Holding Proxy Advisors Accountable

It’s been happening for some time now: proxy advisory firms are feeling the pressure from what some refer to as controversial practices. This mounting tension came to a head in June when the House Financial Services Committee passed a bill that would reform much of the way proxy advisory firms operate. The bill is on its way to a full House vote.

But to understand how we got to where we are today, let’s briefly look at how all this came to be …

In 2013, the Securities and Exchange Commission convened to hold a roundtable discussion on the influence that proxy advisory firms had on shareholders and corporations.

SEC Chair Mary Jo White said she was “particularly interested in the discussion of conflicts of interest that may or may not arise in connection with the participation of proxy advisers in our system …”

The duopoly that exists today (ISS and Glass Lewis) is very powerful when it comes to influencing the outcomes of corporate proxy votes, and they’ve been the subject of much debate.

Some believe that the lack of competition in the space creates a problem in itself. Others argue that proxy advisory firm ISS in particular has an especially pernicious conflict of interest because of its corporate governance consulting side of the company.

This concern has reached congress with the Corporate Governance Reform and Transparency Act of 2016 aka the Proxy Advisory Firm Reform Act. The act would require that proxy advisory firms register with the SEC, and disclose information about how they advise and whether any potential conflicts of interest exist.

(Note: You may have noticed this bill has been referred to in two different ways: The Corporate Governance Reform and Transparency Act is an updated version of the original Proxy Advisory Reform Act)

This development has instigated a strong reaction, not the least of which has come from ISS itself.

From Modest Beginnings

There was a time when mutual funds and other institutional investors routinely ignored proxies and didn’t vote on them. Then the Department of Labor stepped in with regulations to make it clear that these investors were, in fact, expected to vote. This created a problem, however—many institutional investors were simply not set up to review the thousands of proxies being sent to them by the companies whose shares they hold. They needed a quick-fix solution.

Proxy advisory services provided the quick fix. They became popular because they filled a business need by providing the help with voting proxies that some institutional investors required.

This WSJ article gives a brief history on the development of proxy advisory firms:

In 2003, SEC rules and related actions allowed institutional investors to rely on advice from third-party advisory firms to fulfill their fiduciary obligations when they voted their shares. In prior years, Department of Labor regulations had effectively established a mandate for all institutional investors to vote their shares on all proxy issues. But many institutional investment advisers lack the resources to consider thoughtfully the hundreds or thousands (or more) of proxy issues that come before them for a vote. As a result they rely largely—or in many cases nearly exclusively—on the advice of proxy advisory firms.

Proponents of proxy advisories find their research to be useful. This paper, “A Defense of Proxy Advisors,” points out the benefits of having these firms as a key part of the system:

Proxy advisors have dramatically transformed shareholder voting. Traditionally, even large institutional investors tended to follow the Wall Street Rule—vote with management or sell your stock—because the economics did not justify incurring any expense in deciding how to vote. The emergence of proxy advisors who perform proxy research for a modest fee paid by each of thousands of institutions now enables these investors to vote intelligently …. Because of these developments, business managements can no longer ignore, but must cater to, shareholder interests.

The author of the paper asserts that today, “corporate managers resent being dethroned,” and that they have “mounted a campaign to press the SEC to impose new regulations to hobble proxy advisors and, thereby, to neutralize institutional shareholders.”

Mounting Controversy

Not everyone, however, believes that the proxy advisory services are an unmitigated good. Those who are more skeptical of proxy advisory firms note that:

• Their best practice recommendations attempt to impose a one-size-fits-all model onto corporations with unique needs
• Their corporate governance metrics for assessing public companies are ambiguous and disruptive
• They cause corporations to incorrectly put their focus on their governance ratings
• The nature of the duopoly and lack of competition in the proxy advisory sector produces lackluster results
• The consulting services offered by ISS creates an inherent conflict of interest
• They make it difficult for companies to innovate and make their own decisions about governance (for example, bylaws)

In a 2010 publication that highlighted a study by Professors Robert Daines (Stanford Law School/Graduate Business School), Ian Gow (Harvard University) and David Larcker (Stanford Business School), showed that there was no evidence that proxy advisory recommendations helped shareholders.

“We found no evidence that the firms they believed to have ‘good governance’ actually had higher returns, market valuations, fewer lawsuits, or other outcomes that shareholders would like,” Daines told the Financial Post, adding that “there was some evidence that the firms they considered to be well governed did worse on this score.”

This is a big deal when you consider that public company boards list proxy advisories as the third-most influential party behind investors and analysts, according to Daines, and that an ISS recommendation in favor of a given shareholder proposal increases the approval vote on average by 15 percent, according to James R. Copland of the Manhattan Institute in this Harvard Law School blog.

To that, Copland points out that “when it comes to shareholder proposals, a small, thinly funded outfit with 600 employees in Rockville, Maryland, is acting like an owner of fifteen percent of the total stock market.”

As the controversies surrounding proxy advisories mounted, governing bodies began to take note. After the 2013 SEC roundtable discussion, the SEC issued a Staff Legal Bulletin in 2014 titled in part “Proxy Voting Responsibilities of Investment Advisors.”

In this interpretive guidance, the SEC clarified that investment advisors have a duty to ascertain the proxy firm’s competence to analyze proxy issues, and a duty to provide ongoing oversight.

In other words, it’s not OK to hire a proxy firm and blindly follow their recommendations.

Whether you’re for proxy advisories or against them, the proposed Proxy Advisory Firm Reform Act is now on the table. As mentioned earlier, it was passed by the House Financial Services Committee on June 16, and is on its way to a full House vote.

The Corporate Governance Reform and Transparency Act

The proposed bill, introduced by Congressman Sean Duffy, aims to “improve the quality of proxy advisory firms for the protection of investors and the U.S. economy, and in the public interest, by fostering accountability, transparency, responsiveness, and competition in the proxy advisory firm industry.”

Among other things, the bill asserts that the SEC needs statutory authority to oversee the proxy advisory firm industry. The bill proposes that proxy advisory firms register with the SEC.

Further, the bill would amend the Securities Exchange Act of 1934 by specifying what the application for a proxy firm to register with the SEC would contain:

An application for registration under this section shall contain information regarding … the procedures and methodologies that the applicant uses in developing proxy voting recommendations, including whether and how the applicant considers the size of a company when making proxy voting recommendations … any potential or actual conflict of interest relating to the ownership structure of the applicant or the provision of proxy advisory services by the applicant, including whether the proxy advisory firm engages in services ancillary to the provision of proxy advisory services such as consulting services for corporate issuers, and if so the revenues derived therefrom …

Reactions to the Bill

In a statement, the ISS said the proposed bill would “weaken, or perhaps even destroy, the existing fiduciary bond between proxy advisers and their shareholder clients.”

It also added:

The proposed legislation would move proxy advisers out of a well-established investor-centric federal regulatory regime to a brand new bureaucratic maze that is designed to allow corporate executives and their representatives to pressure proxy advisers to back management positions on issues ranging from CEO compensation and director elections to mergers and insider-led leveraged buyouts.

The Council of Institutional Investors also opposed the bill, and in a letter stated:

The Proxy Advisory Firm Reform Act appears to us to be a solution in search of a problem, and to overreach. We do not believe there is compelling empirical evidence that institutional investors are abdicating and outsourcing their voting responsibilities, and current SEC guidance makes it clear than investment advisors have a duty to maintain sufficient oversight of third-party voting agents. We do believe that proxy advisory firms play a useful role for institutional investors, and that the bill proposes new requirements without clarity on how proxy voting works in practice today, and without sufficient analysis of costs and benefits.

For now, we are all waiting for the house to vote on the matter (and mind you, it's an election year, which likely means nothing will happen before a new president takes office). Even without a vote, however, proxy advisory firms must certainly be on notice that their practices are being scrutinized now more than ever.

The views expressed in this blog are solely those of the author. This blog should not be taken as insurance or legal advice for your particular situation. Questions? Comments? Concerns? Email: phuskins@woodruffsawyer.com.