Overview

Partly as a result of formal petitions for rulemaking by the AFL-CIO and the Teamsters, and partly as a result of the public company financial scandals that gave rise to the Sarbanes-Oxley Act, the SEC has proposed that investment companies and investment advisers be required to provide substantial disclosure about proxy voting matters.[1] The Fund Proposals would require investment companies to disclose voting policies and procedures and information about actual votes cast. The Adviser Proposals would require investment advisers to adopt written policies and procedures, and to inform clients about them and about how to obtain information about actual votes cast. This Alert describes how these proposals would affect both investment companies and investment advisers.

Investment Companies

Voting Policies and Procedures

The Fund Proposals would require an open-end fund to disclose in its SAI, and a closed-end fund to disclose in Form N-CSR filings,[2] the policies and procedures that it uses to determine how to vote proxies for portfolio securities. The Fund Proposals assume that all funds in fact have policies and procedures on proxy voting. To the extent that a fund does not have written policies and procedures, or its current policies and procedures do not address certain items, it would have to formalize or amend them.

The Fund Proposals suggest that these policies and procedures should cover:

• procedures that a fund uses when a vote presents a conflict between the interests of fund shareholders, on the one hand, and those of the fund's investment adviser, principal underwriter or affiliates, on the other;
• the extent to which a fund delegates voting decisions to its investment adviser (or sub-adviser) or a third party, or relies on third-party recommendations;
• the fund's approach to matters that may affect substantially shareholder rights or privileges; and
• the support or weight given to the views of company management.

Policies also should cover voting on specific types of issues, such as:

• corporate governance matters, mergers and anti-takeover provisions;
• changes to capital structure;
• stock option plans and other management compensation issues; and
• social and corporate responsibility issues.

Voting Record

Disclosure of Complete Voting Record

The Fund Proposals would add new Item 2 to proposed Form N-CSR, requiring each fund to disclose the following information for each matter considered at any shareholder meeting during the period where the fund was a shareholder of record entitled to vote. A registrant that offers multiple funds would have to provide this information separately for each fund:

• the issuer's name, ticker symbol and CUSIP number;
• the shareholder meeting date;
• a brief identification of the matter voted on;
• whether the matter was proposed by the issuer or by a security holder;
• whether the fund cast its vote on the matter;
• how the fund cast its vote (e.g., for, against, or abstain); and
• whether the fund cast its vote for or against management.

Additional Disclosure of Votes That Are Inconsistent With Policies and Procedures

The Fund Proposals would require a fund to disclose in its annual and semi-annual reports to shareholders any proxy votes (or failures to vote) that are inconsistent with the fund's proxy voting policies and procedures and provide reasons for the inconsistent votes.

Availability of Proxy Voting Information to Fund Shareholders

The Fund Proposals also would require a fund to disclose to its shareholders the availability of information about voting policies and procedures and its voting record. Funds would be required to make voting information available without charge, upon request, and would be required to send information within three business days of receipt of any request.

Commentary

The Fund Proposals will likely be controversial. Twice in the 1970s, the SEC unsuccessfully sought to require funds to provide information about proxy voting of portfolio securities.[3] However, the current political and investor climate may lead to the adoption of this latest effort. The SEC has asked for both broad and specific comments on the Fund Proposals.

The SEC estimates the costs of industry-wide compliance with the Fund Proposals to be $14 million, a figure that seems exceedingly conservative. At the SEC open meeting at which the Fund Proposals were approved, at least two Commissioners were quite troubled by the steep costs associated with the Fund Proposals, particularly given that the Fund Proposals come on the heels of the Sarbanes-Oxley Act, which has its own substantial implementation costs. Although recognizing that the costs will be relatively high, the SEC stated that it believes such costs are outweighed by the benefits, including that disclosure of this type may encourage funds to become more engaged in corporate governance of issuers held in their portfolios, which could benefit all investors and not just fund shareholders.

The SEC also believes that shedding light on mutual fund proxy voting could illuminate potential conflicts of interest and discourage voting that is inconsistent with fund shareholders' best interests. The Fund Proposals do not address the challenges of reconciling different shareholder groups' views of what may be in the best interests of shareholders as a whole. Nor do they fully recognize the potential for shareholder groups and companies to try to influence funds and management on voting policies and particularly votes.

In our view, some of the most onerous aspects of the Fund Proposals include the extent of detail that would have to be included in the voting reports filed with the SEC, and the heightened exposure to civil (and perhaps criminal) liability that CEOs and CFOs will face as a result of these additional items being added to the "certified" report on Form N-CSR. As these officers now must familiarize themselves with every aspect of Form N-SAR and become personally involved in evaluating disclosure controls and procedures and internal controls, the Fund Proposals will saddle CEOs and CFOs with the additional burdens of certifying proxy voting policies, procedures and actual votes cast. It appears to us that the certifications mandated by Sections 302 and 906 of the Sarbanes-Oxley Act contemplated neither certifications of such a broad range of detail, nor the micromanagement of the time that CEOs and CFOs allocate to specific daily tasks.

Investment Advisers

In a companion release, the SEC also proposed to require that investment advisers exercising voting authority over client proxies: adopt policies and procedures reasonably designed to ensure that the adviser votes in the best interest of clients; disclose to clients information about those procedures and policies; disclose how clients may obtain information on actual votes cast; and retain voting records.

Voting Policies and Procedures

The Adviser Proposals would require registered investment advisers[4] that have voting authority, to adopt written policies and procedures governing their exercise of voting authority over client securities. Although the SEC has not mandated any specific form, the policies and procedures, must, at minimum: (i) be written; (ii) describe how the adviser addresses material conflicts between its interests and those of its clients with respect to proxy voting; and (iii) address how the adviser resolves those conflicts in the best interest of the clients.

The SEC also believes that effective policies and procedures should, among other things, describe the basis on which voting decisions are made, and identify personnel involved in various aspects of the voting decisions. The extent of reliance on third parties or committees should also be covered.

Information About Voting

The Adviser Proposals would also require an investment adviser to inform its clients how they can obtain information from the adviser on actual votes. Unlike the Fund Proposals, however, new Rule 206(4)-6 does not prescribe the nature, format or scope of the information that must be disclosed. The Adviser Proposals also would require advisers to describe their voting policies and procedures to clients and to furnish a copy to clients upon request.

Recordkeeping for Proxy Voting

In addition, the Adviser Proposals would amend the investment adviser books and records rule (Rule 204-2) to require advisers to maintain detailed records about their proxy voting activities for five years.

Commentary

The circumstances and backdrop that gave rise to the Fund Proposals—namely, the perceived enormity of the voting power these holders collectively have to affect the outcome of shareholder votes and influence corporate governance—also gave rise to the Adviser Proposals. Accordingly, it seems that the Adviser Proposals are designed not only to ensure that advisers fulfill their fiduciary duties by properly exercising voting discretion, but also, and perhaps more importantly, to influence the way a public company behaves.

Like the Fund Proposals, the Adviser Proposals will most certainly be controversial. Advisers might reasonably ask whether the SEC shouldn't be treating the root causes of the recent financial scandals with substantive changes to the way public companies operate and report (e.g., demanding that companies expense options) rather than with third-party disclosure changes (e.g., requiring advisers to disclose whether they voted to approve a particular company's options package).

In the end, it is worth noting that advisory clients voluntarily delegate their right to vote proxies, trusting their adviser to vote them appropriately. After all, advisory clients could contract to retain voting authority or obtain voting information if they so chose. To compel advisers to provide information that the vast majority of clients have not sought seems counterintuitive.

Comments Due

Comments on both the Fund Proposals and Adviser Proposals must be received by the SEC on or before December 6, 2002.

Prepared by: Marco E. Adelfio (202) 887-1530

 

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Footnotes:

[1]: Proposed Rule: Disclosure of Proxy Voting Policies and Proxy Voting Records by Registered Management Investment Companies, Inv. Co. Act Rel. No. 25739 (Sept. 20, 2002) (the "Fund Proposals"); and Proposed Rule: Proxy Voting by Investment Advisers, Inv. Adv. Act Rel. No. 2059 (Sept. 20, 2002) (the "Adviser Proposals").

[2]: Form N-CSR is the form that was recently proposed by the SEC to be used by funds to file certified shareholder reports under the Sarbanes-Oxley Act of 2002.

[3]: Rule proposals covering these matters were made in 1971 (withdrawn in 1976) and in 1978 (withdrawn in 1978).

[4]: Rule 206(4)-6 would not apply to smaller advisers that are registered only with state securities authorities, nor would it apply to advisers that rely on an exemption from registration under Section 203(b) of the Investment Advisers Act, such as the "14 or fewer clients" exemption.