The release of the Conference Board report ‘Just What Is the Corporate Director’s Job?’ in the United States renewed attention regarding the role of the board of directors of a public company. It also raised a related question: just what is the proxy adviser’s job, and why do we care? The report suggests that proxy advisers perceive the board’s role as executing a series of tasks and lacking a coherent whole. To understand how this may affect companies and investors, we need to look at how proxy advisers came to be, why they have so much power, and how their function might be improved.
The post World War II period has seen an enormous increase in the size of global capital markets and in the speed at which money moves. Ever greater care on the part of regulators, companies and investors alike as to understanding the parties’ responsibilities and their role in driving increased value for their various beneficiaries has been required. In the mid 20th century, for example, a fiduciary could invest only in blue chip bonds. As markets evolved, such rules were clearly costly and regulatory focus shifted from defining allowed investments toward trying to clarify the standards of behaviour entailed for fiduciaries responsible for someone else’s money.
Post war expansion saw companies grow to unprecedented size and perceived corporate responsibility came to include company-funded pension and healthcare plans. States and other large public employers followed suit. Eventually, these defined benefit plans were largely replaced with defined contribution plans in which employees directed their own investments among an array of choices, and mutual funds grew to huge size. Capital markets, once dominated by retail investors, came to be the playground of the institutional or professional investor, which now hold an estimated 75 percent of public company shares. At each level, underlying investors need explanations as to why certain actions, and thus gains or losses, had occurred. Structured communication procedures evolved to help investors compare various investments on an apples to apples basis.
Managing this torrent of money, interpreting these communications and the growing body of regulations has fuelled the growth of professional investment advisers, trust companies, mutual funds, pension and investment consultants, attorneys, actuaries, accountants and a fairly recent addition: the proxy adviser. Proxy advisers help investors decide how to vote on the matters that require approval from shareholders of the public companies in which they hold investments.
Boards of directors of public companies must consult their owners, the shareholders, before taking certain actions. Their shareholders, often large institutions in turn in charge of other people’s money, need to understand the issues involved in order to vote. These annual shareholder votes, collected through the solicitation of voting ‘proxies’, have long been in use. Shareholders, however, often ignored the voting opportunity. In 1974, however, the Employee Retirement Income Security Act became law, and required fiduciaries responsible for corporate pension and healthcare related investment portfolios – not only to vote, but to vote responsibly. Fiduciaries for other large pools of money followed suit, and institutional investors began to scrutinise corporate board candidates, shareholder proposals and other corporate matters for their portfolio companies.
Analysing governance matters required a different set of skills and a great deal of investor time – and presented an opportunity for a new kind of professional service provider, as Institutional Shareholder Services, the first proxy adviser, was formed in 1985: an organisation able to focus full time on governance matters and help fiduciaries decide on their positions.
In 2003, the US Securities & Exchange Commission tightened voting standards further. Those voting client proxies were to ensure that their votes were in the best interests of their clients. Legal liability for fulfilling their obligation to vote became a serious worry, which increased investors’ reliance on the ‘professional’ proxy adviser as a way to reduce litigation risk. The result was a huge increase in reliance on proxy advisers ISS and Glass Lewis, which now control 97 percent of the market for proxy advice. Together they affect 38 percent of votes cast at US public company shareholder meetings.
Decades of regulation intended to support free and open markets has now put enormous power over the policies, and thus the fortunes, of many US listed corporations and their beneficial owners in the hands of two firms which are not subject to market or regulatory scrutiny, and for which no level of the now intricate system has voted. The SEC has created an exemption from its proxy rules for proxy advisory firms, so they are not governed by the disclosure rules that apply to other participants in proxy voting.
Their processes are secret, their information sources not clear, their reports not publicly available and often not available to the companies on whose voting matters they are advising shareholders unless the company purchases them. Their concentration of market power is very high and inevitably they are often conflicted, serving corporate clients with advice on positioning, investor clients on voting, and even recommending action on initiatives brought by their own clients. Remarkably, disclosure of such conflicts is not required. Finally, the information they rely on may or may not be correct, and there is no consistent mechanism available to the companies involved to review the proxy advisers’ positions in advance of a position being taken. In short, they are accountable to no one.
Harvey Pitt, former chairman of the SEC, summed up the issues in representing the US Chamber of Commerce before a meeting of the House Subcommittee on Capital Markets and Government Sponsored Enterprises. “Proxy advisory firms are unregulated; more significantly, they operate without any applicable standards – either externally imposed or self-imposed – and do not formally subscribe to well-defined ethical precepts, while cavalierly rejecting private sector requests for transparency in the formulation of their proxy advice, as well as increased accountability for the recommendations that they make,” he said. “This lack of any operable framework for such a powerful presence on economic growth and corporate governance is unprecedented in our society.”
Various bills to tighten regulation of proxy advisory firms have been introduced in Congress. These would require proxy advisory firms to: (i) register with the SEC; (ii) employ an ombudsman to receive complaints about voting information accuracy; (iii) disclose potential conflicts of interest; (iv) disclose procedures for formulating proxy recommendations and analyses; and (v) in essence, provide companies with an opportunity to review and comment on a proposed recommendation by a proxy advisory firm before the recommendation is provided to investors.
Given the broad sweep of events that brought these two to such remarkable power, we can likely count on the fact that such dominance is not sustainable. Large investors and corporations will fight back, and regulatory change will occur. Until then, as the saying goes, power corrupts, and absolute power corrupts absolutely.
This article previously appeared in the Oct-Dec. 2017 issue of Risk & Compliance.