Author: Rongeet Poddar is a recent graduate of West Bengal National University of Juridical Sciences, Kolkata and an incoming associate at a distinguished Indian law firm.
The regulation of proxy advisory firms has proven to be a contentious issue in India. On 3rd August 2020, the Securities and Exchange Board of India (‘SEBI’) has issued ‘Procedural Guidelines for Proxy Advisors’ to streamline corporate governance practices at listed entities. The voting decisions of institutional investors at shareholder meetings are shaped by the guidance and research analysis received from proxy advisors. Institutional investors involve financial institutions such as pension or mutual funds that accept deposits from third-party investors and invest on their behalf.
The expertise of these firms contributes to greater shareholder activism and ensures that management or shareholder proposals are subject to piercing scrutiny. Therefore, they are employed by institutional institutors as fiduciaries to reduce the cost of monitoring the affairs of the company. Proxy advisory firms have assumed a critical role in recent years as they bridge the information asymmetry that used to disincentivize participation of institutional investors in the Indian corporate landscape. It has prompted SEBI to review its regulatory framework in furtherance of an expert committee’s recommendations.
Concerns raised by the SEBI Working Group on Proxy Advisors
Proxy advisory firms in India are subject to registration and governed by the SEBI (Research Analyst) Regulations, 2014. Section 24(2) of the Regulations incorporates a Code of Conduct under its Third Schedule which seeks to address, inter alia, the critical issue of conflict of interest in proxy advisory firms. However, the Code of Conduct did not specify the obligations expected to be undertaken in pursuance of due diligence.
In May 2019, the Working Group on Issues Relating to Proxy Advisors, appointed by SEBI, had been entrusted with the task of reviewing the provisions. The Report of the Working Group highlighted that the decision-making by institutional investors is often characterized by ‘robo-voting’, i.e. mechanical adherence to the voting recommendations by proxy advisory firms. The recommendations of the firms thus had severe implications on company affairs. Additionally, the inclination among proxy advisors to prescribe higher governance standards than existing legal norms was evaluated. The Report opined that such the rationale behind such aspirational standards must be clearly spelt out to the investors. Even though factual errors were rare, disagreements with the proxy advisor’s recommendations were also underlined as a bone of contention for companies.
The Working Group notably observed that conflict of interest in proxy advisory firms could have a detrimental impact on corporate governance. Dominant shareholders in listed companies are likely to be in a position to influence their functions by incentivizing fraudulent practices as proxy advisors act as a countervailing force to their interests. The prevalence of concentrated shareholding patterns under the influence of promoter-families in the Indian jurisdiction thus presents a unique conundrum for regulators. Furthermore, a listed company or a group of listed entities may have a shareholding interest in the proxy advisory firm. An ancillary activity of the firm may also provide a wide range of business consultancy services to companies with respect to which institutional advisors are offered voting guidance. The prospect of board inter-locking poses another major threat to impartial decision-making. On this basis, the Working Group had proposed a voluntary best practices code for the proxy advisory industry that would adopt a ‘comply or explain’ regulatory model. The institutional investors were also advised to introduce an industry-wide stewardship code to stimulate transparent practices.
Recent interventions of SEBI
The Guidelines for Proxy Advisors formulated by SEBI take effect from January 2021. The new regime provides an additional safety net to the Code of Conduct prescribed under the SEBI (Research Analysts) Regulations. It imposes an obligation upon proxy advisory firms to formulate voting recommendation policies and disclose such policies to the institutional investors. It has also provided for an annual review of voting recommendations to safeguard its integrity. The methodologies adopted in its research practices and recommendations also must be explained to the clients such that the institutional investors can make informed decisions. A clear channel of communication also has to be stated by the proxy advisors besides alerting their clients of material revisions or factual errors in the voting recommendation.
Finally, the proxy advisors have been entrusted with the responsibility of sharing their reports with its clients and the company besides publicizing the sharing policy on their website. The Guidelines offer scope for the firms to revise their advisory reports by incorporating an addendum if the company has a contrary viewpoint. Finally, SEBI prescribes disclosures of conflict of interest, particularly those emanating from ancillary business activities of proxy advisory firms and seeks to institute robust measures to disclose and mitigate such conflicts.
Moreover, on 4th August 2020, the capital markets regulator has released a grievance resolution mechanism for institutional investors in case there is a divergence of opinion on voting recommendations offered by proxy advisory firms on agenda items at the general meetings. It empowers SEBI to intervene and resolve concerns of non-compliance by proxy advisors with the provisions of Code of Conduct under the SEBI (Research Analysts) Regulations in addition to the recent Guidelines for Proxy Advisors. The redressal mechanism has been instituted to enable active participation of minority shareholders such as the institutional investors in corporate governance decisions by exercising their ownership rights in furtherance of Regulation 4 (2) (a) of the SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015.
The revamp of the regulatory framework on proxy advisory firms affirms that market failures have contributed to information distortion resulting from positions of conflict of interest. The renewed focus on securing the independence of proxy advisory firms is thus a well-calibrated move. The revised framework is expected to usher in better corporate governance outcomes as it is likely to empower institutional investors to engage in shareholder activism. The institution of the dispute settlement system can be expected to improve accountability on the part of proxy advisory firms and enhance their efficacy as market intermediaries in response to the emphasis on due diligence under the revised norms.
However, the multiplicity of obligations can also be counterproductive as it is likely to increase costs of compliance for the proxy advisory firms and lead to delays in regular operations. The threat of being pulled up by SEBI for non-compliance may also create a chilling effect. It is interesting to note that a defamation suit had been filed against a leading proxy advisory firm in the recent past for allegedly making unfavourable observations in its reports against the directors of a prominent company. Such instances could lead to further uncertainty as there is no established judicial precedent of the ideal conduct expected from the proxy advisory firms. SEBI’s dispute resolution mechanism thus could be clogged by multiple allegations of recalcitrant conduct. As emphasized in the Working Group Report, mere differences in opinion based on authentic factual data must not become the subject of litigation.
It remains to be seen if the economic impact of regulation is severe enough to dilute the quality of services rendered by these firms. Moreover, the onerous burden of compliance may create undesired entry barriers for new firms to disrupt the oligopolistic status quo enjoyed by three domestic proxy advisory firms currently operating in the market. Curtailing the autonomy of the firms may not necessarily result in course-correction and eliminate malpractices. SEBI must exercise its regulatory powers to facilitate a level-playing field in the market for proxy advisory firms such that the institutional investors sanction inaccurate analysis and voting recommendations as consumers in the long run.
The views expressed in this Blog Post are solely of the Contributor.