Regulatory Policy

SEC Mulls a Step Backward on Corporate-Governance Oversight

(Jonathan Ernst/Reuters)
Biden's SEC chairman has indicated he will look the other way on potential conflicts of interest at proxy-advisory firms.

Although spun as a win for investors, SEC Chairman Gary Gensler’s recent announcement that he will not enforce a 2020 rule to regulate proxy-advisory firms could undermine the governance of corporate America. The move comes without justification during one of the busiest proxy seasons on record — one which has demonstrated the increasing influence of shareholder proposals on corporate management.

For the past two years, the SEC carefully studied and weighed the impact of proxy advisers — firms that sell voting recommendations to investors during proxy season — before finalizing a new rule to address concern over conflicts of interests, erroneous voting recommendations, and the inability for companies to respond or point out problems with these recommendations in a meaningful way.

Given the thousands of shareholder proposals that an institutional investor must vote each year, asset managers have increasingly outsourced the responsibility to proxy-advisory firms. But the drawbacks of this arrangement have been a bipartisan concern for securities regulators for over a decade.

The trouble with outsourcing shareholder voting, a question taken up by the SEC in its recently halted reforms, is whether investment advisers can fulfill their fiduciary duty to clients while relying on third parties for key corporate-governance decisions without conducting their own diligence. In the worst cases identified by experts, investors often automatically vote proposals immediately following recommendations issued from an adviser — a practice known as robovoting.

To make matters worse, the main provisions of the rules were not set to come into effect until next year, meaning the commission staff will have to reexamine changes they just finished implementing months ago without any new data. The limited data that is available from 2020 showed a slight yet encouraging decline in robovoting.

Stepping back to consider the broader SEC priorities indicated by the move, what is perhaps most troubling is a nod to empower more passive voting and less active participation in the shareholder process. Throughout the 2021 proxy season so far, proxy-advisory firms, rather than investors themselves, have called the shots in hotly debated corporate matters. Meaningful debates over the material proposals among shareholders should be encouraged but should not hinge on large blocks of passive funds following the recommendations of a third party (with no fiduciary duty to those invested in the company).

Earlier this proxy season, I wrote about why two institutional-shareholder proposals presented at Berkshire Hathaway’s annual meeting were wrong for the firm. The proposals called for Berkshire’s board to gather and report information on climate mitigation and diversity promotion across every one of its portfolio companies.

Berkshire, however, is a decentralized holding company owning scores of autonomous subsidiaries acquired over 50 years that it intends to hold forever. The proposals, said to encourage long-term thinking at Berkshire, called upon its board to repudiate this time-honored structure by injecting directors into core areas of managerial autonomy. Proponents such as CalPERS failed to grasp that Berkshire’s historical culture is responsible for the company’s leadership on climate change and personnel diversity.

Berkshire’s other shareholders defeated these proposals by a wide margin, with 75 percent opposed.  The lopsided outcome reflects the fact that Berkshire’s shareholder base remains dominated by quality shareholders, including many families and individuals, who actively choose to buy Berkshire stock and hold it indefinitely.

On the other hand, the remaining shares are dominated by institutional investors. Besides CalPERs, this cohort includes large passive indexers such as BlackRock, which own stocks such as Berkshire simply because they are in the index, not because they understand or appreciate the company. There are also, of course, the robotic subscribers to ISS and Glass Lewis, the two main proxy-advisory firms, which misguidedly advised their followers to vote against the Berkshire model.

While Berkshire’s engaged shareholders rebuffed the activists, most other public companies do not enjoy this luxury. They have a greater share of institutional investors that likely rely on the one-size-fits-all recommendations of proxy advisers or their own cookie-cutter policies.

Many in the institutional-investment community are right to point out the useful function played by proxy advisers on procedural matters and the benefits these services can pass on to investors in the form of low-cost indexing. However, widespread use of this advice should come with some oversight. If the SEC reverses its actions in relation to proxy advisers, the firms will remain effectively unregulated and unaccountable along with their institutional-investor clients.

In his statement on the recent announcement to suspend the proxy adviser rules, Chairman Gensler began on the hopeful note that he would instruct his staff to consider “whether to recommend further regulatory action regarding proxy voting advice.” All the more reason why this apparent step backward comes as both a surprise and a loss to investors.


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