The Securities and Exchange Commission adopted rules paying cash awards to whistleblowers whose information leads to successful enforcement of federal securities laws.

The rules, adopted by a 3-2 vote, implement a Congressional directive in the 2010 Dodd-Frank Wall Street Reform Act.

SEC Chairman Mary Schapiro said that while the Sarbanes-Oxley Act has helped protect whistleblowers and improve internal reporting systems at public companies, “too many people remain silent in the face of fraud. Today’s rules are intended to break the silence of those who see a wrong.”

She added: “Already the whistleblower provision of the Dodd-Frank Act is having an impact.  While the SEC has a history of receiving a high volume of tips and complaints, the quality of the tips we have received has been better” since the law was adopted, “and we expect this trend to continue.”

The SEC’s original proposal had drawn heated comment from the business community.  Many comments insisted the rules would weaken internal compliance procedures by not requiring whistleblowers first to report information internally.

Anticipating the SEC’s latest decision, House Republicans recently proposed legislation that would require whistleblowers to use internal compliance procedures before approaching federal regulators.

The latest rule-making signals that “the SEC has chosen to put trial lawyer profits ahead of effective compliance and corporate governance,” declared an official of the U.S. Chamber of Commerce.  “The company is in the best position to immediately investigate and mitigate any violations, not the SEC who will be inundated with thousands of tips it won’t be able to handle.”

SEC Commissioner Troy A. Paredes, one of  two Republicans who voted against the final rulemaking,  said the Commission “missed its opportunity” to create a program that generates high-quality tips, doesn’t encourage “frivolous, spurious, or unduly speculative tips,” and doesn’t “thwart internal compliance programs.”

He said the program may inundate the SEC with tips, some of low quality,, that will “risk diverting SEC resources” from more important priorities.

The Commission’s fact sheet and a link to the final rules is here.

The rules permit an award of 10% to 30% of federal monetary sanctions of more than $1 million.  In determining the amount, the SEC will take into account the significance of the information, assistance provided by the whistleblower, law enforcement interest in making an award, and participation by the whistleblower in internal compliance systems. And awards may be reduced if there is evidence that “the whistleblower intentionally interfered with his or her company’s internal compliance systems.”

People who won’t be eligible for whistleblower awards include attorneys who attempt to use information from clients for themselves; foreign government officials; those who obtained the information illegally; officers or directors of an entity who learned of the information from another person; compliance and internal personnel and public accountants working on SEC engagements.

The final regulations, which will be effective in about 60 days, include a form for whistleblowers to fill out.

Mary Schapiro, head of the Securities and Exchange Commission, is finding herself in the hot seat quite a bit this week. Today, she heads to the Hill today to advocate for a funding increase, which Congressional Republicans have said that her agency doesn't deserve.

SEC Chairman Mary Schapiro

Schapiro has also been criticized for hiring a top lawyer for the agency who had financial ties to Bernard Madoff, whose massive Ponzi scheme the agency failed to pursue for years despite many red flags. The SEC's former general counsel, David Becker, was hit with a lawsuit last month by the trustee recovering funds for Madoff's victims.

Becker has said that he disclosed to Schapiro in 2009 that his late mother had an account with Madoff. He said the agency's ethics counsel told him that possible enforcement actions against Madoff "did not have a direct and predictable effect" on his financial interests and permitted his involvement in Madoff-related work, including helping determine compensation for Madoff2019s victims.

In letters to six Republican lawmakers this week, Schapiro said she had instructed Becker to sort out the matter with agency2019s ethics officer, the Washington Post reported yesterday. She also asked the SEC2019s Inspector General to investigate whether Becker had a conflict of interest.

The inspector general, David Kotz, had previously investigated the agency2019s failure to uncover Madoff2019s fraud. He found that while the SEC had failed to pursue Madoff, it "did not find that any improper professional, social or financial relationship on the part of any former or current SEC employee impacted the examinations or investigations."

That report was released in late 2009. Becker assumed the post as the SEC's top lawyer in early 2009 and served for two years. He had previously served in the same position from 1999 to 2002.

But that's not the only criticism the agency is facing this week. The Project on Government Oversight, an independent watchdog group, sent Shapiro a letter faulting the agency for failing to discipline employees and contractors for wrongdoing. From POGO:

A POGO review found that of at least 98 SEC employees recommended for disciplinary action since 2008, only 11 were fired or removed from their contract. While many employees received lesser forms of discipline, the SEC took no action whatsoever in the case of 10 employees, many of whom the OIG found to have committed serious offenses.

Some of the cases involved employees who were recommended for discipline as part of the inspector general's Madoff investigation, said POGO. A spokesman for the SEC declined to comment to Politico on the letter, but said it takes seriously the recommendations of the inspector general.

The SEC is tasked with helping to implement the Dodd-Frank financial reform bill. Congressional Republicans, who have long been quick to criticize the agency, have sought to slash the agency2019s budget despite urging from Wall Street lawyers and investor groups for the agency to be adequately funded.

As Forbes blogger Halah Touryalai has noted, the $1.4 billion SEC budget requested by the Obama administration is less than Bank of America's 2010 marketing budget alone, less than what Citigroup spent on marketing and advertising in 2010, and several times less than what JP Morgan has set aside to fight lawsuits.

ProPublica is an independent, non-profit newsroom that produces investigative journalism in the public interest.   This article is republished with permission under a Creative Commons license.

When President Obama came into power on the heels of the financial crisis, he pledged to beef up the Securities and Exchange Commission, a chief watchdog of Wall Street. But with a strapped budget and the changing political winds in Congress, that plan may come up short.

The SEC has already begun cutting back on investigations and enforcement because of uncertainty about its budget, including delaying getting testimony from witnesses and performing audits, the Wall Street Journal reported today.

In a release on its website earlier this month, the SEC said it had already delayed implementing six parts of the financial reform bill because of budget constraints, including creating offices to work with whistleblowers and to oversee credit rating agencies.

President Obama wanted a 12 percent budget increase for the SEC, but that extra money may not be approved. From the Journal:

The SEC could be a target of newly empowered Republicans in the House who have vowed to cut future spending to 2008 levels.

"Why are we rewarding the agency that failed so miserably on so many fronts?" complained Rep. Scott Garrett (R., N.J.).

While the Dodd-Frank financial reform bill gives the SEC more power, it also gives it more work to do, laying out nearly 100 new regulations the agency must write and implement. And the Journal reports that without an infusion of new staff, the organization will need to divert resources from enforcement to rulemaking. SEC Chairwoman Mary Shapiro says her organization needs 800 additional employees to implement all the requirements of financial reform.

"A lot of the Dodd-Frank work is sapping resources and staff time that should be devoted to regulatory oversight," James Allen, head of capital-markets policy at the CFA Institute, told the paper.

Meanwhile, the companies are lining up to lobby on those rules. For example, more than 260 companies have told the SEC that a new program to pay whistleblowers for tips undermines the companies’ own internal compliance systems, the Journal separately reported today. And energy companies have been lobbying to make new regulations over derivatives more lax. The New York Times' Dealbook reported on a meeting with the SEC last week:

While Morgan Stanley, Goldman Sachs and TIAA-CREF also attended the meeting, the loudest pleas came from the energy companies.

Their simple message for regulators? Just trust us.

You can check out details on all meetings with lobbyists on the SEC’s website.

ProPublica is an independent, non-profit newsroom that produces investigative journalism in the public interest.   This article is republished with permission under a Creative Commons license.

Regulators and rulemakers led the list of 100 most influential people affecting corporate governance in America’s board rooms in 2010, according to the National Association of Corporate Directors.

Administration officials on the list include President Barack Obama, David Axelrod, Rahm Emanuel and Valerie B. Jarrett.  Re-elected to the list were Sen. Christopher Dodd and Rep. Barney Frank, authors of the Wall Street Reform and Consumer Protection Law, and Securities and Exchange Commission Chairman Mary L. Schapiro.

The list, published in Directorship Magazine, is based on a survey of 15,000 public company directors and executives. The magazine doesn’t rank the 100 but instead selects several people each from a number of categories including regulators, directors, CEOs, governance policy makers, attorneys and professors.

Corporate directors in the top 100 include Dina Dublin (serving on the boards of Microsoft, Accenture, Pepsico); J. Michael Cook (Comcast, Burt’s Bees,  International Flavors and Fragrances);  Raymond J. Groves (Boston Scientific);  Bonnie G. Hill (Home Depot, AK Steel Holding, California Water Service Group, Yum! Brands); and Mellody Hobson (DreamWorks Animation, Estée Lauder, Starbucks).

CEOs who are also top 100 directors include Steven Ballmer of Microsoft, Rex Tillerson of ExxonMobil, Warren Buffet of Berkshire Hathaway, Steve Jobs of Apple, and Ellen Kullman of DuPont.

Based on the selections, Harvard University claimed bragging rights.  According to the Harvard Law School Forum on Corporate Governance and Financial Regulation blog, the Directorship 100 list includes twenty-seven individuals who are Harvard Law School faculty or fellows, guest Contributors to the blog, and/or Harvard Law School alumni – suggesting, the blog says, that Harvard and its governance program play  “a central role in the corporate governance landscape.”

Said Directorship Magazine:  “All members of the Directorship 100, regardless of how they arrived here, have power and influence. Some of it is new, some of it is long-standing.  Our modest job is to reveal those who exert the kind of influence that will permit the continued, if sometimes shaky, path that our system of capitalism is on, and the importance of corporate governance as a critical guidepost along the route.”

Given the green light by Congress, the Securities and Exchange Commission approved and released a long-awaited rule on proxy access — procedures under which shareholders can get their nominees for corporate directors included in proxy materials issued by public companies.

The SEC three times had made a run at proxy access rules, which include changes long sought by corporate governance activists, but hadn’t issued a final policy in the face of political and corporate resistance.  This year’s Dodd-Frank Wall Street Reform and Consumer Protection Act (Section 971) authorized the SEC to write the rules.

Under the new rule approved by the Commission, shareholders seeking access to corporate proxy  materials would:

--have  to own at least 3% of the total voting power entitled to vote at the meeting.
--be able to aggregate holdings to meet the 3% requirement.
--be required to have held their shares for at least three years.
--not be able to use the new rule "if they are holding the securities for the purpose of changing control of the company."
--be able to include one nominee or a number up to 25% of the board, whichever is greater. (If a board had three members, shareholders could nominate one; if a board had eight members, up to two nominees could be proposed).

The SEC said "'smaller reporting companies" would be subject to the rule only after a three-year phase-in period. Commission staff said the three-year delay would enable smaller companies to see how the rule works at larger companies and how it would affect them.  It would also let the commission determine whether changes in the rule might be required, the staffers said.

New rules generally take effect 60 days after publication in the Federal Register, SEC staff said.

The new rule -- called Rule 14a-11 -- requires shareholders to submit nominees no later than 120 days before the anniversary date of the mailing of the prior year proxy statement. Thus, if the rule becomes effective on Nov. 1, 2010, it would be available at companies that mailed their last annual meeting proxy statement no earlier than March 1, 2010.

Vote on Party Lines

As had been widely expected, the SEC acted on a 3-2 vote to adopt the new procedures, with Republican commissioners Troy Paredes and Kathleen Casey voting no.  Commissioner  Casey said the proposal represents “a series of arbitrary choices” that empower institutional shareholders “to the detriment” of individual shareholders and that the proposal is “likely to result in significant harm” to the economy.

Commissioner Parades protested that under the new rules, shareholders would be “unable to opt out” of the procedures “even if they want to,” and said it is at odds with state corporate law, particularly in Delaware.

SEC Chairman Mary Schapiro said shareholders should expect to see “dozens of instances of give and take” as the new rules take effect.  She called the proposal “rational, balanced and necessary” and pledged the SEC would prepare to make “prompt changes” to the rules if they seem appropriate.

Commissioner Elisse Walter said the proposal at last gives shareholders “a genuine alternative” in voting on directors.  The right to vote is meaningless, she said, if shareholders have no choice other than nominees presented by management.

Three Percent Rule

The 3% rule is a significant hurdle, making challenges at large companies such as International Business Machines or Exxon Mobil Corporation particularly difficult.  But pension, union and other large funds could pool their votes with other investors to offer candidates. (Congressional conferees turned down efforts by Sen. Christopher Dodd of Connecticut to include a 5% ownership threshold in the financial reform bill.)

Reacting to the proposal, the U.S. Chamber of Commerce said the SEC “is responding  to the campaign of a small group of special interest activist investors while ignoring the needs of the vast majority of investors who will never be able to use proxy access.”

Some groups had urged the SEC to permit “private ordering” of proxy access procedures — letting companies establish their own procedures to create proxy access under Delaware and other state corporate regulations.  Across-the-board rules, they argued, aren’t always appropriate. And a number of companies urged the SEC to permit shareholders to opt out of proxy access procedures.

Opponents gave the SEC a number of objections to proxy access.  Richard Templeton, chairman, president and chief executive of Texas Instruments, said the process “would promote a focus on short-term interests and could result in what are essentially annual proxy contests...distracting management and board attention from the creation of long-term shareholder value.”

Legal Challenges Likely

Challenges to the rules seem likely.  Bloomberg recently reported that the U.S. Chamber of Commerce has retained Eugene Scalia of the law firm Gibson, Dunn & Crutcher (and son of U.S. Supreme Court Justice Antonin Scalia) to “review the forthcoming SEC rules for a potential legal challenge.” The Chamber’s Center for Capital Markets Competitiveness says “...the SEC has failed to demonstrate a compelling need for this rule-making or how capital markets will be made more efficient by its adoption.”

Some companies have found the best defense is a good offense — engaging major shareholders to see if some middle-ground resolution is possible short of a board challenge.  Indeed, Weil, Gotshal & Manges LLP corporate partner Holly Gregory has advised companies to “Know who your large owners are — the top twenty or thirty shareholders — and consider whether to reach out to them in advance of the next meeting to find out what their concerns are, especially with regard to board composition and executive compensation.”

And, she adds, “Ensure that investor relations personnel are well-versed on institutional investor and proxy advisor positions on ‘hot button’ issues — as well as the company’s rationale where its approach departs from these positions.”

Proxy battles can also be expensive, notes writer Julie Connelly in Corporate Board Member magazine (Third Quarter 2010) in an article titled “Proxy Access: Worth Little More Than a Hill of Beans.”

Proxy battles entail legal fees, proxy-solicitation costs, and, in some cases, payments to prospective board candidates.  Indeed, there’s general agreement that finding candidates to serve on board is getting more difficult, given increased demands on a director’s time and exposure. To help identify potential board candidates, the pension fund of the California Public Employees’ Retirement System, the nation’s largest in terms of assets, is creating a "Diverse Director Database.”

J. W. Verret, an assistant professor of law at George Mason University’s law school, has been thumbing his nose at proponents of proxy access with a series of “16 defenses” he is proposing for boards of directors to thwart the expected SEC proposal. (One example: if shareholders can nominate a quarter of the board, give decision making to an Executive Committee of the Board made up of the other 75%.)

Editor's Note 8/25/2010: This article has been updated from an earlier version to reflect the outcome of the SEC vote and to incorporate additional comments.

Correction 8/30/2010: This article has been updated from an earlier version to correct a reporting error with regard to advice given to companies by Holly Gregory of Weil, Gotshal & Manges LLP.

The Securities and Exchange Commission wants some help with its bulging agenda.

The agency faces a deluge of new rule-making tasks, many tied to the recently enacted Dodd-Frank financial reform legislation.

SEC Chairman Mary Schapiro

To jump-start the process, SEC Chairman Mary Schapiro is loosening up the procedures to gather public comment. “We are expanding our process beyond what is legally required,” she said in a July address to the U.S. Chamber of Commerce’s Center for Capital Markets Competitiveness. “We are inviting public comment even before the various rules are proposed and before the official comment periods have begun.

“We have created a series of e-mail inboxes—that can be accessed at www.sec.gov -- so that anyone interested can easily weigh in.”

All submissions on the comment system will be posted on the Commission’s web site with personal identifying information included.

The new arrangement comes with some ground rules, which the SEC chairman called “best practices.”  The SEC staff will “try to meet with any interested parties who seek to meet with us,” she said, but it may have to limit the number of meetings and will limit multiple meetings with the same party.  The staff will ask persons requesting meetings to provide in advance an agenda of intended topics for discussion; participants will be encouraged to submit written comments to the public file.  And,  she said,“I expect we will hold public hearings on selected topics.”

Chairman Schapiro highlighted five areas among the “many topics on our plate”:

OTC Derivatives. The new law brings oversight to the over-the-counter derivatives market, and new rules will address capital and margin requirements, mandatory clearing, operation of executive facilities, business conduct standards for swap dealers and public transparency for transactional information.

Fiduciary Duty. The new law calls for a study of existing standards of care for broker-dealers and investment advisers. Currently, she noted, “there’s a difference between a broker and an adviser” and an investor “can be treated differently based on who they’re getting their investment advice from.”  Advisers are supposed to put the interest of clients before their own, while broker-dealers are supposed to make “suitable” recommendations.

After the study is finished, she noted, “we will have the authority to write rules that would create a uniform standard of conduct for professionals who provide personalized investment advice to retail customers.”

Hedge Funds advisers will have to register with the SEC.

Corporate Disclosure. “We will be adopting many rules in this area – especially in the area of executive compensation.” Under the new act, advisory say-on-pay votes will be required at all companies at least once every three years. And shareholders will also have a say on golden parachute payments to executives.

Companies will be required to calculate and disclose median total compensation of all employees and the ratio of CEO compensation to that of employees

New rules will address standards of independence for compensation committees and for conflict of interest standards when retaining compensation consultants. And rules will establish that brokers cannot vote on compensation matters.

Chairman Schapiro said she intends to have new rules concerning shareholders’ ability to nominate director candidates in effect “in time for the 2011 proxy season.”

Credit Rating Agencies. The new law requires rulemaking on disclosure, controls, conflicts of interest and analyst training, as well as on preventing sales and marketing considerations from influencing credit ratings.

Photo by talkradionews, via Flickr

FACT SHEET ISSUED BY THE U.S. SECURITIES AND EXCHANGE COMMISSION

Seeking Public Comment on the U.S. Proxy System

SEC Open Meeting

July 14, 2010

Overview

Last year, SEC Chairman Mary Schapiro directed the Commission’s staff to undertake a comprehensive review of the U.S. proxy system – the system that governs the way in which shareholders can vote their shares regardless of whether they attend shareholder meetings.  Today, more than 600 billion shares are voted at more than 13,000 shareholder meetings every year.

In the three decades since the Commission last conducted a comprehensive review, there have been dramatic changes affecting the operation of that system.  Those include technological innovations, changes in the nature of stock ownership, consolidation of proxy distribution service providers, growth in other types of proxy service providers, and new financial products.

As part of its review, the Commission is considering today whether to issue a concept release seeking public comment on concerns raised by investors and industry participants relating to the accuracy, reliability, transparency, accountability, and integrity of the U.S. proxy system.

What is the U.S. proxy system?

The U.S. proxy system governs how investors vote their shares on matters presented to shareholders at shareholder meetings.  Most investors vote their shares by proxy – that is, they give authority to someone else to vote their shares according to their instructions.  This means that investors can vote their shares without having to attend shareholder meetings.

Many investors are “record owners” – that is, their names are listed in the company’s shareholder records – and they can vote their shares directly by granting a proxy.  The vast majority of investors in U.S. companies, however, hold their shares in “street name” – that is, in customer accounts with a securities intermediary, which is usually a broker or bank.  To vote their shares, these investors, who are also known as “beneficial owners,” typically give voting instructions to their securities intermediary or to a third party (known as a “proxy service provider”) retained by the securities intermediary to receive voting instructions on its behalf.

In turn, the securities intermediary will reflect the beneficial owners’ voting instructions when executing its proxy for shares held in its customer accounts.  Ultimately, proxies from record owners and proxies from securities intermediaries (reflecting voting instructions from beneficial owners) are delivered to a vote tabulator to determine the outcome of the vote.

What issues does the concept release address?

The concept release, which requests comment on matters relating to the U.S. proxy system, is organized under three general areas:

• Accuracy, transparency, and efficiency of the voting process.
• Communications and shareholder participation.
• Relationship between voting power and economic interest.

The specific matters covered in those areas are:

Over-voting and under-voting of shares:  At times, a broker-dealer – or other securities intermediary – may cast more votes, or fewer votes, than the number of shares that the intermediary actually holds. This imbalance results from the way securities transactions are cleared and settled in the U.S. markets.

Some securities intermediaries, primarily broker-dealers, have developed methods to reconcile their records and allocate votes to their customers in order to avoid “over-voting.”  One of those methods, however, may result in “under-voting,” which occurs when investors who are allocated the ability to vote fail to do so, and other investors who do vote may be allocated a number of votes fewer than the number of shares they hold.

The concept release seeks comment on whether over-voting or under-voting is a problem, and if so, whether the method used by the broker-dealer to allocate votes should be disclosed, and whether the Commission should require the use of a particular method.

Vote confirmation:  The concept release explores the possibility of requiring vote tabulators, securities intermediaries, and proxy service providers to provide each other with access to vote data so investors and issuers can confirm that votes have been received and tallied according to investors’ voting instructions.

Proxy voting by institutional securities lenders:  Institutional shareholders often lend their securities, and shares on loan generally cannot be voted by the lender unless the shares are recalled.  Without sufficient advance notice of the matters to be voted on, lenders may not be able to recall shares in time to vote on matters of interest.  The concept release examines whether shareholders would be helped by requiring the agenda items at shareholder meetings to be identified earlier, so that lenders can make a decision to re-call their shares and vote on issues important to them.  In addition, the concept release explores whether mutual funds and closed-end funds should be required to disclose the number of shares that a fund votes at a particular meeting, in addition to how that fund votes.

Proxy distribution fees:  Stock exchange rules, last revised in 2002, establish the maximum fees that a member broker-dealer may charge an issuer as “reasonable reimbursement” for forwarding proxy materials.  In response to concerns about whether this fee structure continues to constitute reasonable reimbursement, the concept release discusses several potential actions, including having the stock exchanges revise the fee schedule or eliminate it in favor of allowing market forces to determine appropriate fees.

Issuers’ ability to communicate with beneficial owners of securities:  Some issuers have expressed concerns that they are limited in their ability to communicate directly with their shareholders.  These issuers cite the “street name” system of ownership, as well as rules allowing beneficial owners to object to having their identities disclosed to issuers, as reasons for this concern.  Among other things, the concept release seeks comments on whether to preserve, eliminate, limit, or discourage the use of objecting beneficial owner status.

Potential means to facilitate retail investor voting participation: The concept release presents several ideas that could potentially improve retail investor voting participation, including:

• Improving investor education
• Enhancing brokers’ Internet platforms
• Permitting advance voting instructions for retail investors
• Enhancing investor-to-investor communications
• Improving the use of the Internet for distribution of proxy materials

Data-tagging proxy-related materials:  At the suggestion of the SEC’s Investor Advisory Committee, the concept release seeks comment on whether data-tagging proxy-related data, such as information relating to executive compensation and director qualifications, might enhance a shareholder’s ability to analyze issuer disclosures to make informed voting decisions.

Role of proxy advisory firms:  Some companies and investors have raised concerns that proxy advisory firms may be subject to conflicts of interest or may fail to conduct adequate research and base recommendations on erroneous or incomplete facts.  As a result, the concept release seeks comment on improving disclosure of potential conflicts of interest, enhancing regulatory oversight over the formation of voting recommendations, and requiring eventual public disclosure by proxy advisory firms of their voting recommendations in Commission filings.

Dual record dates:  Companies set a date – known as the “record date” – on which persons who are shareholders on that date are entitled to receive notice of a meeting and to vote at the meeting.  If a shareholder sells after the record date, that person (who no longer holds the shares) still has the right to vote.  This can mean that holders without an economic stake in the matter can influence the outcome of a vote.

Recent changes to state law, however, now allow for “dual record dates” – one for determining who is entitled to receive notice of the meeting and a later one for determining who can vote at the meeting.  The concept release requests comment on whether the Commission’s rules should be revised to accommodate dual record dates.

“Empty voting”: The concept release requests comment on whether “empty voting” and related activities are being used to inappropriately influence corporate voting results.  “Empty voting” occurs when a shareholder’s voting rights substantially exceed its economic interest in the company – that is, its voting rights are “decoupled” from its economic interest.  For example, if a holder of shares buys a put option to sell those shares, the holder retains voting rights on all of those shares, even though it has hedged away at least some of its economic interest.  Empty voting can also occur if a shareholder sells its shares after the record date of a shareholder meeting, but before the meeting.  In that instance, the shareholder retains the right to vote those shares, even though it no longer has an economic interest in those shares.  The release requests comment on, for instance, whether the Commission should consider requiring disclosure of decoupling activities as a possible regulatory response.

* * *

With respect to each of these topics, the concept release describes the concerns that have been expressed by market participants, presents several possible regulatory responses to such concerns, and presents specific questions for public comment.

What are the next steps?

There is a 90-day public comment period for this concept release.

by James Hyatt

Proxy advisory services -- the firms that handle the chore of voting shareholder proxies for institutional investors, and at the same time provide stiff appraisals of corporate conduct – may be about to start receiving their own report cards for a change.

A lot of Corporate America thinks it's about time.

The services' influence has certainly been growing in the wake of corporate scandals and ever more heated debates over ethical behavior and attention to social responsibility issues.

The proxy services play a key role because institutional holders turn to them for advice when voting billions of shares at annual meetings. The services get paid to help manage the actual proxy voting process and they also weigh in on management-vs-shareholder debates over such hot button issues as compensation, the makeup of boards of directors, and proposals on corporate disclosures and behaviors.

For almost a decade, academics, corporate officials, regulators and shareholder activists have kicked around the issues of proxy advisory service behavior and performance: do they exercise too much influence; does their advisory business influence their voting recommendations; is more formal oversight needed?

The Advisory Industry

A lot of the conversation, of course, is aimed either in a veiled way or implicitly at the 800-pound gorilla in the room, RiskMetrics Group and its influential proxy advisory unit ISS Governance – which, by some estimates, advises half the world’s common stock.  RiskMetrics had $303 million of revenues in 2009; of that, almost half or $145 million came from the ISS segment. The company last year issued proxy and vote recommendations for more than 37,000 shareholder meetings in 108 countries and voted 7.6 million ballots representing over 1.3 trillion shares.

RiskMetrics in 2009 had 3,500 clients in 53 countries, including 70 of the 100 largest investment managers, 43 of the 50 largest mutual fund companies, and 42 of the 50 largest hedge funds.

(RiskMetrics in March said it would be acquired by MSCI Inc. for about $1.55 billion in cash and stock, subject to various approvals.  MSCI calculates more than 120,000 indices daily and its Barra unit provides risk models and portfolio analytics.)

In addition to RiskMetrics, other major proxy advisors include Glass Lewis & Co.; Egan-Jones Proxy Services; Marco Consulting Group; Proxy Governance, Inc.; Governance Metrics International; and CtW Investment Group.  (RiskMetrics, Marco Consulting and Proxy Governance are also registered with the SEC as investment advisers.)

New Scrutiny

Questions about proxy advisors have been raised in the past. The Government Accountability Office, the audit arm of the U.S. Congress, took a look at proxy service providers in 2007 and an SEC Compliance Alert in mid-2008 addressed some proxy voting issues as well.

Nonetheless, questions about the performance and role of proxy advisory services continue to simmer.  SEC Chair Mary Schapiro told the Practising Law Institute last November:

“...we'll be asking about the role of proxy advisory firms in corporate voting.  Given the influence that these firms' recommendations have on corporate voting outcomes, we'll probe the need for rules to ensure that advisory firms are basing their research and recommendations on accurate and reliable information.  And, that they are providing adequate disclosure of any conflicts of interest they may have in providing voting recommendations. “

Given the pressures surrounding the new financial services legislation, the SEC may find such steps pretty far down on its agenda.   But regulators are being pressed for action by members of the "Shareholder Communications Coalition," comprised of the Business Roundtable, the National Association of Corporate Directors, the Society of Corporate Secretaries and Governance Professionals, the National Investor Relations Institute, and the Securities Transfer Association, whose members often find themselves the object of proxy service criticism.

In March 2010, the Coalition distributed a “discussion draft” on” proxy advisory services: “The Need for More Regulatory Oversight and Transparency”. Among its criticisms: institutional investors that hire third-party proxy advisory firms often find that firm guidelines “do not evaluate the facts and circumstances of each public company with respect to the matters to be voted on; instead, these guidelines encourage a “one-size-fits-all” or “check the box” methodology.”

RiskMetrics, it notes, provides corporate governance and executive compensation consulting services as well as voting recommendations on proposals at shareholder elections – which, the study suggests, “may create conflicts of interest”.  Moreover, all proxy advisory firms may face conflicts when an institutional client is backing a specific ballot proposal or has instigated a “vote no” campaign against directors.  The SEC, the draft suggests, should examine such situations for conflicts.

The draft report recommends that proxy advisory firms:

--be subject to more robust oversight by the SEC;
--be required to register as investment advisers;
--be subject to conflicts of interest disclosure; and
--have “a complete and total separation” of the proxy advisory business from all other business including consulting and research services.

It also calls for public disclosure of procedures, guidelines and assumptions for making voting recommendations and voting decisions, calls for institutional investors to exercise more due diligence concerning delegation of decisions to proxy advisory firms, and calls on the firms to maintain a public record of all their voting recommendations and voting decisions.

The report concludes: “We believe that proxy advisory services have an oversized impact on the proxy process. Despite their large role, proxy advisory firms generally remain unregulated and unsupervised and often are not transparent with regard to their standards, procedures, methodologies, and conflicts of interest.”

Dual Roles

RiskMetrics’ 2009 annual report acknowledges the “perceived conflict of interest between the services we provide to institutional clients and the services, including our Compensation Advisory Services, provided to certain corporate clients.”  It concedes that “in the event that we fail to adequately manage these perceived conflicts of interest, we could incur reputational damage.”  RiskMetrics spells out its policies regarding conflicts and disclosures here.

Asked for comment on the recent proxy advisory discussions, a RiskMetrics spokesman said the company is awaiting the substance of the SEC’s concept draft “and will refrain from making  any comment before it is available.”

One of the testier critics, Tamara C. Belinfanti, an associate professor at the New York Law School, in a legal studies research paper in 2009 argued “The Case for Increased Oversight and Control” over the proxy advisory and corporate governance industry.

She builds her argument around “agency theory,” or situations where one party uses another party to act on his behalf but where the parties’ “incentives are misaligned” – classically, in the case of corporations, the separation of ownership and control.

Ms. Belinfanti declares: “From an agency theory perspective, ISS presents a lethal combination – significant power and virtually no accountability.” And, she says, “ISS bears minimal residual risk of a poor voting decision vis-à-vis company shareholders.”

She argues for the SEC to regulate the proxy advisory industry “similar to the regulation it is currently contemplating for registered credit rating agencies,” for an oversight board for the industry similar to the Public Company Accounting Oversight Board, and for the mutual fund industry to pay more attention to proxy advisor decisions “and not simply follow the vote recommendations of these advisors.”

In March this year, Ms. Belinfanti posted a more acerbic comment about RiskMetrics on The Huffington Post, prompted by the MSCI acquisition announcement:  “ISS is incompetent and it is only a matter of time before markets and regulators realize ISS…is a ticking time bomb waiting to explode.” She noted that ISS had given high governance ratings to Lehman Brothers and AIG before their financial woes.  And she said MSCI’s governance rating was “in the bottom 2.5% of all S&P 400 companies in terms of corporate governance,” declaring the merger agreement “belies the reliability of its own corporate governance ratings system.”

"Prudent Man" Standards

A recent posting at the Harvard Law School Forum on Corporate Governance and Financial Regulation by attorneys at Latham & Watkins LLP raises other issues, commenting on “The Parallel Universes of Institutional Investing and Institutional Voting”.

SEC and Labor Department ERISA rulings, they note, require that institutional investors vote portfolio shares under “prudent man” standards, which often has resulted in outsourcing voting mechanics and recommendations to the proxy advisory firms. (The burden is huge; there are more than 10,000 public U.S. companies.)  Other investment managers have created an internal “corporate governance” staff to vote portfolio shares.

The result, the authors argue, is that voting policies are often applied in a one-size-fits-all fashion that doesn’t take into account a company’s particular circumstances. And, they declare, “economic ownership and economic decision making have been effectively decoupled from voting decisions throughout most of the investment management world.”

The separate interests of the investment community and the governance community, they argue, mean that public companies “need to engage in constructive and separate dialogues with each constituency. “Too often, corporate governance issues are seen as a distraction from a company’s goal of creating economic value for its shareowners. Although this may be true, it is also somewhat beside the point because voting decision makers at the company’s institutional shareowners demand otherwise.”

James Hyatt, a retired reporter and editor for The Wall Street Journal, has been writing about business ethics and social responsibility issues since 2005.

Encouraged by recent Securities and Exchange Commission guidance, institutional investors have filed a record 95 shareholder resolutions on climate change issues for the 2010 proxy season.

The resolutions, up 40% from last year, have been presented to some of the nation’s largest coal companies, electric power and oil producers, home builders, big box retailers, financial institutions and “other businesses that investors believe are not adequately disclosing and managing potential climate-related business impacts,” according to the Ceres coalition of groups working on sustainability issues.

Ceres directs the Investor Network on Climate Risk, composed of 80 institutional investors with collective assets of $8 trillion.

The SEC in January said a number of areas involving climate change may trigger disclosure requirements when they involve the impact of legislation and regulation, the impact of international accords, the indirect consequences of regulation or business trends, and physical impacts of climate change.

"We are not opining on whether the world's climate is changing, at what pace it might be changing, or due to what causes. Nothing that the Commission does today should be construed as weighing in on those topics," SEC Chairman Mary Schapiro said at the time. "Today's guidance will help to ensure that our disclosure rules are consistently applied."

“We want our companies to closely look at the impact climate change legislation and regulation have on them, to realistically assess those risks, and to consider the indirect consequences of climate change-driven regulation and business trends on their activities,” said Jack Ehnes, CEO of CalSTRS (California State Teachers' Retirement System), which manages $131 billion dollars in assets.

Mindy S. Lubber, president of Ceres, said “climate change presents clear material risks and opportunities for U.S. businesses – and investors have a right to know which companies are well prepared and which are not.”

Investors often withdraw proposals when they receive a positive response from companies; 28 resolutions have been withdrawn this year, Ceres said.

Resolutions filed so far include measures asking for disclosures from ConocoPhillips on how it is addressing the impact of oil sands operations; from ExxonMobil on oil sands investments and reduction of greenhouse gases; and from Southern Company on GHG emissions targets and on the hazards of coal waste disposal.

When do you know that ESG (or factoring environmental, social, and governance issues into investment and corporate decisions) has gone mainstream? One clue is this week's announcement that MSCI (Morgan Stanley Capital International) is acquiring ESG research conglomerate RiskMetrics (which gobbled up ESG pioneers KLD, Innovest, and Institutional Shareholder Services over the past three years). Another is the agenda of last week's meeting of the Securities and Exchange Commission's Investor Advisory Committee (IAC), which included items such as "ESG Disclosure Work Plan" and "Proxy Voting Transparency." So what does this mean?

The fact that an Investor Advisory Committee even exists – one of SEC Commissioner Mary Schapiro's first initiatives, to return to the "Commission's traditional role as the investor's advocate" (in the words of Committee sponsor, SEC Commissioner Luis Aguilar) – is testament to the success of the G part of the ESG equation: the SEC is governing itself more democratically. The Committee acts as the SEC's sounding board, rebounding guidance to the Commissioners on their regulatory agenda. The Committee's 18 members each represent a different constituency – with the AFL-CIO's Damon Silvers representing labor, and ProxyDemocracy Director Mark Latham representing individual investors, for example.

"Of course, the Commission doesn't have to act on anything the Committee recommends," IAC member Adam Kanzer of Domini Social Investments, who represents the ESG community of social investors, told me in an interview this week. But the very existence of the Committee establishes a mechanism for expressing the public mind – so the Commission would need a damn good reason to act against its recommendations.

The ESG equation squares the circle, reuniting the bifurcation the ol' Investor Responsibility Research Center (which got eaten up by Institutional Shareholder Services in 2005 established with its separate "social and environmental" and "governance" departments (no more having to track down either Meg Voorhes or Carol Bowie, as ESG creates a both/and.) Also, the ESG formulation has turned on its head the traditional perception of sustainability issues as time-wasting, extraneous concerns that drain on returns to potentially material risks and opportunities that investment trustees and corporate directors must factor into decision-making.

Kanzer and Stephen Davis of Yale's Millstein Center for Corporate Governance, chair of the Investor as Owner Subcommittee, outlined the workplan on ESG disclosure (according to meeting attendee Peter DeSimone of the Social Investment Forum, the socially responsible investing industry organization):

• In April, Subcommittee members will hold a meeting on the benefits of ESG disclosure to investors from a risk management perspective;
• In May, they will look at accounting standards and triggers for disclosure of contingent liabilities in the United States and other markets;
• In June, they will review reporting standards, including the Carbon Disclosure Project (CDP) and the Global Reporting Initiative (GRI), and look at information collected by the European Commission during its six meetings on ESG disclosure over the past year;
• In the summer, the Subcommittee plans to hold a public hearing on ESG disclosure to coincide with another meeting of the entire SEC.

The SEC Staff Interpretation released last month – the Commission Guidance Regarding Disclosure Related to Climate Change – set precedent on the E part of ESG disclosure. The guidance does not introduce new rules, but rather clarifies existing rules requiring companies to disclose material risks related to climate change, such as projected impacts of new legislation and international treaties capping carbon emissions.

Predictably, the move prompted opposition: House Financial Services Committee Ranking Member Spencer Bachus (R-AL) fired a letter to Chairman Schapiro voicing "very serious concerns" that the move represents the SEC trying to "promote a political agenda through regulation" and "will impose potentially significant compliance costs on issuers with little apparent benefit to investors." The preponderance of evidence and opinion debunking his concerns (think Stern Report and CDP) raises serious questions whether Bachus is promoting a political agenda through obstruction. Similarly, Senator John Barrasso (R-WY) introduced the Maintaining Agency Direction on Financial Fraud (or MADOFF) bill explicitly to "block" mandatory climate risk disclosure.

Bachus and Barrasso may be spitting into the wind. The corporate community generally understands and even encourages climate change regulation to create certainty and level the playing field through initiatives such as Business for Innovative Climate and Energy Policy (BICEP) and the US Climate Action Partnership (USCAP). Even recently-departed USCAP members BP, ConocoPhillips, and Caterpillar "have reiterated their belief that climate change is a real and serious issue, and that greenhouse gas emissions must be reduced," according to SustainAbility Vice President Jeff Erikson, who pointed to a ConocoPhillips press release re-stating support for federal climate change legislation. "The disagreement instead seems to be in the details of which industries will be most disadvantaged under legislation that USCAP supports," Erikson continued, before voicing disappointment at the three companies' decisions to leave USCAP.

Finally, the Investor Advisory Committee returned to the question of democracy in the wake of the recent Citizens United v. Federal Election Commission case, which considerably expanded corporate political contribution rights. The Investor as Owner Subcommittee voiced its intention to mirror its ESG disclosure proposal by proposing better disclosure or corporate political contribution limits.

The very existence of the Committee expands democratic mechanisms at the SEC, which allows and encourages the submission of public comments to the Committee - twenty five have come in as of this date.  Given the leverage opportunity the IAC represents, maintaining SEC momentum on ESG and corporate democratization may require more of a groundswell to demonstrate widespread public support for these measures – time to "sharpen your pencils."

Bill Baue is Executive Director of Sea Change Media, and Executive Producer/Host of Sea Change Radio, a nationally syndicated show with a global podcast audience. This article was first published on CSRWire.