SEC concept release: new rules - now what?

The SEC has been chewing over issues related to the way investors vote their shares in 
public companies for at least the last two decades. In July, following passage of Dodd-Frank, the commission voted unanimously to take a step toward modernizing the complex array of 
regulations governing the process.

In a 151-page concept release, the SEC spelled out how the proxy system operates and asked for comments on a wide range of regulatory issues aimed at helping it address one overarching question: does the system 
operate ‘with the accuracy, reliability, transparency, accountability and integrity that shareholders and 
issuers should rightfully expect?’

‘The proxy is often the principal means for shareholders and public companies to communicate with one another, and for shareholders to weigh in on issues of importance to the corporation,’ SEC chairman Mary Schapiro said prior to the vote. ‘To result in effective governance, the transmission of this communication must be – and must be perceived to be – timely, 
accurate, unbiased and fair.’

The concept release divided its call for comments into three broad areas, defined as follows: whether the SEC should take steps to enhance the accuracy, 
transparency and efficiency of the voting process; 
whether rules should be revised to improve shareholder communications and encourage greater participation; whether voting power is aligned with economic interest, and can SEC disclosure requirements provide investors with sufficient information about this issue?

First step
‘This isn’t the first time the commission has focused on these issues,’ notes Catherine Dixon, a partner at Weil Gotshal & Manges and former chief counsel of the SEC’s Division of Corporation Finance. ‘The concept release is, however, an important first step in a 
rule-making process that could result in fundamental 
changes to the way companies and shareholders 
communicate with each other.’

Particular criticism has been leveled at the system for counting and managing the votes of street name investors. That’s because the regulatory framework was created years before the explosion of electronic 
communications and the advent of complex equity hedging arrangements that can complicate the issue of who is considered the registered owner of a share.

The current system, notes Niels Holch, executive director of the Shareholder Communications Coalition (SCC), ‘wasn’t designed for the current needs of issuers and investors. It was created in a pre-internet world – a world where corporate governance didn’t have the same level of priority it has today.’

By issuing a concept release, the SEC is trying to ‘confirm that the market agrees there are concerns, and that those concerns warrant action,’ says William Davis, a partner in Baker & McKenzie’s Houston office. ‘It is trying to gauge people’s temperature before it starts changing things or even proposing to change them.’

Some of the more contentious elements of the 
commission’s concept release include the issue of 
intermediaries, share lending and voting. In the 1970s, a growing number of investors began buying stocks through broker-dealers, banks and other intermediaries, which held the stocks on their behalf in depositories. Issuers were no longer automatically made aware of the identity of the buyer of the stock. The SEC’s solution was to require these intermediaries to pass proxy 
materialsto their clients on behalf of issuers, obtain voting information and pass it back to the company.
In doing so, the SEC also created two categories of individual investors: those who consent to having their identities revealed to the companies whose stock they own, or non-objecting beneficial owners (NOBOs), and those who object to such a disclosure, dubbed objecting beneficial owners (OBOs).

This system has created several problems. For one thing, intermediaries often lend shares to other institutions (for a profit) for the purposes of short selling or other financial transactions. That can unwittingly result in them sending out proxy materials to two ‘owners’ for the same share, as the ownership is split between two clients at two different times; this can dilute vote counts and render them inaccurate, explains Holch. He and his SCC allies are advocating a ‘pre-vote reconciliation’ requirement that would have intermediaries ensure votes are not cast twice on the same shares.

Among the questions the SEC is asking are: what are the advantages and disadvantages and effectiveness of various methods used by securities intermediaries to reconcile votes? Is there evidence of over-voting and under-voting? Should investors who have paid the full price for securities be allocated voting rights over those who buy them on margin?

The SEC is also considering whether investors who themselves decide to lend out their shares should be notified earlier about the content of upcoming 
shareholder meetings. That would allow them to recall shares in time to be the shareholder of record granted the right to vote those shares at the meeting.

Mixed messages
Another thorny issue relates to how companies can communicate with their shareholders. The SCC is 
advocating eliminating the OBO/NOBO distinction, which would allow issuers to contact investors directly rather than having to go through intermediaries.

Many broker-dealers are opposed to the proposal, arguing that it would violate shareholders’ privacy rights. Holding a nominee name is more expensive and would essentially shift the cost of maintaining privacy from the issuer – which currently has to bear the cost of delivering proxy materials to a shareholder through a series of intermediaries – to the individual who wishes to remain anonymous. ‘The SEC has to balance a 
variety of very sensitive and, in some instances, potentially conflicting interests at work here,’ notes Dixon.

One area that’s sure to generate controversy should the SEC choose to propose changes is the role of proxy advisory firms in shareholder votes. ‘Both companies and investors have raised concerns that proxy advisory firms may be subject to undisclosed conflicts of interest, may fail to conduct adequate research, or may base 
recommendations on erroneous or incomplete facts,’ Schapiro said at the hearing, in explaining the rationale for probing this area.

In recent years, proxy advisory firms like RiskMetrics/ISS, Proxy Governance and Glass Lewis have emerged as powerful forces at annual meetings, even though they don’t own stock in the companies in question. Some of these proxy advisers offer governance ratings and voting recommendations that are widely 
followed by investors and have become a key tool for shareholder activists pushing for good governance 
standards. But while these firms are advising investors, they may also be offering consulting services to the 
companies they are rating – a potential conflict of interest, and a situation that is illegal in other industries.

Under scrutiny
In a June 2007 report from the General Accounting Office, the investigative arm of Congress, investigators noted that ‘the business model of the dominant 
advisory firm – Institutional Shareholder Services (ISS) – has been cited by industry participants and analysts as creating a significant potential conflict of interest. ISS advises institutional investor clients on how to vote their proxies and at the same time provides consulting services to help corporations develop management proposals and improve their corporate governance.’

ISS officials, the report notes, have said they have taken steps to help mitigate the problem, including publicly disclosing information about the potential 
conflict on the company’s website and requiring 
relevant disclosures to its institutional investor clients.

These and other questions are sure to generate reams of comment from the different players involved. In the end they could result in a dramatic overhaul, 
but such an outcome is months away.

‘The SEC just asked a lot of questions and threw out a lot of ideas on how the system might be changed. It is not taking a particular position yet on any of 
these issues,’ Dixon notes.