The Peril of an Expectations Gap in Proxy Advisory Firm Regulation

Over the last few years, Congress and Securities and Exchange Commission (SEC) were put under pressure to seriously consider regulating proxy advisory firms. Financial industry and government leaders have voiced concern that proxy advisory firms exert too much power over corporate governance to operate unregulated. The SEC as well as the Congress have investigated and debated the merits of proxy advisory regulation. The U.S. House of Representatives held a hearing on the matter in June of 2013, and the SEC followed this hearing with a roundtable discussion in December of 2013. On June 30, 2014, the Investment Management and Corporate Finance Divisions of the SEC issued a bulletin outlining the responsibilities of proxy advisors and institutional investors when casting proxy votes. As of yet, no binding regulation has been promulgated, despite repeated calls for it.

My article, Great Expectations: The Peril of an Expectations Gap in Proxy Advisory Firm Regulation, urges policymakers to consider the potential for an Expectations Gap if proxy advisory regulation is adopted. An Expectations Gap arises when the parties interested in regulation, in this case particularly the mass media, academics, politicians and the general public (the recipients of the regulatory signal, hereinafter: signalees), hold overly optimistic expectations of a regulation’s efficacy and overall positive impact. This article illuminates the Expectations Gap problem likely to arise if proxy advisory firms are regulated in the manner currently suggested by academics, practitioners and policy-makers.

This article shows that an Expectations Gap may be created because signalees do not hold all the information required to accurately assess a regulation’s effectiveness (a situation of asymmetric information) and are susceptible to cognitive biases that may cause them to misjudge the effectiveness. Further, it demonstrates how the Expectations Gap may persist because signalees lack sufficient incentives or capabilities to reduce the gap.

Taken together, the creation of an Expectations Gap and the low probability that signalees will close it can lead to two major unintended consequences. These consequences will allow proxy advisors and institutional investors to gain private benefits at the expense of proxy voting efficiency, shareholder value, and good corporate governance.

First, regulation may cause increased confidence in proxy advisory firms while actually decreasing the quality of services provided by these firms. Due to the Expectations Gap, the regulation’s effectiveness may be overestimated by signalees, who would perceive it to be an efficient tool for supervising proxy advisors. Consequently, regulation may also release advisors from some degree of the “undesirable” attention and pressure currently exerted by signalees in the absence of regulatory intervention. Such pressure now flows through the media and is exerted by the public companies currently opposing advisors’ unrestrained operation. Furthermore, regulatory intervention in proxy advisors’ operation may provide advisors with quasi-insurance, allowing them to deflect reprobation and responsibility towards the SEC in cases where their suboptimal analysis and recommendations fail to prevent corporate wrongdoing. All of the aforementioned factors could lead to a responsibility deficit and may unintendedly cause proxy advisors to invest less in research and recommendation process. At the end of the day, the quality of proxy advisors’ services could suffer.

Second, regulation may drive the institutional investors to become even more dependent on proxy advisors. Such regulation is likely to cause the advisors to serve as de facto gatekeepers. From the institutional investors’ perspective, regulation of proxy advisors may allow them to share with the advisors any criticism they receive regarding the manner in which they cast proxy votes and fulfill corporate governance responsibilities. This would create a blame game, allowing institutional investors to shift the blame on the advisors and even on the SEC in a case of a governance failure or scandal. As this article will explain, the danger posed by the Expectations Gap and its perverse effects are particularly relevant in cases like proxy advisors regulation where it is difficult to measure whether the regulated party has actually done a good job.

The article does not suggest that regulation of proxy advisory firms is ill-advised. Instead, it suggests incorporating the Expectations Gap theory into the regulatory process by four means. First, regulatory agencies should integrate an appraisal of potential Expectations Gaps into the Regulatory Impact Analysis, which is conducted by regulatory agencies when contemplating new regulatory and policy issues. As a second solution, the article suggests that promulgations of regulations, at least significant ones, should include “disclaimers,” in order to shape and limit expectations arising from the regulation by pointing to potential incongruities between the regulation’s purpose and performance. Third, the article proposes that an agency publishing a notice of final rulemaking in the Federal Register should include a section detailing how the agency will implement the rule and test its effectiveness over time. Fourth and finally, the article suggests that the content of informational communications released by agencies regarding new, significant regulation should be monitored by a disinterested third party, perhaps the Office of Information and Regulatory Affairs. Taken together or individually, all of these measures could help prevent significant regulatory Expectations Gaps from forming, and in turn prevent the negative consequences caused by the Gaps. These suggestions are applicable to any new regulation that is susceptible to an Expectations Gap in general and to proxy advisory regulation in particular.

The full article is available for download here.