Behind the SEC’s War on Freedom of Speech

(Bloomberg Opinion) -- Modern investors have diversified portfolios with stakes in hundreds – sometimes thousands – of companies. Proxy advisory firms provide these investors with objective, unbiased recommendations about how they should exercise the voting rights tied to their shares.

The largest proxy advisory firms generally side with the management of the companies. But they will take an opposing side if company directors are not fulfilling their oversight responsibilities or if the managers try to entrench themselves in their jobs by adopting scorched-earth anti-takeover devices.

A number of corporate managers are enraged when proxy advisory firms call them to account for acting against the interests of the company's shareholders. What is surprising is that the Securities and Exchange Commission has chosen to favor management and undermine shareholders' rights and interests.

The SEC is proposing new regulations that both stifle the ability of proxy advisory firms to criticize management and provide management with an inappropriate power to influence the advisory firms' recommendations. Proxy advisory firms do much-needed research on issues — like whether incumbent directors should be re-elected; whether a company should have a board whose directors are elected to staggered terms; and whether a company should enter into a merger that might involve reductions in the headcount at corporate headquarters, but would be wealth-creating for shareholders. The advisory firms also are an important voice for linking executive compensation more closely to corporate performance.

Corporate managers have the Business Roundtable and the U.S. Chamber of Commerce representing and lobbying for them in the halls of Congress and in the backrooms of the federal bureaucracies. These groups object to anyone advising shareholders to vote to rein in the self-interested proclivities of corporate executives.

The SEC's move to regulate proxy advisory firms is a naked political gambit. It offers a solution to a problem that does not exist. There has been no significant episode on record of a proxy advisory firm making a material false statement about a company. Moreover, a mechanism is already in place for independent proxy advisers to correct any errors brought to their attention.

The politics behind this proposal has been ugly. In an apparent “astroturfing” campaign that was described by Bloomberg News, the SEC received ghost-written letters in support of the proposed regulations that were fraudulently represented as letters from ordinary investors.  The SEC apparently relied on these fake letters in measuring public support for its proposed regulations and is now said to be investigating this scheme to subvert the agency's rulemaking process.

Nevertheless, at the behest of corporate interest groups, the SEC is fast-tracking a proposal that would give every corporation the right to review a proxy advisory firm's recommendations as much as five days before the proposals are delivered to shareholders, who are the firm's actual clients.

These companies are allowed to provide “feedback” on these proposals. While proxy advisory firms would not be compelled to accept revisions suggested by corporate managers, any advisory firm that does not accept this input exposes itself to the very real danger of being named as a defendant in a securities fraud suit brought by the company on the grounds that it “knowingly” countenanced the distribution of a misleading proxy.

Worse, the SEC proposes that companies also be allowed to prepare a written response to be included as a hyperlink along with the advisers' report.

 If companies don't like the proxy providers' findings, they can even see to it that the shareholders don't have access to these opinions.  Under current legal standards, a proxy advisory firm is subject to sanction if it knowingly publishes a false statement. One of the SEC's proposed rules  would subject an advisory firm to civil or even criminal penalties for vague, inadvertent transgressions such as publishing statements that later are deemed to be “misleading.” Proxy advisory firms under the proposed rules would even be subject to penalties for relatively minor errors such as failing to cite studies that produce different results from any studies cited by the firms.

 It is indeed strange that the SEC, whose mission is to protect investors, is putting its thumb forcefully on the scale in favor of companies and against investors. Its proposal would land a one-two punch against corporate democracy and freedom of speech. Not only is the commission demonstrating a deep hostility for the value of dissent. It is also abandoning the idea that the free and open exchange of competing views will result in the triumph of good investment policies over inferior ones.

To contact the editor responsible for this story: Katy Roberts at kroberts29@bloomberg.net

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

Jonathan Macey is a professor at Yale Law School and the Yale School of Management.

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