Proxy Plumbing

“Proxy plumbing” is an informal name for the system by which proxy materials land in shareowners’ mailboxes each year. The name is apt. Today’s proxy plumbing is confusing, inefficient and expensive, much like some interconnected jumble of water pipes, joints and faucets. It creates barriers that ensure—at almost all corporations in almost all years—the only party soliciting proxies is management.

One of the USPX’s long-term goals is scrapping the existing system of street name registration and replacing it with a direct registration system. That will fix many of the problems with today’s proxy plumbing. But we need to do more. While we work for a universal direct registration system, shareowners are being disenfranchised by the existing system. We must seize every opportunity to patch or make incremental improvements in that system. Also, even when a switch is made to direct registration, problems will remain. The challenges of proxy plumbing are much larger than the single issue of street name registration.

Proxy plumbing has many aspects. These have names like over-voting, empty voting, OBO/NOBO, client-directed voting, proxy voting platforms, proxy advisors, Rule 452, vote confirmation, etc. For an excellent introduction, see a concept release issued by the SEC for comment in July 2010. It tends to downplay some of the problems, so supplement your reading with the detailed comment letter the USPX submitted in response to the concept release. Here’s some background.

It had been 30 years since the SEC performed a comprehensive review of the US proxy system when, in July 2010, they released their concept release. They did so largely in response to lobbying by a group called the Shareholder Communications Coalition (SCC), whose members include the Business Roundtable, the Society of Corporate Secretaries and Governance Professionals and the Securities Transfer Association.

As you know, most of what the USPX does brings us into conflict with either the corporate community or financial community. The typical dynamic is

financial community + corporate community vs. USPX

This time it is different. The financial community likes today’s broken down proxy system. They like holding shares in fungible bulk form. They like naked short selling and securities lending. The corporate community dislikes the current proxy system because of the risk it poses to corporate elections: over-voting, manipulation, buying and selling of proxies, etc. Most of the reforms the corporate community would like are things we too would like. This is a rare instance where the dynamic is:

financial community vs. corporate community + USPX

In August 2009, the aforementioned SCC sent the SEC a proposal for reform. If you read it side-by-side with the SEC concept release, which came out a year later, you will see that the SEC concept release is essentially asking “What does everyone think about the SCC proposal? What parts, if any, should we implement?” Of course, the SEC concept release covers some issues beyond those raised in the SCC proposals, so it looks like they did some homework. The concept release also floats some undesirable solutions, which may may be a result of Wall Street or Broadridge lobbying.

We like 95% of what the SCC is advocating. They aren’t proposing the elimination of DTC or securities lending (although, like us, they don’t care for either). Pragmatically, they are making recommendations they think are achievable at this point in time. Pragmatically, the USPX is supporting them, which is why, on October 20, we submitted a 29 page comment letter in response to the SEC’s concept release. Some recommendations in our letter go well beyond the SCC proposal. Here are highlights from our letter.

On the issue of over-voting in corporate elections:

In an honest election, votes that aren’t cast should remain not cast. You don’t offer those votes up to whomever would like a little extra suffrage: “Unused votes here! Who would like ‘em?” That, essentially, is what the post-reconciliation and hybrid methods do, at least as described in the Concept Release. By “recycling” votes other shareowners have chosen not to cast, they boost certain shareowners’ voting power beyond what it would be if individual shares were tracked through clearance and settlement to individual beneficial owners …

The few available accounts of over-voting suggest that errors, lost votes, double- or triple-counted votes or perhaps intentional abuse contribute as much, if not more, to the problem of over-voting than the issues of securities lending, margining and failed trades mentioned in the Concept Release. In this light, over-voting may be viewed as a symptom of broader underlying problems. We understand the securities industry is taking steps to address the narrow problem of over-voting. That is good, but assurances that the problem has been addressed may come across as like a doctor assuring a patient her symptoms have been treated. Treating symptoms is nice, but what about the underlying problem?

We believe the Commission needs to conduct a thorough investigation of all possible causes of inaccuracy in corporate elections.

On the extent to which amendments to NYSE Rule 452, which eliminated broker discretionary votes in uncontested director elections, increased the likelihood that corporations will not meet quorum at annual meetings:

We do not believe it is a purpose of the Commission to help corporations achieve quorum. If they had more difficulty achieving quorum, corporations might take more effective actions to attract participation by individual investors in the proxy process.

A more important concern, not raised by the SEC, is the need for shareowners to be able to affirmatively withhold their proxy as an important strategy where shareowners believe the process being followed is illegitimate. The possibility of such an action was raised at Intel in late 2009 after they announced they might hold a virtual-only meeting.

On proposals to create some tracking systm to confirm shareowner votes are tabulated as cast:

… we would not endorse such a system without knowing specifics or without both a feasibility study and cost-benefit analysis. Before the Commission invests significant resources in such an initiative, we would ask if those resources wouldn’t be better deployed elsewhere.

Most of the problems with today’s proxy system arise because of the current system whereby shares are immobilized by DTC and shareowners trade security entitlements. This system was intended as a temporary stop-gap in the 1970s, when it was implemented. At the time, technology to support an automated direct registration system didn’t exist. Today, that technology could easily be implemented. Rather than keep patching the broken-down system of DTC and immobilized stock certificates, perhaps resources should be invested in a comprehensive direct registration system. That would solve many problems with the current proxy system, including that of confirming votes.

On the OBO/NOBO rule, which allows shareowners to withhold their identities from the corporations they invest in:

We believe it is in the public interest that individuals not be allowed to finance corporate activities—with their potential to produce enormous good or enormous evil—anonymously. We understand some believe anonymity is important for the conduct of certain speculative trading activities. We are unimpressed and remind the Commission that its mandate says nothing about facilitating speculative trading. To our knowledge, finance theory offers only one argument in support of speculative trading: that it tends to increase liquidity. We have reservations about this claim and note that, if anything, our stock market is too liquid. A little less liquidity might get investors to focus more on good corporate governance and a less on the direction of the Dow.

The OBO/NOBO distinction should be scrapped. Shareowners should not be allowed to refuse direct corporate communications.

On the topic of proxy voting platforms for retail investors and client-directed voting:

We strongly advocate that the Commission support the development of free proxy voting platforms for retail investors. New technology or paradigms will encourage participation in the proxy system and improve corporate governance. This initiative should be integrated with that of client-directed voting. If the two are implemented as competing alternatives for shareowners, they will both be diminished. Banks and brokers should not be offering their retail clients options such as “always vote with management”, “always vote against management” or “vote according to this third party’s recommendations”. Rather, they should be offering their clients the single option of transferring their proxy to a voting platform that would then make all the same options—and many more—available to them.

Because the voting platforms would receive proxies—and not VIFs—they could pass client votes directly to vote tabulators, bypassing the expense and inevitable errors associated with passing votes back to the client’s securities intermediary and then on to Broadridge. Institutional investors benefit from innovation and experimentation by the proxy voting platforms they use. Retail investors would similarly benefit from such innovation and experimentation by retail proxy voting platforms.

On the three distinct regulatory notions of shareowner forums, proxy advisors and proxy voting platforms:

Another important step for the Commission will be to clarify, once and for all, proxy solicitation rules. In recent years, the Commission has made significant steps to liberalize proxy solicitation rules, especially for shareowner forums and proxy advisors. But much uncertainty remains. That uncertainty is dissuading investment and participation in innovative platforms and solutions. We strongly encourage that rules for shareowner forums, proxy advisors and proxy voting platforms be both simplified and harmonized. Those three structures are more similar than they are different. They pose similar regulatory issues. Inevitably, we anticipate that important innovations will come from hybridizing two or all three into more comprehensive solutions. Uniform regulatory treatment will facilitate this.

On empty voting:

Empty voting is entirely detrimental to the public interest, despite strained attempts to suggest otherwise. To the extent that it arises from speculative tools, we believe the Commission should prohibit those tools or seek authority from Congress to prohibit them. Such tools include equity short selling and the associated device of equity securities lending. All equity derivatives are inherently speculative. Unlike commodities, where manufacturers or consumers may be forced to take positions they need to hedge, equity derivatives are inherently speculative. If you want to hedge an equity position, sell the equities. Conceivably, equity derivatives might be used to reduce equity exposure while avoiding capital gains taxes. We would, however, agree with the Internal Revenue Service that such use is inappropriate.

In the course of a single decade, our economy has experienced two market-induced meltdowns unlike anything since 1929. Some investors are concluding that our stock market has become a form of casino capitalism. The Commission needs to choose which is more important: speculative trading or honest corporate elections.

We strongly advise the Commission, for the public good, to (1) outlaw equity short selling and equity securities lending and (2) seek from Congress authority to outlaw all forms of equity derivatives. Shareowners who liquidate equities between the record data and annual meeting should not be allowed to vote those liquidated shares.

Once the SEC has had time to review comment letters, we anticipate they will issue new proposed rules.

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