Circuit Courts split over the SEC’s regulatory treatment of proxy advisors

The Fifth and Sixth Circuits are currently split over the legality of the Securities and Exchange Commission’s (SEC) Proxy Advisory Rule. Depending on what happens next, we may see the case get elevated to the US Supreme Court.

This circuit split denotes how increasingly problematic the proxy advisory duopoly is becoming. Critics have particularly taken issue with how Glass Lewis and Institutional Shareholder Services (ISS) seemingly enjoy special immunity from corporate and regulatory accountability.

The circuit split came when, in September, the Sixth Circuit Court of Appeals upheld the SEC’s amendments to its rules governing proxy voting advice. This came several months after the Fifth Circuit Court opposed the Biden-era changes.

The Court found that the current SEC did not violate the law when it amended two Trump-era requirements for proxy advisory firms to exercise greater transparency when issuing advice.

SEC divided over the regulatory treatment of proxy advisors

Under the 2020 guidelines, proxy firms were required to confront the targeted companies about their voting recommendations prior to issuing them to their institutional clients.

Since proxy advisors often promote advice on shareholder proposals aimed at influencing the company’s operations, this gives the company itself the ability to review such advice and respond.

Certain proxy recommended proposals can slip under the radar of proper review unless the firm’s board of directors are properly notified about the advice well before their annual meeting.

This requirement marked an important step toward transparency, as Glass Lewis and ISS typically issue recommendations on shareholder proposals directly to the institutional investors they serve.

Institutional investors like asset managers, pension funds, and education savings accounts often automatically “robo-vote” in favor of the solicited recommendations, rather than the actual shareholders.

This process causes shareholders to be two steps removed from the actual decision-making process regarding proposals that shape the company. Robo-voting also facilitates neglect, as most investors merely rubberstamp proxy recommendations rather than critically review them.

Providing proper notice of proxy advice affords the targeted company time to raise red flags and point out potential concerns with the solicitation being offered. The registrant firm itself has more to lose when overlooking a problematic proposal pushed by a proxy advisor than the more detached institutional investors who typically have a stake in multiple companies.

Requiring proxy firms to be upfront about the nature of their advice helps move the proxy voting process out of the shadows. By rescinding its transparency provisions, the SEC has denied corporations the ability to counter or rebuff proxy solicitations before they propel radical shareholder proposals onto the proxy ballot.

The second major requirement from the Trump-era amendments requires proxy advisors to issue public disclosures about their conflicts of interest. While the 2022 amendments kept this requirement in place, the SEC’s Divisions of Corporate Finance and Examinations have overlooked several obvious conflicts.

Perhaps the most glaring is that proxy advisors softly threaten institutional clients to purchase their consulting services or else risk receiving negative recommendations on sensitive matters like director elections and executive compensation.

Glass Lewis has often recommended votes against directors if the company refused to adopt internal climate change mitigation policies that they’ve endorsed.

“They [proxy advisors] provide consulting services to help companies avoid negative recommendations from their advisory firm,” says Charles Crain, VP of Domestic Policy at National Association of Manufacturers (NAM), at a recent hearing. “And then, if the proposal passes, they are going to help you implement it.”

The SEC has turned a blind eye to this soft coercion that the proxy duopoly engages in, which also reduces the likelihood of institutional investors pursuing advice from proxy competitors like Egan Jones, Sustainalytics, and Strive. The proxy duopoly directs both the incentive to follow their advice and the means to carry it out.

Courts divided over proxy firms—what may come from the circuit split

The recent circuit split has created a regional fracture in compliance with the SEC’s rules on proxy voting. Given the Fifth Circuit ruling, certain states in the south will  likely abide by the 2020 transparency requirements. On the other hand, the Sixth Circuit ruling will see several states honor the SEC’s 2022 revisions.

We also may not see a full resolution to this issue from the Supreme Court. It remains unclear whether the SEC plans to appeal their loss in the Fifth Circuit.

The Fifth Circuit upheld NAM’s assertion that the SEC violated the Administrative Procedure Act (APA) when it amended its 2020 requirements to treat proxy advisory recommendations as solicitations.

The court also opposed the SEC rescinding the provision requiring proxy firms to issue advance notice and awareness of their recommendations to companies.

The SEC’s failure to justify why it rescinded the 2020 provisions triggered an APA violation. The Fifth Circuit’s decision appears more reasonable than the Sixth Circuit’s because the APA requires agencies to justify their rulemaking actions without duplicity.

The SEC failed to provide proper justification to both the public with its 2022 changes and in court, something that the courts have refused to tolerate based on the precedent set in Motor Vehicle Mfrs. Ass’n v. State Farm (1983).

The circuit court split reveals the SEC’s internal conflict over how to properly regulate proxy advisory firms. The prior SEC leadership got it right in bringing proxy firms out of obscurity before the companies impacted through their voting advice to investors.

While we may not see an appeal of the circuit split, many are eyeing a parallel challenge, ISS v. SEC, emerging from the Federal District Court for the District of Columbia.

The court ruled that the SEC acted unlawfully when rescinding its 2020 proxy solicitation requirement that a proxy firm’s voting advice be considered a “fee.” Both the SEC and NAM opposed this ruling and appealed the district court’s decision.

Despite once occupying an obscure space in shareholder advisement, proxy advisory firms are increasingly becoming a public concern. Only time will tell whether the Supreme Court will issue the final say on the SEC’s fractured regulation of proxy advisors or if the new Congress decides to address the issue first.