Proxy firms may feel pinch under DOL proposal

ISS, a registered investment adviser with the Securities and Exchange Commission, also provides corporate-governance consulting services through its wholly owned ISS Corporate Services Inc. ISS’ consulting services could be interpreted under the proposed regulation to be in conflict with the proxy advisory services ISS offers institutional investors such as pension funds, ERISA attorneys said.

“The department opened a Pandora’s box by providing that any SEC-registered investment adviser may be a fiduciary, even if they only offer occasional incidental and generalized advice,” said A. Richard “Brick” Susko, an attorney who specializes in the Employee Retirement Income Security Act of 1974 at law firm Cleary Gottlieb Steen & Hamilton LLP.

Gary Hewitt, an ISS spokesman, said that it is unclear exactly how the Labor Department’s proposed rule would affect his company.

“We’ve managed these potential conflicts for years with a firewall between our corporate and institutional businesses,”he said.

“A critical component of the firewall is the research team not knowing the identity of the corporate-issuer clients. Our proxy advisory clients do have access to the identities of our corporate clients,” Mr. Hewitt said.

“The open question is what the DOL is contemplating requiring us to do, and it’s premature to speculate.”

The Labor Department’s proposed rule would extend fiduciary obligations to other proxy advisory firms — at least to firms registered with the SEC as investment advisers, according to ERISA attorneys.

The fact that the rule could single out SEC-registered investment advisers is a sore point for Proxy Governance Inc., a proxy advisory firm that is registered as an adviser with the SEC.

“If you’ve got two entities doing the same thing, they should be subject to the same rules, regardless of whether one is registered with another agency or not,” said Steven Wallman, founder and chief executive of Foliofn Inc., the parent firm of Proxy Governance. He was an SEC commissioner from 1994 through 1997.

Egan-Jones Ratings Co. and Glass Lewis & Co. LLC also offer proxy advisory services. But the SEC’s website doesn’t list the companies as agency-registered investment advisers.

Kent Hughes, managing director of Egan-Jones, said that the company doesn’t comment on regulatory matters.

Bob McCormick, chief policy officer for Glass Lewis, could not be reached for comment.

A SURPRISE

The fact that the Labor Department’s proposed rule could extend fiduciary obligations to proxy advisory services firms came somewhat as a surprise, because the key target of the agency’s proposal had long been thought to be investment consultants. Labor Department officials have made little secret of their concern about payments that some investment consultants receive from money managers when their clients hire money managers recommended by the consultants.

Along with extending fiduciary standards to investment consultants and proxy advisory firms, the proposed rule also could apply the enhanced requirements to anybody who provides investment advice to a plan or a plan’s participants.

“Our reading is that the fiduciary standard would apply to any professional who is providing investment advice to a plan sponsor, including an actuary, an accountant or an attorney,” said Paul Klauder, vice president and managing director of SEI’s Institutional Group. SEI offers a manager-of-managers program in which the company acts as a fiduciary.

“Anybody in the same room with a fiduciary ought to be concerned whether these rules make them a fiduciary as well,” Mr. Susko said.

If adopted, the new rule will subject proxy advice and the investment-related advice of consultants, broker-dealers and others to the full panoply of ERISA fiduciary obligations, including prohibitions on self-dealing and other conflicts.

In its proposed regulation, the Labor Department contends that an overhaul of its fiduciary definition is sorely needed because the current definition makes it too easy for entities that offer investment-related advice to employee benefit plans to avoid a fiduciary obligation to the plan.

Under the existing definition, in order to be considered a fiduciary, the entity that offers the advice to the plan has to be offering that advice on a “regular basis,” subject to a “mutual” understanding that the advice will serve as “primary basis” for plan investment decisions involving plan assets, according to the text of the proposed rule.

The proposed rule makes it clear that parties offering investment advice to employee benefit plans for a fee would be subject to the fiduciary obligations if they represented that they were acting as fiduciaries or were registered at the SEC as investment advisers, and the advice “may be considered in connection with making investment or management decisions with respect to plan assets.”

In the text of its proposed rule, the Labor Department said that pension executives want impartial advice from consultants, appraisers and other advisers.

“These persons significantly influence the decisions of plan fiduciaries and have a considerable impact on plan investments,” the text of the proposed regulation states. “However, if these advisers are not fiduciaries under ERISA, they may operate with conflicts of interest that they need not disclose to the plan fiduciaries who expect impartiality and often must rely on their expertise.”

CHILLING EFFECT

Some ERISA attorneys contend that the new fiduciary definition is so expansive that it could have a chilling effect on investment advice.

“Anybody giving advice may be more careful when the advice that they provide is likely to be relied upon, even where it’s pretty clear that the advice will not be the primary basis for the plan’s decisions,” said Andrew Oringer, an ERISA attorney with the law firm Ropes & Gray LLP.

“If adopted, [the proposed rule] will significantly increase the transaction costs borne by plans and their participants, and adversely affect the way plans … buy and sell investment products, and their access to such products,” Melanie Nussdorf, a partner at the law firm Steptoe & Johnson LLP, wrote in an e-mail.

“This is going to reduce the amount of advice given by competent professionals to plans and/or significantly increase its costs,” Mr. Susko said.

But Assistant Labor Secretary Phyllis Borzi, who heads the Employee Benefits Security Administration, said during an Oct. 21 teleconference for reporters on the proposed rule: “If it dries up the schlocky advice that … fiduciaries are getting, I don’t have a problem with that.”

Mr. Klauder said that SEI supports the agency’s proposed regulation because it raises the regulatory bar for all investment consultants.

“For years, the majority of investment consultants have operated in a non-fiduciary capacity and provided access to managers without fiduciary accountability, but they will now be held to a higher standard,” he said.

Broker-dealers offering investment advice to plans also would have to assume fiduciary obligations for that advice and make clear to the plan fiduciary when they were merely in sales mode, according to the proposed rule.

“When you’re just selling as opposed to advising, you’ve got to give a disclosure saying that your interests are adverse and that you’re not giving impartial investment advice, and that’s pretty tough,” said Jason Bortz, an ERISA attorney for the law firm Davis & Harman LLP.

Comments on the proposed rule are due Jan. 20, Ms. Borzi said.

Doug Halonen is a reporter with sister publication Pensions & Investments.

Related Topics: DOL