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SEC Issues Tough Guidance for Proxy Advisory Firms

WASHINGTON (The Deal) -- The Securities and Exchange Commission late Monday issued long-expected new tough restrictions on proxy advisory firms, including specific disclosure requirements for any conflicts and allowances for institutional investors to abstain from key votes in proxy battles and strategic M&A nonbinding proposals.

At issue are the two main proxy advisory firms - Institutional Shareholder Services Inc. and Glass Lewis & Co. LLC. They provide institutional investors with recommendations on key votes - issues like executive pay, poison pills and stock buybacks are often high on dissident shareholder's proposals.

In addition, they also make key recommendations for or against dissident candidates nominated by activist investors seeking to pressure corporations into deals or to make other changes.

Corporate critics have been pressing the SEC to hike restrictions on the advisers, arguing that they wield too much power over key votes. They argue that activist investors force too many nonbinding votes on social policy issues, political disclosure of lobbying spending or even CEO pay packages that may not impact shareholder value.

Prior to the new SEC provisions, institutional investors had interpreted two no-action letters from the agency as meaning that they were obliged to vote on all matters. It also made them feel as though they could rely on the proxy advisers as a way to discharge their fiduciary duty.

The new guidance would allow institutional investors to abstain from voting any of its proxies in certain situations or would allow the fund manager and its client to agree that the manager will focus its resources only on certain kinds of proposals.

The net effect of the new provisions is that smaller institutional investors may feel more comfortable picking and choosing among nonbinding shareholder proposals or abstaining altogether.

Until now, smaller institutions with fewer resources felt compelled to vote their shares in these situations and many relied on recommendations - either for or against a dissident shareholder - issued by proxy advisory firms. Many smaller investors find it an overwhelming task to monitor and vote on proposals in their portfolios of hundreds of thousands of companies. As a result an ISS or Glass Lewis recommendation in favor of a dissident slate or one that backs management may have less of an influence among investors.

An adviser to a high-profile activist investor argued that it was a "terrible development" that "undermines shareholder democracy."

In addition, the SEC urges institutions to make sure that the proxy advisory firm has the capacity to adequately analyze proxy issues before relying on them. It also added that if a proxy advisory firm makes an error, the investor must try to make sure that the adviser is taking steps to reduce similar mistakes in the future.

Critics including Rep. Patrick McHenry, R-N.C., have urged the agency to require the two proxy advisory firms to better disclose how they make their recommendations to see if they have any conflicts of interests. Corporate opponents of the advisory firms have argued that some special interests, such as the largest activist public pension fund clients of the proxy advisory firms that have strong opinions that are unfairly influencing the proxy advisory firm recommendations and guidelines at the expense of less-vocal mutual funds and other institutions. In addition, opponents have argued that some corporations worry that they have to buy ISS corporate-governance consulting services in order to get a good recommendation.

In response, the SEC guidance clarifies that a proxy advisory firm must provide fund managers receiving recommendations with specific disclosure of any "significant" relationship" or "material interest" it has with the company it is issuing its report on. The agency argued that ISS must provide specific disclosures - boilerplate language wouldn't suffice.

"We do not believe that boilerplate language that such a relationship or interest may or may not exist provides such notice," the SEC said. "In addition, we believe the disclosure should enable the recipient to understand the nature and scope of the relationship or interest, including the steps taken, if any, to mitigate the conflict, and provide sufficient information to allow the recipient to make an assessment about the reliability or objectivity of the recommendation."

Opponents of the proxy advisory firms didn't get everything they were seeking. The agency, for example, didn't require ISS and Glass Lewis to register with the SEC and open up their books to periodic inspections, something some critics had sought.

The guidance comes after the two Republicans on the SEC's five-member panel - Michael Piwowar and Dan Gallagher - have been vocal in recent months about their concerns that investors are over-reliant on the proxy advisory firms. ISS and Glass Lewis did not respond to requests for comment.

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