The Fifth and Sixth Circuits are currently embroiled in a contentious debate over the legality of the Securities and Exchange Commission’s (SEC) Proxy Advisory Rule, with far-reaching implications for corporate governance and regulatory oversight. Depending on the outcome, this case may ultimately be elevated to the US Supreme Court, potentially reshaping the landscape of proxy advisory firms and their influence on shareholder decisions.
This circuit split highlights the escalating concerns surrounding the proxy advisory duopoly, with critics arguing that Glass Lewis and Institutional Shareholder Services (ISS) operate with de facto immunity from corporate and regulatory accountability. The lack of transparency and potential conflicts of interest have raised eyebrows among investors, policymakers, and corporate leaders, sparking a renewed debate about the need for stricter regulations and greater oversight.
The circuit split emerged in September, when the Sixth Circuit Court of Appeals upheld the SEC’s amendments to its rules governing proxy voting advice, which had been introduced in response to the Biden administration’s efforts to promote greater transparency and accountability. This decision came several months after the Fifth Circuit Court opposed the Biden-era changes, citing concerns about the SEC’s authority and the potential impact on corporate governance.
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, despite criticisms from some quarters that the SEC had not gone far enough in promoting accountability and disclosure.
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, a move designed to promote greater transparency and accountability in the proxy advisory process. This requirement marked an important step toward increasing the visibility of proxy recommendations and allowing companies to respond to potential concerns or inaccuracies.
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, highlighting the need for greater transparency and communication between proxy advisors and corporate leaders. The requirement for advance notice and awareness of proxy recommendations affords the targeted company time to raise red flags and point out potential concerns with the solicitation being offered.
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, a practice that has raised concerns about the potential for proxy advisors to exert undue influence over corporate decision-making. This process causes shareholders to be two steps removed from the actual decision-making process regarding proposals that shape the company, facilitating neglect and a lack of engagement among investors.
Providing proper notice of proxy advice helps move the proxy voting process out of the shadows, allowing companies to counter or rebuff proxy solicitations before they propel radical shareholder proposals onto the proxy ballot. By rescinding its transparency provisions, the SEC has denied corporations the ability to respond to proxy recommendations in a timely and effective manner.
The second major requirement from the Trump-era amendments requires proxy advisors to issue public disclosures about their conflicts of interest, a move designed to promote greater transparency and accountability in the proxy advisory process. While the 2022 amendments kept this requirement in place, the SEC’s Divisions of Corporate Finance and Examinations have overlooked several obvious conflicts, including the potential for proxy advisors to use their consulting services as a means of exerting influence over corporate decision-making.
Perhaps the most glaring example of this is the practice of proxy advisors softly threatening 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, highlighting the potential for proxy advisors to use their influence to promote specific policy agendas.
“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.” This cozy relationship between proxy advisors and corporate leaders has raised concerns about the potential for conflicts of interest and the need for greater transparency and accountability.
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, creating a self-reinforcing cycle of influence and control.
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, with the Fifth Circuit ruling likely to apply in certain states in the south and the Sixth Circuit ruling applicable in several other states. Given the uncertainty surrounding the SEC’s plans to appeal their loss in the Fifth Circuit, it remains unclear whether the Supreme Court will ultimately weigh in on the issue.
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, a decision that has been hailed as a victory for corporate leaders and investors seeking greater transparency and accountability. The court also opposed the SEC rescinding the provision requiring proxy firms to issue advance notice and awareness of their recommendations to companies, citing concerns about the potential impact on corporate governance and decision-making.
The SEC’s failure to justify why it rescinded the 2020 provisions triggered an APA violation, highlighting the need for greater transparency and accountability in the regulatory process. 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, a standard that the SEC failed to meet in this instance.
