Proxy Advisers Should Be Designated ERISA Fiduciaries
In his nomination hearing, Scalia faced tough questioning from Senate Democrats about his commitment to putting forth a rule that would ensure retirees receive unconflicted advice, however little was mentioned about extending this protection to advice from proxy advisers, where the DOL also has an important role to play.[1]
Despite the recent focus on the U.S. Securities and Exchange Commission’s oversight of proxy advisers,[2] DOL action on proxy advisers under the Employee Retirement Income Security Act of 1974 has the potential to have an even greater impact than any changes from the SEC.
ERISA protects private sector employees and retirees by setting minimum standards for employee benefit plans. Significantly, over $11 trillion worth of assets[3] held in employee pension benefit plans is governed by ERISA.
Under ERISA, the DOL has consistently designated shareholder voting as a part of the fiduciary duties of a plan manager since 1988.[4] As a result, it is somewhat surprising to find that the DOL has yet to designate proxy advisers, the primary provider of shareholder voting recommendations, as ERISA investment advice fiduciaries.
These for-profit companies recommend how investors should vote and process the vote itself, and the SEC has already confirmed that federal proxy rules apply to their reports.[5] Alarmingly, research suggests[6] that in many instances, the analysis provided by proxy advisers will not actually be reviewed by the plan manager, who instead automatically votes in line with guidance.
As my recent paper[7] explores in depth, designating proxy advisers as investment advice fiduciaries would ensure their recommendations are made solely in the interests of the beneficiaries. It would also require proxy advisers to show they have performed their own due diligence in formulating recommendations, and that their recommendations are consistent with an investment strategy to maximize the returns of the employee’s benefit plan.
If proxy advisers were specifically required to comply with ERISA’s fiduciary duties, traditional concerns regarding one-size-fits-all voting recommendations, conflicts of interest and a lack of transparency over underlying methodologies would be assuaged. For instance, there has been significant alarm[8] about how proxy advisers generate recommendations. Proxy advisers create voting recommendations largely through a low-cost, low-value approach, whereby a set of one-size-fits-all corporate governance principles is automatically applied to all companies in a client’s portfolio, providing recommendations for tens of thousands of shareholder meetings.
Proxy advisers lack the resources and the expertise to adequately analyze voting recommendations in critical and unique company events, such as proxy contests and mergers and acquisitions, across each of these shareholder meetings. The largest proxy adviser, Institutional Shareholder Services Inc., reportedly[9] dedicates a team of only eight research analysts to review these hugely complex and important situations.
These practices and the overreliance on proxy advisers likely lead to a breach of a plan manager’s duty of care due to the uninformed nature of such recommendations. By designating proxy advisers as investment advice fiduciaries, the DOL can ensure that they are required to dedicate additional resources and effort to proxy contests and mergers and acquisitions to fulfill their duty and outline the steps they took in disclosures to the DOL.
Outside of the outsourcing of voting to proxy advisers, the use of environmental, social and governance, or ESG, objectives by institutional investors has risen dramatically[10] in recent years. This is not to say that financially material risks and opportunities arising out of ESG factors cannot be considered in voting recommendations. Under ERISA, the use of these factors is acceptable, but only in the context of a risk-return analysis, with the maximization of shareholder wealth as the sole objective.
Proxy advisers have played a leading role in ESG’s growing prominence. For example, ISS provides a specialty report for multi-employer pension plans, or Taft-Hartley plans, that closely tracks proxy voting guidelines set by the American Federation of Labor and Congress of Industrial Organizations, whose policy[11] is to “generally oppose proposals that limit shareholder power by issuing dual class shares,” despite significant evidence[12] that equity portfolios that exclude companies with dual class share structures significantly underperform the market as a whole.
This likely violates the ERISA requirement that plan managers make decisions to maximize returns, despite Taft-Hartley plans falling under ERISA protections. Under a DOL rule designating proxy advisers as fiduciaries, ISS would have to scrap this report and instead produce an analysis through the lens of shareholder wealth maximization.
While recent and proposed SEC actions in relation to proxy advisers are clearly important steps to rectify long-standing concerns with their influence over shareholder voting, DOL action is also warranted. It will ensure the millions of people with employee benefit plans are also afforded the ERISA protection they are due on corporate governance matters, with wealth maximization at its heart.
Now that Scalia’s nomination[13] has been approved by the Senate and he has been sworn in as labor secretary, he should prioritize this change to secure adequate protection for ERISA plan beneficiaries.
