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E-MailTao Li is Assistant Professor of Finance at Warwick Business School. This post is based on a forthcoming article by Professor Li.
With ever growing institutional shareholdings and recent regulatory reforms to enhance shareholder rights, proxy advisory firms, ISS and Glass Lewis in particular, have a large influence on shareholder votes. It is thus critical that these independent advisory firms issue unbiased recommendations and be free of potential conflicts of interest. My article, Outsourcing Corporate Governance: Conflicts of Interest within the Proxy Advisory Industry, publicly available on SSRN, provides the first study on whether and when conflicts of interest can arise from serving both shareholders and issuers.
This study begins by examining what factors drive Glass Lewis’s coverage decision. The advisor is more likely to cover larger companies with higher institutional ownership, consistent with the fact that it is institutions who hire proxy advisory firms like Glass Lewis. It also tends to cover better performing firms, and those for which ISS issues potentially biased recommendations, as reflected in voting disagreements between investors and ISS. Furthermore, if a firm is held by institutions whose portfolios are already substantially covered by Glass Lewis, it will have a relatively high probability of being covered. This is likely due to a lower marginal cost of coverage when the advisor already covers a large proportion of a potential client’s portfolio.
More importantly, I find that after Glass Lewis’s initial coverage of a new firm, ISS begins to take a tougher stance towards its possible corporate clients (proxied by large firms), compared to non-client firms. Compared to major shareholder and management sponsored proposals such as governance-related proposals and executive compensation plans, the effect of competition on uncontested director elections is weaker, consistent with the fact that voting guidelines for director elections, especially those for re-appointed director nominees, are more transparent, and there may be less room for bias without competition. However, if we separately examine first-time director nominees who potentially involve greater information asymmetry and uncertainty, the results suggest that competition makes ISS tougher with these new director nominees at possible client firms. Similar results exist for director elections at underperforming firms, for which correct advice would be more valuable. Similar to “routine” director elections, I do not detect any effect of competition for routine, miscellaneous and social proposals.
Some may argue that there could be efficiency gains from combining the business consulting and proxy advisory services in the same firm. Although both ISS and Glass Lewis tend to rely on company filings and other publicly available sources to make their recommendations, the business model ISS adopts could lead to a unique information acquisition process—ISS’s corporate clients could have received valuable advice and thus deserve a better recommendation. For example, assuming ISS has value-increasing advice on compensation policies, it makes sense that it would advise its institutional clients to vote for a compensation proposal that it helps to draft. In the absence of conflicts of interest, however, it would be difficult to explain why competition would lead to a larger drop in ISS’s support rate for its possible client firms, compared to control companies.
Shareholder value would be negative affected if biased recommendations have real negative consequences beyond effects on voting outcomes. To study whether potential bias in ISS’s recommendations has incremental impact on firm outcomes, I compare proposals with potentially biased recommendations from ISS that pass to those that fail within a narrow margin. Firms with such proposals that narrowly pass perform marginally worse subsequently. However, executives at these firms have higher abnormal compensation, higher growth in pay and more cash payments. This suggests that potential bias in ISS’s recommendations allows managers to enjoy greater private benefits.
As an information intermediary in financial markets, proxy advisors play an important role in monitoring corporate governance practices at public firms, and providing objective advice to their institutional clients. The failure of such functions can adversely affect shareholder value, as evidenced by the failure of credit ratings agencies before the recent financial crisis or the overly optimistic recommendations by stock analysts during the “dot-com bubble” in the early 2000s. Furthermore, proxy advisory firms’ coverage and recommendations could serve as a screening mechanism for activist investors, who often seek changes in target firms’ operations and corporate governance. Relatedly, I show that when firms are targeted by activists in the previous year, the likelihood that ISS’s potential bias occurs drops by almost three percentage points. Interestingly, the effect is stronger for firms targeted by activist hedge funds and for companies going through proxy contests, consistent with the notion that activist hedge funds are an effective force in corporate governance.
Overall, my results suggest that conflicts of interest is a real concern in the proxy advisory industry, and increasing competition can help to alleviate them to a certain extent. Competition itself, however, may not be enough to completely eliminate these conflicts. Competition is likely to remain imperfect in financial markets. Because investment advisers are required to vote in the best interests of clients (a fiduciary duty), some institutions may find it safer to buy ISS’s services even if they prefer the competitor’s. As the more powerful player, ISS’s “certification effect” could be valuable in case a lawsuit occurs.
Finally, it is important to note that while I find ISS’s advisory services can be improved when it makes recommendations for possible client firms, this paper does not discredit ISS’s positive effects on financial markets overall. Proxy advisory firms provide a range of services that investment advisers find useful in fulfilling their proxy voting responsibilities, as detailed in the SEC’s 2010 Concept Release on the U.S. Proxy System.
The full article is available for download here.
