Proxy adviser have now come to play an important role for listed companies in Switzerland with a significant free float. The breadth of the phenomenon is relatively recent and coincided with the enactment and entry into force of the Ordinance against Excessive Compensation for listed companies (OaEC; Verordnung gegen übermässige Vergütungen in börsenkotierten Unternehmen (VegüV)), which mandates, inter alia, a binding shareholder resolution on say on pay. The increased power of proxy advisers also gives rise to some concerns and to the question of how to address them.

By Thomas U. Reutter (Reference: CapLaw-2015-16)

1) Proxy Advisers and their Increased Power

Until recently, ISS used to be primarily associated with a company providing facility services in corporate Switzerland. Not anymore. Institutional Shareholder Services, Inc., best known under its acronym ISS, is well known and sometimes feared among boards and executive management of Swiss listed companies. Although ISS appears to be the most visible international proxy adviser in Switzerland, peers like U.S. based Glass Lewis & Co. LLC, PIRC (Pension & Investment Research Consultants Ltd) and Manifest based in the U.K., IVOX from Germany and Proxinvest from France have been active in respect of Swiss listed companies as well. While some of these firms are pure proxy advisers, most of them offer other services including corporate governance advisory, class action claims management, management of disclosure of major shareholdings and similar services to institutional investors or listed companies.

Of course, Switzerland boasts its own proxy advisers: Z-rating (formerly part of Z-Capital, an investment management firm), Ethos (a foundation for ethical investments) and SWIPRA (Swiss Proxy Adviser; a foundation sponsored by Swiss investment funds). All of them focus their activities and voting recommendations on Swiss listed companies.

Undoubtedly, proxy advisers deserve great praise in fostering good corporate governance, enhanced transparency of listed companies and bolstering shareholder rights. However, a few doubts are lingering. These doubts relate to conflicts of interests, a lack of transparency of reasons behind a voting recommendation and a lack of understanding of the specific issuer or context.

2) Merits and Areas of Concern

It would clearly be best practice for proxy advisers to establish and publish general voting guidelines, which set out in a general manner how proxy advisers will recommend to vote under a given set of facts. However, not all of the proxy advisers establish such guidelines in a level of detail allowing a reader to draw conclusions as to the likely voting recommendation in a given set of facts. Neither are they required to do so by law. Listed companies are therefore at times left in the dark as to the reasons of a “no” recommendation for a proxy adviser. For example, a proxy adviser may issue a “no” recommendation in respect of a binding shareholder vote on board compensation without publishing the reasons leading to a “no” recommendation. In the specific case, the proxy adviser had composed a group of peer companies and calculated a median of compensation per board member. The peer group was not disclosed publicly and was disclosed to the issuer only after repeated requests to do so. The listed company had no opportunity to challenge the peer group (e.g. on the basis that such peer group should only have included companies without a controlling shareholder whose representatives are often compensated by such shareholder). Neither did the public or shareholders generally have the opportunity to assess whether the specific recommendation was warranted or not.

This lack of transparency is often combined with a lack of communication with the issuer. Even when the proxy adviser had previously issued a general guideline on voting, the outcome of a specific voting recommendation is often not a case of black or white. This is because the guidelines must, by necessity, be principle based and warrant interpretation and adaptation in specific cases. Often, however, proxy advisers lack the time or the resources to understand a specific issuer and its circumstances and use their respective criteria rather schematically. For example, in the recent adaption of the articles of incorporation to the OaEC, most of the proxy advisers recommended a “no” vote whenever they saw the word “option” as a (potential) part of the executive compensation in one of the clauses of the articles. However, they did not have an issue with “share purchase entitlement awards” (anwartschaftliche Bezugsrechte auf Aktien). Would not an option to receive shares also constitute a share purchase entitlement award?

It appears that proxy advisers often base their recommendations on “tick the box” analysis rather than a research of the specific issuer or its country of incorporation. For example, whenever issuers exceed certain thresholds in a motion to shareholders to approve a general authorized capital – usually 20% of the existing capital –, the recommendation will most likely be “no”, irrespective of the issuer or the circumstances. By the same token, whenever a board member whose term of office exceeds 12 years will seek re-election, the recommendation will most likely be “no”, irrespective of the circumstances (for example, the executive management being in a transition phase).

The problem, it seems, is only to a limited extent rooted in the general voting guidelines. These guidelines, if any, often allow for exceptions in specific cases. However, the (most often junior) researchers of the proxy advisers generally lack the time or the energy to research the specific case or to talk to the issuer ahead of their recommendation. The result is a rather schematic recommendation, which may at times just be unhelpful, but at times also harmful to the listed company concerned.

A further area of concern revolves around conflicts of interest. Proxy advisers may be engaged in consultancy businesses to companies that are also included in their proxy recommendations. Some proxy advisers offer corporate governance advice to listed companies. Of course, a proxy adviser who has advised a listed company will be inclined to apply its discretion in favor of such listed company when issuing a voting recommendation.

Finally, there is hardly any liability for the acts of proxy advisers if they only issue recommendations. No matter how ill-founded a recommendation may be, if merely recommendations are issued by a proxy adviser, a company will find it difficult to successfully invoke any injunctive relief or claim for damages. Hence, private legal remedies tend not to be a deterrent for proxy advisers.

3) Regulation Globally – Regulation in Switzerland

These areas of concern would appear to call for some regulation. However, little has been done in this respect. In the EU, the European Securities and Market Authority (ESMA) has undertaken an extensive analysis of the proxy adviser industry and has found no evidence of market failure requiring regulatory intervention. However, ESMA also noted that there were “a number of concerns regarding conflicts of interest management and the transparency of analysis and advice” and hence recommended the establishment of an EU Code of Conduct for proxy advisers (see www.esma.europa.eu; press release dated 19 February 2013 “ESMA recommends EU Code of Conduct for proxy adviser industry”).

In ESMA’s view, a Code of Conduct for proxy advisers should focus on the following principles:

• Identifying, disclosing and managing conflicts of interest: Proxy adviser should avoid conflicts of interest or at least disclose them and adopt measures of mitigation.
• Fostering transparency to ensure the accuracy and reliability of the advice: Proxy advisers should issue and disclose publicly their general voting policies and methodologies and the sources used in making specifi c recommendations. Proxy advisers should also take into account local market, legal and regulatory conditions and disclose whether and, if applicable, how they have been taken into account. Finally, proxy advisers should inform investors about their dialogue with the issuers as well as of the nature of such dialogue.

Although the above principles clearly address most of the areas of concern previously described, it seems that not much progress has been made in finalizing the proposed Code of Conduct.

The situation is slightly different in the United States. While neither the U.S. have a specific proxy adviser regulation, proxy advisers are regulated under the federal securities laws if they seek the power to act as proxy for their clients (constituting a “solicitation” under the federal proxy rules). However, if proxy advisory firms limit their activities to issuing reports with recommendations, they will not be under direct supervision by the SEC (see www.sec.gov/interps/legal/cfslb20.htm; SEC Staff Legal Bulletin N. 20 (IM/ CF): Proxy Voting: Proxy Voting Responsibilities of Investment Advisers and Availability of Exemptions from the Proxy Rules for Proxy Advisory Firms). However, there is some indirect regulation through the regulation of investment advisers. The SEC has issued guidance to investment advisers as to their responsibilities in selecting and supervising proxy advisers. For example, investment advisers should consider consistency and quality of proxy recommendations as well as the manner in which conflicts of interest are dealt with by the proxy advisers in the initial selection and periodic review of proxy advisers. However, the SEC did not issue any specific substantive rules, which would require proxy advisers directly, or indirectly through the regulation of investment advisers, to make specific disclosures or to interact with issuers in a required manner.

Proxy advisers are not regulated in Switzerland either. However, a group of associations and foundations including, inter alios, the Swiss Pension Association representing institutional investors, the major associations of corporate Switzerland (economiesuisse, SwissHoldings, Swiss Banker’s Association) and Ethos, a proxy adviser, have issued “Guidelines for institutional investors governing the exercising of participation rights in public limited companies” (see www.swissinvestorscode.ch). In Principle 3, the Guidelines state that institutional investors must select proxy advisers carefully and must supervise them. Also, institutional investors should not blindly follow recommendations by proxy advisers, but critically examine recommendations and try to identify conflicts of interest. Interestingly, the Guidelines also proclaim a right of the listed company to be heard ahead of recommendations on controversial issues. However, the Guidelines in general and the right to be heard in particular appear to have little relevance in practice. There may be several reasons for that. The Guidelines are addressed to institutional investors (as opposed to proxy advisers), involve only a limited number of relevant players and are essentially non-binding (based on a “comply or explain” regime).

4) What would be the Substance of a Proxy Adviser Regulation?

In an ideal world, proxy advisers would adhere to a procedure that is perceived fair, transparent and conflict free by all players involved. This should also be the goal of any potential proxy adviser regulation. ESMA’s suggested Code of Conduct clearly goes into the right direction with its focus on avoiding and disclosing conflicts of interest and increasing transparency. However, the proposed rules seem to only cover a bare minimum. Further granularity would have to added; not in the sense of detailed regulatory regime, but in the sense of a comprehensive but still principle based framework.

An additional element worth considering is the right of the listed company to be heard ahead of a recommendation. This right could be combined with the requirement on proxy advisers to submit investors not only their own analysis and recommendation, but also the statement, if any, by the issuer concerned setting out its own position. This right to be heard would avoid potentially flawed assessments by the proxy adviser due to a lack of understanding of local markets or legal regimes. It would also unveil any “tick the box” approach by proxy advisers and therefore increase their scrutiny and diligence of analysis. Investors would benefit because they receive the analysis and arguments from both, the proxy advisers and the listed company and can therefore make a better informed voting decision.

5) Should Switzerland take Action?

Regulating proxy advisers does not seem to be on top of the political agenda in Europe and the U.S. It would be difficult for a small country like Switzerland to be a first mover in regulation of proxy advisers. In order to be effective, the regulation would have to address proxy advisers based abroad, e.g. ISS or Glass Lewis based in the U.S. providing advice to Swiss but also non-Swiss shareholders. The only link to Switzerland would be the headquarters of the listed company whose shares confer the voting rights for which recommendations will be issued. However, the proxy adviser issuing the advice and the institutional investor retaining such advice are likely to be based outside of Switzerland and may even be based in the same third country. Hence, the relationship between the proxy adviser and the institutional investor receiving the advice may be entirely governed by a foreign jurisdiction. The only reason for Switzerland to legislate would be that the effect of such relationship could occur in Switzerland, similar to the “effects doctrine” in competition law. However, legislation based on this principle will likely face resistance internationally unless there is consensus among the relevant countries that the “effects doctrine” is the proper way to address regulation of proxy advisers internationally.

Proxy adviser regulation may have its benefits if undertaken on a broad international scale. However, Switzerland on its own is unlikely to be able to effectively address the areas of concern in proxy adviser activity by regulatory action.

Thomas U. Reutter (thomas.reutter@baerkarrer.ch)