June 28, 2018

Senate Banking, Housing, & Urban Affairs Committee “Legislative Proposals to Examine Corporate Governance”

Key Takeaways

  • Proxy Advisors: Chairman Mike Crapo (R-Ind.) asked if the voices of long-term retail investors are being represented in corporate governance and what the role of proxy advisors plays in that representation. Stuckey replied that “Mr. and Mrs. 401k” are represented by investment managers that largely vote with proxy advisors, so their interests are being represented. She noted that if proxy advisors are a disincentive to companies going public, then long-term retail investors will not have the same investment opportunities, and that is a concern.
  • FINRA Arbitration Awards: Sen. Pat Toomey (R-Pa.) expressed concerns that S. 2499 could cause fees to increase and spread costs across firms that have not done anything wrong. Quaadman said he shares those concerns and noted that the legislation will incentivize more fines, take resources away from FINRA, and result in good actors subsidizing bad actors.
  • Small Business Audit Correction Act of 2018: Sen. Tom Cotton (R-Ark.) discussed how the bill will correct an unintended consequence of the Dodd-Frank Act that increased audit costs for small, non-custodial broker-dealers. Quaadman agreed, adding that these firms will still be subject to Generally Accepted Auditing Standards (GAAS) and that the legislation “is a good way to rebalance the system” between private and public companies. 

Witnesses

  • Thomas Quaadman, Executive Vice President, U.S. Chamber Center of Capital Markets Competitiveness
  • Darla C. Stuckey, President and CEO, Society for Corporate Governance
  • Professor John C. Coates, Junior Professor of Law and Economics, Harvard Law School
  • Damon Silvers, Policy Director and Special Counsel, American Federation of Labor and Congress of Industrial Organizations 

Opening Statements

Chairman Mike Crapo (R-Idaho), Senate Banking Committee

Chairman Crapo stated that he intends to work with Senator Brown and others to get more of their proposals through to the Senate floor. He mentioned, however, that while some of the proposals worked on have been considered by the House of Representatives, most have not. Crapo highlighted the bills being discussed at today’s hearing and thanked those who have submitted feedback, adding that he looks forward to hearing what modifications the witnesses have to offer.

Ranking Member Sherrod Brown (D-Ohio), Senate Banking Committee

Senator Brown discussed several of the bills and followed up by saying that corporate boards seem to focus on preserving their jobs and maximizing their compensation instead of investing in their own business or in other people and businesses. Brown highlighted that the short-term focus has been obvious because of the amount of stock buybacks that have taken place. He then iterated that shareholders play a key role in company oversight but that the system needs to have tools to help and watch over companies. He noted his support specifically for the Corporate Governance Reform and Transparency Act, the Cybersecurity Disclosure Act, and the 8-K Trading Gap Act of 2018. Finally, he stated that he wants more bills that enhance investor confidence because that helps the businesses and the communities they serve.

Testimony

Thomas Quaadman, Executive Vice President, U.S. Chamber Center of Capital Markets Competitiveness
In his testimony, Quaadman stated that there is a “crisis of entrepreneurship” and a “calcification of startups in the United States.” He continued that business creation rates have not rebounded since the Great Recession and that 60 percent of counties in the U.S. have more companies go out of business than are created. He also noted the decline in public companies and that the growth experienced in the past has been “wiped out.” Quaadman requested more policies that will help businesses grow but noted that reports of a rise in Chinese venture capitalism shows there is not a lot of time to get these policies in place. He noted that the Chamber supports the Corporate Governance Reform and Transparency Act, The Fair Investment Opportunities for Professional Experts Act, and the Expanding Access to Capital for Rural Job Creators Act. On the contrary, he noted problems with the Cybersecurity Disclosure Act, the Brokaw Act, the 8-K Trading Gap Act of 2018, and the Compensation for Cheated Investors Act. Quaadman did note, however, that for the bills that the Chamber took issue, they were willing to work with the Senators proposing those bills.

Darla C. Stuckey, President and CEO, Society for Corporate Governance
In her testimony, Stuckey began with a discussion of the decline in public company ownership, noting that two bills before the committee could improve the climate for public ownership. She explained that H.R. 4015, The Corporate Governance Reform and Transparency Act, would provide much needed oversight to proxy advisory firms and would require necessary transparency in their disclosures, noting that the proxy advisory market is dominated by two firms, Institutional Shareholder Services (ISS) and Glass Lewis, adding that these groups have “enormous” and “unmatched” shareholder influence. She then criticized these firms for making mistakes in their proxy vote summaries and lamented the fact that their recommendations are not made available to most companies before their issuance. She expressed a willingness to work with the proxy advisors and institutional investors about their costs concerns. With regards to S. 1744, the “Brokaw Act,” Stuckey expressed support, praising its shortening of the reporting period for acquisition of five percent of a company’s stock and its insuring that investors’ securities positions are made transparent. She closed by voicing her opposition to S. 536 and the 8-K Trading Gap Act.

Professor John C. Coates, Junior Professor of Law and Economics, Harvard Law School
In his testimony, Coates praised the committee for a bipartisan, focused set of proposals. He endorsed S. 536, the Cybersecurity Disclosure Act, noting that it does not establish a requirement to hire a cybersecurity expert, but only requires a company to report on whether or not they have one. He denied any slippery slope arguments against the bill, claiming that cybersecurity, unlike almost any other issues, affects all public companies and thus deserves closer oversight. He then endorsed the 8-K Trading Gap Act and S. 2953, the “Expanding Access to Capital for Rural Job Creators Act”. Despite some concern around discouraging shorts, Coates endorsed the Brokaw Act, noting that it does not make sense that long positions must be disclosed while short ones need not be. He did add the caveat that a “sunset provision” should be added, letting the bill die at a future point if the Securities and Exchange Commission (SEC) does not think it is performing well. He endorsed the idea of the FINRA bill, though he recommended that the oversight ability be shifted away from FIRNA to the SEC. He closed by voicing opposition to H.R. 4015.

Damon Silvers, Policy Director and Special Counsel, American Federation of Labor and Congress of Industrial Organizations
In his testimony, Silvers noted that the bills before the committee should look to accomplish three things: effectively protect investors from self-dealing by their hired money managers, ensure a level playing field for all investors, and prevent a recurrence of the dynamics that led to the Financial Crisis of 2008. With those ideals in mind, Silvers voiced strong opposition to H.R. 4015, arguing that it effectively gave corporate boards and CEOs the ability to control the people who should be holding them accountable. He stated that the bill would establish punitive regulatory obligations for proxy advisors while concurrently allowing companies to delay vote recommendations in order to coerce the proxy advisory firms. Regarding S. 2756, Silvers voiced concern that the proposed baseline to qualify as an accredited investor was far too low, and thus opposed the bill. He offered support for the Brokaw Act, S. 1754, believing a disclosure of short positions to be common sense. Similarly, he praised S. 2499, saying it would increase accountability and public trust in the financial system. He briefly offered support for S. 536, the 8-K Trading Gap Act, and S. 2953, before closing by re-emphasizing his opposition to H.R. 4015.

Question & Answer

H.R. 4015, “Corporate Governance Reform and Transparency Act of 2017”

Crapo asked if the voices of long-term retail investors are being represented in corporate governance and what the role of proxy advisors plays in that representation. Stuckey replied that “Mr. and Mrs. 401k” are represented by investment managers that largely vote with proxy advisors, so their interests are being represented. Stuckey noted that if proxy advisors are a disincentive to companies going public, then long-term retail investors will not have the same investment opportunities, and that is a concern. Stuckey also noted that public, state, and private pension beneficiaries generally do not have a voice.

Brown also asked about proxy advisors, and Coates noted that the bill expects the government to fix the problem by having the SEC regulate it, which would pass on costs and discourage competition, suggesting that lawmakers should find the existing problems within the legal regime before adding regulatory burden. Silvers noted that advisors have a fiduciary duty and the bill compromises the substance of the relationship between the advisor and client, adding a layer of significant cost to what is otherwise a de minimis expense that adds substantial value.

Sen. Tim Scott (R-S.C.) asked panelists to discuss the conflicts of interests consulting firms have. Stuckey and Quaadman explained that for a fee a consulting firm can draft proxies, investors can purchase research from the same consulting firm, shareholders can have these firms draft proposals, and then the consulting firm can then vote on shareholder proposal they created. Quaadman added that these consulting firms have also pitched that if their services are used, customers will receive a better score, and criticized these firms for not disclosing conflicts of interest. Toomey echoed Scott’s concerns.

Sen. Thom Tillis (R-N.C.) discussed previous no-action letters from the SEC. Stuckey replied that those letters created proxy advisory firms as they exist today, and withdrawing the letter would help address the issues and revert the system back to how it functioned before proxies existed. Quaadman noted that proxy advice should be data-driven and based on shareholder returns, and that the lack of disclosure of conflicts of interest has created “serious problems” with proxy advice.

Sen. Heidi Heitkamp (D-N.D.) questioned whether proxy firms carry a fiduciary obligation. Quaadman replied that when it comes to clients and advisor firms there is a fiduciary obligation, and Silvers continued that proxy firms typically owe some type of duty to their clients, and financial institutions further owe obligations to their underlying investors.

Toomey noted there has been a shift in funding from public markets to private markets, and there are increased challenges and risks for public companies. He noted that environmental, social, and governance (ESG) investing is good if there is full disclosure, but if the underlying agenda is not fully disclosed, there is risk that it is inconsistent with what best serves the interests of investors. Quaadman and Stuckey agreed that an ESG’s agenda should be fully disclosed, and if not, the boardroom is not the appropriate place to debate social policy. 

  1. 2499 (FINRA Arbitration Awards)

Sen. Pat Toomey (R-Pa.) expressed concerns that S. 2499 could cause fees to increase and spread costs across firms that have not done anything wrong. Quaadman said he shares those concerns and noted that the legislation will incentivize more fines, take resources away from FINRA, and result in good actors subsidizing bad actors. Quaadman also noted that there are only a small number of cases that this legislation is seeking to address.

  1. 536, “Cybersecurity Disclosure Act of 2017”

Sen. Jack Reed (D-R.I.) stressed the importance of cybersecurity and how his bill is the “mildest form of disclosure,” merely asking companies to disclose if they have a cybersecurity expert but not making it mandatory. Coates replied with his worry that if such legislation is not passed, the next cyber attack (such as the one that hit Equifax) will result in a one-size fits-all approach to disclosure that will not work as well as this bill would.

In response to a question from Sen. Tom Cotton (R-Ark.), Coates noted that it is almost impossible for businesses to function without technology, such as smartphones, but that this technology exposes information systems of the company, stressing the benefit of such disclosures.

  1. 3004, Small Business Audit Correction Act of 2018

Cotton discussed the Small Business Audit Correction Act and how it will correct an unintended consequence of the Dodd-Frank Act that increased audit costs for small, non-custodial broker-dealers. Cotton noted that while it has been stated that the SEC or FINRA could relieve the compliance burden on these firms, such regulations could be reversed in the future so legislation is needed. Quaadman agreed, adding that these firms will still be subject to Generally Accepted Auditing Standards (GAAS) and that the legislation “is a good way to rebalance the system” between private and public companies.

  1. 2756, “Fair Investment Opportunities for Professional Experts Act”

Sen. Catherine Cortez Masto (D-Nev.) stated that the income threshold for an accredited investor has not been updated since 1982 and asked the panelists if this should be expanded. Coates replied that he is in favor of moving towards experience and education for defining an accredited investor rather than net worth and income thresholds. Silvers agreed that the wealth threshold is too low and added that there is a shift towards private markets happening because it is easier for firms to access capital, but that it results in less information and transparency available. 

8-K Trading Gap Act of 2018

Sen. Chris Van Hollen (D-Md.) discussed the 8-K Trading Gap Act of 2018, which addresses the four-day period between when a company determines there has been a significant event and when it is required to be disclosed, and what trading activity is allowed in that time frame. Quaadman noted that some companies have automatic stock purchases and others do not, and there needs to be further clarity to address that. Both Quaadman and Stuckey said they agreed with the intent of the bill, but additional discussion is needed on various provisions.

For more information on this hearing, click here.