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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Remarks Before the SIFMA Proxy Symposium


Erik R. Sirri

Director, Division of Market Regulation
U.S. Securities and Exchange Commission

New York, NY
October 16, 2007

Thank you. It is a pleasure to join you today. I want to thank the Securities Industry and Financial Markets Association for inviting me to speak with you today. At the outset, let me remind you that the views I express are my own and not necessarily the views of the Commission, the individual Commissioners, or my colleagues on the Commission staff.1 Today, I would like to discuss the latest activities and information on vote distribution and proxy processing and broker discretionary voting.

Vote Distribution and Proxy Processing

Shareholder suffrage is critically important. Indeed, one of the pillars of corporate governance is the very powerful concept of shareholder democracy. A key issue with corporate elections is the process by which beneficial owners get to vote. Commission staff has dedicated a significant amount of time and energy to examining vote distribution and proxy processing at the beneficial owner level. As a part of this examination, my staff and I have met with individual firms to discuss out how they distribute "proxies" to and collect votes from their customer base and what, if any, business models underlie those procedures. As Don [Kittell] mentioned in his opening remarks, the Commission held a series of roundtables last May, where representatives of exchanges, broker-dealers, transfer agents, investors, and others shared their views on the current system and discussed possible improvements to the process. We learned a number of interesting things related to the processing of votes among beneficial owners. We are grateful for the sharing of ideas from the Roundtable as we press forward.

Today, I will briefly address what I've learned from our review, the issues I believe are relevant to the proxy voting process, and some issues that may need to be addressed in the near term.

What is the problem?

I have heard complains about broker-dealers casting more votes on behalf of itself and its customers than it holds at DTC — sometimes referred to as "over-voting." Our first step was to try to identify this problem. To do that, my staff has spent quite a bit of time learning about how various brokers handle their proxy processing, which varies among firms. From that effort, I identified a number of possibilities as to why the over-voting problem was occurring. While there may be many reasons for the perceived problem — such as the legal, regulatory, and operational complexities of the proxy process and the U.S. clearance and settlement system — the most significant reasons that are contributing to this perceived problem seems to be fails-to-deliver and securities lending.

It may be helpful here to review with you a bit the complex landscape in which proxy processing takes place. The vast majority of U.S. investors hold their securities positions as beneficial owners through one or more securities intermediaries, typically brokers. In fact, approximately 85% of exchange-traded securities are held by securities intermediaries on behalf of themselves or their customers. Most of these securities are deposited with The Depository Trust Company, a Commission-registered clearing agency acting as a securities depository, and are held in fungible bulk for the benefit of DTC participants. Broker participants of DTC own a pro-rata interest in the aggregate number of shares of an issue held by DTC, and their beneficial owners, the end customer, own an interest in the shares in which their brokers have an interest.

Consequently, there are no specific shares directly owned by either the broker participants of DTC or the underlying beneficial owner. As a result, a beneficial owner's ownership cannot be tracked to specific shares but rather its ownership interest is represented as a securities entitlement at his or her broker-dealer. Each of those beneficial owners don't own the actual shares credited to their account but rather they own a bundle of rights defined by federal and state law and by contract with their broker. Consequently, a beneficial owner may not have the "right" to vote the securities credited to his or her account. It depends on what the beneficial owner's contract says. That's news to a lot of people.

This process of holding in fungible bulk is a critical component to our national system for clearance and settlement. Another core component of our national system is the netting system, sometimes referred to as CNS system (Continuous Net Settlement), operated by the National Securities Clearing Corporation (NSCC).

Early in the clearance and settlement process, NSCC, a Commission registered clearing agency, steps between the two parties to a trade and nets each party's many trade obligation to a single receive or deliver of funds and a single receive or deliver of securities in each issue. When a broker fails to deliver securities to NSCC, NSCC allocates the fail using a random distribution algorithm to a broker that is due to receive securities of that issue. This novation and netting process precludes identifying or tracking which specific customer of a broker failed to receive shares.

The broker that did not receive securities because of the CNS allocation will nonetheless credit the securities positions to its customers' accounts even though no shares were credited to its DTC account. This creates an imbalance between the number of securities credited to the broker's DTC account and the number of shares credited to the broker's customer accounts. If the broker does nothing to reconcile this imbalance, the firm may ultimately wind up trying to cast more votes (i.e., the number of shares credited to its customer accounts but not received) than it is entitled to vote (i.e., the number of shares credited to its DTC account).

Similarly, securities lending may contribute to the overvoting problem as well. Even though the industry-standard lending contract allocates the vote to the borrower, the lender broker may not reconcile its records to reflect it no longer has the vote or loaned securities. As a result, if the loaned securities are not returned on or before record date, both the borrower and the lender may attempt to submit a vote for the same securities.

As my staff and I got deeper into our fact-finding, we discovered there was another more pervasive potential problem — "under-voting." Some firms discussed their preliminary analysis of their customers' voting behavior. While the numbers are very rough, these firms reported that approximately only 30% of the retail customers allocated votes actually submit votes to the broker (versus 90% of institutional customers). Why is this a problem? Well, if too few beneficial owners vote, then issuers may have a difficult time achieving a quorum. It became clear that any regulatory initiative designed to address the over-voting problem should not exacerbate it.

Addressing the Issue: Adequate Disclosure of Reconciliation and Allocation Methodologies

When my staff and I started thinking about this issue, we considered whether we should require a particular manner in which brokers decide which of their customers should be allocated a vote. But after talking with a large number of industry participants, we began thinking about an entirely different regulatory approach. Let me explain.

When an imbalance occurs between the number of securities on deposit in the broker's DTC account and the number of securities credited on its records to its customer accounts, the broker can either (1) allocate to each of its customers one vote for each share credited to the customer's account and if too many votes are submitted, the broker will have to decide which votes will count, or (2) decide which customers (or itself as a holder of securities) will get to vote and how many shares they get to vote.

Reconciliation and allocation methodologies vary significantly among brokers, with some fairly complex schemes. We also discovered that in many cases, the reconciliation and allocation methods selected by the firm were based on the firm's business model and customer base.

Some brokers reconcile and adjust their stock records on an aggregate basis, making sure that the total number votes allocated to customers is not more than the number of shares on deposit at DTC, before mailing out the proxy materials — a process known as pre-reconciliation. When following the pre-mailing reconciliation process (pre-reconciliation), the broker-dealer determines which investors are entitled to vote and adjust their stock records prior to sending the proxies to their customers. Although firms use various criteria to make these adjustments as to which customers are entitled to vote, firms typically adjust their records to reflect securities on loan. Customers with fully-paid securities usually are given first priority and allocated a vote. To allocate any remaining votes among their margin account customers, the firms generally use a lottery or pro rata method.

In another process, data is reconciled to accommodate an over-vote situation after the broker-dealer's customers have submitted their votes — a process called post-mailing reconciliation. If the broker-dealer votes in excess of its position at DTC, the broker-dealer will reconcile or adjust the number of votes to correspond to its DTC position. The manner in which the adjustment is made varies among firms. Some simply reduce the number of votes cast by the firm's proprietary position. Others use formulas whereby they may allocate only a certain number of votes or a certain percentage of the broker-dealer's overall position to customers with securities purchased on margin. Others use a lottery system.

The methods by which brokers allocate votes to their specific customers also vary significantly. The are too many permutations to go into here, but some of the differences involve whether the broker first allocates imbalances to their own proprietary accounts, whether brokers allocate imbalances on a lottery or a pro rata basis, and whether brokers prioritize between margin account customers who specifically request a vote. Clearly, whether a customer is capable of casting a vote is determined in part by the reconciliation and allocation methodologies used by its broker.

Brokers decide upon their particular reconciliation and allocation methodologies based on the firm's business model and its customer base. I believe that, some firms allocate to its customers a vote for the shares credited to the customer's account, while other firms appear to give priority to customers with fully-paid positions over customers in a margin account (who may not have fully paid securities). Most firms appear not to vote their proprietary positions if there is an imbalance.

Given the number of variables that influence the choice of reconciliation and allocation methodologies that may be appropriate, I do not believe it best to mandate any particular methodology. In fact, it may be optimal for brokers to use one methodology if its customer base is largely retail and another methodology if its customer base is largely institutional. I believe that many of the concerns about the proxy distribution and voting process can be addressed effectively by setting forth principles that would apply in every voting situation and by requiring brokers to adequately disclose their voting policies.

I'll highlight some principles based on my current thinking: first, customers with fully-paid securities should never have their vote decremented by their broker. Second, brokers should decrement votes from their proprietary account before decrementing votes from any customer account. Finally, customers should be aware what measures they need to take to better ensure themselves of having a vote if they want a vote.

Regarding proxy distribution and vote processing, customers should be made aware of the methodologies used by their brokers. The decision of what reconciliation and allocation methodology to use should be left up to the firm, but the decision of how, when, and where to disclose such methodologies so that customers know how voting is being handled by their broker and how to best preserve their ability to vote should be standardized.

So, how can we accomplish this? Basically, the answer is disclosure that is clear and made available as often as is sensible. At this point, I am thinking about a number of disclosure options, such as the following:

  • That a customer's ability to vote is subject to the terms of the customer's account agreement signed with its broker;
  • The reasons why the customer may not be allowed to vote some or all of the securities positions credited to its account, which should include an explanation that brokers may rehypothecate shares held in a margin account and that a customer's may not be able to vote some or all of its securities due to the securities being out on loan;
  • A description of the process used by brokers to allocate votes among customers and proprietary positions when the broker has an imbalance; and
  • A description of the alternative steps a customer could take to retain the ability to vote shares represented by the securities position credited to its account.

So how and when these disclosures should be made? Since brokers routinely communicate with their customers, these disclosures could be made in the course of their regular correspondence. For example, the customer account agreement, margin agreement, stock loan agreement, and the proxy materials are all logical places to include disclosure on the rights and obligations of customers with regards to voting their securities positions. Moreover, disclosure relating to a customer's specific account and the broker's reconciliation and allocation methodologies should be included in all communications to the customer that are voting-specific, such as the proxy material mailing containing the voter information card or any other issuer communication that involves a corporate election. Finally, many broker-dealers maintain a website to provide information for customers in an easily accessible manner. All disclosure relating to voting policies and procedures affecting customer accounts, including those disclosures made in customer account agreements, margin agreements, and stock loan agreements, should be made available on the broker-dealer's web site.

I recognize the importance of the right to vote in corporate elections, and I share the concerns about any issues in that process. So given the appropriateness of so many different allocation and reconciliation methodologies currently used by broker-dealers, I am concerned with creating transparency of a complex process so investors are apprised of their voting situation. I think disclosure of reconciliation and allocation methodologies will go a long way to giving transparency to the proxy distribution and voting process, ultimately building investor confidence in the process. I may be calling some of your firms in the near future to continue to discussing some of the ideas my staff and I have in this regard.

Broker Discretionary Votes

Another timely topic that you will be hearing discussed a lot today is broker discretionary voting. A majority of U.S. investors own their securities as beneficial owners through one or more securities intermediaries such as broker-dealers or banks. If the beneficial owner does not vote, under a New York Stock Exchange rule, the securities intermediaries are allowed to vote on certain routine matters. This is commonly called broker discretionary voting. Traditionally, it has been the practice of brokers to vote uninstructed shares on so-called "routine matters" in favor of management, the theory being that if shareholders don't bother to vote on these matters but still own the stock they presumably support management. Broker discretionary voting has been in place for more than 50 years, and one of the major advantages for issuers is that broker discretionary voting help issuers meet quorum requirements when beneficial owners do not vote their shares. Broker-dealers cannot vote for beneficial owners on contested matters and, for the most part, this has not been an issue since it appears that, when there is a contest, shareholders tend to vote so quorum is met.

Historically, the New York Stock Exchange treated the uncontested election of directors as a routine matter eligible for broker votes. The New York Stock Exchange also treats "just vote no" and "withhold vote" campaigns as non-contested matters eligible for broker votes, and this position has not been without controversy.

One of the panels you will hear from today involves the Proxy Working Group, which was formed by the New York Stock Exchange to review and make recommendations on the exchange's proxy voting rules. In June of 2006, the Proxy Working Group made numerous recommendations to the New York Stock Exchange, including eliminating the broker votes in non-contested elections of directors. Following the Proxy Working Group's recommendation, the New York Stock Exchange filed a proposal with the Commission to prohibit broker votes in non-contested elections of directors. In response to comments from the mutual fund community, the NYSE amended its proposal to exclude non-contested director elections for registered investment companies from this prohibition.

In the meantime, there have been other interesting developments. First, an increasing number of issuers have moved from a plurality vote standard to a majority vote standard for the election of directors, which would make the votes even more important for issuers. Second, the Securities Industry and Financial Markets Association recommended that brokers consider voting uninstructed retail shares in proportion to the voting instructions each broker actually received from its retail clients. Following this recommendation, at least four brokers implemented proportional voting based on the retail vote this year. Next, the Commission held a series of roundtables last May on the proxy voting process. Finally, the Proxy Working Group is continuing to meet to discuss broker votes and examine alternatives such as proportional voting.

As a result of these developments, my staff and I are in the process of evaluating broker votes in light of the roundtable discussion and the brokers' recent experience with proportional voting. The New York Stock Exchange's proposal should be viewed within the broader context of shareholder voting and communication. Given this broader review, the New York Stock Exchange recently notified its issuers that the proposal would not be in effect for shareholder meetings held during 2008.

Proxy processing and vote distribution and broker discretionary voting are two issues the Commission will be facing, and I look forward to hearing both discussed here today.

We will continue to reach out to issuers, broker-dealers, clearing agencies and others. It goes without saying that these issues are important. I look forward to working with you and SIFMA in the coming year. Thank you.



Modified: 10/31/2007