Today, Jeff Mahoney, General Counsel at the Council of Institutional Investors (CII), weighs in on two recent pieces of legislation with serious implications for investors. The first, H.R. 5311, could weaken U.S. corporate governance, undercut proxy firms’ ability to uphold their fiduciary obligation to their investor clients and reorient any surviving firms to serve companies rather than investors. The second, H.R. 5424, could provide exceptions so private equity and hedge funds would not have to file a form that the SEC and other regulators use to track risks in the financial system. These exceptions would roll back transparency and reporting requirements CII believes are critical to investor protection.
In approving H.R. 5311, the Corporate Governance Reform and Transparency Act of 2016, last month, the House Financial Services Committee promoted legislation that, if enacted, would diminish, rather than improve, corporate governance to the detriment of the investing public.
The U.S. system of corporate governance relies on the accountability of boards of directors to shareowners. Proxy voting by pension funds and other institutional investors is a critical means by which long-term shareowners are able to hold boards accountable.
Proxy voting by pension funds and other long-term investors is facilitated by proxy advisory firms. Proxy advisory firms like Institutional Shareholder Services and Glass Lewis offer for a fee data, analysis and tailored vote recommendations to help institutional investors exercise their ownership rights on literally thousands of proxy issues annually.
Many pension funds and other institutional investors are concerned, that if enacted, H.R. 5311, would:
- Require that proxy advisory firms (1) provide companies advance copies of their recommendations and most elements of the research informing their reports, (2) give companies an opportunity to review and lobby the firms to change their recommendations and (3) establish a heavy-handed “ombudsman” construct to address issues that companies raise.This right of pre-review would give companies substantial influence over proxy advisory firms’ reports, potentially undermining the objectivity of the firms’ recommendations. On a practical level, this right of review would delay pension funds and other institutional investors’ receipt of the reports and recommendations for which they have paid.
The requirement that the proxy advisory firms resolve company complaints prior to the voting on the matter would create an incentive for companies subject to criticism to delay publication of reports as long as possible. Pension funds and other institutional investors would have less time to analyze the reports and recommendations in the context of their own customized proxy voting guidelines to arrive at informed voting decisions. Time already is tight, particularly in the highly concentrated spring “proxy season,” due to the limited period between company publication of the annual meeting proxy statement and annual meeting dates.
Moreover, the proposed legislation does not appear to contemplate a parallel requirement that dissidents in a proxy fight, or proponents of shareowner proposals, also receive the recommendations and research in advance. This would violate an underlying tenet of U.S. corporate governance that holds where matters are contested in corporate elections, management and dissident shareowners should operate on an even playing field.
- Require the Securities and Exchange Commission (SEC) to assess the adequacy of proxy advisory firms’ “financial and managerial resources.”The entities that are in the best position to make these types of assessments are the pension funds and other institutional investors that choose to purchase and use the proxy advisory firms’ reports and recommendations. In 2014, the SEC staff issued guidance reaffirming that investment advisors have a duty to maintain sufficient oversight of proxy advisory firms and other third-party voting agents. There is no compelling empirical evidence indicating that the guidance is not being followed or that the burdensome federal regulatory scheme contemplated by the proposed legislation is needed.
- Create costs for institutional investors with no clear benefits.
The proposed legislation would appear to result in higher costs for pension plans and other institutional investors – potentially much higher costs if investors seek to maintain current levels of scrutiny and due diligence around proxy voting. Moreover, the proposed legislation is highly likely to limit competition, by reducing the current number of proxy advisory firms in the U.S. market and imposing serious barriers to entry for potential new firms. This would also drive up costs to investors. Given these economic impacts, it is troubling that that there appears to be no cost estimate on the provisions of this proposed legislation.
Last month, the U.S. House of Representatives approved H.R. 5524, the Investment Advisors Modernization Act of 2016. The proposed bill, if enacted, would roll back some of the recent pro-investor regulatory requirements regarding oversight and transparency of private equity funds that grew out of the Dodd-Frank Wall Street Reform and Consumer Protection Act.
For example, H.R. 5524 would remove certain reporting requirements for large private equity funds and treat them like other equity funds. In Congressional testimony, Jennifer Taub, professor of law at Vermont Law School warned that if enacted, such a provision would:
[P]romote opacity by allowing private equity funds to retreat into the shadows, gaining exceptions from completing form PF just a few years after they began doing so. This information is important to monitor for systemic risk and to protect investors. If enacted, private equity fund advisers could stop completely section 4 of the form. This section provides important information related to leverage and counterparty risk. It also includes information concerning geographic and industry breakdown of portfolio companies.
In addition, if enacted, section 1c of Form PF would apparently no long[er] have to be completed by hedge fund advisers with between $150 million and $1.5 billion in [assets under management] AUM. The information is very important as it provides insight into trading and clearing of derivatives as well as short-term wholesale funding including bilateral and triparty repo[s]. Given that derivatives and the short-term wholesale funding markets accelerated the financial crisis and still remain a source of risk, it is critical for the SEC … to gather this information.
Neither H.R. 5311 nor H.R. 5424 are likely to be enacted as stand-alone legislation before year end. However, they could potentially be included as riders to “must-pass” legislation to fund the federal government in December. Thus, investors and other interested market participants should consider contacting members of their Congressional delegation expressing their views on these two bills that could harm investors. The Council of Institutional Investors sent a letter September 7 to the Speaker of the House and the House Minority Leader expressing strong opposition to H.R. 5424. Another CII letter sent September 6 to the Chair and Ranking Member of the Senate Banking Committee conveyed serious concerns about H.R. 5311.