Public Comment: SEC Staff Roundtable on the Proxy Process

Summary of Study

Bottom Line: Any regulation of the proxy advisory industry should carefully consider the effects on 1) institutional investors’ incentives to perform independent governance research and 2) proxy advisors’ incentives to produce high-quality recommendations. 

Proxy advisors have the positive effect of allowing shareholders who find it difficult or costly to do independent governance research to vote informatively by following proxy advisors’ recommendations. Yet they have the negative effect of crowding out independent research by institutional investors and informed shareholder voting, amplifying the negative impact of recommendation errors. 

If the quality of proxy advisors information is low, the negative effect dominates: there is excessive over-reliance on its recommendations and insufficient private information production. In contrast, the positive effect dominates when the quality of proxy advisors’ recommendations is high. Potential regulation should therefore carefully examine effects on proxy advisors’ incentives to provide informative recommendations.

Whether the presence of proxy advisors improves the quality of shareholder voting crucially depends on the firm’s ownership structure. In firms with very dispersed ownership, the presence of proxy advisors is beneficial. This is because in the absence of any recommendations, these small dispersed shareholders would vote completely uninformatively (for example, always with management), and following proxy advisors’ recommendations is better than completely uninformative voting.

In contrast, in firms with relatively more concentrated ownership, where more shareholders would otherwise do their own independent governance research, the “crowding out” effect may be significant and can lead to less informed voting outcomes.

The presence of litigation pressure over institutional investors’ voting practices has two counteracting effects. The positive effect is that it induces institutions to vote more informatively than without litigation pressure. The negative effect is that litigation pressure induces institutions to rely too much on proxy advisors’ recommendations. Higher litigation pressure is detrimental if proxy advisors’ recommendations are not sufficiently precise.

Increased competition in the proxy advisory industry can be a double-edged sword. The potential negative effect of competition is that it may lead to reduced fees for proxy advisors’ recommendations. Lower fees would crowd out shareholders’ independent governance research even more, which may be detrimental. The potential positive effect of competition is that it may encourage proxy advisors to compete on the quality of their recommendations, leading to more informative and precise recommendations.

Read the full comment letter here.