PROXY ADVISORY services used to be an obscure feature of corporate America. No longer. These geeky outfits, which review mountains of proposals put forward by shareholders on topics ranging from mergers and executive pay to climate change and diversity, then issue recommendations, can sway how their clients vote. Given that most are big institutional investors with clout, this advice matters. Earlier this year analysts at Credit Suisse, an investment bank, predicted that proxy advisers’ counsel would decide the fate of Bristol-Myers Squibb’s mammoth $74bn bid for Celgene, a rival drugmaker.
Big institutional investors like Capital Group and Fidelity have in-house teams to deal with such matters. But most funds rely on outside advisers. Two of them dominate the business. Institutional Shareholder Services (ISS), owned by Genstar, an American private-equity firm, provides proxy recommendations on over 40,000 shareholder meetings in more than 100 countries each year. Glass Lewis informs some 20,000 votes in 100 countries. It is owned by two Canadian asset managers. Between them, ISS and Glass Lewis control 97% of America’s proxy-advice market.
Their client base has boomed. In 1950 institutions held only 10% of American shares. By 2018 it was close to 80%. As shareholder activism has grown in America, so have proxy battles—from 270 campaigns in 2012 to over 300 this year. Proliferating passive investment funds, led by Vanguard, are keenly handing their voting rights over to proxy advisers.
Business lobbies have had enough. “We have been concerned about proxy advisory firms for some time,” says Tom Quaadman of the US Chamber of Commerce. He argues that they lack transparency and have “significant” conflicts of interest arising from their consulting divisions, which advise companies on improving corporate governance. A report from the chamber last year bemoaned an onslaught of “zombie proposals”, which come up repeatedly—and repeatedly fail to win a majority of votes.
In August America’s Securities and Exchange Commission (SEC) ruled that voting recommendations made by the advisers amounted to “solicitations” under proxy rules, a higher regulatory standard than the firms faced before. They would, for instance, have to prove compliance with anti-fraud provisions. ISS filed a lawsuit in response. On November 5th the SEC proposed more rule changes, “to improve the accuracy and transparency of proxy voting advice”. Among other things, these would raise the minimum share of votes required for shareholder proposals to succeed and let target firms review proxy recommendations twice before investors see them.
Corporate groups are cock-a-hoop. The National Association of Manufacturers, one of those spearheading the proxy war, declared that the proposal was “a significant victory” that “sets up reasonable guardrails” on the proxy process. Joseph Grundfest of Stanford Law School sees nothing wrong with giving firms the chance to challenge the factual basis of recommendations: “As long as ISS is accurate in everything it does, it has no additional legal liability.”
Nonsense, say critics of the new provisions, who liken them to slapping a tax on advice critical of management. Charles Elson of the University of Delaware argues the SEC proposal is “a punitive solution looking for a problem”. He believes that business chambers’ claims of vast numbers of errors in proxy recommendations are overblown. It is telling that few of the proxy advisory firms’ institutional clients, who would be most affected by erroneous or conflicted advice, are complaining.
On the contrary. “The goal of the co-ordinated, corporate-funded campaigns…is to make it harder and more expensive for institutional investors to get the expert advice they need to hold executives accountable,” says the Council of Institutional Investors, which represents funds with $4trn in assets under management. Chris Ailman of the California State Teachers’ Retirement System, which has $242bn in assets, fears a return to “egregious management behaviour”. “People have forgotten Enron and WorldCom,” he warns, referring to two huge corporate-fraud scandals in the early 2000s.
Drew Chapman of Baker Botts, a law firm, sees the proposed rule changes as double-edged. More transparency should in principle benefit investors. But tougher solicitation rules may make it easier for a firm’s management to sue the proxy firms over advice it does not like—possibly discouraging them from being overly critical.
The SEC’s proposal now enters a 60-day comment period. The regulator is expected to make a final ruling early next year. The advisory firms may then challenge it in court. That could stretch the fight out by months, or even years.
Another outcome is possible. The SEC could instead modify the proposal to soften its sharp edges. This would push proxy firms to be more transparent, especially about possible conflicts of interest, but without burdening them with costly new regulations and reporting requirements. Robert Jackson, a dissenting commissioner on the SEC (and rare regulator with deep expertise in data analytics), makes the economic case for finesse.
Mr Jackson’s research suggests that bosses are right to complain about nuisance proposals. Shareholder votes put forward by “gadflies”—the ten most prolific submitters in any given year—coincided with declines in returns at American target firms in the months following a shareholder meeting. However, listed American firms which faced non-gadfly proposals outperformed the market by 5% one year after the shareholder meeting at which they were presented was held.
That implies that any final SEC ruling should put off gadflies, but not other proposals that would keep managements honest. Doing this will not be easy. But the SEC can surely do better than its current suggestions. These seem overly kind to managers—and, in Mr Jackson’s words, “swat at a gadfly with a sledgehammer”.■
This post was originally posted at https://www.economist.com/business/2019/11/16/proxy-advisers-come-under-fire.