CSA Consultation Paper 25-401 Regarding Potential Regulation Of Proxy Advisory Firms

This letter is submitted on behalf of the ICD in response to the invitation to comment on a potential securities regulatory response to address the concerns about proxy advisory firms identified by the Canadian Securities Administrators in CSA Paper 25-401.

Context 

Why is the ICD commenting on the CSA Paper? Simply put, the exercise of voting rights by shareholders is a critical component of effective corporate governance. 

Our proxy voting system has been built on the fundamental principle that if someone is soliciting a proxy in connection with voting at a shareholder meeting, they must provide prescribed information regarding their identity, any material interest in the issuer and the matters to be voted on and disclosure of the substance of such matters in sufficient detail to enable reasonable security holders to form a reasoned judgment on such matters. Issuers, dissidents, and their respective directors and officers have potential liability under securities laws in the event of a misrepresentation in the materials which they send to shareholders.    

Directors take these disclosure obligations seriously as they are a primary communications channel to shareholders and are accountable if they do not. 

Currently, proxy advisory firms, who have become an intermediary in the communications channel, are not held to this, or any standard, yet we believe they exert significant influence on the exercise of voting rights.   

We recognize that proxy advisory firms play an important role in assisting their clients with their voting franchise. Their growing influence and business reflects the important market niche they service. 

This disconnect between influence and accountability requires CSA attention. Our comments below, seek to offer pragmatic observations, perspectives and proposed solutions. 

We do so, by addressing the concerns identified by the CSA, namely: 

• Potential conflicts of interest 
• Lack of transparency 
• Potential inaccuracies and limited opportunity for issuer engagement 
• Perceived corporate governance implications 
• Extent of reliance by institutional investors 
• Potential securities regulatory frameworks  

Potential Conflicts of Interest 

We agree with the potential conflicts of interest that have been identified by the CSA in section 4.1 of the CSA Paper. We also agree that a number of regulatory approaches and solutions to deal with the problem are possible. 

We would recommend that proxy advisory firms be required to expressly disclose their conflicts on any matter in respect of which they are issuing a voting recommendation. This disclosure should be comprehensive, explicit and not boiler plate. We would also recommend that proxy advisory firms be required to set up “walls” and adopt other structural solutions to eliminate bias in the advice they provide.   

We have serious reservations about whether walls and disclosure adequately address all conflict of interest situations. For example, we do not believe that a proxy advisory firm should be able to issue a voting recommendation on a particular matter where they have provided consulting services to the issuer or their investor client or owner has a material interest. 

Lack of Transparency 

As a general matter, we are not troubled by non-public disclosure of a proxy advisory firm’s voting recommendations to its clients on matters of business to be considered at a meeting of shareholders. This is consistent with the contractual nature of the relationship between a proxy advisory firm and its clients and the lack of legal safeguards applicable to these communications. 

As will be seen below, we have a different view with respect to shareholder meetings where the proxy advisory firm intends to issue a voting recommendation contrary to the recommendation contained in the management information circular (a “contrary recommendation”) or is developing its proxy voting guidelines. 

Potential Inaccuracies and Limited Opportunity for Issuer Engagement 

Corporate directors expend considerable time, care and attention to ensure that information circulars meet legal standards for disclosure. They are accountable if they do not. 

Proxy advisory firms significantly influence voting outcomes but have no similar duty or accountability. 

The ICD believes this imbalance requires rectification. It is critical that shareholder voting decisions be based on meaningful and accurate disclosure. 

We are aware of circumstances where voting recommendations of proxy advisory firms contained mistakes and inaccuracies. We are also aware of concerns that have been expressed by directors and issuers about the quality and inexperience of proxy advisory firm staff who are required to analyze and opine on complex subject matter. 

What should be done about this? One approach would be to level the playing field and require that proxy advisory firms abide by all the same rules as anyone else who issues a communication likely to influence the giving or withholding of a proxy. We recognize that this might not be a practical solution given the sheer volume, compressed time periods and costs that proxy advisory firms would face with this approach in any given annual meeting proxy season. 

In our view, at a minimum, the CSA should support a pragmatic solution to this problem. 

Such a solution would require that: 

Where the proxy advisory firm intends to issue a contrary recommendation, it be required to discuss this with the issuer and share its report with the issuer before its completion and publication to voters; and 

If the outcome of this process is still an intended contrary recommendation, the issuer be provided with sufficient time and the opportunity, if it wishes to do so, to include a response in the materials that are ultimately provided to the proxy advisory firm’s clients.  

We believe this approach will greatly reduce the likelihood that the shareholder is voting based on misinformation and reflects a light handed but potentially very effective and pragmatic solution to the problem. It is imperative that a solution be found for this problem as the status quo is unacceptable.  We believe this approach should be pursued by the CSA, at a minimum. The solution will also require that issuers be provided with sufficient time to provide their comments and obtain board approval, if necessary. Public disclosure requirements, to the extent applicable would, also have to be adhered to.  

We note that, as pointed out in the CSA Paper, the New York Stock Exchange Commission on Corporate Governance recommended that proxy advisory firms should be required to disclose the company’s response to their analysis and conclusions. We also note that, pursuant to its board engagement policy, the Canadian Coalition for Good Governance (“CCGG”) generally provides the issuer’s board of directors with an opportunity to comment on its draft reports before they’re made available to CCGG members.   

To further reduce the likelihood that the shareholder is voting based on misinformation and to address the concerns that have been expressed by directors and issuers about the quality and inexperience of 

proxy advisory firm staff who are required to analyze and opine on complex subject matter, the CSA should consider setting standards of adequacy for the performance of this work. 

Development of Corporate Governance Standards 

We believe that proxy advisory firms can make a positive contribution to corporate governance. In order to do so we believe that the process for development of their proxy voting guidelines should include the opportunity for consultation with the issuer and director communities so that the guidelines take into account perspectives of these key constituencies. 

As well, it is important that the guidelines not be cast in stone, as “one size does not fit all” in corporate governance and corporate governance should not become a “tick the box” exercise. 

We note with interest a recent draft working paper by the Rock Center for Corporate Governance that concludes that issuers in the U.S. that modified their executive compensation to conform to proxy advisory firm guidelines and voting recommendations actually suffered shareholder value diminution. This reinforces the need for dialogue with the issuer and director communities in the development of these guidelines and is consistent with the ICD’s support of effective shareholder engagement, as for example with the CCGG. 

Reliance By Institutional Investors 

This is best commented on by institutional investors but we believe that proxy advisory firms are influential and play an important role in voting outcomes. 

The extent of influence and reliance may not be able to be easily calculated but we note the practice of issuers and dissidents to publicize a proxy voting firm’s recommendation in contested meeting situations. Value is obviously being ascribed to the recommendation by participants. 

We wish to emphasize the importance the ICD places on the exercise of the right to vote and would encourage all shareholders to take the requisite time, care and attention in exercising this important franchise. Outsourcing this function to a proxy advisory firm, even if the shareholder retains a theoretical ability to re-vote the position, in our view, is an abdication of responsibility. Our proxy voting system should marry the exercise of voting power and economic interest, not divorce them. 

Potential Securities Regulatory Frameworks 

A number of options are available to the CSA in this regard. At one end of the spectrum, comprehensive and particularized regulation could be considered. We are suggesting a less intrusive and more pragmatic approach, as a minimum. 

In our view, proxy advisory firms should be given one year to adopt the approach recommended in this letter as a best practice. If, after one year, proxy advisory firms do not do so or this minimalist approach proves to be deficient, the CSA should regulate further. 

Other 

In our comment letter dated March 28, 2011 responding to the OSC Staff Notice 54-701 request for comments on shareholder democracy issues we noted the importance of ensuring the integrity of the proxy voting system and expressed concerns about empty voting. We would encourage the CSA to embrace and advance those initiatives. 

Conclusion 

The ICD believes the exercise of voting rights by shareholders is a critical component of corporate governance. The director community believes that voting decisions must be based on accurate and proper disclosure. There is currently a disconnect between the influence of proxy advisory firms and their accountability that undermines this aspect of corporate governance and impacts the integrity of our capital markets. A number of options are available to the CSA in this regard. At a minimum, we would recommend that proxy advisory firms be given a year to adopt the following best practices: 

• Expressly disclose their conflicts on any matter in respect of which they are issuing a voting recommendation; 
• Set up “walls” and adopt other structural solutions to eliminate bias in the advice they provide;
• Refrain from issuing a voting recommendation on a particular matter where they have provided consulting services to the issuer or their investor client or owner has a material interest; 
• Where the proxy advisory firm intends to issue a contrary voting recommendation, it be required to discuss this with the issuer and share its report with the issuer before its completion to ensure fairness and accuracy and enable the advisory firm to present a more fully considered view; 
• If the outcome of this process is still an intended contrary recommendation, the issuer be provided with sufficient time and opportunity, if it wishes to do so, to include a response in the materials that are ultimately provided to the proxy advisory firm’s clients; and 
• Consult with issuers and directors in the development of proxy voting guidelines along with other stakeholders and develop guidelines that are not cast in stone. 

Proxy advisory firms should be given one year to adopt the foregoing as best practices. If after one year, proxy advisory firms do not do so or this minimalist approach proves to be inadequate, the CSA should regulate further. 

To further reduce the likelihood that the shareholder is voting based on misinformation and to address the concerns that have been expressed by directors and issuers about the quality and inexperience of proxy advisory staff who are required to analyze and opine on complex subject matter, the CSA should consider setting standards of adequacy for the performance of this work.