On Monday, the SEC announced that John Coates has been appointed Acting Director of Corp Fin.  He has been the John F. Cogan Professor of Law and Economics at Harvard University, where he also served as Vice Dean for Finance and Strategic Initiatives.  If that name sounds familiar—even if you haven't been one of his students—it may be because he sometimes pops up in Matt Levine's  column in Bloomberg as the author of "The Problem of Twelve," which he describes as the "likelihood that in the near future roughly twelve individuals will have practical power over the majority of U.S. public companies." Beyond that, he has been a very active member of the SEC's Investor Advisory Committee, and Committee recommendations he has authored may give us some insight on his perspective on issues.

In addition, Acting Chair Allison Lee has named Satyam Khanna to a new post as senior policy advisor for climate change and ESG, signaling, as we have discussed repeatedly, Lee's continued focus at the SEC on ESG issues, such as climate and diversity. (See, e.g.,   this PubCo post and  this PubCo post.) 

SideBar

In his paper,  " The Problem of Twelve," Coates argues that "[t]hree ongoing mega-trends are reshaping corporate governance: indexing, private equity, and globalization. These trends threaten to permanently entangle business with the state and create organizations controlled by a small number of individuals with unsurpassed power." With regard to index funds, for example, he contends that most analyses have overlooked

"a first-order consequence...that is, the wealthiest organizations in the world, with more revenue than most states—will soon be concentrated in the hands of a dozen or fewer people. Conventional analyses have emphasized that the individuals who control index funds have weak incentives to use that control....But conventional analyses mistakenly assume that index funds must make significant expenditures to influence companies and neglect economies of scale in exercise of power. They also neglect the power of control threats to discipline, and non-wealth utility derived from power. Index funds increasingly possess the 'median vote' in corporate contests. That gives them an ability, even if contingent, to make crucial decisions across most public companies. Unless law changes, the effect of indexation will be to turn the concept of 'passive' investing on its head and produce the greatest concentration of economic control in our lifetimes. More fundamentally, the rise of indexing presents a sharp, general, political challenge to corporate law. The prospect of twelve people even potentially controlling most of the economy poses a legitimacy and accountability issue of the first order—one might even call it a small 'c' constitutional challenge."

Coates observes that index funds exercise influence in three ways: first, they "form 'policies' regarding various kinds of decisions that the boards and managers of their portfolio companies must make."  As they meet with representatives of other institutional shareholders, they "achieve significant coordination over many if not all topics on which shareholders routinely vote." The second channel of influence is through engagement with their portfolio companies.  The "third channel of influence—control contests, activist campaigns, and mergers—[is] where the indexed funds have their greatest potential for influence....Index funds are increasingly the pivotal votes in such contests," especially "if the top indexed funds take similar positions." The "bottom line of this influence," he continues, "is very different than what the term 'passive' investment implies. Rather than blindly choosing stocks in their index and then ignoring them, index fund managers have and are increasingly using multiple channels to influence public companies of all sizes and kinds. Their views on governance issues, their opinions of CEOs, their desires for change at particular companies, their response and evaluations of restructuring or recapitalization proposals from hedge fund activists—all of these matter intensely to the way the core institutions in the U.S. economy are operating."

As Levine comments on Coates's analysis:  "The thing is, though, that if you find the 'Problem of Twelve' sort of creepy and unsettling when applied to issues of corporate governance and profitability, isn't it even weirder when applied to, like, the environment, or the social contract for U.S. workers? ...What if large public companies are the most effective locus of political power in the world today, and what if Larry Fink is one of the most influential people at a lot of large public companies [see  this PubCo post], and what if he decides to use his influence and those companies' power to do things that would once have been the responsibility of governments? What if Larry Fink has been elected to a position of vast political power, not by the old-fashioned mechanism of people going to the polls and giving him their votes, but by the new, late-capitalist mechanism of people giving him their money to manage?"  (See  this PubCo post.)

Proxy plumbing. In 2019, the SEC's Investor Advisory Committee voted to submit to the SEC revised  recommendations, authored principally by Coates, that addressed "proxy plumbing"—the panoply of thorny problems associated with the infrastructure supporting the proxy voting system. (See  this PubCo post.) It is widely recognized that the current system of share ownership and intermediaries is a byzantine one that accreted over time and certainly would not be the system anyone would create if starting from scratch. There is also broad agreement that the current  proxy plumbing system is inefficient, opaque and, all too often, inaccurate. As the recommendations observed, under the current system, shareholders "cannot determine if their votes were cast as they intended; issuers cannot rapidly determine the outcome of close votes; and the legitimacy of corporate elections, which depend on accurate, reliable, and transparent vote counts, has been called into doubt." For the most part, the recommendations would not have reinvented the proxy voting system, instead targeting improvements that were considered essentially "low-hanging fruit." However, there appeared to be a consensus that eventually more would need to be done. The Committee recommended that the SEC

  • require end-to-end vote confirmations for end-users of the proxy system, potentially commencing with a pilot involving the largest companies;
  • require "all involved in the system to cooperate in reconciling vote-related information, on a regular schedule, including outside specific votes, to provide a basis for continuously uncovering and remediating flaws in the basic 'plumbing' of the system";
  • conduct studies on share lending (to understand the extent to which share lending "contributes to errors, over-votes or under-votes, and whether the effect of share lending on voting entitlements is effectively disclosed to investors") and on investor views on anonymity (to find out whether so many investors really want to be anonymous "objecting beneficial owners"—which effectively precludes direct company contact—or whether they choose to be OBOs due to confusion or incentives of intermediaries); and
  • adopt its proposed 'universal proxy' rule, with the modest changes that would be needed to address objections that have been raised to that proposal. (See  this PubCo post.)

Interestingly, there was a lot of discussion about proxy plumbing, including a roundtable, during former SEC Chair Jay Clayton's tenure (see, e.g.,  this PubCo post), but not much action taken.  Was the problem too overwhelming?  Will Coates now seek to move these changes forward?

Shareholder proposals/proxy advisors.  In 2020, the Investor Advisory Committee voted to submit to the SEC a  recommendation, again authored principally by Coates, regarding SEC rule proposals on proxy advisory firms and shareholder proposals. The recommendation was highly critical of both proposals as unlikely to reliably achieve the SEC's own stated goals, and ultimately advised the SEC to rethink and republish the proposals and reconsider the related guidance it had issued. (Apparently, Coates's initial draft of the recommendations was a bit more harsh than the version approved, as he indicated to the Committee that the current version reflected substantial revisions, including removing the word "failure" throughout.) The recommendation contended that the proposals were almost futile without addressing in parallel more basic proxy plumbing issues (as the Committee had previously recommended, as discussed above) and that the SEC had not adequately identified the underlying problems that were intended to be remedied, provided a sufficient cost/benefit analysis or discussed reasonable alternatives that might have been proposed. The recommendation also considered the SEC's proposal regarding shareholder proposals to be inadequate in failing to discuss the value of shareholder proposals, including trends in favorable vote results (which had increased over time). Nor did the proposal adequately analyze the types of proposals that would be excluded under the revised thresholds and the value of those proposal to shareholders.  In addition, the recommendation argued that the proposal did not adequately consider the impact of the proposed changes on smaller shareholders or potential unintended consequences.  And again, the recommendation was critical of the SEC's failure to discuss alternatives. While Coates did not object to the notion of increasing the eligibility thresholds, he thought the SEC should have been more incremental in its approach and then studied the impact before raising the thresholds incrementally again.

The Coalition for Sensible Safeguards identified the new shareholder proposal rule and the new proxy advisor rule as potential candidates for action under the Congressional Review Act, which provides that recently finalized rules may be jettisoned by a simple majority vote in Congress and a Presidential signature.  Both of these rulemakings were the subject of strong dissents from the Democratic SEC Commissioners. And as discussed in  this PubCo post, the SEC's Investor Advocate also recommended reversal of both of these rulemakings. (See  this PubCo post.) Will Congress provide an opportunity for Coates to revise these rulemakings—or perhaps chuck them altogether?  

Human capital. The human capital disclosure rulemaking is a different story. In 2019, the Committee voted to  recommend that the SEC consider imposing human capital management disclosure requirements as a part of its Disclosure Effectiveness Review and disclosure modernization project. The recommendation was once again drafted by Coates.  However, the recommendation was quite flexible, indicating that the disclosure requirements might be limited to the most basic, purely principles-based disclosure, asking companies to "detail their HCM policies and strategies for competitive advantage and comment on their progress in meeting their corporate objectives."  Alternatively, the requirements could be more prescriptive, mandating use of specific metrics, some of which companies might already use to measure the success of their HCM strategies and investments.  For example, the recommendation suggested that Reg S-K, Item 101, could be expanded to require more information about the breakdown of workers into full-time, part-time and contingent categories, as well as key performance indicators, such as rates of turnover, internal hire and promotion, safety, training, diversity and standard survey measures of worker satisfaction. Discussion of applicable company policies on these topics might be included.  Item 101 also requests information about competitive conditions, which could be interpreted to apply to "productivity and competitive advantages of the issuer's employee population, relative to competitors and available pools of labor." Through the SEC comment process, the staff could seek to elicit data about the education, experience and training of the workforce. In addition, proxy disclosure could address how human capital is being "incentivized and managed" by augmenting executive comp disclosure with summaries of material information about broader workforce compensation and incentives, such as factors considered in pay and promotion decisions and organizational structures related to HCM.

As it turned out, in adopting a human capital disclosure requirement, the SEC went strictly principles-based. However, Clayton remarked that, while the SEC is not prescribing "specific, rigid metrics," under the principles-based approach, he did "expect to see meaningful qualitative and quantitative disclosure, including, as appropriate, disclosure of metrics that companies actually use in managing their affairs." (See  this PubCo post.) Presumably, Corp Fin, under Coates's direction, will be reviewing the disclosures to assess the level of compliance and perhaps providing guidance to help flesh out the principles-based requirement.   

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