Seven Questions about Proxy Advisors

David F. Larcker is the James Irvin Miller Professor of Accounting, Emeritus; and Brian Tayan is a Researcher with the Corporate Governance Research Initiative at Stanford Graduate School of Business. This post is based on their recent paper.

We recently published a paper on SSRN (“Seven Questions about Proxy Advisors”) that examines the role and function of proxy advisors.

The proxy advisory industry—in which independent third-party firms provide voting recommendations to institutional investors for matters on the annual proxy—has grown in size and controversy. Despite a large number of smaller players, the proxy advisory industry is essentially a duopoly with Institutional Shareholder Services (ISS) and Glass Lewis controlling almost the entire market.

The recommendations of these firms are prominent, especially in matters such as contested director elections, the approval of large pay packages, corporate takeovers, and other closely contended issues. Nevertheless, the degree to which these firms influence voting outcomes and corporate choices is not established, nor is the role they play in the market. Are proxy advisory firms information intermediaries (that digest and distill proxy data), issue spotters (that highlight matters deserving closer scrutiny), or standard setters (that influence corporate choices through their guidelines and models)? Because of the uncertainty around these questions, disagreement exists whether their influence is beneficial, benign, or harmful. Defenders of proxy advisors tout them as advocates for shareholder democracy, while detractors fashion them as unaccountable standard setters.

The tension has played out on the regulatory front with the Securities and Exchange Commission (SEC) subjecting proxy advisory firms to heightened standards in 2019 only to decline to enforce those standards two years later.

In this Closer Look, we examine seven important questions about the role, influence and effectiveness of proxy advisory firms.

Question #1: What Is the Market Role for Proxy Advisors?

Proxy advisory firms sell recommendations to institutional investors on their view of how to vote proxy proposals across thousands of companies. ISS describes its recommendations as “independent and objective shareholder meeting research and recommendations… to help [institutional investors] make informed investment stewardship decisions, and to help them manage their voting responsibilities.” Glass Lewis describes itself as “a trusted ally of more than 1,300 investors globally who use our high-quality, unbiased [research] … to help drive value across all their governance activities.” These descriptions are consistent with a role as information intermediaries, with proxy firms offering the benefit of economies of scale to aggregate and analyze information that would be costly for individual investment firms to replicate on their own. Iliev and Vitanova (2023) arrive at this depiction in their analysis of voting recommendations.

A second and related idea is that proxy advisory firms are issue spotters. In this description, the value of proxy advice comes from sifting through thousands of issues to identify those that require additional attention and analysis—which the investment firm itself then conducts. Sarro (2021) argues that this is the real role that proxy advisors play, concluding, “[Their] influence derives primarily from their ability to direct institutional investors’ attention away from some proposals and toward others.”

Another theory is that proxy firms are controversy creators. Closely contested proxy matters are beneficial to the proxy advisory firm because close contests increase the economic value of a proxy advisor’s recommendation. (In this way, proxy advisory firms do not have the same economic interests as those of investment advisors.) Malenko, Malenko, and Spatt (2023) argue that proxy advisory firms benefit from “biasing” recommendations (their word) to increase the frequency of close votes in order to increase demand for their services.

Another theory is that proxy advisors are agenda setters. Through survey data, Hayne and Vance (2019) demonstrate that boards feel pressure to alter their governance practices to conform to the standards of proxy advisory firms, despite a preference for alternative structures (see Exhibit 1). They conclude that proxy advisors are not merely information intermediaries but agenda setters because the one-size-fits-all nature of their voting guidelines compels conformity among corporate practices.

Currently, we do not have consensus about the role or roles that proxy advisory firms play.

Question #2: How Do Proxy Advisors Derive Their Influence?

Proxy advisor recommendations influence voting outcomes. The degree of influence, however, is not established. Brav, Cain, and Zytnick (2022) show that institutional investors are highly sensitive to an opposing recommendation from proxy advisory firms, with opposition from ISS associated with a 51 percent difference in institutional voting support compared with only a 2 percent difference among retail investors. Malenko and Shen (2016) estimate a negative recommendation from ISS leads to a 25 percentage point reduction in voting support for say-on-pay proposals. Data from Copland, Larcker, and Tayan (2018) show a negative recommendation from ISS is associated with a 17 percentage point reduction in support for equity-plan proposals, 18 points for uncontested director elections, and 27 points for say on pay. Rose (2021) examines “robo-voting”—the practice of fund managers voting in lock-step with the recommendations of ISS (defined as 99.5 percent alignment). He identifies 114 institutions managing $5 trillion in assets that robo-vote (see Exhibit 2). Iliev and Lowry (2015) find that 25 percent of institutional investors vote “indiscriminately” with ISS (see Exhibit 3).

What is unknown is whether the influence proxy advisory firms exert on voting practices is evidence of the value of their services (i.e., the quality of their recommendations) or distortions caused by the regulatory environment. Generally, firms purchase services because of the value vendors provide, and it might be the case that institutional investors purchase voting recommendations from ISS and Glass Lewis because they are a cost-effective means of making informed voting decisions.

On the other hand, it might be that economic demand for voting recommendations is artificially inflated by the regulatory environment. The SEC requires institutional investors to vote all matters on the proxy and to make their votes public. To satisfy this obligation, institutional investors must develop proprietary guidelines or rely on guidelines developed by third parties. Firms whose voting patterns are closely correlated with ISS or Glass Lewis recommendations apparently have elected to rely extensively on these guidelines. Whether they do so because they find these guidelines value-enhancing to their shareholders or an inexpensive way of meeting a regulatory requirement to vote is uncertain.

Question #3: How Do Proxy Advisory Firms Test the Validity of Their Recommendations?

Because institutional investors rely on proxy voting guidelines to inform their voting decisions, it is important that proxy advisory firms test their standards through a rigorous analytical process to ensure accuracy.

We do not have detailed information about how policy guidelines are developed. ISS discloses some information about how it updates policies; Glass Lewis does not disclose this information. The ISS annual update cycle includes the following steps:

  1. Internal review of emerging issues, regulatory changes, and trends
  2. Review of academic literature, empirical studies, and market commentary
  3. Survey of and roundtable discussion with investors and corporate issuers
  4. Release of draft policy updates
  5. Open review and comment period
  6. Release of final policy updates

We do not know whether, as part of this process, ISS tests existing guidelines through empirical analysis to ensure they are associated with positive outcomes, such as increased operating- or stock-price performance or a lower incidence of governance failures (such as restatements, regulatory violations, lawsuits, or bankruptcy). Without empirical evidence demonstrating these associations, we will not know whether proxy advisory firm guidelines are in the interest of shareholders.

Professional researchers have examined some aspects of ISS and Glass Lewis policies, and the results of these studies are mixed. Alexander, Chen, Seppi, and Spatt (2010) find ISS recommendations in contested director elections are positively associated with shareholder returns. Larcker, McCall, and Ormazabal (2013) study stock option repricing plans and find that plans that conform to ISS criteria are associated with lower returns, lower future operating performance, and higher employee turnover. In a separate study, Larcker, McCall, and Ormazabal (2015) find shareholders react negatively to companies that revise their executive compensation programs to make them more consistent with ISS guidelines for say on pay. Conversely, Dey, Starkweather, and White (2023) find that companies that receive relatively low say-on-pay support and engage with ISS exhibit positive future returns. Daines, Gow, and Larcker (2010) study ISS governance ratings and find they are not predictive of future operating performance, stock-price performance, or governance failure.

Our understanding of the rigor and reliability of proxy advisor guidelines would be greatly enhanced through additional study. Unfortunately, ISS voting recommendations have been removed from the databases that academics previously have used to conduct these studies, making future studies impossible. (In response to questions from the Stanford Graduate School of Business Library about how to access ISS voting recommendations for research purposes, ISS responded that it “will not be able to offer any options / channels to access that data set moving forward.”) Without access to voting recommendations, researchers are unable to assess the reliability and validity of proxy advisory firm guidelines.

Question #4: How Do Proxy Advisory Firms Evaluate Individual Directors?

Proxy advisory firms provide voting recommendations on individual director nominations at all public companies. The sheer number of directors makes this work onerous. By one count, there are approximately 40,000 directors of public companies in the U.S. alone. To provide an accurate assessment requires knowledge of the skills, domain expertise, and boardroom contribution of each director. From a practical perspective, it is challenging to develop an informed view of each director without access to the individuals themselves or some insight into how board meetings are conducted.

Proxy advisors say little about how they determine the effectiveness of directors. Glass Lewis says it assesses directors on their independence and performance. ISS evaluates them on independence, board composition, responsiveness, and accountability. Beyond, this, we do not know how proxy advisors measure the effectiveness of a director at the individual, committee, or board level.

Cai, Garner, and Walkling (2009) and Choi, Fisch, and Kahan (2010) show that ISS and Glass Lewis recommendations influence the voting results of uncontested director elections, while Alexander, Chen, Seppi, and Spatt (2010) show they heavily influence contested elections.

The recommendations of proxy advisors will take on newfound importance in the age of universal proxies, in which activist investors are able to directly nominate dissident board members side-by-side with the company’s nominees on the annual proxy. Proxy advisors will be positioned to directly influence the composition of public boards by recommending a vote for certain individual candidates over others. Whether they are able to reliably weigh the merits of competing individual nominees is an open question.

Question #5: Can Proxy Advisors Detect “Excessive” CEO Pay?

Few matters in corporate governance are more controversial than executive compensation. According to one survey, 75 percent of Americans believe CEO pay is too high.

For this reason, stakeholders pay considerable attention to the voting recommendations of proxy advisory firms. One study shows negative recommendations from ISS and Glass Lewis reduce support for say-on-pay by around 30 percent. Another estimates 25 percent. Data on equity plan proposals suggest an impact of approximately 20 percent.

ISS and Glass Lewis have developed elaborate models to inform their voting recommendations for executive pay plans. Glass Lewis takes into account the relation between pay and company performance, the mix of short- and long-term incentives, the mix of variable and fixed elements, the relation between pay and risk, the choice of peer groups, and disclosure practices. It recommends against “excessive bonuses,” “excessive risk-taking,” and “excessive payouts.”

ISS considers many of these same factors and generally recommends against pay packages that include what it describes as “problematic” elements. These include “egregious” pay contracts, “overly generous” new-hire packages, “abnormally large” bonuses without a clear link to performance, “excessive” perquisites, and “problematic” severance. ISS also recommends against multi-year employee equity plans that exceed proprietary thresholds for total shareholder value transfer (SVT).

While both firms provide extensive disclosure about their pay recommendations, we do not know how these firms determine which practices are excessive or egregious. Professional researchers have extensively studied CEO pay and, overall, little consensus exists about whether CEO total compensation on average is set at the right levels, whether it is properly aligned with performance, and whether it encourages appropriate risk-taking. It might be that proxy advisory firms have independently developed frameworks to distinguish fair and unfair pay practices; if so, these models have not been externally vetted.

Nevertheless, companies pay careful attention to proxy advisory guidelines when designing pay. A study by The Conference Board, NASDAQ, and the Rock Center for Corporate Governance at Stanford University finds that approximately three-quarters (72 percent) of publicly traded companies review the compensation policies of a proxy advisory firm and a significant percentage of these make changes to pay structure in response.

Edmans, Gosling, and Jenter (2023) find that approximately half of companies (53 percent) offer less pay to the CEO than they otherwise would in order to avoid a negative recommendation from a proxy advisory firm. Jochem, Ormazabal, and Rajamani (2021) find that CEO pay levels have declined in variation within industry and size groups, with proxy advisor influence being one cause of this decline; they find negative shareholder outcomes associated with this trend. Cabezon (2024) finds that the distribution of pay components—salary, bonus, equity, and other elements—across firms has also become more standardized, with pressure from proxy advisors one cause of this trend; he too finds standardization to be associated with lower shareholder value. It is far from clear that these outcomes are beneficial to shareholders and stakeholders.

Question #6: Does a Proxy Advisor’s View of ESG Influence Its Recommendations?

Proxy advisory firms are known primarily for recommendations on traditional corporate governance concepts. While they also provide recommendations for shareholder resolutions on environmental and social matters, their support—at least historically—was fairly muted. For example, ISS generally has supported proposals to the extent they “enhance or protect shareholder value,” address “business issues that relate to a meaningful percentage of the company’s business,” but do not concern matters “more appropriately / effectively dealt with through governmental action” or are otherwise “best left to the discretion of the board.”

With the rise of ESG investing and ESG issues, ISS has entered the business of providing ESG ratings. A rating is fundamentally different from a recommendation on a proposed corporate provision. According to ISS, its ratings are

designed to enable institutional investors to support their investment strategies by assessing the environmental, social, and governance (ESG) performance of corporate issuers. In the context of the ESG Corporate Rating, ESG performance refers to a company’s demonstrated ability to adequately manage material ESG risks, mitigate negative and generate positive social and environmental impacts, and capitalize on opportunities offered by transformation towards sustainable development.

The evaluation of ESG performance is a phenomenally complicated undertaking. Professional researchers have painstakingly scrutinized the methodologies and predictive ability of ESG ratings and are divided whether it is possible to evaluate ESG quality and, if so, whether a single rating has informational value. (ESG ratings are also known to have low correlation across providers, suggesting they are either not reliably measuring the same construct or they are measuring different constructs—see Exhibit 4).

The risk for issuers is that a proxy advisor’s view of ESG quality might influence its recommendations on proxy items in a way that is not in the interest of shareholders. For example, in the 2021 proxy contest between ExxonMobil and Engine No. 1, ISS backed three of the four directors put forward by Engine No. 1 because of their advocacy for ESG concepts, swinging the outcome of a closely run election just before a sharp upturn in traditional energy markets. In 2024, ISS recommended against the reelection of five directors to the board of Berkshire Hathaway because of ESG factors, without regard to the recent or long-term success of the company.

Spatt (2021) finds the proxy-maximizing incentives of proxy advisory firms are not aligned with those of investors and can encourage these firms to promote controversy or cater to ESG investors to increase own market share at the expense of beneficial owners.

Question #7: Are Proxy Advisory Firms Independent?

Institutional investors rely on proxy advisors to provide an independent assessment of proposed corporate and shareholder actions. However, whether proxy advisory firms are independent is an unresolved question. Some proxy advisors receive consulting fees from the same companies whose governance and ESG practices they evaluate, and the potential exists that they alter their voting recommendations to gain or retain business. Ma and Xiong (2021) show, using a theoretical model, that conflicts of interest can bias voting recommendations and decrease firm value.

Some evidence suggests this might be occurring. Li (2018) examines voting recommendations and finds that ISS shifts its positions to make them more favorable to the preferred position of the client company when Glass Lewis initiates coverage of that company. He concludes “conflicts of interest are a real concern.”

Policymakers have the option to introduce safeguards to assure the independence of proxy advisory firms. One approach is increased disclosure. Malenko and Malenko (2019) and Edelman (2013) argue the quality of recommendations would improve through greater transparency. An alternative approach would be to designate proxy advisory firms as fiduciaries. Spatt (2021) points out that these firms are outliers in the financial services industry, being subject to lower standards of accountability than institutional investors, auditors, and credit rating agencies. He argues that a fiduciary standard would align the interests of proxy advisors with those of shareholders. Sharfman (2020) also makes this point. Another approach, put forward by Manna (2021), would be to require greater separation between the consulting and advisory businesses of these firms.

Why This Matters

  1. The proxy advisory industry is marked by considerable controversy regarding its purpose, influence, value, and objectivity. What is the reason for this controversy? Why have researchers been unable to demonstrate the purpose and role of these firms? Why do market participants and regulators disagree so starkly over their contribution? Is the proxy advisory industry—as currently structured—a net benefit or cost to shareholders?
  2. Considerable disagreement exists over the influence that proxy advisory firms have on voting outcomes. What explains the large swings in voting outcomes that seem to be associated with their recommendations? Are investors making “informed decisions” based on information provided by these firms, or are they “blindly following” recommendations? Would the influence of proxy advisors be lessened if institutional investors were not required to vote?
  3. Considerable evidence suggests that proxy advisor guidelines influence corporate practices, particularly in the area of compensation design. Are these guidelines associated with improved outcomes? What research do proxy advisory firms conduct to satisfy themselves that their guidelines are beneficial to shareholders and stakeholders? Why don’t these firms provide greater transparency around their methodologies?
  4. Proxy advisory firms have recently made the decision to remove their voting recommendations from research databases that professional researchers have used to conduct empirical studies on voting practices. As a result, future research into the questions discussed in this Closer Look will be greatly inhibited. What is the justification for this decision?

Links to SSRN: https://ssrn.com/abstract=4808820

 

Exhibit 1: Perceived Market Role of Proxy Advisory Firms

Source: Hayne and Vance (2019).

 

Exhibit 2: Institutional Investors Voting in Alignment with ISS

Rose (2021).

 

Exhibit 3: Institutional Investors Voting with ISS, By Issue

Iliev and Lowry (2015).

 

Exhibit 4: Correlation among ESG Ratings Providers

CFA Institute (2021)

Kevin Prall, “ESG Ratings: Navigating Through the Haze,” blog posting at CFA Institute (August 10, 2021).

 

Berg, Kӧlbel, and Rigobon (2022)

Florian Berg, Julian F. Kölbel, and Roberto Rigobon, “Aggregate Confusion: The Divergence of ESG Ratings,” Review of Finance (2022).

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