be properly aligned if any changes in securities ownership occur between the record date and the voting date. For example, if an owner of securities sells his or her securities after the record date, but before the voting date, he or she still has the voting interests associated with the securities sold. To address this failure to align voting power with economic interest, some states have allowed the use of dual record dates. Instead of using the same record date for the notice of a shareholder meeting and for shareholder voting purposes, dual record dates allow two separate determinations by an issuer. By using dual record dates, an issuer may set the record date closer to the meeting or actual voting date, which reduces the chances that the investor will no longer have an economic interest in the issuer.

The SEC sought comments on the following:

  • whether issuers want to use dual record dates
  • whether the SEC should take actions that encourage or discourage the use of dual record dates
  • whether investors would receive the appropriate disclosure documents in a timely manner if dual record dates were used

“Empty Voting” and Related “Decoupling” Issues

The ability of investors to separate a securities’ voting interest from the securities’ economic interest is called empty voting and decoupling. Empty voting is where the votes have no underlying economic interest in the securities voted, or when investors hedge their investment in an issuer or vote with borrowed securities. Here, decoupling refers to the separation that occurs when the economic interests are separated (or decoupled) from the voting interests. Because empty voting and decoupling may result in former security holders, hedgers or securities borrowers being able to vote on securities without an underlying economic interest, the SEC sought comments that address:

  • whether to require investors to disclose on their voting information form that they have full economic interest in the securities voted
  • whether to only allow voting by persons who possess pure long positions (interests not hedged or shorted)
  • whether to prohibit empty voting
  • whether rule changes are needed to provide more disclosure and transparency to decoupling

Conclusion

Comments in response to the Concept Release are currently available on the SEC’s website.2 As of the date of this alert, no new or amended rules have been proposed or adopted in response to the Concept Release. However, issuers should continue to watch for new or amended rules promulgated in response to the Concept Release.


 
1
Release 34-62495 (July 14, 2010), available at: http://www.sec.gov/rules/concept/2010/34-62495.pdf 

2 Comments on Concept Release on the U.S. Proxy System, available at: http://www.sec.gov/comments/s7-14-10/s71410.shtml.

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