In a complaint filed by the SEC against Eric Lipkin in June 2011, the SEC charged the employee of Bernard Madoff Investment Securities LLC (BMIS) with helping to perpetuate Madoff’s fraudulent, multi-billion dollar Ponzi scheme. Lipkin worked in Madoff’s advisory operation and was charged by the SEC with repeated material misrepresentations. Among the many allegations in the SEC’s complaint, Lipkin helped BMIS mislead customers who sought the firm’s proxy voting records.
According to the complaint, BMIS did not participate in proxy voting because the firm did not actually purchase stock on behalf of investment advisory clients. Lipkin researched proxy information to determine what issues were being voted upon. He would then draft letters to clients making inquiries, which falsely stated that BMIS had voted with corporate management on these proxy votes. Creating these fictitious records helped to cover up Madoff’s phony “split-strike conversion strategy.”
The typical proxy voting problem uncovered by securities examiners is nothing like the scheme orchestrated by Madoff and his co-conspirators. The issue is whether the RIA fulfilled its fiduciary duty in connection with proxy voting.
A proxy is an agent legally authorized to act on behalf of another party. When a company holds its annual meeting to vote on issues affecting the corporation, most shareholders don’t attend. Proxies authorize a designated person to cast votes according to the instructions given by the shareholder. At the onset of an advisory relationship, advisors must make it clear to clients if the RIA or the client is responsible for making decisions regarding how proxies should be voted.
Fiduciary Duty as it Relates to Proxy Voting
As we saw during our analysis of an RIA’s fiduciary obligations, proxies must be voted in the best interest of the client. RIAs do not, however, owe a fiduciary duty to vote proxies. If an RIA does not vote proxies for clients, the firm must fully disclose it will not perform this service in its Form ADV disclosure brochure. On several occasions, RIAs were criticized for having a proxy voting policy inconsistent with their Form ADVs.
To comply with its fiduciary obligations, an RIA must be certain that the firm’s policies and procedures relating to proxy voting are thorough and address potential conflicts of interest. If RIAs are authorized to vote proxies, they must always make decisions in their clients’ best interests.
Background on the Proxy Voting Rule
Rule 206(4)-6 under the Investment Advisers Act helps to ensure that SEC-registered advisors act in the best interests of their clients when exercising proxy voting authority. Furthermore, RIAs must comply with Rule 204-2, requiring them to retain proxy voting books and records.
The SEC adopted Rule 206(4)-6 to regulate proxy voting by RIAs with the responsibility to vote their clients’ proxies. As a fiduciary, an RIA owes each of its clients the duties of care and loyalty to all services undertaken on the client’s behalf, which may include proxy voting. To satisfy its duty of loyalty, RIAs must cast proxy votes in a manner that the advisor believes will advance the best interest of its client. The RIA should never put its own interests ahead of the client’s.
Under Rule 206(4)-6, it is a fraudulent, deceptive, or manipulative act, practice, or course of business for RIAs to exercise voting authority over client proxies before taking the following steps:
- Adopting and implementing written policies and procedures that are reasonably designed to ensure that the RIA votes proxies in the client’s best interest
- Disclosing to clients what they need to do to obtain information regarding how their proxies were voted
- Describing proxy voting policies and procedures and furnishing them to clients upon request
The policies and procedures implemented pursuant to Rule 206(4)-6 must be in writing and part of an RIA’s compliance manual. They must be designed to ensure that proxies are voted in the best interest of each client, and must address how material conflicts of interest between the RIA and the client are resolved. It is not sufficient for policies and procedures to stipulate that all proxies will be voted in the best interest of the client.
RIAs may have a number of conflicts affecting how they vote proxies. By adopting and implementing policies and procedures for voting proxies, clients are less likely to be harmed by these potential conflicts of interest.
RIAs having explicit or implicit voting authority must comply with Rule 206(4)-6. Therefore, even when the advisory contract is silent on this point, the rule applies because the RIA’s voting responsibility is implied by an overall delegation of discretionary authority. The rule does not apply, however, to RIAs that provide clients only with general advice about voting proxies and do not have authority or responsibility to vote them.
If an RIA manages assets on a discretionary basis but does not vote proxies, Form ADV Part 2A and the firm’s advisory agreement should advise clients that this is their own responsibility. It is also a good idea for an RIA’s compliance manual to spell out that the firm does not vote proxies for clients if that is the firm’s policy.
Enforcement Action Arising out of RIA’s Proxy Voting Rule Violations
On May 8, 2009, the SEC announced that it had filed charges against INTECH Investment Management LLC and the firm’s former chief operating officer (COO) for violating the proxy voting rule. According to the SEC’s press release, this was the first enforcement action brought by the SEC based on a proxy voting rule violation. The SEC alleged that the RIA failed to address how the firm would handle material conflicts of interest in their proxy voting policies and procedures. The SEC also charged the firm and its COO with committing other violations of Rule 206(4)-6.
INTECH and its COO consented to the SEC’s order without admitting or denying any of the Commission’s findings. The firm agreed to pay $300,000 and the COO was assessed a penalty of $50,000. Both the firm and the COO were censured and ordered to cease and desist from violating Rule 206(4)-6.
Although it is unusual to see enforcement actions arising from an RIA’s failure to enact thorough and complete proxy voting policies and procedures, it is common for examiners to observe deficiencies during compliance exams. For example, examiners may observe that an RIA’s disclosure brochure, advisory contracts, and policies and procedures clearly state that the firm does not vote proxies on behalf of clients. A problem arises if examiners discover the advisor is, in fact, voting proxies for some clients but not others.
Record-Keeping Requirements Pertaining to Proxy Voting
Rule 204-2 requires RIAs to maintain certain records relating to proxy voting. RIAs that exercise voting authority with respect to a client’s securities are required to make and retain all of the following:
- Copies of all policies and procedures in accordance with Rule 206(4)-6
- A copy of each proxy statement that the RIA receives regarding a client’s securities. A firm may comply with this requirement by relying on a third party, such as a proxy voting service, or the SEC’s Electronic Data Gathering, Analysis, and Retrieval (EDGAR) system
- A record of each vote cast by the RIA on behalf of a client. A firm may fulfill this requirement by relying on a third-party service to provide these records, which must be able to supply proxy voting records promptly if requested to do so
- A copy of any document created by the RIA that was material in deciding how to vote proxies on a client’s behalf or that articulates the basis for that decision
- A copy of each written request from clients asking for information regarding how the RIA voted proxies on their behalf
An RIA must also retain copies of any written response to clients who ask for information regarding how the firm voted their proxies. The written response must be retained, even if the client’s request was not in writing.
The Big Picture
RIAs are not required to vote proxies on behalf of their clients. If they do not, however, the RIA’s policies and procedures, disclosure brochure, and advisory agreement should clearly articulate that the firm will not undertake this task. Where an RIA does assume responsibility for voting proxies, the firm’s policies and procedures should help to ensure that votes are cast in the best interest of the client.
RIAs sometimes contradict themselves in their Form ADVs, advisory agreements, and policies and procedures. For example, an RIA may disclose in its Form ADV that the firm votes proxies for clients. The firm’s advisory agreement, however, may state that the RIA has no obligation to vote clients’ proxies. The inconsistency is exacerbated when the RIA’s policies and procedures spell out a process for voting proxies that isn’t followed. All three of these documents should be consistent on proxy voting. If the RIA does vote proxies on the client’s behalf, the process should be clearly defined in the firm’s policies and procedures and should be followed to the letter. If there are inconsistencies, an RIA will run into problems during a compliance examination.
Clients are informed about an advisor’s proxy voting policies in their advisory contracts and in the firm’s Form ADV disclosure brochure. Figure 19-1, shows an example of language used by advisory firms in their disclosure brochures.
Figure 19-1. Proxy Voting Disclosure Brochure Language
We will determine how to vote proxies based on our reasonable judgment of the vote most likely to produce favorable financial results for you. Proxy votes generally will be cast in favor of proposals that maintain or strengthen the shared interests of shareholders and management, increase shareholder value, maintain or increase shareholder influence over the issuer’s board of directors and management, and maintain or increase the rights of shareholders. Generally, proxy votes will be cast against proposals having the opposite effect. However, we will consider both sides of each proxy issue. Unless we receive specific instructions from you, we will not base votes on social considerations.
Conflicts of interest between you and our firm, or a principal of our firm, regarding certain proxy issues could arise. If we determine that a material conflict of interest exists, we will take the necessary steps to resolve the conflict before voting the proxies. For example, we may disclose the existence and nature of the conflict to you, and seek direction from you as to how to vote on a particular issue; we may abstain from voting, particularly if there are conflicting interests for you (for example, where your account(s) hold different securities in a competitive merger situation); or, we will take other necessary steps designed to ensure that a decision to vote is in your best interest and was not the product of the conflict.
*Used with permission from National Compliance Services, Inc.
Although clients receive an RIA’s disclosure brochure, there is no obligation to provide copies of the firm’s policies and procedures. One advisory firm mistakenly believed it was required to send out its proxy voting policies on an annual basis, which is not the case. Certainly, if a client asks to see copies of the RIA’s policies and procedures, the firm should provide them.