Time to Regulate Proxy Advisory Firms
In the world of corporate governance, proxy advisory firms like ISS (Institutional Shareholder Services) and Glass Lewis have become increasingly important. Their role advising large institutional investors on how to cast their shareholder votes on a broad spectrum of corporate governance issues has deep significance on major policies at most of America’s publicly traded companies.
But despite this influence these firms remain largely unregulated, avoiding many of the transparency and disclosure requirements to which other major financial industries are subject.
This discrepancy is a major and escalating source of concern and led the American Council for Capital Formation to explore the issue for the for time. Our new report, “The Conflicted Role of Proxy Advisors,” finds compelling evidence that greater oversight of these firms is indeed required.
This is partly due to the sheer breadth of advisory firms’ reach. The large institutional investors they counsel own significant shareholdings in almost every major corporation and typically follow proxy advisors’ recommendations 80 percent of the time.
While many investors may be under the impression that proxy firms are neutral arbiters, drawing on best practices to help maximize shareholder value, that’s not always the case. ISS, Glass Lewis, and their peers are in fact for-profit companies that are frequently incentivized to align with their clients. What’s more, in a reversal of the normal corporate incentive structures, these firms not only consult their clients but also rate them, creating a complex and all too-often conflicted business relationship.
This kind of conflict is not tolerated in other industries. Notably, the passage of the Sarbanes-Oxley Act in 2002 required separation of the parts of financial institutions that provide ratings and those that offer consulting services to the same businesses, for precisely this reason.
The potential for conflicts of interest is exacerbated by a total lack of transparency over the process by which advisory firms establish their annual voting guidelines. Critics, not unreasonably, have expressed concern that amendments to standards may be less motivated by governance enhancement and more related to increasing the market for services.
Consider, for example, how proxy firms have recently begun to increase their focus on environmental and social issues. Their recommendations have stimulated the creation of new reporting obligations, which extend well beyond existing disclosure requirements and rely on unaudited corporate social responsibility and environmental data. Typically, regulation of this scale is the responsibility of government, not the private sector.
ISS and Glass Lewis both allow non-public commentary on their voting guidelines. These are updated annually, providing their mutual, hedge, and pension fund clients with an opportunity to directly shape the standards by which they will be judged. Constantly changing their policy positions may be good for proxy firms’ bottom lines, but there’s little to suggest that it drives shareholder value, especially given the burdensome nature of reporting requirements.
Our report finds that the current proxy guidance system disproportionately disadvantages small and mid-cap businesses. These companies are less likely to have the resources to respond effectively to eternally shifting reporting requirements. Moreover, American companies are also undermined vis-à-vis their European counterparts, who are already subject to more stringent disclosure obligations.
The report goes on to outline down three common-sense recommendations we believe will provide important protections for the average American main street investor.
First, the government must intervene and force greater disclosure of any conflicts of interest, both real and potential.
Second, proxy advisory firms should make clear who has influenced their voting guidelines, as well as the justification for any changes. Disclosure will better enable investors to understand the underlying rationale and influence behind policy shifts.
Finally, investors should be advised to be cautious of proxy advisory products drawn from unaudited and incomplete disclosures.
The current lack of regulation and oversight on proxy advisory firms is concerning to say the least. All too often, every day retail investors who know nothing about the complex web of interdependent relationships that underpin our financial system are the ones who wind up getting penalized. Proxy advisory firms must be held to the same standards of conflict disclosure and transparency as the publicly held companies they monitor.
Tim Doyle is Vice President of Policy and General Counsel at the American Council for Capital Formation.