A Flawed System That Endangers Investors: Proxy Advisory Firm Failings
There is growing consensus that proxy advisory firms are not operating in a way that serves the best interests of America’s Main Street investors.
The proxy advisory space is effectively a duopoly, with two firms, ISS and Glass Lewis, controlling 97 percent of the market. Without clear regulatory oversight, they have become quasi-regulators and de-facto standard setters of corporate governance at America’s public companies, despite merely positioning themselves as providers of independent research.
Although ISS claims that it is simply an “independent provider of data, analytics and voting recommendations to support [their] clients in their own decision-making,” academic studies have shown that a negative recommendation from the company has the potential to influence a shareholder vote by up to 25 percent. The outcomes of these votes carry significant weight on a company’s performance and outlook.
Despite their influence, proxy advisory firms are not subject to effective regulatory oversight.
Nearly every other participant in the proxy process is subject to some regulatory oversight. Targeted reforms are needed to protect investors and ensure firms are considering the interests of companies’ long-term shareholders.
The U.S. Chamber of Commerce and the National Association of Manufacturers are calling for specific reforms to address four main concerns that companies and investors have raised with their business practices.
To learn more about the below failings, and to find more examples of companies raising these issues, see this analysis by the American Council for Capital Formation.
Proxy Advisors Lack Transparency and Rely on One-Size-Fits-All Methodologies
Even though the standards they set for companies often exceed regulatory mandates, proxy advisory firms provide little public information on how they set their polices and reach recommendations on proxy ballot measures. Their methodologies are effectively a black box into which companies have no insight.
The result is an overreliance on problematic, one-size-fits-all guidelines that do not consider the unique nature of the businesses they purport to evaluate, even when so-called custom voting policies are used.
This lack of issuer- and industry-specific standards leads to voting recommendations that fail to utilize the most appropriate metrics to help investors evaluate performance. For example, many public companies have noted that the peer groupings advisory firms use to benchmark their performance often include companies in different industries with entirely different business models.
There is significant concern about proxy firms’ lack of resources and expertise leading to voting guidelines that are inapplicable to company governance and unhelpful to investors. In a review of the 2018 proxy season, the U.S. Chamber of Commerce and Nasdaq found that only 39 percent of companies surveyed believed that proxy firms carefully researched an issue before formulating a recommendation.
After Glass Lewis misapplied a key metric used to analyze a real estate investment trust (REIT), the trust filed statements with the SEC to highlight the firm’s reliance on a one-size-fits-all model based on factors irrelevant to the REIT industry.
The trust pointed out that REIT investors look to performance metrics like Funds From Operations (FFO) and Net Asset Value (NAV), rather than the one-size-fits-all Earnings Per Share (EPS) recommendation issued by Glass Lewis.
Further, it noted significant deficiencies in Glass Lewis’s peer group comparison, highlighted by the inclusion of several incongruent peers – including several outside of Glass Lewis’s own standards for peer comparisons.
The REIT also noted that Glass Lewis miscalculated the company’s market capitalization by more than $1 billion, significantly misstated changes in CEO pay, and failed to record the company’s membership in the S&P 500.
Proxy firms should be required to show they are making issuer-specific recommendations and be encouraged to engage in a public notice-and-comment process during policy development.
The SEC should encourage transparent standard-setting, require the firms to disclose the factors used in developing its policies, and require the firms to justify any one-size-fits-all guidelines by conditioning a proxy solicitation safe harbor on meeting certain standards of transparency.
Proxy Advisors Have Fundamental Conflicts of Interest
ISS and Glass Lewis have significant conflicts of interest, which call into question the validity and reliability of their recommendations.
The most high-profile and controversial of these sits within ISS, which not only rates public companies’ performance against its governance standards, but also sells consulting services to companies on how to meet those standards through its Governance Advisory Services.
Glass Lewis is owned by the Ontario Teachers’ Pension Plan, which has an ownership stake in many of the issuers on which Glass Lewis makes recommendations and which actively proposes proxy ballot measures while taking strong positions on measures.
Glass Lewis has been accused of issuing guidance which supports its owner’s initiatives in the past.
A week before a supply company’s 2016 annual meeting, its CEO learned that ISS had issued a recommendation against a company director.
When the CEO called the proxy advisor, he was told that ISS could help the company address the issue if it became a client at a cost of about $30,000 per year.
Rep. Sean Duffy, who sponsored legislation to reform the industry, compared these sorts of scenarios to a protection racket run by “Vinny down the street.”
Since then, the company has continued to receive the same answer when discussing shareholder proposals with ISS, making clear that they would have a smoother process if they were to become an ISS consulting client.
The SEC should require proxy firms to have robust policies and procedures to avoid and disclose potential conflicts. Further, if investment advisers are relying on proxy firms to mitigate their own potential conflicts, they should ensure that the firms’ conflicts do not impact their research or recommendations.
The SEC should clarify the fiduciary duty of proxy firms to act in shareholders’ best interests and, similarly, clarify that use of proxy advisory firms is not necessary or sufficient for an investment adviser to mitigate its own conflicts. Also, the SEC should condition a proxy solicitation safe harbor on the firms’ effective disclosure and mitigation of conflicts of interest.
Proxy Advisor Reports Have Frequent and Significant Errors
Proxy advisory firms’ guidance frequently includes errors and other inaccurate information. As far back as 2010, the SEC itself highlighted concerns that “proxy advisory firms may…fail to conduct adequate research and base recommendations on erroneous or incomplete facts.”
A review of supplemental SEC filings found 139 significant errors, failings and material disputes in the 2016 – 2018 proxy seasons. Given the tight window to file corrections and additional liability that companies assume when they file, this is likely only the tip of the iceberg.
Part of the issue may stem from resourcing. In 2016, ISS had a global research staff of 370 full time employees that “covered more than 40,000 global shareholder meetings.” Glass Lewis maintains a staff of 360 individuals to cover 20,000 meetings a year, with only half of its team dedicated to research.
This limits their ability to conduct accurate, fair, company-specific analysis on such a wide range of proxy measures – a problem the firms compound by employing part-time seasonal workers with limited training.
When ISS recommended against a 2017 shareholder vote on a say-on-pay proposal at a risk management company, the company pointed out that ISS employed a questionable methodology when it overstated the CEO’s front-loaded award by more than 100 percent and the long-term annualized value of the compensation package by more than 600 percent.
ISS acknowledged its methodology would artificially inflate the CEO’s compensation – but persisted and ultimately recommended against the company’s proposal.
Proxy firms should have policies and procedures to ensure recommendations are not based on inaccurate or misleading information. Further, the firms should allow companies to identify errors and respond to misleading assumptions or methodologies in their reports to provide investors the complete picture.
The SEC’s proxy solicitation safe harbor for proxy firms should make clear that firms must base their recommendations on accurate information and engage with issuers to ensure accuracy. Similarly, the SEC should provide clarity to the market by continuing to make clear the due diligence requirements investment advisers have when relying on proxy firm recommendations and that such recommendations does not relieve them of their duty to make an independent analysis.
Proxy Advisors are Unwilling to Engage with Stakeholders to Ensure the Accuracy of Market Signaling Information
Errors in proxy advisors’ guidance are exacerbated by an unwillingness to engage with companies to address them. ISS only provides draft reports to companies in the S&P 500, while Glass Lewis will only share full reports with companies for a fee.
When companies are granted access to draft recommendations, they report minimal time for research and response. Companies that do not see recommendations until they are published have found the proxy firms unwilling to discuss them.
The problem is particularly severe for smaller companies, which have limited resources to respond to a report and are less likely to secure a meeting with a proxy firm or investors.
Respondents to the Chamber of Commerce and Nasdaq’s 2018 Proxy Season survey said that when they asked for a preview of recommendations they were provided a draft only 44 percent of the time. Companies also reported getting as little as an hour to respond, with the most common response window being one or two days.
A separate survey found companies need three to five business days to effectively respond to an adverse recommendation. However, according to a 2018 paper, almost 20 percent of votes are cast within three days of a proxy firm’s negative recommendation. A second study found that 175 asset managers, representing more than $5 trillion in assets under management, follow proxy advisory firms’ recommendations over 95 percent of the time. So even if a company did attempt to correct a mistake, limited time combined with proxy advisor automatic voting triggers reduce a company’s ability to adequately mitigate the effects of bad recommendations.
In June 2018, Darla Stuckey, President of the Society for Corporate Governance, provided a vivid example of small companies’ challenges in dealing with proxy firms in her testimony to the Senate Banking Committee.
One company received a recommendation against its executive compensation policy because ISS made a “clear mathematical mistake” in its calculations. After the company pointed out the mistake, ISS acknowledged the error but refused to correct or revise its report. With little time for the company to engage with investors, the negative recommendation led to a failed say-on-pay vote.
The following year, ISS again recommended against the compensation policy – because the previous year’s vote had been so low. ISS failed to recognize that its error caused the poor showing and then compounded its mistake by recommending against both the say-on-pay proposal (again) and the entire compensation committee (for failing to make changes based on the error-induced vote the previous year). The company was able to conduct enough outreach to re-elect its directors, but the say-on-pay vote failed again.
Proxy firms should be required to engage with issuers and companies should have access to draft recommendations with sufficient time for review. In the event that a company takes issue with a recommendation, the proxy firm should include the issuer’s views as a “dissenting opinion” in the final report.
The SEC’s proxy solicitation safe harbor for proxy firms should include clear provisions on engagement and review of recommendations. Similarly, the SEC should make clear the due diligence requirements that investment advisers have when relying on a firm’s recommendations.