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E-MailAna M. Albuquerque is Associate Professor of Accounting at Boston University Questrom School of Business; Mary Ellen Carter is Associate Professor of Accounting at Boston College Carroll School of Management; and Susanna Gallani is Assistant Professor of Business Administration at Harvard Business School. This post is based on their recent paper.
Proxy advisors recommend to institutional investors how they should vote on the nomination of board members and other corporate governance issues, including executive compensation. The advisor with the largest US market share is Institutional Shareholder Services (ISS). ISS and other advisors do not own equity in the companies about which they provide voting advice, nor do they have any fiduciary duty to the shareholders of those companies; they don’t, in short, have skin in the game. Thus a key question is whether ISS’s voting recommendations really do inform investors and—of particular interest to us—whether ISS can identify, with its “against” recommendations, low quality compensation practices.
In a recent paper, we find it can. Specifically, we show that ISS’s “against” recommendations are associated with worse future industry-adjusted performance. However, we also find that the quality of ISS’s recommendations appears to be hurt by its workload. That is, we find that the firm’s ability to identify poor compensation practices relates only to companies with non-December fiscal year-ends. Resource constraints faced by ISS during its busy season, when it is analyzing the many firms with December fiscal year-ends, appears to influence the quality of its recommendations.
A challenge in our research design is defining low quality compensation practices. Compensation contracts are often idiosyncratic, making it difficult to define an objective benchmark for quality. And ISS recommendations evaluate aspects of compensation practices (e.g., communication practices of compensation committees or policies related to CEO succession) not directly reflected in the level of pay or the components of the contract. For these reasons, we take a different approach. Assuming that firm performance is influenced by the quality of its compensation practices—for example, high pay-performance sensitivity encourages the CEO to work harder to improve future performance—we expect that firms with low quality compensation practices have lower industry-adjusted accounting performance. Why investigate accounting performance and not stock returns? Stock returns have confounding problems such as the possibility that investors might be reacting to the issuance of an unfavorable recommendation rather than to underlying compensation quality or that returns may capture other information unrelated to the assessment. Indeed, we confirm these concerns, finding limited evidence of a negative relation between assessments and stock returns.
Although the literature documents a strong association between ISS recommendations and Say-on-Pay (SOP) voting outcomes, we exploit discordances between these two to evaluate whether shareholders are better at evaluating pay practices than ISS. We use two measures for shareholders’ assessments—SOP voting outcomes and large mutual fund companies’ SOP votes. With SOP outcomes, we find that shareholders are no better than ISS at identifying low quality compensation practices. Even when shareholders pass SOP, a negative recommendation by ISS is associated with lower levels of performance that are indistinguishable from cases where the SOP vote did not pass. But again, only for non-December fiscal year-end firms.
In contrast, we find evidence that the largest three fund companies—BlackRock, Vanguard and State Street Global Advisors—are better than ISS at identifying poor compensation practices. Future performance is lower for firms that have at least one of the fund companies voting against the pay package, even when ISS recommends “For”.
The SEC recently issued new rules around the activities of proxy advisors, promulgating fair and transparent disclosures with the aim of encouraging timely and accurate information for the voting process. Although we acknowledge that the SEC is balancing several objectives, our evidence suggests that the rules may have not gone far enough. Companies with December fiscal year ends might have benefited from the opportunity to comment on ISS recommendations, given the effect of resource challenges that it faces in the busy proxy season.
The paper is available for download here.
