Companies Look to the SEC to Rein in Proxy Advisory Firms

While the SEC has put rulemaking for a Dodd-Frank Act provision on regulating proxy advisory firms on the back burner, advocates of the measure continue to push for increased oversight of firms, which they say have run amok.

Critics of proxy advisories, like ISS and Glass Lewis, say that the firms are susceptible to serving as a mouthpiece for special interest groups, face conflicts of interest, and reveal too little about the “cookie cutter” methodologies they use to produce the reports and vote recommendations relied upon by investors. Oversight and regulations, they say, would ensure their activities and positions are in the best interest of investors and the companies they review.

Critics also want an extended review and response period that better allows companies to assess and, if necessary, correct or contest reports.

At the center of the controversy are the recommendations proxy advisories are making to large investors on advisory votes on compensation. As of the 2011 proxy season, a non-binding vote by shareholders of a publicly traded company must be taken on whether to approve or disapprove the executive compensation program at that company. This year, ISS changed the methodology it uses to assess compensation programs at public companies, and many companies are not happy with the results.

“Say-on-pay is causing some disagreements between issuers and some of the proxy advisory firms,” says Niels Holch, executive director of the Shareholder Communications Coalition, a group composed of the Business Roundtable, National Investor Relations Institute, and the Society of Corporate Secretaries & Governance Professionals. “It certainly raises the compensation issue higher up on the profile of many investors because they have to vote up or down on the whole compensation package. Obviously individual issuers approach compensation differently, but the large proxy advisory firms tend to take a one-size-fits-all approach to compensation. It is just going to lend itself to disagreements or different points of view.”

“What we've seen the past two proxy seasons is that there is a strong correlation, if not causation, with proxy advisory firm recommendations and ‘say-on-pay' outcomes,” says Tim Bartl, president of the Center on Executive Compensation. “The influence of proxy advisers, in some cases even over large companies, is pretty significant.”

Research released in March by The Conference Board, the NASDAQ OMX Group Inc., and Stanford University's Rock Center for Corporate Governance found that more than two-thirds of U.S. companies say their executive compensation program is influenced by the policies and voting recommendations of proxy voting advisers like Institutional Shareholder Services (ISS) and Glass Lewis, the nation's two largest such firms. In particular, a majority of corporate boards are likely to change CEO compensation to gain a favorable “say-on-pay” recommendation from these firms.

The research was based on a survey of 110 large and mid-cap public companies. Of those, 72 percent review the policies of a proxy advisory firm or engage with one to receive feedback and guidance on their proposed executive compensation plan; 70 percent reported that their compensation program is influenced by that guidance.

An ongoing issue this proxy season are disputes over “peer groups” used as a point of comparison to compare a company's compensation plan. For example, the peer group ISS measures performance against is made up of similarly sized companies within a particular GICS code, part of a proprietary database created by Standard & Poor's.

There is often disagreement surrounding the attempt at an “apples to apples” comparison.

J.C. Penney, for example, has paired itself with Walmart, Disney, Target, and Pepsi as it prepares for its June 1 annual meeting. ISS, however, has rejected those comparisons to companies with far greater revenues as “aspirational.” Conversely, ISS drew criticism from Marriott Corp. executives for including auto part stores in their peer group, rather than other hotel chains.

“The problem is that we are wholesaling corporate governance by putting into the hands of institutional shareholders and their advisers' determinations regarding to executive pay,” says Joseph Bachelder, founder and senior partner of New York based Bachelder Law Firm, who specializes in executive compensation.

The rise of proxy advisory firms provides the “preemption of the historical judgment of individual directors overseeing CEO pay,” he says.

“Proxy advisory firms, most notably ISS and Glass Lewis, have their hands full during proxy season and do not always get the facts straight.”

—Joshua Henke,

Managing Director,

Longnecker & Associates

“One of the problems with the use of statisticians, such as those provided by ISS, is that we overlook the fact that leadership is a very individual thing,” Bachelder says.

“Proxy advisory firms, most notably ISS and Glass Lewis, have their hands full during the proxy season and do not always get the facts straight,” says Joshua Henke, managing director of executive compensation firm Longnecker & Associates. “We have seen numerous instances where these firms have misread financial statements or misunderstood a company's compensation practices and made costly mistakes when issuing proxy recommendations.”

“Bottom line, a proxy advisory firm's role is to make black-and-white recommendations on an issue that is far from black and white,” he adds. “Say-on-pay is a great step forward in allowing shareholders to have a voice on compensation programs; however, proxy advisory firms do not accurately measure pay versus performance nor understand the environment in which public companies compete.”

“Don't forget, they are looking at thousands of companies in a compressed period of time,” says Donald Kalfen, a partner and senior consultant for Meridian Compensation Partners, a consultant on executive and board compensation. “It is quite a feat to say the least. I think they probably get it right the vast majority of the time, but it is hard to get it right all the time. These compensation programs are very nuanced.”

The debate over the regulation of proxy advisory firms is nothing new. It has been on the SEC's radar since 2010's promotion of “proxy plumbing.” In a December speech, SEC Chairman Mary Schapiro stressed that the commission is still considering guidance on how federal securities laws should regulate the activities of these firms.

“We would like to see the SEC come up with a unique framework under the Investor Advisors Act for these firms,” Holch says. “Some of them (ISS included) are registered as investment advisers now, but it is really designed for people who are taking investments from others and doing other sorts of functions that really aren't the same as what these firms do for their clients.”

“Despite disclaimers, the perceived conflict of interest between ISS' consulting arm and the recommendations taint the objectivity of its analysis,” Bartl says. “There is still a belief among some companies that by taking advantage and by engaging the consulting side that they will be viewed more positively. Sending out a three paragraph flyer with a page-long disclaimer behind it doesn't necessarily blunt the desire to want to go ahead and engage that service.”

ISS failed to reply to an interview request for this story by deadline, and Glass Lewis, the second largest, was also unable to provide a spokesman prior to publication.

CONFLICTS OF INTEREST

Below the Center on Executive Compensation examines conflicts of interest at proxy advisers:

While concerns about conflicts of interest at proxy advisors

date back decades, these concerns have never been resolved and

continue to attract high-profile attention. Evidence of the

continuing high level of concern over this issue includes the fact

that the U.S. Government Accountability Office (GAO) has twice

been asked by Congress to study the issue—most recently in 2007—and the issue plays a central role in a “concept release” on the U.S. proxy system issued by the U.S. Securities and Exchange

Commission in July 2010.

Concerns about conflicts of interest in the industry fall into

four general categories:

1. Potential conflicts that arise when proxy advisors provide

services to both institutional investors and corporate issuers on

the same subjects;

2. Potential conflicts related to proxy advisors providing

recommendations on shareholder initiatives backed by their

owners or institutional investor who are clients;

3. Potential conflicts when the owners, executives or staff of

proxy advisory firms have ownership interests in, or serve on

the boards of, public companies that have proposals on which

the proxy advisors are making voting recommendations; and

4. Potential conflicts when proxy advisory firms are owned by

firms that provide other financial services to various types of

clients.

The Center believes that some of these conflicts need to be

eliminated and others need to beat least fully disclosed, so that the

information presented in proxy firm analyses can be placed in the

appropriate context. The following sections will describe the

extent to which each of these potential conflicts pertain to the

major proxy advisory firms and how those firms describe these

conflicts and the measures they have taken to address them. 

Source: Center on Executive Compensation.

The latter firm has recently had to publicly defend its efforts to avoid conflicts of interest.

On May 31, the Chamber's Center for Capital Markets Competitiveness (CCMC) petitioned the Securities and Exchange Commission to monitor the San Francisco-based firm and its owner, the Ontario Teachers Pension Plan (OTPP).

In a letter to the SEC, CCMC detailed the “activist pension fund's” opposition to the board of directors of NYSE-listed Canadian Pacific Railway. That stated opposition, and support of an alternative slate of directors, “was followed by Glass Lewis issuing a vote recommendation in the parents' favor during the heated proxy contest earlier this month,” it claims.

“Glass Lewis' vote recommendation in favor of its parent company calls into question the role of proxy advisory firms in corporate governance, the lack of transparency by proxy advisory firms in making vote recommendations, and the potential conflicts of interest that may benefit certain activist investment funds,” CCMC wrote.

Glass Lewis has refuted the allegations, stating that “OTPP is the owner of Glass Lewis, not its operator” and maintaining its independence. It further asserted that it does not offer consulting services to public corporations or directors and takes precautions to ensure its research “is objective at all times and under all circumstances.” An in-house Research Advisory Council is tasked with ensuring that research ‘'consistently meets the quality standards, objectivity, and independence.''

In a Feb. 9, 2010, comment letter to the SEC, Egan-Jones, another leading proxy advisory firm was dismissive of the “desire of some issuers to review drafts of proxy advisory firm reports” saying that it would “risk compromising our independence.”

The comment letter also challenges criticisms that “proxy advisory firms may base their recommendation on a one-size-fits-all governance approach.”

“At Egan-Jones our voting guidelines are just that—guidelines,'' wrote managing director Kent Hughes. “An institutional investor understandably may ordinarily want consistency in the way it votes on certain matters across numerous issuers. We disagree strongly with the pejorative description ‘one-size-fits-all' applied by such commentators. Such appellation does not do justice to our intellectual and individual process.''