The Proxy War Against Proxy Advisors

“Proxy war” – a war instigated by a major power which does not itself become involved.
–Oxford English Dictionary

On November 5, 2019, the U.S. Securities and Exchange Commission (“SEC”) released for public comment a proposal for a series of rule amendments, which, if adopted, have the potential to significantly change the way proxy advisory firms provide voting advice and shareholders vote proxies (the “Proposed Amendments”). The release comes on the heels of separate SEC guidance on the use of proxy advisors issued in August 2019, which itself was a follow-up to a roundtable discussion convened in November 2018. Prior to these recent actions by the SEC, separate bipartisan bills had been introduced in the US House and US Senate that would have subjected proxy advisors to additional regulation and oversight.

Typically, when a normally obscure corner of the financial markets gets this much attention from the SEC and Congress, it is after a headline-grabbing scandal, such as the collapse of Enron or the unmasking of Bernie Madoff’s Ponzi scheme. But there has been no such scandal involving proxy advisors. So, why are they getting so much attention from the nation’s top regulators?

The recent calls for action are the culmination of lobbying effort by think tanks, business trade associations and corporate executives in a decades-long struggle between the nation’s corporate managers and activist shareholders. Since the proxy reforms of the 1980s gave shareholders a greater say over matters of corporate governance, groups representing corporate interests have been fighting to retain their grip on corporate control. These recent calls for the regulation of proxy advisors represent a coordinated effort by corporate interests, acting through a series of proxies, to undermine activist shareholders and the voting reforms that have given shareholders more say and influence over corporate matters. These corporate interests are seeking to use the mechanisms of government regulation to weaken shareholders’ voting rights. What the advocates of reform really want is to make it more difficult for shareholders to vote independently of management.

The SEC’s Proposed Amendments

The SEC approved and released the Proposed Amendments on November 5, 2019 after a split 3-2 vote. If adopted, the proposal would impose a mandatory company review period for proxy adviser recommendations and create stricter conflicts disclosure requirements. It calls for amending Rule 14a-1(1) under the Exchange Act to make it clear that proxy voting advice may be considered a type of “solicitation” under the rules and revising Rule 14a-2(b) to provide a specific exemption from the information and filing requirements of the proxy rules for proxy advisors that meet a series of conditions, which include providing enhanced disclosure of their conflicts of interest, giving companies between 5 and 10 days (depending on the number of days between the filing and the annual general meeting) to review and provide feedback on the proxy voting advice before it is released, and requiring proxy advisors to include in their reports a hyperlink to the company’s or soliciting person’s response to the advice. The proposal also includes an amendment of Rule 14a-9 clarifying when proxy voting advice could be misleading.

The curious thing about many of the proposals for proxy voting reform, including the SEC’s latest proposal, is that they would create an additional choke point in what is already a complex, multi-layered system. The underlying concern is that that proxy advisors’ errors lead to suboptimal voting decisions harm shareholder value. The assumption underlying this view—sometimes stated, sometimes not—is that executives and directors know what’s best for their companies and, in many instances, shareholders do not. Almost by definition, this means that recommendations that don’t agree with management are viewed as inaccurate, uninformed, and value destroying. No one denies that proxy advisors sometimes make mistakes. Mistakes are inevitable in any process involving human input and judgment. But perfection is not now, nor ever was, the relevant standard of care for providing research or advice.

The SEC’s preferred approach is to require mandatory company review of all proxy voting materials. There is reason to doubt whether company review will lead to better proxy voting advice. At a minimum, it would create serious timing challenges. As it is, proxy advisors have only limited time to process millions of ballots. Giving companies a right to review would only further foreshorten the time proxy advisors have to process proxies and make recommendations, potentially leading to more errors committed in the rush. Further, giving companies an additional say in the process could have a chilling effect on proxy advisors’ willingness to issue truly independent advice. If they believe that every disagreement over a subjective determination like a say-on-pay vote is likely to lead to a messy confrontation with management, they may be less inclined to issue negative advice.

Institutional investors continue to use proxy advisors because they continue to perceive value from the services. Increasing the regulation of proxy advisors will increase the cost of proxy advisory service, which may lead to fewer institutional investors using those services or using them less. If the increased costs or decreased value of third-party proxy advice were to lead institutional investors to do more of the proxy voting research themselves, that would not necessarily lead to better voting outcomes. The proxy would still need to be voted, and someone would have to bear the costs of managing it. Institutional investors do not have an obvious advantage in producing better or more accurate proxy voting research. Placing more of the burden on their already resource-constrained back offices is unlikely to improve the information quality of proxy votes, and more likely to make it worse. ISS and Glass Lewis at least face market discipline from mutual competition if clients believe that one of them is making too many mistakes or too often making recommendations that fail to promote shareholder value. Institutional investors have little choice but to seek help from somewhere.

One potential consequence of the mandatory review period required by the Proposed Amendments is that proxy advisors will cover fewer companies and issue fewer proxy voting reports. There are only so many days on the calendar in April and May, and proxy advisors are only able to rely so much on temporary seasonal staffing. Some clients need proxy advisors to cover the biggest, most widely-held names, such as the companies in the S&P 500; while others need them to provide auxiliary research and recommendations on the less well-known and thinly traded small- and mid-cap companies. The extreme timing pressure imposed by the mandatory review period may force proxy advisors to focus their efforts on the most profitable (i.e., widely-held) names. The days of ISS covering upwards of 40,000 different companies may be over. That means institutional investors voting with management more frequently for smaller and more thinly-traded companies.

The Proxy War Against Proxy Advisors

If proxy advisory services were really as riddled with errors, transparency problems, and conflicts as their critics allege, one might expect their clients to be leading the charge for reform. After all, they are the ones paying for the supposedly faulty research and it is their shareholder value that is being harmed. But institutional investors and asset managers are not complaining. By in large, institutional investors have come out in favor of the present proxy services model and have defended ISS and Glass Lewis publically. According to the Council of Institutional Investors, institutional investors believe that proxy advisory services are a critical, cost-effective part of the shareholder voting process and many of the proposed reforms, including giving issuers a mandatory right to review, would threaten proxy advisors’ independence and increase costs without any real benefit. If there were strong dissatisfaction among clients with the services being provided by proxy advisors, they wouldn’t be lobbying in support of the status quo, and one would expect market forces, i.e., competition, to arise to exploit it.

The attack on proxy advisors is not about the quality of proxy advisors’ recommendations. It is a maneuver to wrench back control from shareholders. The campaign for proxy advisor regulatory reform has coincided with a number of other changes that have served to increase the influence and visibility of shareholder voting. It is these measures, not the proxy advisors’ errors or conflicts, that are the real source of the corporate insiders’ consternation. The corporate lobbyists know that the alternative to shareholders voting on the basis of recommendations from proxy advisors is not shareholders doing more proxy research themselves. It is shareholders more frequently voting with management, which is exactly the point. While investment managers face pressure from institutional investors to vote all or substantially all proxies, they face similar if not greater pressure to control costs. The proponents of increased proxy advisor regulation are making a strategic wager that, if the costs of proxy advisory services increase enough, many institutional investors will rethink their approach. Without the services of the proxy advisors, institutional investors would be forced to choose between the similarly unattractive options of casting uninformed votes or not voting at all. And activists, meanwhile, faced with the prospect of even more daunting odds, would be less likely to bring proposals in the first place.

The last decade has seen a marked increase in the number of shareholder proposals relating to environmental, social and governance (“ESG”) issues. Such resolutions have included proposals to increase climate risk reporting, limit political spending, report on gender pay disparities, and stop certain practices considered unethical to animals. Perhaps the best known of the successful ESG proposals to get through the SEC vetting process were the 2017 ballot measures brought by the New York State Comptroller and the Church of England to Exxon Mobil and by CalPERS to Occidental Petroleum to study the impact of climate change on their businesses. The measures were noteworthy because they survived SEC challenge and were ultimately supported by a majority of the companies’ shareholders, following favorable recommendations by ISS and Glass Lewis. More recently, CalPERS, State Street Global Advisors and others announced plans to vote against certain board nominations if the companies fail to nominate more diverse candidates for their board seats. As a result of these campaigns, by July 2019 the last member of the S&P 500 with an all-male board of directors announced that it would be appointing its first female director.

First, shareholders demanded majority voting and the declassification of staggered boards, making directors more vulnerable to attacks by activists. Then shareholders began asking for a greater say on matters that corporate executives hold dear: executive pay and board nominations. And now management teams must respond to a perpetual series of shareholder proposals asking them for unnecessary (in management’s view) reports and useless policies. Individually, these developments, occurring over a twenty-year period, represent a series of modest incremental changes in shareholders’ influence in corporate governance; but collectively, they signify a shift in the balance of power between institutional investors and corporate management. What was once the sole domain of corporate executives has gone through a period of democratization—albeit a modest one—and the corporate executives don’t like it. It has not gone unnoticed that votes against management became much more common after the proxy advisors appeared, and corporate executives and directors have reacted accordingly.

If You Really Want to Improve the Quality of Proxy Voting…

The proxy advisory industry developed as a market solution to the problems of institutional investor proxy voting. Before endorsing regulatory intervention, it’s worth first asking if there are other potential market solutions to address the existing deficiencies. The standard market-based response to a market failure is to promote competition. An obvious path for a would-be competitor to ISS and Glass Lewis would be to offer a similar service at a reduced cost. From the customer’s perspective, the ideal price of a service is always free.

The idea of a service provider offering its services to customers for free, or nearly so, is not as outlandish as it might first appear. There are many examples of products or services offered to end-users for free and supported by alternative revenue sources. Most government data is supported through tax revenue and provided to the public for free. The equivalent in the proxy research space would be if the NYSE or Nasdaq used a portion of its revenue to support independent proxy voting research. Many non-profits and think-tanks produce research that is offered for free and financially supported by donations and foundation grants. An alternative for-profit financial model would be one in which the seller of the research data, in this case, the corporations, pays for the service. While the buyer-pay model has been pervasive in the proxy advisory industry since its inception, a seller-pay model has prevailed in elsewhere in the financial industry, the most notably in credit ratings.

There are of course other ways to improve the quality of shareholder voting besides raising the bar on shareholders’ third-party service providers. The most obvious way is to limit the voting rights of uninformed or disinterested voters. In the extreme, that takes the form of full shareholder disenfranchisement.

Although the right to elect directors and vote on other important corporate matters is often taken for granted, it need not be so. Ford Motor Company, The New York Times Co., CBS and News Corp. all have dual-class structures that give founders or a controlling family super voting rights. More recently, prominent technology companies such as Google (now Alphabet Inc.), Facebook, LinkedIn, and Snap held initial public offerings with dual-class shares, attracting renewed interest in the practice.

It is costly and time-consuming to research and cast informed votes, and while shareholders collectively have an interest in value-maximizing voting outcomes, very few institutional investors have an economic incentive to invest the resources necessary to be fully informed on any particular proxy vote. The traditional solution to this collective action problem is to require financial intermediaries to exercise a reasonable standard of care in the voting of proxies on behalf of their clients. This is the approach that has been blessed into law by the SEC and Department of Labor. Another solution would be to use pricing mechanisms to incentivize institutional investors to seek the best and most reliable information or, if they make a rational determination that the cost of procuring the information does not exceed the benefit, then not to vote at all.

Two pricing mechanisms that have been used in other contexts to improve voting outcomes (from the perspective of the entrenched leadership) and discourage marginal voters from voting are poll taxes and literacy tests. Both devices have deservedly bad reputations due to their historical use to disenfranchise African American voters in the South, but, if one can put that ugly history aside, it is easy to imagine how devices that make shareholder voting more expensive would eliminate the problem of poor quality proxy research. If there was a cost to shareholder voting, only the shareholders truly interested in the outcome, who are also the shareholders most likely to do their own independent research or closely scrutinize third-party research, would be inclined to vote. The SEC considered the idea of prohibiting pre-populated or automatic voting mechanisms in connection with its recent rulemaking but ultimately decided against it on the grounds that it would discourage shareholders from voting and make it difficult for companies to meet quorum requirements.

Each of these solutions have problems of their own. In some cases, they would require majority shareholder approval to adopt, which would likely face stringent opposition, and they may run afoul of existing SEC rules, Delaware Corporations Law or exchange listing rules. They also run counter to companies’ general interest in achieving greater shareholder voting turnout on most routine matters. Nonetheless, if the proxy voting problem is ultimately a problem of shareholders making uninformed or misinformed proxy votes, there are other potential mechanisms that might improve the information quality of shareholders’ voting besides further regulation of proxy advisors.

The full paper is available here.