The Role of Proxy Advisory Firms

In our article The Role of Proxy Advisory Firms: Evidence from a Regression-Discontinuity Design, forthcoming in the Review of Financial Studies, we analyze the effect of Institutional Shareholder Services (ISS) recommendations on shareholder voting outcomes. Over time, regulators and market participants have become increasingly concerned with the influence proxy advisors allegedly have on investors’ votes and have pushed for stringent regulation of the proxy advisory industry. However, there is disagreement about whether the impact of proxy advisors’ recommendations is as strong as is sometimes claimed. On the one hand, concerns about ISS’s outsized influence are consistent with the strong positive correlation observed between ISS recommendations and voting outcomes. On the other hand, assessing the actual influence of ISS has been difficult because of the omitted variable problem: the same unobservable firm characteristics that lead ISS to give a negative recommendation can also lead shareholders to withdraw their support for the proposal, leading to an upward bias in the estimates of the ISS effect. Prior literature concludes that ISS recommendations move at least some fraction of the votes, but whether this fraction is large or small remains unclear. As a result, many observers believe that the influence of proxy advisors is significantly overstated and that stringent regulation may do more harm than good.

In our paper, we address this empirical challenge and estimate the causal effect of ISS by exploiting exogenous variation in ISS recommendations generated by a cutoff rule in ISS voting guidelines. Specifically, when giving recommendations on say-on-pay proposals over 2010-2011, ISS used to conduct an initial screen of companies focusing on their one- and three-year total shareholder returns (TSRs) and only performed a deeper analysis of the company’s compensation practices if its TSRs fell below the median of peers in their 4-digit Global Industry Classification Standard group (“TSR cutoff”). This cutoff rule allows us to use a regression discontinuity design to estimate the effect of ISS on say-on-pay voting outcomes over 2010-2011. The rule implies that firms below the cutoff undergo more scrutiny to achieve a positive ISS recommendation than firms above the cutoff, and hence the probability of a negative ISS recommendation should increase discontinuously just below the cutoff. Indeed, we show that relative to firms just above the cutoff, there is a 15% increase (from 10% to 25%) in the probability of a negative say-on-pay recommendation for firms just below the cutoff. This jump is large given that the average probability of a negative recommendation in our sample is 12.7%. At the same time, the somewhat arbitrary nature of the cutoff suggests that firms around the cutoff are similar across all characteristics, except for, potentially, the ISS recommendation. Thus, the discontinuous decrease in voting support, which we observe for firms just below the cutoff, can be attributed to the causal effect of ISS.

Our regression discontinuity (RD) analysis shows a strong effect of ISS on 2010-2011 say-on-pay voting outcomes: relative to positive recommendations, negative ISS recommendations lead to a 25 percentage point decline in voting support. In other words, ISS moves about a quarter of the votes in our sample. This effect is economically significant: prior literature shows that dissent above 20% is viewed as an indication of substantial shareholder dissatisfaction and leads companies to change their compensation practices. We also show that the influence of ISS is stronger in firms where institutional ownership is larger and less concentrated and where there are more institutions with high turnover or small positions, consistent with the hypothesis that such shareholders have stronger incentives to rely on ISS instead of performing independent research. Our estimates are robust to using multiple specifications and bandwidths and to controlling for various firm characteristics. We also use our results to discuss the informativeness of ISS recommendations relative to the information that shareholders possess independently.

The key assumption of our RD design is that whether a firm falls just above or below the cutoff is locally random. We perform several tests to verify this assumption and show that the results are not driven by differences in firm characteristics around the cutoff. First, we redo our analysis on several samples for which ISS did not apply its cutoff rule and show that in all these samples, voting support is continuous around the cutoff. Second, we verify that the distribution of various elements of executive compensation and other firm characteristics is smooth around the cutoff. Third, we alleviate the concern that firms manipulate their TSRs to move above the cutoff by performing the McCrary (2008) density test. Fourth, we consider several placebo cutoffs and show continuity in voting support around them.

The RD design does not allow us to estimate the causal effect of ISS for other types of proposals or for firms away from the cutoff and after 2011, so one should be cautious in extrapolating our estimates to the general effect of ISS recommendations. However, we examine the OLS estimates of the ISS effect and find that they are close to the RD estimates in our main sample, and that they are very stable over time and across different subsamples of firms. Assuming that the omitted variable bias in OLS estimates remains small in these other samples, this suggests that the 25% effect could be generalized to other firms and to subsequent years.

Overall, our article suggests that at least based on the sample of 2010-2011 say-on-pay votes, the influence of ISS does not seem overstated. Our findings contribute to the ongoing debate on the role and economic impact of proxy advisory firms.

The full article is available for download here.