Texas Enacts New Law to Regulate Proxy Advisory Firms

Criticism of proxy advisors is at an all-time high as public companies grow increasingly frustrated with proxy advisors' lack of transparency, error-prone reports, and rampant conflicts of interest. In response, the Texas Legislature recently adopted SB 2337 to regulate proxy advice that relates to companies that are organized or have their principal place of business in Texas, as well as companies that have sought, but not yet received, shareholder approval to reorganize in Texas. Jones Day partner Ferrell Keel testified to the Texas State Senate Committee on State Affairs on SB 2337 and the need for regulation, as discussed in our Alert, "Holding Proxy Advisors' Feet to the Fire."  

SB 2337 imposes significant disclosure obligations on proxy advisors to provide investors with the financial rationale for voting advice. If a proxy advisor makes "nonfinancial" recommendations that are "not solely in the financial interest of the shareholders," SB 2337 requires proxy advisors to clearly explain "with particularity, the basis of [their] advice … and that the advice subordinates the financial interests of shareholders to other objectives, including sacrificing investment returns or undertaking additional investment risk." SB 2337 broadly defines "nonfinancial" recommendations to include, among other things, advice based on ESG or DEI goals and sustainability scores, as well as advice to vote in opposition to a company's recommendation on a shareholder proposal if such advice is not accompanied by a Written Economic Analysis, as described below.  

Notably, if a proxy advisor provides voting advice in opposition to a company's recommendation on any proposal or nominee—even if it is "solely in the financial interest of the shareholders"—the bill requires proxy advisors to disclose, among other things, "any specific financial analysis" that supports its recommendation (unless the client expressly requests services for a nonfinancial purpose). See SB 2337, Sec. 6A.102(a)(3) and the discussion of "Materially Different Disclosure Requirements" below. Although SB 2337 does not define or explain how detailed a "specific financial analysis" needs to be, one can imagine that the degree of specificity required will be a topic of debate next proxy season.  

We expect SB 2337 to have broad ramifications. For one, these disclosure obligations significantly increase proxy advisors' costs with respect to advice relating to Texas companies, and proxy advisors will need to navigate the challenges that arise from formulating their advice on a state-by-state basis. Companies and investors outside of Texas will have additional insight into proxy advisors' methodologies and be able to more closely scrutinize and challenge the soundness of proxy advisors' methodologies and recommendations. Retirement plan fiduciaries and institutional investors may grapple with whether and how to rely on this type of advice in light of their fiduciary duties and any express or implied contractual obligations to maximize investment returns.  For companies headquartered or incorporated in Texas, SB 2337 will rewrite the playbook for obtaining votes.  

For companies seeking to reorganize in Texas next proxy season, this is welcome news since proxy advisors will not be able to recommend against a move to Texas unless they comply with the bill's significant disclosure obligations and provide a specific financial analysis supporting their recommendation. 

Notable elements of SB 2337 are outlined in further detail below.  

Financial Interest Disclosure Requirements  

Proxy advisors have the following obligations if they provide advice that is not solely in the financial interest of shareholders:  

• Explain, with "particularity," the basis of the proxy advisor's advice and that the advice "subordinates the financial interests of shareholders to other objectives, including sacrificing investment returns or undertaking additional investment risk to promote one or more nonfinancial factors";
• "Conspicuously" state that advice is not being provided solely in the financial interest of shareholders because it is based on one or more nonfinancial factors; 
• "Immediately" provide a copy of the notice to the subject company; and 
• "Publicly and conspicuously" disclose on the proxy advisor's website that its services are not based solely on the financial interests of shareholders (collectively, the "Financial Interest Disclosure Requirements"). 

Note that there are a number of categories of advice that SB 2337 considers "not provided solely in the financial interest of the shareholders," including: (i) advice wholly or partly based on ESG or DEI goals, sustainability scores, or membership in or commitments to organizations advancing such initiatives; and (ii) a shareholder proposal recommendation in opposition to a company's recommendation if not accompanied by a Written Economic Analysis.  

"Materially Different" Disclosure Requirements 

Unless a client has "expressly requested proxy services for a nonfinancial purpose," a proxy advisor's advice that is in opposition to a company's recommendation on any proposal or nominee will be considered "materially different" advice that must:  

• Comply with the Financial Interest Disclosure Requirements, as applicable; 
• Notify all recipients of the advice, the subject company, and the Texas Attorney General of such recommendation; 
• Disclose whether the recommendation is based solely on financial interests; and 
• Disclose "any specific financial analysis" that supports the recommendation (collectively, the "Materially Different Disclosure Requirements"). 

A proxy advisor must also comply with the Materially Different Disclosure Requirements if it makes different recommendations to different clients—i.e., conflicting advice—and the clients have not "expressly requested proxy services for nonfinancial purpose."  

Shareholder Proposal Disclosure Requirements 

If a proxy advisor gives voting advice in opposition to a company's recommendation on a shareholder proposal, the advice will not be considered as "provided solely in the financial interest" of shareholders unless it provides a written economic analysis that includes: 

• The short-term and long-term economic benefits and costs of implementing the proposal;
• An analysis of whether the proposal is consistent with the client's investment objectives and policies; 
• The projected quantifiable impacts of the proposal, if adopted, on the client's investment returns; and 
• An explanation of the methods and processes used to prepare the economic analysis (collectively, the "Written Economic Analysis"). 

Any such recommendation would also need to comply with the Materially Different Disclosure Requirements.  

Enforcement  

"Affected parties"—including companies that are the subject of the proxy advice and their shareholders and recipients of proxy advice—may seek declaratory or injunctive relief for violations of SB 2377. The Texas Attorney General may intervene in any such action.  

Violations of SB 2337 will also be deemed a "deceptive trade practice" under Texas law that are actionable by the consumer protection division of the Texas Attorney General's office.