Understanding the Impact of America’s Clampdown on Proxy Advisors

In 2003, the SEC put forward a rule that required institutional investors to disclose their votes and provide an explanation as to why they voted the way they did. This paved the way for the rapid growth and influence of proxy advisors such as Institutional Shareholder Services, Inc. (ISS) and Glass Lewis, & Co. (Glass Lewis), which quickly became a cost- and time-effective resource for funds seeking to rationalize their vote decisions.

The SEC has once again shifted the paradigm by recently declaring that proxy voting advice provided by proxy advisory firms generally constitutes a “solicitation” and issuing guidelines for investment advisors to follow when voting for their clients. When the SEC started its process, it was clearly interested in reforms that would “rebalance” the role of the proxy advisors and “protect the interests of the broader shareholder universe.” Politicians had previously advanced this agenda by introducing bills—such as House Bill 4015, introduced in 2017 and passed in 2018, and Senate Bill 3614, introduced in fall 2018—requiring proxy advisors to register with the SEC, among other things. While none of these bills became law, they have helped to fan the flames of public attention on an issue most average investors know nothing about.

It is estimated that ISS and Glass Lewis have more than 97% market share in the proxy advisory space (Egan-Jones, Segal Marco Advisors, and ProxyVote Plus make up the balance) with many investors subscribing to more than one. Establishing a proxy advisory firm takes not only a significant financial investment but also a tremendous knowledge base, so it is unlikely a new entrant or even one of the smaller players will shift this balance any time soon.

How Did We Get Here?

While calls to regulate or “crack down” on proxy advisors are not necessarily new – indeed, they have flared up from time to time over the last 15 years—the present debate has been stoked by a confluence of combustible factors. A series of high-profile, controversial decisions from proxy advisors, complaints from well-funded companies about “mistakes”, a business-friendly administration in the White House, and a general populist mood in the U.S. led SEC Commissioner, Elad Roisman, to call the vote recommendation process led by proxy advisors “complex” and “unreliable”.

Critics argue that unless you have spent years in the industry, and inside the proxy advisors themselves, there is little transparency about how they construct their analysis and resulting vote recommendations. Once you figure it out, chances are they’ll change their approach, adding a new, hidden layer of complexity to their formula. This can be massively frustrating for boards that are trying to thread the needle by formulating shareholder proposals that are both the right thing for the business and will win over ISS and Glass Lewis.

When you add in so-called robo-voting (where shareholders are set to auto-vote their proxies based on a proxy advisor’s recommendation) and the challenges of correcting what is seen as inaccurate commentary, the frustration related to the inability to alter an influential but opaque process is compounded.

The Case For Regulation

Led by high-profile organizations such as the U.S. Chamber of Commerce, the National Association of Manufacturers, NASDAQ, and the New York Stock Exchange, the campaign against proxy advisors hinges on fairness to corporate America and the small retail shareholders whose interests they have co-opted to validate their cause.

Specifically, these groups argue that companies should have more ability to address proxy advisors’ recommendations before they are handed to shareholders, and perceived conflicts of interest and a lack of transparency must be openly addressed. For example, ISS has been singled out because it sells consulting services to companies via ISS Corporate Solutions (ICS) while also providing vote recommendations on the same companies.

Proponents for regulation even launched a million-dollar ad campaign and website (www.proxyreforms.com) designed to put the spotlight on proxy advisors and their purported shortcomings, positioning them as unregulated, secretive entities prone to mistakes and conflicts of interest that “put the retirement savings of hardworking Americans at risk.”

Numerous solutions to these concerns have been presented, including registering with the SEC, establishing an ombudsman and compliance officer at each proxy advisor, requiring the filing of documents with the SEC, and a general prohibition on “unfair, coercive, or abusive practices.”

At the very least, that providing voting guidance should be considered proxy solicitation and therefore follow applicable SEC rules and that proxy advisors should disclose and protect against conflicts of interest—a view the SEC has taken heed of.

In the end, whether or not you subscribe to this view depends on whether or not you believe a proxy advisor has the capability to sufficiently evaluate the issues they are presented with and whether or not you believe the investors who subscribe have the time, resources, and competency to analyze the recommendations given.

Anecdotally, at Kingsdale, we know, from our conversations with shareholders and from witnessing the expansion of in-house governance teams, that shareholders are taking back the decision-making process (to the extent it ever really left) as governance is increasingly seen not only as a risk mitigation screen but also as a lever to create value. Custom voting policies are being designed and refined to reflect underlying client appetites and to create a competitive advantage.

While ISS and Glass Lewis have become data points for further internal analysis, they are no longer seen as the ultimate decision-makers on how shareholders vote.

It is worth noting that for all the talk of conflicts of interest, a lack of transparency, and factual errors in their analytical processes, most of it does not appear to be coming from the most important part of the proxy advisor and shareholder voting equation: those who are actually paying for the vote recommendations. At an SEC roundtable held in November 2018, investors expressed general satisfaction with the service provided by proxy advisors. More recently, the Council of Institutional Investors issued a letter to the Commissioners of the SEC on October 15, 2019 expressing its concern over the latest actions that it feels “may reduce investor participation in the corporate governance voting process, and is likely to undermine investor protection, upend efficiency in the critical area of corporate governance and impair capital formation by diminishing corporate managerial accountability. The letter was co-signed by 60 public and union pension funds, religious orders, hedge funds, mutual funds, and other asset managers and investor organizations.

SEC Clampdown: Guidelines, Not More Regulation

On August 21, 2019, the SEC issued two sets of new guidelines to address these issues and clarify how various entities can comply with existing laws or regulations that it believes apply. Specifically, the SEC issued an interpretation clarifying why it believes proxy advisory firms’ advice is considered “solicitation”, or a “communication to security holders under circumstances reasonably calculated to result in the procurement, withholding or revocation of a proxy”. As such, existing regulations require such entities to provide underlying facts, reasoning, and assumptions to demonstrate their advice is not misleading. The SEC also clarified that proxy advisors cannot share recommendations that are materially false or misleading under the applicable federal rules.

In addition, the SEC issued guidance to assist investment advisors in fulfilling their proxy voting responsibilities. The guidance did not impose any new requirements on asset managers but provided ways they can oversee proxy advisory firms and fulfill their fiduciary duty to their clients. Of note, they offer guidance for investment advisors on how to judge whether retaining a proxy advisor is appropriate, actions to take if they believe a proxy advisor has made an error of fact or omission, and how to evaluate the service provided on an ongoing basis.

SEC Guidelines for ISS and Glass Lewis

Proxy advisors should consider disclosing:

• Methodology used to formulate advice and deviations from previous guidelines
• Third-party sources used
• The extent to which third-party materials were factored in
• Conflicts of interest
• That such conflicts of interest be explained in “reasonably sufficient detail”

Kingsdale’s Take

As critics of proxy advisory firms have called the SEC’s guidelines a “first step” and expressed the desire to see it and other regulators take further action, we do not believe this issue has gone away. Yes, it may quiet down as the market digests the impact, but once a controversial decision again comes into the spotlight, it is likely business groups will again drive forward for full regulation.

In our view, the key issue is not the proxy advisors themselves but whether or not a company believes a shareholder is capable of making a fully informed decision, regardless of what ISS and Glass Lewis might say. It is akin to an athlete lamenting one call by a referee in the final seconds of the fourth quarter when the team did nothing to help its chances of winning for the first 99% of the game. Don’t put yourself in a situation where someone else can decide your fate.

The most common mistake we see is a lack of—or imprecise—disclosure by the issuer leading to analysis by the proxy advisors that the issuer deems unfair. Make your case thoroughly and clearly.

We do not believe shareholders are looking for politicians to dictate a structure that tells them how to interact with a private service provider they have contracted. Regulating or restricting an independent third party from providing voting advice would be like regulating the editorials of newspapers during political elections who espouse their views on how people should vote. We believe shareholders are more than capable of making their own judgments and critically reviewing the analysis they receive—if they choose to.

To the extent further change is demanded, that change should be within the purview of the subscriber and those they have contracted with to provide services. Presumably, if the service providers are getting it wrong, their clients will take them to task and policies will be updated via their respective annual survey processes.

Proxy advisors are providing what their subscribers have requested—advice that fits within the scope they have defined for how they want to vote on certain matters. They are not looking for additional commentary or arguments from management—that is already available to them in the company’s proxy solicitation materials and from direct engagement with management itself. If a company wants to ensure ISS and Glass Lewis provide clarity beyond the proxy materials they have filed, they have the opportunity to discuss it with them and to file additional information at any point prior to, or after, the release of the proxy advisors’ reports.

We indeed note the sensitivities around this topic, given that a small number of auto-votes can greatly impact the outcome of a proxy battle depending on shareholder composition.

Anecdotally, we have found that in certain situations, such as a contested vote or a questionable say-on-pay recommendation, subscribing shareholders are willing to hear an alternative argument from the company on why their circumstance should be considered unique. After all, with hundreds of millions if not billions invested, why wouldn’t they want to ensure they get it right?

We would be more inclined to give credence to the concerns raised if there were evidence that “passive” investing meant more passive voting and deferral to the proxy advisors alone, without sober second thought, but that does not appear to be the case.

It is incumbent on companies concerned about ISS and Glass Lewis to take accountability for ensuring their shareholders are fully informed before a vote—in fact, well before. Here is what we recommend:

• Actively engage shareholders so the voices of ISS and Glass Lewis are not heard in isolation
• Understand ISS and Glass Lewis policies and to what extent the unique circumstances of your company will be considered in their analysis
• Understand how shareholders make their voting decisions, what their internal voting policies are, and the extent to which they deviate from the proxy advisors
• Seek to engage the proxy advisors outside of proxy season to ensure their analysts are well versed in your company and its industry
• If eligible, make use of ISS’s draft review process and the pre-publication review of annual meeting reports
• Make clear disclosure (mainly via proxy materials) to justify the decisions made by your board