The nation’s largest shareholder advisory firm, Institutional Shareholder Services Inc. (“ISS”), recently filed suit against the SEC over new guidelines meant to give investors more transparency into how proxy advisory firms make their voting recommendations. The SEC’s concern focuses on the growing influence of proxy advisory firms, which guide shareholders on how to vote on a variety of topics related to corporate governance, director elections and executive pay. The influence exerted by proxy advisory firms is magnified by the reliance that investment advisers place on such advice in making voting decisions on behalf of influential institutional investors. The SEC’s guidance is an attempt to curb the growing influence that proxy advisors have over a variety of corporate-governance issues. Regardless of the merits of the action taken by the SEC, the question that underlies the case turns on one of procedure.

On August 21, 2019, the Securities and Exchange Commission issued an interpretation (the “Release”) of Exchange Act Rule 14a-1(l) that proxy voting advice provided by third party proxy advisory firms, such as ISS and Glass Lewis, generally constitutes a “solicitation” under the federal proxy rules and related guidance regarding the application of the antifraud provisions in Exchange Act Rule 14a-9 to proxy voting advice. As background, the federal proxy rules apply to any solicitation for a proxy with respect to any security registered under Exchange Act Section 12 and authorize the SEC to establish rules and regulations governing such solicitation as necessary or appropriate to the public interest or for the protection of investors.

Under Exchange Act 14a-1(l), a “solicitation” includes, among other things, a communication to security holder under circumstances reasonably calculated to result in the procurement, withholding or revocation of a proxy and, pursuant to previous SEC guidance, includes communications by a person seeking to influence the voting of proxies by shareholders, regardless of whether the person itself is seeking authorization to act as proxy for such shareholder. Whether a particular communication is a solicitation turns on the purpose for which the communication was published as evidenced by the substance of the communication and the circumstances under which it was transmitted. Because advice provided by proxy firms generally describe proposals that will be presented at the registrant’s shareholder meeting and provides a “vote recommendation” for each proposal that indicates how a client should vote, the SEC believes that such advice constitutes a solicitation under the rules.

The SEC’s interpretation does not affect the ability of proxy advisory firms to rely on the exemptions for the federal proxy rules’ filing requirements. Such exemptions provide relief from the obligation to file a proxy statement, as long as the advisory firm complies with the exemptions set forth within the Rule. However, solicitations that are exempt for the federal proxy rules’ filing requirements remain subject to Exchange Act Rule 14a-9, which prohibits any solicitation from containing any statement which, at the time and in the light of the circumstances under which it is made, is false and misleading with respect to any material fact. Importantly, such solicitation must not omit to state any material fact necessary in order to make the statements therein not false or misleading. Depending on the materiality of the information and the particular circumstances, the SEC indicated in its Release that proxy advisory firms may need to disclose additional information to avoid issues under Exchange act Rule 14a-9, including: (a) explanation of the firm’s methodology used to formulate its voting advice on a particular matter; (b) non-public information sources and the extent to which the information from these sources differs from the publicly available disclosures; and (c) any material conflicts of interest that arise in connections with providing the proxy voting advice in sufficient detail so that the client can assess the relevance of such conflicts.

Of material concern to proxy advisory firms such as ISS and Glass Lewis, by noting in the Release that proxy voting advice is subject to the antifraud provisions of the federal proxy rules, the SEC’s guidance may foreshadow SEC enforcement action against proxy advisers for making materially false or misleading statements or omitting material facts when providing such proxy voting advice.

Importantly, the Release was issued simultaneously with a sister release which provides guidance to investment advisers that rely on such third-party proxy advisory firms. Under the Investment Advisers Act, investment advisers owe a fiduciary duty to their clients, including with respect to proxy voting. Proxy advisor firms provide their voting recommendations to their investment adviser clients with the expectation that those recommendations will be used by their clients to assist in fulfilling their fiduciary duties when making voting decisions. From the SEC’s perspective, the sister release was intended to reiterate the Commission’s focus on the importance of investment advisers’ voting responsibility on behalf of their clients and the applicability of proxy rules to proxy voting advice. Following the Release, SEC Chairman, Jay Clayton, went on record that the tandem release will “provide clarity to investment advisers regarding proxy voting responsibilities, and ultimately benefit their clients.” The SEC further advises investment advisers to review their policies and procedures in light of the recent guidance in advance of this year’s proxy season.

The Release has generated both positive and negative commentary. Commissioner Allison Lee, in her dissenting remarks, noted that she believed that the release imposed new legal requirements but were being adopted without formal notice and comment under the federal Administrative Procedures Act. Proponents counter that the Release constitutes interpretive guidance regarding the SEC’s views of existing law and, as such, does not constitute new rulemaking.

On October 31, 2019, months after the Release, ISS filed a lawsuit against the SEC for its rule interpretation, claiming in a complaint filed in the federal district court in Washington, D.C. that the rule interpretation (which is binding on the business model of ISS) is not in accordance with the notice and comment guideless of the Administrative Procedure Act and that the Release was an arbitrary and capricious abuse of the agency’s power. If allowed to stand, the August interpretation and guidance would effectively treat the advice proxy advisers provide to their clients in the same away that the SEC regulates proxy solicitations.

The CEO of ISS, Gary Retelny, was quick to point out that “unlike a person or firm engaged in a proxy solicitation, ISS is indifferent to the ultimate outcome of a shareholder vote and does not seek to achieve a certain outcome.” From the perspective of ISS, the position espoused by the SEC in the Release, together with SEC indications that it will focus more in the space of proxy solicitation, substantially interferes with ISS’s ability to provide independent, consistent advice in a timely manner. ISS believes that the SEC inappropriately altered the regulatory regime applicable to the voting advice provided by proxy advisory firms and the new interpretation is unlawful.

As a result of the SEC’s guidance and the ensuing ISS litigation, the 2020 proxy season may see unexpected shifts in proxy advisor influence. It is unclear what, if any, effect the SEC’s initiative will have on the 2020 proxy season. Given this uncertainty, it is important for companies to understand their shareholder base, including those that have historically been influenced by ISS and Glass Lewis, and continue to engage shareholders in advance of proxy solicitations to avoid surprises in the 2020 proxy season.