Yet Another Congressional Proposed Corporate Reform: Proxy Advisory Firms in the Crosshairs

Ed Batts is partner and co-head of the M&A and Private Equity groups at Orrick, Herrington & Sutcliffe LLP. This post is based on an Orrick publication.

Over the past six months, U.S. legislators have engaged in an unusual burst of energy to introduce three separate bills regulating various areas affecting U.S. public company corporate governance:

  • The Cybersecurity Disclosure Act of 2015 would require disclosure of whether public company boards contained a cyber-security “expert” or, if not, why not. The bill, introduced by Senators Jack Reed (D-RI) and Susan Collins (R-ME), appears stranded in the Senate’s Banking, Housing and Urban Affairs Committee.
  • The Brokaw Act would shorten the trigger grace period for filing a Schedule 13D after acquiring 5% or more of an issuer’s stock from ten to two days. It also would require disclosure of any party who “coordinated” with the filer, targeting activist “wolf packs.” This bill, sponsored by Senators Tammy Baldwin (D-WI) and Jeff Merkley (D-OR), is sitting with the same Senate committee and may become subject to political season vagaries, particularly as supporters including Senators Bernie Sanders and Elizabeth Warren. However, ironically, it may find bipartisan support as the current ten day Schedule 13D filing period is viewed as archaic by many corporate issuers. At the very least, this proposed legislation has worried activist investor firms enough to band together in an unprecedented lobbying effort.
  • Last—but certainly not least—Congressmen Sean Duffy (R-WI) and John Carney (D-DE) introduced in the House Financial Services Committee the Proxy Advisory Reform Act of 2016, which appears to have the most impetus for movement through the labyrinth of legislative crafting.

As foreshadowed by its title, the Duffy/Carney draft legislation targets proxy advisory firms. Decades ago, the dull duty of voting in favor of management proposals was viewed as so mundane that generally it was entrusted to an investment firm’s mailroom personnel. A few corporate scandals created questions as to this automatic practice. Equally importantly, the Department of Labor—as the U.S. primary regulator of retirement savings—chimed-in by declaring that investment funds owed a fiduciary duty to their investors when voting shares.

Since many funds lacked the scale to cost-effectively vet and decide positions on all the myriad companies in their portfolios, the concept of outsourcing those decisions to a group effort led to the creation of proxy advisory firms. Today, that market is dominated by two providers: Institutional Shareholder Services (ISS), owned by a private equity firm, and Glass Lewis, owned by Canadian pension funds. Clients (investment firms) pay ISS and Glass Lewis to read, evaluate and recommend voting on company annual meeting proposals. For many years, the weight of these firms was such that a recommendation “for” or “against” was extremely likely to sway the vote.

Increasingly over the past decade, however, as fund flows have both surged in overall volume and become more concentrated with the largest players—most notably burgeoning index funds—various investment shops have created and/or significantly reinforced their own in-house governance functions. Investors are largely divided into:

  • Actively-Managed Funds, such as Fidelity Investments, Capital Research and T. Rowe Price;
  • Index Funds, such as Vanguard, BlackRock and State Street Global Advisors (SSGA);
  • Hedge Funds; and
  • Retail Investors.

Large investors with actively managed or index funds often use proxy advisory recommendations as a triage mechanism—the recommendations are useful but not dispositive of how a large investor may vote. Nonetheless, many smaller investment funds appear to continue to defer entirely to whatever ISS and Glass Lewis may recommend. And mid cap or small cap companies may not receive much independent scrutiny, even from investors with well-established internal voting departments.

Accordingly, ISS and Glass Lewis recommendations remain both important and, sometimes, controversial. Public companies tend to have three primary complaints about proxy advisory firms:

  • Opaque Criteria: Certain criteria used in evaluating proposals—particularly in the area of executive compensation and the refreshing of employee equity inventive plans, are perceived as “black boxes,” generally not easily understood and inflexible when applied to unusual or unique circumstances.
  • Inaccurate Analysis: ISS and Glass Lewis are responsible for evaluating thousands of proxy statements—the majority of which still occur within the traditional compressed spring cycle of a couple of months for companies whose fiscal year end is December 31. The advisory firms can be perceived as making mistakes in the analysis, for which they may or may not be open to conversation and correction. The proxy firms would maintain that with sufficient advance planning, an issuer will have plenty of time to help correct mistakes—but issuers who are running businesses may not have that at the forefront of their list of priorities.
  • Apparent Conflicts of Interest: ISS offers consulting services—fees to essentially explain their blackboxes. They claim to “firewall” the consulting segment of their business from the proxy advisory segment—going to the extent that the respective teams are housed in separate buildings. In return for consulting fees, ISS will work with a company to model the company’s compensation policies and corporate governance policies. Nonetheless, there is a perception of an apparent—or at worst actual—conflict of interest in offering companies services for which a company is then scored by ISS.

In response to these complaints, the Proxy Advisory Reform Act of 2016 proposes to force proxy advisory firms to:

  • SEC Registration: Register as such with the SEC and certify that the firm has the requisite “financial and management” resources to function.
  • Recommendation Pre-Review: Give an issuer sufficient reasonable opportunity to review draft recommendations and to have an ombudsman office that assists issuers that purport to need corrections to such recommendations.
  • Business Model Disclosure: Disclose a firm’s top twenty clients by revenue, any potential conflicts of interest and describe how clients do not have ‘undue influence’.

Some industry observers—including the proxy advisory firms, to no surprise—view the issue of conflicts as a red herring—notwithstanding the appearance that may be given externally. While theoretically such fees may create an appearance of impropriety, ISS’s response is that it goes to great lengths to ensure a division between consulting and scoring.

On a practical level, it is a complete unknown as to what reasonable standard the proxy advisory firms will be held in having discussions with thousands of issuers on recommendations—and what level of “financial and management” resources would be required under SEC registration. Proxy advising is not a particularly high margin field—and both of the dominant players remain modest in financial scope. In addition, mandating public disclosure of the twenty largest clients by revenue would force revelation of what even the firms’ most antagonistic of opponents would admit seems to be highly confidential and proprietary information about the firms’ respective businesses.

That said, such is the ire that has provoked the bill, that an indirect consequence may be the bolstering of an appeals/consultation process with issuers and more transparent engagement from proxy advisory firms overall. Even if the draft legislation were to languish as other bills appear to be doing, the mere introduction has forced a focused, substantive discussion on the role and financial wherewithal of proxy advisory firms—topics which have been the subject of strong opinion for some time but hitherto not under the bright lights of legislative hearing rooms.

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