Investment Advisers Act of 1940 - Rule 206(4)-6
Egan-Jones Proxy Services
May 27, 2004
Kent S. Hughes
Egan-Jones Proxy Services
61 Station Road
Haverford, PA 19041
Dear Mr. Hughes:
In your letter dated December 16, 2003, you ask for guidance concerning investment advisers that use the recommendations of independent third parties to vote client proxies. Your inquiry generally relates to the circumstances under which a third party may be considered independent under Rule 206(4)-6 under the Investment Advisers Act of 1940 (the "Advisers Act"), which was adopted by the Commission to address the voting of proxies by investment advisers on behalf of their advisory clients.1 This letter confirms and expands upon the guidance that we provided to Egan-Jones Proxy Services ("Egan-Jones") on January 15, 2004.2
An investment adviser may face direct and indirect conflicts of interest in voting the proxies of its clients, including its fund clients, when it has the discretionary authority to vote the proxies.3 For instance, if a broker-dealer that is affiliated with an investment adviser provides investment banking services to an issuer that is soliciting proxies, that relationship could influence the adviser to vote its clients' proxies in its affiliate's interest, rather than in the best interests of its clients, thus breaching the adviser's fiduciary duty of loyalty to its clients.4 To address these and other conflicts, the Commission adopted Rule 206(4)-6 under the Advisers Act to require registered investment advisers to adopt and implement policies and procedures that are designed to ensure that their clients' proxies are properly voted, material conflicts are avoided and fiduciary obligations are otherwise fulfilled.
In the Rule 206(4)-6 Adopting Release, the Commission indicated that an investment adviser could demonstrate that its vote of its clients' proxies was not a product of a conflict of interest if the adviser voted the proxies in accordance with a pre-determined policy based on the recommendations of an independent third party.5 An investment adviser that votes client proxies in accordance with a pre-determined policy based on the recommendations of an independent third party will not necessarily breach its fiduciary duty of loyalty to its clients even though the recommendations may be consistent with the adviser's own interests. In essence, the recommendations of a third party that is in fact independent of an investment adviser may cleanse the vote of the adviser's conflict.6
An investment adviser that retains a third party to make recommendations regarding how to vote its clients' proxies should take reasonable steps to verify that the third party is in fact independent of the adviser based on all of the relevant facts and circumstances. A third party generally would be independent of an investment adviser if that person is free from influence or any incentive to recommend that the proxies should be voted in anyone's interest other than the adviser's clients. Such a person generally could not be an "affiliated person" of the investment adviser as that term is defined in the Advisers Act, or have any material business, professional, or other relationship with the investment adviser.7 For example, a person that provides services to an investment adviser's employee benefit plan in exchange for compensation may be inclined to recommend that the proxies should be voted in the interests of the adviser in order to curry favor and maintain its business relationship with the adviser.8
In your letter, you ask whether a proxy voting firm would be considered to be an independent third party if the firm receives compensation from an issuer ("Issuer") for providing advice on corporate governance issues. We believe that the mere fact that the proxy voting firm provides advice on corporate governance issues and receives compensation from the Issuer for these services generally would not affect the firm's independence from an investment adviser.9
An investment adviser should not, however, conclude that it is appropriate to follow the voting recommendations of an independent proxy voting firm without first ascertaining, among other things, whether the proxy voting firm (a) has the capacity and competency to adequately analyze proxy issues, and (b) can make such recommendations in an impartial manner and in the best interests of the adviser's clients. An investment adviser could breach its fiduciary duty of care to its clients by voting its clients' proxies based upon the proxy voting firm's recommendations with respect to an Issuer because the proxy voting firm could recommend that the adviser vote the proxies in the firm's own interests, to further its relationship with the Issuer and its business of providing corporate governance advice, rather than in the interests of the adviser's clients. The proxy voting firm's relationship with an Issuer thus may present a conflict of interest that is in addition to any conflict of interest that the investment adviser may have.
Accordingly, an investment adviser should obtain information from any prospective independent third party to enable the adviser to determine that the third party is in fact independent, and can make recommendations for voting proxies in an impartial manner and in the best interests of the adviser's clients. An investment adviser should establish and implement procedures to identify and address conflicts that can arise on an ongoing basis concerning the third party.10 For instance, under the circumstances that you describe in your letter, the procedures should require a proxy voting firm that is called upon to make a recommendation to an investment adviser regarding the voting of an Issuer's proxies to disclose to the adviser any relevant facts concerning the firm's relationship with an Issuer, such as the amount of the compensation that the firm has received or will receive from an Issuer. That information will enable the investment adviser to determine whether the third party can make recommendations about how to vote the clients' proxies in an impartial manner and in the best interests of the clients, or whether the adviser needs to take other steps to vote the proxies.11
Rule 206(4)-6 under the Advisers Act requires an investment adviser to adopt and implement written policies and procedures that are designed to ensure that its clients' proxies are voted in the clients' best interests, to describe these policies and procedures to their clients, and to provide a copy of these procedures to clients upon request.12 Those procedures should address the use of any independent third party to make recommendations regarding the voting of the proxies of an investment adviser's clients if the use of an independent third party is a material part of the adviser's proxy voting policies. We note that, similarly, a fund must disclose to its shareholders the policies and procedures that it follows for voting proxies, in particular, the procedures that the fund follows when a vote presents a conflict between the interests of the fund shareholders, on the one hand, and those of the fund's investment adviser, principal underwriter, or any affiliated person of the fund, its investment adviser, or its principal underwriter, on the other.13 In addition, if applicable, a fund must disclose in its registration statement that an independent third party makes voting recommendations, or otherwise votes the fund's proxies, and must also disclose the policies and procedures used by the third party to vote the fund's proxies.14
We hope that this information is helpful. Please note that we take no position regarding whether an investment adviser should hire Egan-Jones as an independent third party to vote the proxies of the investment adviser's clients. The decision to hire Egan-Jones in that capacity rests entirely with the investment adviser. If you have additional questions, you may telephone Kathleen L. Knisely, Senior Counsel, or Alison M. Fuller, Assistant Chief Counsel, at 202-942-0659.
Very truly yours,
Associate Director and
December 16, 2003
Mr. Douglas Scheidt
Associate Director and Chief Counsel
Division of Investment Management
United States Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549
Re.: Proxy Voting by Investment Advisors
Dear Mr. Scheidt:
In Section II. A. 2. b. of the Security & Exchange Commission's Final Rule on Proxy Voting by Investment Advisors [17 CFR Part 275; release No. IA-2106; File No. S7-38-02] ("the Rule"), the following language appears in the second paragraph under "Resolving Conflicts of Interest":
"Advisers today use various means of ensuring that proxy votes are voted in their clients' best interest and not affected by the advisers' conflicts of interest.23 An adviser that votes securities based on a pre-determined voting policy could demonstrate that its vote was not a product of a conflict of interest if the application of the policy to the matter presented to shareholders involved little discretion on the part of the adviser.24 Similarly, an adviser could demonstrate that the vote was not a product of a conflict of interest if it voted client securities, in accordance with a pre-determined policy, based upon the recommendations of an independent third party [my italics]."
We respectfully request guidance with respect to the definition, in the preceding paragraph, of the term "independent." For example, does the fact that a firm providing proxy research and recommendations (a "Proxy Research Firm") also receives compensation on corporate governance issues from a corporation that is being researched, affect its independence? Also, in such a case, is the Proxy Research Firm required to disclose the existence of its compensation arrangement and the amount of its compensation? Also, is a fund that uses a proxy adviser that accepts compensation from companies regarding which it provides proxy research and recommendations, required to disclose that fact in its registration statement or otherwise in connection with its disclosure of its votes?
In the interest of saving you research time, below are comments from two published articles on the issue of a firm providing proxy research and recommendations and also providing consulting on corporate governance/proxy matters:
"""These two things can`t coexist,"" says Ted White, director of corporate governance for [Proxy Research Firm] client CalPERS, California`s $133 billion state-employee pension fund. ""It`s a whole lot like the audit industry was. You can`t build your business model around a conflict."""
"[Nell] Minow is now editor of the Corporate Library, which will soon release its own board ratings; her firm does not do business with the companies it evaluates. ""It would compromise our credibility to take any money from them,"" she says."
We would greatly appreciate your comments on this area and look forward to hearing from you.
Very truly yours,
Kent S. Hughes