This article has been authored by Aryan Bhat, a second year law student at National Law University, Delhi.
The securities market in India has grown by leaps and bounds. This year, The Bombay Stock Exchange, Asia’s oldest was ranked as the tenth largest in the world in terms of market capitalization. This is clearly reflective of the growing interest consumers have shown in investing in securities as a means of investment, albeit its high risks. Ideally, an investor would keep a close track of the activities and financial and administrative decisions being made by the company she has invested in and anticipate the implications it would have upon the company’s future financial position. The reality is however, far from ideal. Retail investors often lack the time, resources and even expertise to keep this close watch. For the institutional investors too, to analyse the daily decisions and activities of the large number of companies in their portfolio is a daunting task.Nonetheless, it is vital to ensure that the companies are complying by all their legal obligations and are also making sound business decisions lest the interests of the investors are hampered. This is where the role of the Proxy Advisory Firms has attained wide popularity.
Proxy Advisory Firms(or Proxy Advisors) are market intermediaries which conduct in-depth research and evaluate the merits and demerits of corporate actions such as mergers and acquisitions, takeovers, product launches, governance matters like appointment of top executives, their remuneration etc which are put to vote in a company’s Annual General Meetings and Extraordinary General Meetings. Upon such intensive research, the proxy advisers then advise institutional and retail investors as to how they should cast their vote. In 2018, Deepak Parekh, Non-Executive Director of HDFC barely retained his post as two US Proxy Advisory Firms recommended the investors for voting against him, citing credibility concerns. Proxy Advisors also publicly recommended shareholders against voting for Ajit Gulabchand’s salary hike, calling it disproportionate to the company’s performance. These instances reflect the growing influence of Proxy Advisors on the country’s shareholder activism.
Despite the many advantages that Proxy Advisors have for the investing community, many concerns have been raised regarding their methodology, conflict of interest, reliability and most importantly, the fact that they are so under regulated despite their growing importance. In 2014, SEBI decided to regulate the Proxy Advisers at par with other research analysts under the SEBI (Research Analyst) Regulations, 2014. However, the passage of time led to recognition of more concerns regarding the role of the Proxy Advisors . In August 2020, additional set of guidelines were issued by SEBI.
The author, in this article writes about how the SEBI regulations are well-intended to ensure that the Proxy Advisory Firms maintain their fiduciary duty to the investors, specially in light of concerns pertaining to their conflict of interest and what shall be the extent of these regulations.
Conflict of Interest as a Valid Concern
Since the trend of Proxy Advisory in India is still in its nascent stages, not much qualitative studies have been conducted to prove that their voting recommendations proves influential in Annual General Meetings.However, report prepared by SEBI’s working group last year did acknowledge that Proxy Advisors enabled the minority shareholders to make better informed voting decisions and handle the operational process of voting in corporate matters through precise information backed by research. In developed markets like the United States, where Proxy Advisory Firms gained traction in the 1990s and have since then remained hugely popular, academic research has confirmed that these firms can sway investors’ votes by 70% and that asset managers with more than $5 trillion in assets rely upon their voting recommendations almost 95% of the time on shareholder as well as management proposals.
Given the fact that egregious corporate governance practices, as has been observed on many occasions such as the Satyam scam, Nirav Modi scam etc, have shaken the confidence of the general public in the securities market, mutual funds and retail investors have become even more wary of investing wisely in the stock market and hence the role Proxy Advisory Firms play in evaluating any possible breach of governance norms is highly likely to become more and more significant. Therefore, it becomes pertinent to bring these firms under the scrutiny of SEBI for better transparency and to address the present concerns about them.
One of the most prominent criticisms that Proxy Advisory Firms have faced is that of an actual/potential conflict of interest. It has been observed that firms providing research inputs to help investors in exercising their corporate franchise simultaneously provide consultancy services to listed companies to comply with the standards and norms laid down by the law. This raises legitimate fears of independence and reliability of the information provided by them to the investors. Conflict of interest may arise in four ways: (1) that the firm providing voting recommendation to investors about a certain company might also be helping the same company develop management proposals and improve its corporate governance,(2) the staff, executives and owners of the firm might also have ownership interests or may be board members of companies which they recommend about ,(3) the firm might be a subsidiary of a listed company itself ,or (4) the firm providing recommendations for shareholder proposals might also be backed by owners or institutional investors who would be clients as well.
These associations are problematic because this would make the Proxy Advisory Firms subject to extraneous considerations and thus, unable to fulfill the fiduciary duty they owe to the investors at large. Breach of such fiduciary duty would endanger the interests of the investors as they rely upon these firms to quite an extent to vote on various proposals and resolutions. Yet another way by which the independent functioning of these firms can be undermined is through what is known as Strategic Lawsuits Against Public Participation(SLAPP). Publicly traded companies could file lawsuits against these firms to create an ad terrorem effect and force them into self-censorship. In 2018, ITC limited slapped a 1,000 crore lawsuit against IiAS, one of India’s three Proxy Advisors for defamation as the firm recommended investors for voting against its non-executive director.
Fiduciary Duty towards the Investors
A fiduciary duty, in commercial law is defined as the one where a party hires services of another due to the latter’s special knowledge of subject matter and/or circumstances to act on the former’s behalf for a certain monetary compensation.[i] The party acting in fiduciary duty shall therefore, act for the beneficiary as the beneficiary would itself act. It cannot pursue any course of action which would either cause harm to the beneficiary or gain to the fiduciary.[ii]
In Central Board of Secondary Education and anr v Aditya Bandhopadhyay and ors,the Supreme Court discussed the concept of fiduciary relationship in good detail. The Court stated that a fiduciary duty is characterized by trust,care and confidence. A fiduciary is expected to act in good faith and fairness and for the benefit and advantage of the beneficiary. Such a relationship can arise in either of the following ways: (1) when a person places trust in the faithful integrity of another, who as result gains superiority or influence overt the other, (2)when one person assumes control and responsibility over another, (3) when one person has a duty to act for or give advice to another on matters falling within the scope of the relationship.
By virtue of the nature of their work, it can be said that Proxy Advisory Firms certainly owe a fiduciary duty to the investors at large.Even the additional guidelines of 2020 promulgated by SEBI mandates the firms ,inter alia to adhere to the Code of Conduct as required by the earlier regulations of 2014 which requires them to act in good faith, effectively address and disclose all details regarding any conflict of interest, not engage in any insider trading. Chapter III of the guidelines of 2014 also lays down detailed provisions to facilitate the same- which tacitly forms a fiduciary relationship between the firms and the investors.
The new guidelines stipulate firms to formulate voting recommendation policies and disclose the same to their clients and that the same shall be reviewed annually. Proxy Advisors shall also disclose conflict of interest whenever they are giving their advice and also the safeguards they have put in place to mitigate similar such conflicts. The recommendation reports shall also be made available to clients and companies simultaneously and feedbacks of the latter shall be added by the firm as an addendum to the report or revise the recommendation, as it may deem fit. Providing the opportunity to listed companies to also reply to the research reports prepared and include the same in the report would also help these firms to avoid litigation from the corporate behemoths.
Hene, it can be said that the new guidelines bring the Proxy Advisory Firms under regulatory control-which makes India the only country to do so. These guidelines not only address concerns of Proxy Advisory Firms’ of conflict of interest by investors but also complaints of methodology and inaccurate reports by the listed companies. This makes their functioning more transparent and credible to outsiders which would also compel companies to adhere to the corporate governance norms, fearing negative publicity by Proxy Advisors.
Extent of Regulations
While subjecting Proxy Advisory Firms to the guidelines promulgated is a step in the right direction, it is critical to draw a line as to how much of regulation is justifiable. The Indian State has long been criticised for being too bureaucratic in regulating its business environment. Excessive regulation, in terms of disclosure requirements, paperwork and methodology could increase compliance costs for the Proxy Advisory Firms and also stifle creative thinking and innovation among them. This would also lead to higher barriers to entry in this market-which is also undesirable as studies have shown how increased market competition results in lesser conflict of interest among the Proxy Advisors.
The Eurpoean Securities and Markets Authority(ESMA), also recommended Proxy Advisory Firms to adhere to a prescribed Code of Conduct than to frame binding guidelines as the former was found to be the ideal approach to best ensure efficient interaction between the Proxy Advisors, investors and public companies.
SEBI’s guidelines reiterate the Code of Conduct that firms are bound by and also lay down a set of additional guidelines which are generalistic and broad. Hence, rather than imposing a rigid regime, they appear well-tailored to ensure higher standards of transparency, accuracy and fidelity from the Proxy Advisory Firms. While the regulations have been largely well-received, additional regulations are also being sought in terms of the firms’ revenue model, clientele etc. However, it shall be ensured that such legal regulations don’t become far too onerous for the firms to comply by, since that would affect their quality of performance and reliability among their clients.
The trend of Proxy Advisory Firms is a welcome step for the Indian financial markets whose history is marred by frauds such as the Satyam Scam, Harshad Mehta Scam and the Nirav Modi scam being the latest addition. Proxy Advisory firms, are playing a significant role by making minority shareholders crucial in corporate governance process by providing them voting recommendations backed by in-depth research. This subjects public companies to scrutiny and thus, more accountable to the investing public. However, concerns are also being raised against the Proxy Advisors, most significant of them being that of a potential conflict of interest as quite often, these firms provide voting recommendation about the same companies to which they extend services to improve their legal compliance and financial performance due to which they may not fulfil their fiduciary duty towards the investors.
The guidelines promulgated by SEBI are a step on the right direction as they seek to regulate these firms through a Code of Conduct to make them more transparent. However, it needs to be kept in mind that the regulations don’t transgress into cumbersome, formalistic procedures that would disincentive Proxy Advisors from exercising the necessary due diligence on account of the major costs and procedural formalities involved.
[i] Victor Brudney, Contract and Fiduciary Duty in Corporate Law, 38 B.C.L. Rev. 595 (1997).
[ii] Keech v Sanford, EWHC J76.