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Remarks at Society of Corporate Secretaries & Governance Professionals

Commissioner Daniel M. Gallagher


67th National Conference, Seattle, Washington

July 11, 2013

Thank you Bob [Lamm] for your very kind introduction.  I am delighted to be able to participate in this conference and to address so many of the governance professionals who are on the front lines dealing with the myriad of mandates set forth in federal and state laws and regulations.  In addition to engaging with shareholders, drafting disclosure documents, and dealing with the everyday fire drills that occur at your companies, you and your teams ensure that board members and management have the appropriate knowledge and resources to properly discharge their duties.  This is a full day’s work, which is why so many of you often end up doing board minutes at night.  While much of the work you do may sometimes seem thankless, the importance of your work is certainly not lost on me or, I hope, on your CEOs and boards.
On that note, I need to provide the standard disclaimer that my remarks today are my own and do not necessarily reflect the views of the Commission or my fellow Commissioners. 
Before I begin, I would like to take a moment to acknowledge my colleagues Elisse Walter and Troy Paredes, who are nearing the end of their tenure as Commissioners.  Elisse and Troy joined the Commission within a month of one another during the turbulent summer of 2008, right around the time I became the deputy director of trading and markets, and have since then devoted themselves to furthering the SEC’s mission during a particularly difficult time.  They have done yeoman’s work and they will both be missed.
I’d like to say a few additional words about Troy, who has over the course of his five years as a Commissioner been a quiet but formidable intellectual force, applying his intelligence and expertise to the subjects of disclosure reform and corporate governance, among many others.  Troy has, in addition to being a valued colleague, been a great friend to me as well, and there is no one with whom I’d rather have an hour-long midnight conversation about the subtle implications of a single footnote buried deep within a thousand-page draft rule release.
The SEC is first and foremost a disclosure agency.  As stated on the Commission’s website: “[t]he laws and rules that govern the securities industry in the United States derive from a simple and straightforward concept: all investors, whether large institutions or private individuals, should have access to certain basic facts about an investment prior to buying it, and so long as they hold it.”[1]  The federal corporate disclosure regime was established by Congress and serves as a cornerstone of the Commission’s tripartite mission to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.  The underlying premise of the Commission’s disclosure regime is that if investors have the appropriate information, they can make rational and informed investment decisions.  This is not to say that the disclosure regime was meant to guarantee that investors receive all information known to a public company, much less to eliminate all risk from investing in that company.  Instead, the point has always been to ensure that they have access to material investment information.  One of the underpinnings of this approach is the expectation that through this disclosure regime, companies and their management benefit from the oversight and interaction with the companies’ owners.  President Franklin D. Roosevelt, in a message to Congress encouraging the enactment of the Securities Act, also noted that a mandatory disclosure regime “adds to the ancient rule of caveat emptor, the further doctrine, ‘let the seller also beware.’ It puts the burden of telling the whole truth on the seller. It should give impetus to honest dealing in securities and thereby bring back public confidence.”[2]
Through issuer disclosure, shareholders are able to make informed decisions and hold boards and management accountable for any misallocation or misuse of their invested funds.  If shareholders are displeased, they have the ability to change the behavior of management and direction of the company by exercising their votes at shareholder meetings or, alternatively, voting with their feet, so to speak, by selling their stock.  So, given the historical justifications as well as the logic and rationale behind this mandatory disclosure framework, how has the Commission done in ensuring the proper operation of this system?
Arguably, the Commission’s disclosure regime has been subject to the classic Washington scourge of regulatory creep, in spite of the principle that investors should have access to “basic facts.”  The beauty of the disclosure regime as created by Congress almost 80 years ago was that it did not require government regulators to judge the merits of a company, its board or management structure, or its business practices – those judgments were intended to remain in the hands of investors armed with the knowledge provided by the disclosure of material information.  Today, however, some of our disclosure rules are being used by special interest groups, who do not necessarily have the best interests of all shareholders in mind, to pressure public companies on certain governance and business practices.  The Commission’s recent disclosure rules regarding conflict minerals from the Congo and extractive resource payments made by oil, gas and mining companies are good examples.
As many of you probably know, last week, Judge John D. Bates from the D.C. District Court vacated the Commission’s “arbitrary and capricious” resource extraction rule citing “two substantial errors” on the part of the Commission: misreading the statute to mandate public disclosure of the reports required to be provided to the Commission and refusing to grant any exemptions to the disclosure requirement.[3]  While the information required by these rules may be germane for humanitarian purposes, one would be hard pressed to argue that this disclosure is material to investors in evaluating the performance and determining the value of a company.  In his opinion, Judge Bates wrote, “As the Supreme Court has recognized, ‘no legislation pursues its purposes at all costs.’”[4]  It has been the Commission’s responsibility since its establishment to apply its expertise to define the parameters of the disclosure required by congressional mandates.  Even when those mandates are unusually prescriptive, it is incumbent upon the Commission to use its exemptive authority to balance the value to investors of new disclosure requirements against their costs.  In promulgating new disclosure requirements, the Commission must be mindful about whether the information in question would be objectively material to investors, and would the benefits of disclosure outweigh the costs, which are ultimately and inevitably passed on to investors.  
The vital importance and proven value of our disclosure regime as a whole does not and should not lead to the conclusion that more government-mandated disclosure is always better.  In a speech earlier this year, Commissioner Paredes expressed a concern that I share, noting that the expansion of mandatory disclosure requirements may lead to “information overload,”[5] not just in volume but also in the complexity of presentation.  When the Commission-mandated public disclosure documents of public companies run well into the hundreds of pages, we have to question whether such documents are at all understandable, and of any utility, to investors.  When disclosure documents start to resemble treatises, the wheat gets lost in the chaff.  With too much information, it often becomes difficult for investors to focus and determine what is useful and what is not.  As Justice Thurgood Marshall warned almost 40 years ago, disclosure requirements with “unnecessarily low” materiality standards risk “simply bur[ying] the shareholders in an avalanche of trivial information – a result that is hardly conducive to informed decision making.”[6] When investors are inundated with immaterial information, it increases the likelihood that they will miss key disclosures. Even more likely is the possibility that investors, despairing about the voluminous compilations of corporate minutiae contained in company filings, will never even look at disclosure documents.  In either case, the result is that investors are left less informed when making investing decisions than they would be if presented with a document that didn’t require a magnifying glass to read and a PhD to understand.  The irony that the vast expansion of the Commission’s mandatory disclosure regime may help incentivize investors to throw their hands up and simply ignore company filings is not lost on me or, I’m sure, all of you. 
Given the importance of this issue, it is critical for the Commission to engage with issuers and shareholders to rethink whether the mandatory disclosure rules in their current form are still valuable and whether in some cases it may be better for investors if there was a lower volume, but an overall higher quality, of disclosure.  As I’ve noted repeatedly, disclosure is not costless to issuers, and we cannot forget – because far too many policy makers do forget – that it’s the shareholders who ultimately bear the burden of increased costs on issuers.  If excessive disclosure negatively impacts investors’ ability to process the information with which they are presented, it fundamentally undermines the utility of the disclosure regime.  We need to understand what information investors find useful and beneficial, but we also need to develop a better understanding of the costs of disclosure, especially in light of the tendency to require disclosure on a more and more granular level.   
Another unintended consequence of the increase in mandated disclosure is the rise of proxy advisory firms and the increasing willingness of investment advisers and large institutional investors to rely on such firms in order to ostensibly carry out their fiduciary duties.
Shareholder voting has undergone a remarkable transformation over the past few decades, with particularly marked changes occurring over the past 10 years.  The rise of institutional shareholders as the majority owners of public company shares as well as the increased desire of some policy makers to give shareholders greater influence and power in corporate governance has led to the current dynamic.  In today’s world, institutional shareholders vote billions of shares each year on thousands of ballot items for the thousands of companies in which they invest.  The quantity and length of the documents that shareholders have to review in order to make informed voting decisions has steadily increased over the past few years, as has the average number of items they are asked to vote on which, by some estimates, increased by roughly 50% from 2003 to 2011.[7]
Given the sheer volume of votes, institutional shareholders, particularly investment advisers, may view their responsibility to vote on proxy matters with more of a compliance mindset than a fiduciary mindset.  Sadly, the Commission may have been a significant enabler of this.  In 2003, the SEC adopted a new rule and rule amendments under the Investment Advisers Act of 1940 addressing an investment adviser's fiduciary obligation to its clients when the adviser has authority to vote its clients’ proxies.  Pursuant to the rule, an investment adviser that exercises voting authority over its clients’ proxies is required, among other things, to adopt policies and procedures reasonably designed to ensure that it votes those proxies in the best interests of its clients.[8]  One concern that the Commission was trying to address in that rulemaking was an investment adviser’s potential conflicts of interest when voting a client’s securities on matters that affected its own interests.  In the adopting release, the Commission noted that “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.”[9]  As I’ve noted before, this was akin to what the Commission had earlier done with credit rating agencies – essentially, mandating the use of third party opinions.  When proxy advisors asked the SEC staff for guidance and clarity with respect to the new rule, they got their wish in the form of a pair of staff no-action letters effectively blessing the practice of investment advisers simply voting the recommendations provided by proxy advisers.[10]  At the risk of stating the obvious, staff no-action letters are not approved by the Commission, and do not necessarily represent the view of the Commission or the Commissioners.
It has been argued that these two letters provide investment advisers a potential safe harbor against claims of conflicts of interest when they vote their client proxies.  In one letter, the SEC staff advised that “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.”[11]
I am very concerned that these letters have unduly increased the role of proxy advisory firms in corporate governance.  I also have grave concerns as to whether investment advisers are indeed truly fulfilling their fiduciary duties when they rely on and follow recommendations from proxy advisory firms. 
It is troubling to think that institutional investors, particularly investment advisers, are treating their responsibility akin to a compliance function carried out through rote reliance on proxy advisory firm advice rather than actively researching the proposals before them and ensuring that their votes further their clients’ interests.  The last thing we should want is for investment advisers to adopt a mindset that leads to them blindly casting their votes in line with a proxy advisor’s recommendations, especially given the fact that such recommendations are often not tailored to a fund’s unique strategy or investment goals.  As one academic article has argued: “[i]f the institutional investors are only using the proxy advisor voting recommendations to meet their compliance requirement with the lowest cost, these payments will not compensate proxy advisors for conducting research that is necessary to determine appropriate corporate governance structures for individual firms.  Under this scenario, the resulting recommendations will tend to be based on simple, low cost approaches that ignore the complex contextual aspects that are almost certainly instrumental in selecting the corporate governance structure for individual firms.”[12]
So what should the Commission do?  I believe that we should replace these two staff no-action letters with Commission-level guidance. Such guidance should seek to ensure that institutional shareholders are complying with the original intent of the 2003 rule and effectively carrying out their fiduciary duties.  Commission guidance clarifying to institutional investors that they need to take responsibility for their voting decisions rather than engaging in rote reliance on proxy advisory firm recommendations would go a long way toward mitigating the concerns arising from the outsized and potentially conflicted role of proxy advisory firms. 
In addition, as I have stated in the past, I believe that the Commission should fundamentally review the role and regulation of proxy advisory firms and explore possible reforms, including, but not limited to, requiring them to follow a universal code of conduct, ensuring that their recommendations are designed to increase shareholder value, increasing the transparency of their methods, ensuring that conflicts of interest are dealt with appropriately, and increasing their overall accountability.  I am not alone in raising these issues, as evidenced by the work in Europe by ESMA regarding proxy advisors as well as by the recent Congressional hearing hosted by Congressman Scott Garrett discussing many of these topics.[13]  To be clear, I realize that proxy advisors can provide important information to institutional investors and others.  However, what European policymakers and our own Congress have highlighted is that changes need to be made so that proxy advisors are subject to oversight and accountability commensurate with their role.
Thank you all for your attention.  I've appreciated the opportunity to be here today and share my views on these vitally important subjects, and I wish you a successful conclusion to this conference.

[1] The Investor's Advocate: How the SEC Protects Investors, Maintains Market Integrity, and Facilitates Capital Formation,  
[2] S. Rep. No. 73-47, at 6-7 (1933) & H.R. Rep. No. 73-85, at 1-2 (1933).
[3] American Petroleum Institute, et al. v. Securities and Exchange Commission and Oxfam America, Inc., No. 12-1668 (D.D.C. Jul. 2, 2013).  
[4] American Petroleum Institute at 24 (quoting Rodriguez v. United States, 480 U.S. 522, 525-26 (1987)).
[5] Commissioner Troy A. Paredes, Remarks at The SEC Speaks in 2013 (Feb. 22, 2013) (available at
[6] TSC Industries v. Northway, 426 U.S. 438 at 448-49 (1976).
[7] See Larcker, David F., McCall, Allan L. and Ormazabal, Gaizka, Outsourcing Shareholder Voting to Proxy Advisory Firms, May 10, 2013 at 1.
[8] Final Rule: Proxy Voting by Investment Advisers, 68 FR 6585,
[9] Id.
[10] See “Investment Advisers Act of 1940—Rule 206(4)-6: Institutional Shareholder Services, Inc.” SEC letter to Mari Anne Pisarri, September 15, 2004, and “Investment Advisers Act of 1940—Rule 206(4)-6: Egan-Jones Proxy Services,” SEC letter to Kent S. Hughes, May 27, 2004,
[11] “Investment Advisers Act of 1940—Rule 206(4)-6: Egan-Jones Proxy Services,” SEC letter to Kent S. Hughes, May 27, 2004,
[12] See Larcker fn. 7, at 3.
[13] Capital Markets and Government Sponsored Enterprises Subcommittee Hearing entitled “Examining the Market Power and Impact of Proxy Advisory Firms”, June 5, 2013, See
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