A new proxy adviser regulation in Switzerland?

The Swiss Parliament has adopted a motion requiring the Swiss government to propose a new regulation addressing the conflicts of proxy advisers. The primary focus seems to be on ISS and to a lesser extent on Glass Lewis for their potential dual role in advising institutional investors on voting recommendations and listed companies on corporate governance and compensation. In the absence of a physical presence of these proxy advisers in Switzerland, it remains unclear how the required legislation could be effectively enacted. 

By Thomas U. Reutter / Annette Weber (Reference: CapLaw-2020-24)

1) Proposal for new legislation in Switzerland

Thomas Minder, member of the Council of States submitted a parliamentary motion on proxy advisers on 23 September 2019. In this motion, the Swiss government was asked to propose legislation, for example by amending the Financial Market Infrastructure Act, to address the issue of conflicts of interests of proxy advisers. The legislation required by the motion should be designed to both disclose and avoid conflicts of interests of proxy advisers. It should also consider international developments on this topic. The motion was adopted by the Council of States on 3 June 2020 after being adopted by the National Council. Therefore, the Swiss government is tasked to provide a proposal how to regulate proxy advisers to mitigate conflicts of interests. 

In the reasoning for the motion, Mr. Minder identified conflicts of interests of proxy advisers analyzing Swiss listed companies and offering advisory services to the very same companies on corporate governance and compensation. On a more polemic note, the motion also alleges that some proxy advisers recommend no votes for compensation systems of companies in order to be retained as advisers on a re-design of such systems by these companies. ISS, the big elephant in the room offering both proxy advice to investors as well as corporate governance advice to listed companies, was not specifically mentioned but seems to have been the primary target of the motion. 

The debates in the National Council and in the Council of States were not conducive to learning insights on the motion, but the proposal for regulation was not perceived well by all stakeholders. For example, Swissholdings, the association of multinational companies, claimed that a more comprehensive view on proxy advisers is warranted and added that conflicts of interests are only a part of a more general problem: the quality of proxy advice. 

2) International legislation efforts

In the recent years, the U.S. as well as the EU made efforts to further regulate proxy advisers (see CapLaw-2015-16). In August 2019, the U.S. Securities and Exchange Commission (SEC) issued a new guidance on the role of proxy advisers with the intention to enhance their accountability. The SEC made clear in its guidance that the anti-fraud rules according to Rule 14a-9 of the Securities Exchange Act of 1934 are applicable to proxy advisers as well. The guidance includes recommendations on disclosure of additional information regarding conflicts of interests, the sources of information and methodology used by proxy advisers. In November 2019, the SEC proposed additional rules on the proxy voting process. In particular, the proposal contains rules according to which registrants (i.e., companies listed on a U.S. stock exchange) have the right to be heard, and rules on conflict of interests. 

At the end of October 2019, ISS filed a complaint against the SEC regarding the guidance on proxy advisers issued by the SEC in August 2019 claiming that the SEC exceeded its jurisdiction and violated the U.S. federal Administrative Procedures Act, i.e., challenging the process how the guidance was issued. In addition, ISS claims that proxy advice may not be viewed as proxy solicitation but is a specialized form of investment advice. Earlier this year, the SEC filed an unopposed motion to hold the case in abeyance which leads to a stay in the litigation until the earlier of 1 January 2021 or adoption of the final rules on proxy advisers. During this stay, the SEC will not enforce the guidelines. While it remains unclear what the outcome will be, it is clear that the SEC would like the proxy advisers to take more responsibility.

In connection with the EU Shareholder Rights Directive (Directive (EU) 2017/828 amending Directive 2007/36/EC), the EU added rules for proxy advisers by requiring member states to address the transparency of proxy advisers (article 3j of the said Directive):

Code of Conduct: Proxy advisers are required to publish a code of conduct which they apply and to report the application of the code. Absent the adoption of such a code of conduct or in case of a deviation from the code of conduct when applying it, a proxy adviser needs to provide an explanation.

Information to be disclosed: The implementing rules of the Shareholder Rights Directive adopted by a member state shall require proxy advisers to publicly disclose certain information, such as, the main features of a proxy adviser’s methodology, the main information sources used and the procedures put in place to ensure the quality of research, advice and voting recommendation.

Conflicts of interests: A core piece of the EU regulation on proxy advisers revolves around the disclosure of conflicts of interests. Member states must ensure that proxy advisers identify and disclose actual or potential conflicts to their clients. This includes business relationships that may influence the proxy adviser’s voting recommendations. Member states are not required to enact any substantive rules on conflicts of interest such as organizational measures like information barriers. Only disclosure requirements must be imposed and disclosure itself is limited to the client, i.e. the institutional investors. Conflicts do not need to be disclosed to the investee company or to the public at large. 

In summary, the Shareholder Rights Directive operates with disclosure rules only and does not impose any conduct requirements, and even the disclosure requirements are not particularly stringent.

3) Will COVID-19 impact proxy advice?

Is the strong focus on best corporate governance typical for companies outside of a crisis? Or put differently in German – is it a Schönwetter-Phänomen? In an economic crisis, such as the one caused by the coronavirus pandemic, investors appear to focus less on best practices for corporate governance. Rather, their focus is on how their investee companies can weather the storm. In other words: Survival, resilience and performance of companies are more important than the term of office of a chairperson, whether or not the CEO is also on the board and – horribile dictu – how diverse the board composition formally looks like. 

Not surprisingly therefore, the 2020 shareholder meeting season will be remembered as peaceful and benign in the sense that activism, proxy fights and votes against board proposals were at record lows. Even motions for an increase or extension of authorized capital potentially resulting in substantial dilution for existing shareholders received higher approval rates than in normal circumstances. In a best case, this crisis may be an eye opener for investors and proxy advisers that formulaic “one size fits all” caps on equity capital increases unnecessarily cripple a company’s resilience in a fast approaching economic crisis. Similarly, if the rather formalistic approach of proxy advisers on corporate governance aspects caves in favor of a more substantive one, the crisis would leave a positive mark at least in this respect. 

However, “substance over form” requires judgment. Judgment in turn is more expensive than a strictly followed formal process and bears the risk of failure. The process and profit oriented business model of large proxy advisers hardly leaves any room for a more substantive approach and there is little reason for optimism that proxy advisers will follow a new approach for future proxy advice based on lessons learned from the current crisis. Hence, it is probably fair to say that COVID-19 has not eliminated the desire to scrutinize the need for proxy adviser regulation.

4) Can Switzerland regulate proxy advisers?

For Ethos, the leading Swiss proxy adviser, the answer is yes, given that it is incorporated in Switzerland. ISS and Glass Lewis, the more relevant players not only internationally, but also for all major Swiss listed companies, are beyond the direct reach of the Swiss legislator. These advisers are incorporated outside of Switzerland and usually have no physical presence in this country. Moreover, their clients are institutional investors which are mostly also not incorporated in Switzerland. The only connection to Switzerland is the investment of the proxy advisers’ clients in shares in Swiss listed companies.

The EU has subjected third-country proxy advisers to the rules of the Shareholder Rights Directive to the extent they “carry out their activities through an establishment located in the Union, regardless of the form of that establishment” (article 3j para. 4; Recital 27). Hence, the EU only regulates proxy advisers who have a physical presence in the Union. However, as proxy advisers typically do not even have a branch or similar establishment in Switzerland, the EU approach would likely not work in Switzerland. Switzerland would have to rely on the effects doctrine (Auswirkungsprinzip) established in competition law to regulate the impact of proxy advice activity abroad on Swiss incorporated or Swiss listed companies or on the Swiss financial market. 

Based on this reasoning, the Swiss legislator may arguably address proxy advisers indirectly, e.g. by imposing rules affecting other market participants, such as Swiss listed companies or Swiss investors. In our view, the attachment point for any Swiss legislation should be the listed company and the proxy advisers’ impact on listed companies in this country. 

5) What to expect from the proposed legislation

The Minder proposal will likely end up as a Rohrkrepierer if it tries to address only conflicts of interests. Legislating an international issue without international legislation is tricky enough, but only addressing a corporate law issue of non-Swiss incorporated entities seems desperate. 

Hence, any proposed legislation should broaden its scope and primarily focus on the impact on companies incorporated and listed in Switzerland. To avoid an allegation of extraterritorial reach, the legislation could also be narrowed to proxy advice for Swiss investors in relation to Swiss listed companies. Although this approach does not guarantee that all Swiss listed companies are captured, it is likely that such a rule will affect indirectly a vast majority of Swiss listed companies. Indeed, it may be expected that proxy advisers, probably in response to client demand, will not treat their non-Swiss clients less favorable than their Swiss clients on whom a new legislation may confer additional rights.

In terms of additional substance beyond a mere replication of the standards set in the EU, the Swiss regulator could require that (i) Swiss listed companies on which proxy advisers advise Swiss investors have a right to be heard before the proxy advisers issue a recommendation to their clients, (ii) a statement of the Swiss listed company must be included in the recommendation of the proxy advisers and (iii) proxy advisers have to make their recommendation public either a few days prior to the shareholder meeting or shortly thereafter. 

We believe that the introduction of a right of a listed company to be heard and to have its comments and assessment included in any advice of the proxy advisers would significantly increase the quality of advice without creating any substantial incremental costs for proxy advisers. 

Thomas U. Reutter (thomas.reutter@baerkarrer.ch)
Annette Weber (annette.weber@baerkarrer.ch)