Information Intermediary or De Facto Standard Setter?: Field Evidence on the Indirect and Direct Influence of Proxy Advisors

Proxy advisory firms (PAs) are considered important and useful by some and overbearing by others. On the one hand, PAs fill an information intermediary role by processing large amounts of information and providing voting recommendations to institutional investors on matters such as executive compensation and governance. On the other hand, critics contend that PAs have outsized influence on proxy voting outcomes, which potentially allows them to exert pressure on firms to adopt PAs’ preferred practices. While these views are not mutually exclusive, examining PAs’ role(s) is important for understanding executive compensation design. If PAs primarily serve as information intermediaries, their influence on compensation practices likely occurs only indirectly through their ability to facilitate investors’ monitoring through shareholder votes. If PAs can apply pressure on firms to adopt favored compensation practices, they may be able to directly influence compensation practices. In this latter case, the effect of PA influence depends on the quality of PA recommendations.

To date, research on PAs’ role has primarily focused on the perspective of institutional investors, and PAs’ influence on firm practices is generally inferred based on responses to shareholder votes. Ultimately, whether PAs influence executive compensation practices depends on how internal stakeholders responsible for designing compensation (i.e., board directors with support from human resources [HR] executives and compensation consultants) perceive the role of PAs, which, in turn, helps determine how these stakeholders respond to PA recommendations. In our recent article titled Information Intermediary or De Facto Standard Setter? Field Evidence on the Indirect and Direct Influence of Proxy Advisors, we examine how internal stakeholders perceive the role(s) of PAs, and, relatedly, how they respond to their influence in terms of compensation design. To address these questions, we conduct 37 interviews with board directors, HR executives, and compensation consultants of mainly mid-, large-, and mega-cap public companies to understand their perspective on the role and influence of PAs.

We find that PAs are perceived as having broad indirect influence on compensation practices by supporting investors’ monitoring efforts through an information intermediary role. However, we also find evidence that PAs wield direct influence by identifying preferred practices and enforcing their adoption through voting recommendations. Respondents overwhelmingly view PAs’ recommendations and general guidelines as “telling them what to do,” and frequently share examples of PAs’ influence on their compensation design choices. For example, a board director of a mega-cap firm explained the importance of not approving pay practices that PAs “disagree with” as follows:

You wouldn’t approve something that you thought the proxy advisors would disagree with. You might approve something that the consultants don’t agree with because you hire consultants for advice, but you don’t hire them to grade you. You might approve something that management doesn’t like because that’s too bad. It’s hard for me to see that you would approve something that Glass Lewis or ISS trashed because of the reputation risk.

In the article, we provide rich examples of design choices made by internal stakeholders in direct response to PAs’ firm-specific vote recommendations in addition to their general guidelines. For example, the selection of performance measures (especially total shareholder return [TSR]) as well as the use of equity compensation (especially stock options), tax gross ups, and single trigger change-in-control agreements are frequently identified as influenced by PAs. In some cases, design changes are made to conform to known PA preferences even when the changes go against what the board believes is optimal given the company’s unique circumstances. For example, an HR executive, who described his/her firm as wanting to promote an ownership culture via equity compensation, reported that the firm considered a special equity grant but decided against it because “ISS is going to have a problem with us if we do that”. Similarly, another HR executive lamented, “In a perfect world, our CEO would do broad-based stock options,” but, due to pressure from ISS to reduce burn rate, the firm has been put “on a diet” with respect to the amount of equity issued.

Prior studies primarily examine PA influence in the context of adverse PA recommendations or voting outcomes, which are relatively rare. We find that boards proactively manage compensation issues, known to be “hot buttons” of PAs, to avoid negative vote consequences in the first place. Moreover, we find evidence of PA influence on compensation practices even in firms under no obvious pressure from PA scrutiny or shareholder votes, indicating that PA influence may be more prevalent than previously documented.

Throughout interviews, respondents affirmed common criticisms levied against PAs (e.g., PAs are susceptible to conflicts of interest and employ one-size-fits-all analyses among other criticisms). However, when asked to assess PAs’ overall impact on the executive compensation landscape, internal stakeholders overwhelmingly believe PAs fill a positive role and have improved compensation practices in various ways, primarily by increasing the transparency and accountability of executive compensation and providing an impetus for firms to engage with institutional investors. This more positive perspective contrasts with the negative views expressed publicly by issuers and industry associations.

Our findings help inform the current debate among regulators and market participants over PAs’ “outsized” power and influence, and are relevant to U.S. legislators as they consider whether to restrain this power and influence. An HR executive of a mega-cap company we spoke with pointedly summarized the concern over PAs’ influence:

Some of our largest shareholders own five percent of the company—they deliver five percent of the vote—that’s very important. … Now, [PA firms], they do not own a damn share, but they are delivering, let’s say, 25 percent of the vote. Well, they deserve a lot of your attention, right?

Even if PAs do not intend to wield direct influence, this still reflects a potential structural problem that undermines the ability of the proxy voting system to fulfil its intended corporate governance role. Our article presents evidence that demonstrates the extent of PAs’ power to influence corporate practices, lending validity to this concern. At the same time, our findings also demonstrate the positive influence of PAs, notwithstanding public comments and criticisms to the contrary.

The complete article, which is forthcoming at the Journal of Accounting Research, is available for download here.