The proxy advisory industry

– a time for change?

Proxy advisors manage the logistics of voting billions of shares held by institutional shareholders of companies across the globe. Proxy advisors also provide proxy analyses and vote recommendations to these shareholders on how to vote their shares.

Proxy advisors have been around for over twenty years and now play a central role in corporate elections. For over half the world’s publicly traded shares they are the force that transforms a shareholder’s fundamental right to vote into reality. Public company shares are typically held by large institutional investors more concerned with generating a return on their investment and less with routine voting matters. As a result, many institutional investors outsource the exercise of their voting rights to third-party proxy advisory services.

Until recently, the proxy advisory industry has operated with relatively minimal attention from regulators in the US and abroad, but that may be about to change as the US Securities and Exchange Commission has begun to take notice of the vast power and influence that proxy advisors have on corporate elections and proxy voting.

An overview of the proxy advisory industry
Proxy advisors provide institutional investors with various proxy voting services, such as issuing recommendations on how the investor should vote its proxies on corporate ballot issues, assisting the investor in developing voting guidelines and handling the actual process of casting the investor’s votes.

The industry also plays an active role in shaping the corporate governance debate and in attempting to set the standard for what markets should view as “good” corporate governance. An advisor’s vote recommendations and guidelines on corporate governance matters, such as executive compensation and staggered boards, often embody and reflect their own philosophical view of what makes for sound corporate governance. Accordingly the more clients vote in accordance with a given advisor’s guidelines, the more that advisor’s views of corporate governance become cemented in the public consciousness as reflective of sound corporate governance.

There are seven main proxy advisory firms: RiskMetrics Group, which provides proxy advisory and corporate governance services through its subsidiary, ISS; Glass Lewis & Co. (Glass Lewis); Marco Consulting Group (MCG); Proxy Governance, Inc. (PGI); Egan-Jones Proxy Services (Egan-Jones); GovernanceMetrics International (GMI); and CtW Investment Group (CtW).

Not all players in the proxy advisory industry are created equal. ISS is by far the dominant player in the industry with over 61 per cent market share and a wide-reaching global footprint. In addition to providing proxy advisory services to institutional investors, ISS also issues corporate governance ratings on approximately 8,000 global companies. For a fee, ISS also advises these companies on how to improve their internal corporate governance and by default their ISS corporate governance ratings.

Not surprisingly, this multifaceted role of providing recommendations on how investors should vote in company elections, issuing governance ratings on the very companies on which they are advising investors on how to vote, and offering to help companies who receive a low rating improve their corporate governance by hiring ISS, has led to loud charges of conflicts of interest against ISS.

Glass-Lewis has approximately 36 per cent market share and PGI, MCG, Egan-Jones, GMI and CtW together have approximately 3 per cent market share. Glass Lewis is ISS’ main competitor, but currently ISS’ proxy voting coverage far exceeds Glass Lewis’ with ISS providing coverage on more than 37,000 corporate elections across 108 countries, compared to Glass Lewis’ coverage of 15,000 companies across 70 countries.

Unlike ISS, PGI expressly rejects a one-size-fits-all approach in developing vote recommendations. Instead, PGI develops its recommendations on an “issue-by-company basis”. MCG’s services are specifically targeted to benefit plan sponsor clients. CtW provides a limited number of recommendations to union pension funds. GMI’s services focus more on corporate governance ratings and helping investors assess the governance characteristics of individual companies as opposed to the traditional proxy advisory services provided by the other firms and finally, Egan-Jones markets itself as having deep expertise in credit risk analyses and being the low-cost provider in the proxy advisory industry.

The growth of the industry
The proxy advisory industry has grown over the past two decades as a result of various market and regulatory developments. In 1988, the US Department of Labor took the position that managers of ERISA governed pension plans have a fiduciary duty to vote their portfolio shares in accordance with a “prudent man” standard. This development meant that pension plan managers could no longer simply follow the vote recommendations of company managers, which had been the traditional approach.

Instead, now on each matter up for shareholder vote the fund managers had to act in accordance with this “prudent man” standard and the way that many funds did this was to seek help from the proxy advisory industry to provide the due diligence necessary to satisfy this new standard.

The industry experienced further growth in the early 2000’s. In the wake of the corporate scandals and ultimate collapse of companies like Enron and Worldcom, more institutional investors once again turned to the proxy advisory industry for assistance in assessing the corporate governance practices of operating companies. Then in 2003, the SEC issued a rule that required mutual funds to disclose their complete voting records annually. The SEC adopted this 2003 rule with the hope that “requiring greater transparency of proxy voting by funds [would] encourage funds to become more engaged in corporate governance [issues]…” However, mutual funds became “more engaged in corporate governance” by simply outsourcing the key monitoring and voting functions to the proxy advisory industry.

This unintended consequence is the result of a conflation of factors. First, many institutional investors do not have the internal manpower required to analyse and vote proxies in the multitude of companies in their portfolio. Thus, it is more efficient for them to outsource this function to proxy advisors. Second, many institutional investors like mutual funds typically hold a given company’s stock for a short-period of time and on average own less than one percent of the stock. This in turn means that with the exception of significant events, such as a merger, they have very little incentive to expend resources to monitor routine ballot issues. Finally, investment managers are rewarded for the economic performance of their portfolio and not for making corporate governance better for an individual company or the world at large. As such, fund managers have very little economic incentive to monitor individual company ballot issues and instead often find it more efficient to outsource this function.

In sum, hiring proxy advisors is a no-brainer for many institutional investors because the reality is that proxy issues are often just a function of timing rather than conviction.

The critiques of the industry
 While proxy advisors arguably provide a necessary and valuable service to their institutional investor clients, the proxy advisory industry has come under fire for a range of alleged transgressions, such as (i) providing misguided and ill-informed vote recommendations; (ii) suffering from various conflicts of interests; (iii) operating in a virtual black-box bereft of transparency and free from regulatory oversight or any external monitoring; (iv) taking a one-size-fits-all approach to corporate governance and certain key voting issues without taking into account the specifics of each company; (v) making decisions that affect a company’s vote outcome even though these proxy advisors, unlike company managers, owe no fiduciary duties to the company or its shareholders who are affected by their decisions; (vi) making substantial voting decisions without bearing a concomitant share of the risk; and (vii) wielding significant influence over the vote outcomes of billions of shares at company shareholder meetings both in the US and abroad, even though anecdotal evidence would suggest that there is good reason to doubt the quality and objectivity of many of their vote recommendations.

Newfound attention
The clamour of critiques surrounding the industry is by no means new2. What is new, however, is that for the first time the SEC has publicly voiced its concern about the power and the influence of the industry and the consideration of the need for some sort of oversight.

Last November, SEC Chairman Mary Schapiro pointedly stated:
“…we’ll be asking about the role of proxy advisory firms in corporate voting. Given the influence that these firms’ recommendations have on corporate voting outcomes, we’ll probe the need for rules to ensure that advisory firms are basing their research and recommendations on accurate and reliable information. And, that they are providing adequate disclosure of any conflicts of interest they have in providing voting recommendations.”

Similarly, in a 8 June 2010 speech at the CEO Quarterly Meeting of the Business Roundtable, Chairman Schapiro once again directed her attention at the proxy advisory industry, stating: “…the mechanics of the proxy process have not kept pace with current market conditions or trading practices. For this reason, the Commission will soon consider publishing a Concept Release soliciting detailed ideas about how to modernize this voting infrastructure.” Chairman Schapiro further went on to state that “[w]e would like to hear about…whether proxy advisory firms should be subject to greater oversight (and if so, what that oversight should look like).”

The SEC’s attention to the proxy advisory industry may also be fuelled by the renewed efforts by the Society of Corporate Secretaries and Governance Professionals to draw attention to the issues surrounding the industry. In March 2010, the group sent a discussion draft to the SEC entitled “Proxy Advisory Services: The Need for More Regulatory Oversight and Transparency”, in which it makes the case for the SEC to “review the role of proxy advisory services and the processes used by these firms in generating voting recommendations and making voting decisions” and outlines various suggestions for improving the regulatory oversight and transparency of the industry.

The challenges and the road ahead
Today the influence of the proxy advisory industry on corporate elections and the shaping of corporate governance norms cannot be denied. Moreover, the importance of the industry will only continue to grow as regulators contemplate greater corporate governance regulations and more stringent financial regulations, such as those contained in the sweeping 1,600-page “Restoring American Financial Stability Act of 2010” , which was recently passed by the US Senate.

RiskMetrics’ statement in its 2009 Annual Report sums up this observation perfectly: “In general, regulation has been a key driver to our business growth in the past. In the event that the recent financial crisis results in further regulation, we believe that such regulation could be a driver for growth in our business by increasing the demand for our existing products and services.”

The proxy advisory industry is an inextricable thread in the global corporate election fabric. Proxy advisors are not going anywhere anytime soon and if anything, their influence and importance will only continue to grow with the passage of future financial and corporate governance regulations.

The corporate law world now faces three choices:

(a) let the industry continue to operate in the way it currently does without oversight or transparency;

(b) rely on the industry (and its institutional clients?) to self-correct and develop some sort of self-regulatory framework; or

(c) subject the industry to direct regulatory oversight.

The answer is by no means clear and the problems that surround the proxy advisory industry are part of a bigger problem of a defective proxy voting system in general.

What is clear, however, is that until recently the proxy advisory industry was the elephant in the room. Now with the newfound focus by US regulators, the industry is poised to become a featured act in the running drama of how to fix the broken system of corporate elections.