General Background on Proxy Advisory Firms
Many institutional investors use third-party proxy advisory firms to help them vote their proxies in shareholder elections. These firms offer vote recommendations on proposed corporate directors, as well as management and shareholder proposals. At least two of these firms also have the capability to cast votes directly on behalf of their clients' shares.
Current laws impose fiduciary responsibilities on investment advisers and certain retirement and pension plans in voting their proxies. Through a 2003 SEC rule, investment advisers are now required to adopt policies and procedures to ensure that proxies are voted in the best interests of their clients. Similarly, the Employee Retirement Income Security Act of 1974 (ERISA) has been interpreted as imposing fiduciary obligations to vote proxies for stocks owned by ERISA retirement and pension plans.
Of the firms offering proxy advisory services, Institutional Investor Services (ISS) is the largest, with more than 1,700 clients. ISS is also registered with the SEC as an investment adviser. The second largest firm, Glass Lewis, has more than 1,000 clients and is not registered with the SEC as an investment adviser.
Proxy advisory firms wield significant influence in shareholder elections, as their institutional clients --primarily mutual funds and pension plans-- have large stock holdings compared to other investors. Unfortunately, these firms are not subject to any required disclosures or oversight regarding their ability to control or influence the outcome of a vote. Some advisory services also have an inherent conflict of interest in the voting process because they also provide related consulting services, such as corporate governance ratings, corporate governance advice, executive compensation consulting, and other research services, in addition to providing voting recommendations on proposals submitted in shareholder elections.
The Government Accountability Office Study
In June 2007, the Government Accountability Office (GAO) conducted a study to evaluate conflicts of interest that may exist with proxy advisory firms and the steps that the SEC has taken to oversee these firms. The GAO is the investigative and audit arm of the U.S. Congress.
This GAO study noted that certain industry associations and academics were critical of the potential conflicts of interest which exist among these proxy advisory firms.
SEC Compliance Examinations
In 2008, the SEC started to increase its oversight of the use of proxy voting services through compliance examinations of registered investment advisers and mutual funds. In a Compliance Alert issued in July 2008, the SEC highlighted the following deficient practices by some advisers and funds:
- Board oversight of use of proxy service providers appeared to be weak. In some instances, the funds had neither established controls to confirm that the proxy service providers' recommendations were consistent with the funds' policies and procedures nor requested information regarding conflicts of interest at the proxy service providers.
- Advisers did not document their assessment of proxy service providers. Some firms had not documented their review of the proxy service providers used; therefore, examiners could not assess whether the adviser had established and implemented measures reasonably designed to identify and address proxy voting firms' conflicts of interest. Examiners also could not confirm claims of proxy service provider independence.
- Funds voted inconsistently with their proxy voting policies. Funds attributed these mistakes to clerical errors or misapplication of fund voting guidelines to specific votes.
- Funds did not file Form N-PX containing the funds' proxy voting record as required. In several instances, firms did not include a record of all votes cast on Form N-PX. In other instances, proxies were not included on Form N-PX because they were never voted or funds did not meet the specific requirements of Form N-PX. For example, the form requires funds to briefly identify the matter voted on. Firms sometimes used vague descriptions of votes that did not succinctly describe the proxy matter or the fund's vote on the matter.
- Fund disclosures appeared deficient. Several fund groups did not include the necessary disclosures in their Statements of Additional Information regarding the availability of the proxy voting policies and procedures, as required by Form N-1A.
- Improper fees were charged. An adviser allocated proxy service fees to funds, purportedly for services rendered, which did not hold voting securities that would require such services. Another adviser used soft dollars to pay for proxy voting services unrelated to issuer research without adequately disclosing this practice.
Academic Studies on Proxy Advisory Services
An additional problem with the current proxy advisory system is the "one-size-fits-all" governance ratings that are used by the firms to improve corporate performance. There is now increasing empirical evidence that these corporate governance ratings have little predictive value regarding future stock market performance. Several of the more prominent studies and reports on this topic and the general subject of proxy advisory firms include the following:
- "The Promise and Peril of Corporate Governance Indices." This study by three leading academics --Sanjai Bhagat (University of Colorado), Brian Bolton (University of New Hampshire), and Roberta Romano (Yale Law School)-- analyzes the performance of corporate governance indices in predicting future corporate performance. The paper concludes that there is no consistent relationship between the two, and that the most effective approaches to governance depend on context and a firm's specific circumstances.
- "Rating the Ratings: How Good Are Commercial Governance Ratings?" This study by three Stanford researchers --Robert Daines, Ian Gow, and David Larcker-- evaluates the claim by corporate rating firms that certain governance indices are able to predict future performance and risk. The results of this study indicate that the level of predictive validity for these ratings are well below the threshold necessary to support these claims.
- "Voting Integrity: Practices for Investors and the Proxy Industry." This working draft by Millstein Center Visiting Research Fellow Meagan Thompson-Mann discusses the processes by which investors make voting decisions and provides a draft code of professional practices for the proxy advisory industry.
- "Voting Integrity: Practices for Investors and the Global Proxy Advisory Industry." On March 2, 2009, the Millstein Center for Corporate Governance and Performance released a study on the practices of the proxy advisory industry. The Millstein study recommended the development of an industry-wide code of ethics and urged the SEC to take steps to modernize the U.S. proxy voting system.
- "The Proxy Advisory and Corporate Governance Industry: The Case for Increase Oversight and Control." This study by New York Law School Professor Tamara C. Belinfanti studies the role that proxy advisory services play in the formulation of corporate governance policy. Professor Belinfanti concludes that in a system where proxy advisory services maintain such influence in corporate governance with little accountability or regulatory oversight, the public companies and their long-term shareholders suffer the consequences.
- "Director Elections and the Role of Proxy Advisors." This study by three law professors -- Stephen J. Choi (New York University School of Law), Jill E. Fisch (University of Pennsylvania Law School), and Marcel Kahan (New York University School of Law) -- uses a dataset of proxy recommendations of voting results from uncontested director elections for S&P 500 companies in 2005 and 2006. Of the four proxy advisory firms evaluated, each firm tended to have a focus on a corporate governance issue and issued recommendations depending on that issue. The study concludes that when these differences are known, institutional investors may choose an advisory firm that is tailored to their investors' needs. But when these differences are not known, the proxy advisors may lack accountability and could pursue their own agenda.
Proxy advisory firms have a significant impact on the proxy process, permitting institutional investors to out-source voting analysis and execution. Despite the large role that proxy advisory firms play in the corporate governance arena, they generally remain unregulated and unsupervised. And the firms often are not transparent with regard to standards, procedures, compensation arrangements, and conflicts of interest.
Any evaluation of the proxy voting system by the SEC should include the role of proxy advisory firms. The SEC and industry also should strive to develop solutions that benefit both companies and their shareholders. Proxy advisory firms should be required to make appropriate disclosures about their internal processes, compensation, and conflicts. These firms also should be subject to more scrutiny and regulatory oversight.
The SEC has started to address these issues. In December 2013, the agency held a Roundtable on Proxy Advisory Services. And, on June 30, 2014, the SEC issued Staff Legal Bulletin No. 20, to clarify the fiduciary responsibilities of those institutional investors retaining proxy advisory firms. Click on the link below to review this Staff Legal Bulletin, along with the Coalition's specific recommendations regarding the development of a more robust regulatory framework for proxy advisory firms.