While the 2020 presidential election is the current focus of the media’s attention, the next couple of months happens to be proxy shareholder voting season as well, as shareholders of publicly traded companies will elect boards of directors and vote on various resolutions.
As finance has become increasingly complex over the last few decades, proxy advisory firms have grown accordingly to help with this, becoming more influential than anyone foresaw. The proxy industry — dominated by the duopoly of Glass Lewis and Institutional Shareholder Services — has come under scrutiny of late from academics, media and Congress.
One complaint made by investors is that these entities have been proffering advice that is not in the best interest of shareholders, and instead make recommendations to fund managers that often hew to so-called progressive orthodoxies. They are misusing their influence to back resolutions that cater to the environmental sensitivities of the day or other progressive orthodoxies, regardless of the damage to the long-term profits of companies, and hence investor returns.
The SEC recently proposed a new rule that would constrain their activities and increase the ability of public companies to monitor and respond to the advisors’ voting recommendations. It received more than 1,000 comments on the proposal.
The proxy advisors make a variety of claims in their defense, insisting that allegations of their errors are exaggerated and anecdotal, they don’t wield excessive influence on firms, that no one is obligated to hire or obey them, that enhances transparency would impair the independence of proxy advisors and increase the risk of insider trading, and that their support of “best practices” in corporate governance in recent years has only benefited shareholders.
Those claims are easily refuted.
Claim #1: Allegations of proxy firms’ errors are exaggerated and anecdotal.
Multiple analyses show that the advisory firms commonly make errors. An analysis of supplemental proxy filings from October 2018 found 139 errors across 94 companies. Some errors can be quite significant; for instance, a Wall Street Journal article in August 2019 stated that Oracle co-CEO Mark Hurd’s pay was 100 percent greater than it actually was using ISS data, forcing the paper to issue a correction.
Part of the problem may be the very low level of staffing proxy advisory firms have relative to the amount of issues they cover: ISS covers 40,000 shareholder meetings with only 460 analysts, while Glass Lewis covers 20,000 meetings with just 200. Many “differences of opinion” in supplemental proxies filed in recent years are in fact errors made by proxy advisory firms.
Claim #2: Proxy advisory firms don’t wield excessive influence over institutional investors, and criticism of “robo-voting” is unfounded.
Robo-voting is a symptom of the flaws with the current voting system, whereby institutional investors adopt proxy advisor benchmark voting guidelines automatically. Recent actions taken by the SEC are intended to mitigate this widespread abdication of fiduciary duty.
Numerous studies have demonstrated that the recommendations of proxy advisory firms sway institutional investors by significant margins. One study found that a negative recommendation from ISS for a say on pay proposal can lead to a 25 percent reduction in shareholder support, while another found the influence to be 38 percent.
Claim #3: No one is obligated to buy proxy advisory firms services or follow their recommendations.
Because ISS and Glass Lewis have a duopoly over the market, there is little opportunity for shareholders to shop around for competing proxy advisory firms because there aren’t any. This calls into question any reasonable assumption that there are best practices in the proxy advisory industry, including taking steps to ensure that vote recommendations are based on the best information possible.
Claim #4: Allowing issuers to review and respond to vote recommendations will impair the independence of proxy advisors.
Over the last five years, the annual U.S. Chamber/Nasdaq proxy season survey consistently finds that issuers have a difficult time having their concerns heard. The 2019 survey found that proxy advisory firms granted previews to vote recommendations only 39 percent of the time when requested, and even then companies were only given a couple days to provide input.
To address this, the SEC’s proposed rule would ensure that proxy advisors base recommendations on the most accurate data available, and that institutional investors base their recommendations on all available information. Had such provisions been in place historically, many of the errors may not have been included in final vote recommendations.
Claim #5: Requiring proxy advisory firms to share draft reports will increase the risk of insider trading.
The idea that sharing draft reports will somehow encourage insider trading argument is a red herring: ISS reports are already distributed among ISS employees and institutional clients. Moreover, ISS itself has already demonstrated a weakness when it comes to protecting material, non-public information. The SEC charged ISS in 2013 with “failing to safeguard the confidential proxy voting information of clients participating in a number of significant proxy contests.”
Nothing in current SEC proposals would weaken the commission’s authority to bring insider trading cases, or the duties that managers and board members of issuers have to maintain non-public information confidentiality.
Claim #6: Proxy advisory firms have supported some of the most meaningful “best practices” in corporate governance in recent years.
Research published by the law firm Sullivan & Cromwell notes that ISS supported 74 percent of environmental, social, and governance shareholder proposals in 2018, including 94 percent of political-spending proposals and 87 percent of environmental proposals.
A separate paper by Harvard academic Joe Kalt suggests that such resolutions have “no statistically significant impact on company returns one way or the other” but can often cost millions of dollars to respond to.
As an example, proxy advisory firms helped push the “board declassification” agenda, whereby the majority of public company directors would be up for election every year, rather than every three years.
The logic was that it would make boards more responsive to the demands of investors, but in reality board declassification has served only the interests of short-term and special interest activists over other shareholders, giving them greater leverage to force directors to meet their demands.
The long-term value destruction for shareholders has been estimated to be between $90 billion and $149 billion, however proxy advisory firms show no indication of reversing their past positions in light of this new evidence.
Proxy advisors create a moral hazard in that while they want to ensure that their customers — namely the investment funds that hire them — are pleased with their services, those whose interests are ultimately affected by their recommendations — the investors whose money the funds manage — have no ability to discern their impact on their wealth.
Investment managers have less of a concern with their impact on performance; in a market where relative — not absolute — returns are the common metric, and all investment funds use the same two firms by necessity, managers don’t lose anything from indulging in their political leanings with other people’s money.
But investors do lose from this arrangement, and constraining proxy advisory firms even in this small way will ultimately leave investors with more money in retirement.