The idea of regulating proxy advisory firms has been in the ether for quite some time, but it’s an idea that never quite comes to fruition. However, there seems to be a lot of chatter about this topic now, raising the question: is now the time? According to this paper, The Big Thumb on the Scale: An Overview of the Proxy Advisory Industry, from Stanford’s Rock Center for Corporate Governance, while proxy advisory firms influence institutional voting decisions and corporate governance choices to a material extent, it “is not clear that the recommendations of these firms are correct and generally lead to better outcomes for companies and their shareholders.” In that light, the paper suggests that some type of regulation of proxy advisory firms might be warranted to increase their transparency and improve the reliability of their recommendations.
Even though most matters on proxy cards are run-of-the-mill, proxy voting can serve as “an important vehicle for shareholders to communicate their preferences to the board.” Some are inherently contentious, such as election contests and takeover proposals. But even annual say-on-pay proposals can send “an important signal about shareholder satisfaction with CEO pay and performance.” The authors cite one 2009 study for the proposition that “protest votes in uncontested director elections are associated with higher board turnover, higher management turnover, and increased corporate activity (such as major asset sale or acquisition) in the year following the vote.” From time to time, shareholder proposals can trigger some heated debate—although they almost always involve non-binding precatory proposals—because proposals that garner a majority vote, or even just a substantial one, can put pressure on boards to address the underlying issue. As a result, many activist shareholders use the shareholder proposal process in an effort to effect change.
Still, the voting process is dominated by institutional investors, which hold about 70% of outstanding public company stock, compared with only 30% held by retail investors. Moreover, institutional holders participate in voting more heavily, at a rate of 91% compared with only 29% for retail holders. As a result, institutional investors have “a disproportionately large influence over voting outcomes.”
With the prevalence of institutional holders, economic and regulatory factors “have opened the door for third-party proxy advisory firms to play a substantial role in the proxy voting process.” Economically, while huge asset managers, such as BlackRock, can operate independently with their own expert staffs to conduct research and to evaluate proxy issues, for other smaller institutions, the process is “costly and requires significant time, expertise, and personnel….Third-party proxy advisory firms satisfy a market demand by centralizing these costs so they do not need to be duplicated across multiple investment firms.” In addition, from a regulatory perspective, registered institutional investors have certain transparency and fiduciary obligations, which the SEC has indicated can be satisfied by relying on proxy advisory firms, a position that has also increased the influence of these firms.
But how much influence do proxy advisory firms really have? That seems to be a topic of some debate, largely because it’s difficult to measure how institutional investors, given the same facts, would have voted in the absence of proxy advisors’ recommendations. One study cited in the article estimated that ISS recommendations had limited effect, shifting only 6% to 10% of investor votes. What’s more, institutional investors maintain that they use the recommendations to complement, not substitute for, their own decision-making processes, claiming “that they refer to, but do not rely on, the voting recommendations of proxy advisory firms” and are guided instead by established best practices.
Looking at actual voting outcomes, however, the paper contests that self-assessment, arguing instead that proxy advisors likely have a material, although unspecified, influence over voting behavior:
“An extensive sample of the voting records of 713 institutional investors in 2017 shows that institutional investors are significantly likely to vote in accordance with proxy advisor recommendations across a broad spectrum of governance issues. For example, 95 percent of institutional investors vote in favor of a company’s ‘say on pay’ proposal when ISS recommends a favorable vote while only 68 percent vote in favor when ISS is opposed (a difference of 27 percent). Similarly, equity plan proposals receive 17 percent more votes in favor; uncontested director elections receive 18 percent more votes in favor; and proxy contests 73 percent more votes in favor when ISS supports a measure. While the evidence shows that ISS is the more influential proxy advisory firm, Glass Lewis also has influence over voting outcomes. Glass Lewis favorable votes are associated with 16 percent, 12 percent, and 64 percent increases in institutional investor support for say on pay, equity plan, and proxy contest ballot measures ….Furthermore, some individual funds vote in near lock-step with ISS and Glass Lewis recommendations, correlations that suggest that the influence of these firms is substantial.”
The authors contend that an “extensive review of the empirical evidence shows that an against recommendation is associated with a reduction in the favorable vote count by 10 percent to 30 percent.” According to one study cited in the paper, based on a sample of over 1,300 companies in the S&P 1500, an unfavorable ISS recommendation on a management proposal (such as compensation, antitakeover protections, mergers, and other bylaw-related items) was associated with 13.6% to 20.6% fewer affirmative votes. Looking at the influence of proxy advisory firms on specific matters, the authors conclude, based on cited research, that these firms have a “modest influence” on uncontested elections of directors and a “moderate to large impact” on votes on say on pay and equity comp plans. In the latter case, the authors cited research showing that “shareholders react negatively to the disclosure of plans that meet ISS criteria, and that companies whose plans conform to ISS criteria exhibit lower future operating performance and higher employee turnover.” However, the paper also reported that, based on outside research, that “proxy advisory firms recommendations are beneficial to shareholders in the area of corporate control”; ISS recommendations increased the probability of victory for the dissident slate by 14% to 30%, were “associated with positive shareholder returns” and “may facilitate informed proxy voting.” How to explain these contradictions? The paper suggests that proxy advisory firms may bring greater expertise to bear on more “complex proxy issues, such as proxy contests and mergers and acquisitions.” With regard to other more commonplace issues, “resource and time constraints might compel proxy advisory firms to employ more rigid and therefore arbitrary standards that are less accommodating to situational information that is unique to a company’s situation, industry, size, or stage of growth.”
And it is not just shareholders that are influenced by proxy advisory firms; to win a favorable recommendation, the paper suggests, companies often make governance decisions to conform to proxy advisors’ policy guidelines, particularly on issues such as executive compensation and compensatory plan design. A 2012 survey showed that 72% of public companies “review the policies of a proxy advisory firm or engage with a proxy advisory firm to receive feedback and guidance on their proposed executive compensation plan.” And many companies implement changes in response, including changing disclosure practices, reducing certain benefits or changing the nature of benefits. The authors cite a study of equity comp plan design, which showed that companies tend to design their plans to fall just below ISS limitations.
The extent of the influence exercised by proxy advisory firms amplifies the need for effective policies and voting guidelines, as well as scrupulous objectivity in their application based on meticulous research. Both ISS and Glass Lewis maintain policy guidelines, but, the authors assert, there have been questions raised regarding the rigor and objectivity of their development processes. For example, in 2016, the GAO reported that issuer and investor input, while sought by ISS, was not necessarily incorporated into the final policies. The authors indicate that Glass Lewis does not fully disclose its update process.
Most important, however, according to the authors, is “whether the proprietary models of these firms are effective in identifying companies with governance problems. Neither ISS nor Glass Lewis discloses whether its voting guidelines or historical voting recommendations have been tested to ensure that they are associated with positive future corporate performance, in terms of operating results or stock price returns. This is a notable omission because it is standard practice for research firms to apply back-testing to validate the assumptions in their models. Without comprehensive evidence it is difficult to know whether their voting guidelines are consistent with increased shareholder or stakeholder value.” According to the paper, neither firm discloses its historical recommendation data, contending that this data is proprietary. However, the paper suggests that, after time has elapsed, disclosure should be required to enable independent third parties to conduct “back-testing” to assess the validity of the firms’ models and improve reliability.
Other issues raised in the paper—albeit with the acknowledgement that there is little research to help evaluate these claims—include the absence of any fiduciary duty standard applicable to proxy advisory firm, the absence of any financial incentive to issue accurate recommendations, the presence of conflicts of interest as a result of undisclosed consulting arrangements, and inadequate staffing and other resource constraints. In that regard, the paper compares staffing of 1,000 employees at ISS compared with staffing of 11,700 at Moody’s.
To address these problems, the paper offers two recommendations: first, subject proxy advisory firms to regulation that could include these types of requirements:
- “Maintain adequate resources
- Improve the reliability of recommendations
- Require reliability testing
- Provide past recommendation data for third-party evaluation
- Increase transparency about model and guideline development
- Develop reliable mechanisms for incorporating market feedback on models and guidelines
- Disclose commercial relationships with issuers
- Impose an explicit fiduciary-duty standard”
Second, eliminate the requirement that institutional holders vote on all proxy items, which, the authors suggest, would allow investors to decide whether or not to buy recommendations from proxy advisors.