SEC Hears Plans, Ideas to Reform Proxy Advisory Firms

Proxy advisory firms are again in the spotlight as the Securities and Exchange Commission, after punting on potential reforms for the past three years, may be ready to take steps to increase regulation of the proxy advisory industry.

Last week, the SEC convened a roundtable on proxy advisers, soliciting views on how it might address longstanding concerns. Among the issues cited by critics are the lack of marketplace competition, lack of transparency in how voting recommendations are made, outsized influence, and potential conflicts of interest.

Institutional investors now hold upwards of 75 percent of all company stock and are responsible for voting billions of shares. To assist with this responsibility, they typically retain proxy advisory firms, notably Institutional Shareholder Services and Glass, Lewis & Co., firms that control approximately 97 percent of the market for proxy advisory services. Between them, ISS and Glass Lewis influence the votes of one-fourth to one-half of the shares of the typical mid-or large-cap company. A recent Stanford University study found that opposition by a proxy adviser results in a “20 percent increase in negative votes cast.”

At the roundtable, SEC Commissioner Daniel Gallagher fretted that proxy advisory firms have gained “an outsized role in corporate governance in the United States,” largely as a result of “the unintended consequences of SEC action.”

 In 2003, the SEC adopted new rules and rule amendments requiring an investment adviser that exercises voting authority over its clients' proxies to adopt policies and procedures to ensure it votes those proxies in the best interests of its clients. In response, proxy advisers asked the SEC staff for guidance.

The resulting pair of staff no-action letters “effectively blessed the practice of investment advisers voting by rote the recommendations provided by proxy advisers,” Gallagher said. He is pushing for the SEC to undo the special privileges that were effectively granted to proxy advisory firms. He wants the SEC to withdraw the no-action letters and replace them with Commission-level guidance that imparts fiduciary duties.

In a 2010 concept release often referred to as the “proxy plumbing release,” the SEC revisited the concerns many critics raised about proxy advisory firms. That effort was pushed aside, however, when the Dodd-Frank Act's many rulemaking requirements landed on its doorstep.

Too Much Influence?

SEC Commissioner Michael Piwowar shares Gallagher's concerns about the outsized influence of proxy advisory firms. The matter is especially important now, he said, because many Dodd-Frank Act provisions, such as mandatory say-on-pay votes, make proxy advisory firms “even more influential.”

Piwowar is particularly concerned by the lack of competition, and he described proxy advisory services as “a stable duopoly preserved by near impenetrable barriers for new entrants.”

Niels Holch, executive director of The Shareholder Communications Coalition, laid out steps the SEC could take to remedy concerns. There should be required SEC registration for all proxy advisory firms and the development of a regulatory framework, he says. That framework should establish and enforce an effective internal control structure. He also called for requiring Website disclosure of all methodologies and requiring proxy advisers to maintain records and file annual reports with the SEC.

The Coalition urges that any regulatory exemption from the SEC's proxy solicitation rules should require that proxy advisory firms:

• Provide each public company with an advance copy of any report that includes a proxy voting recommendation and permit it to review and comment on the factual accuracy.

• Disclose when comments have been received by a public company on the front page of a report about that company, with an internet address or link provided for investors to access those comments.

• Make available on its Website without charge (or file with the SEC) a copy of each report that contains a proxy voting recommendation about a public company, no later than 90 days after the shareholder meeting to which the voting recommendation relates.

“I think the proxy advisory business is essentially a scam. Like the CCO business for mutual funds and investment advisers, the demand is largely created by regulators. Without regulation, who would pay for a proxy adviser?”

—James McRitchie,

Corporate Governace Activist

ISS currently provides draft reports only to companies that are listed in the S&P 500. Other companies are not given the opportunity. Glass Lewis does not provide draft reports in advance for any public company.

Holch says the SEC should also consider issuing rules or guidance emphasizing the responsibility of registered investment advisers to exercise appropriate oversight over the proxy voting process. That oversight of proxy advisers should include assessing potential conflicts of interest and a review of internal standards, controls, workflow management, and quality of work.

Darla Stuckey, senior vice president of policy and advocacy for the Society of Corporate Secretaries, would like to see proxy advisory firms pushed away from one-size-fits-all policies. She cited, as an example, a company she worked with that planned to add its former CEO to the audit committee, a move rejected because ISS has a blanket policy that board members shouldn't include former CEOs of the company because of concerns they might lack independence.

“The real shame of it is that the nature of the dialogue and the questions asked in the audit committee are now worse and not as rigorous because the former CEO is not sitting there and you don't have the same level of knowledge needed to ask the tough questions and really grill management,” she said.

In written testimony, the U.S. Chamber of Commerce said that, in its view, “more regulation is not the answer.” Instead, it urged proxy advisers to adopt some new practices. It wants firms to ensure that reports are factually correct; establish a process for correcting errors; and provide vote recommendations that “reflect the individual condition, status, and structure for each company and not employ one-size-fits all voting advice.”

The European View

Below, the European Securities and Market Authority offers recommendations on the EU Code of Conduct.

In February, the European Securities and Markets Authority issued its final report on the proxy adviser industry. The report found that there is no current market failure related to proxy advisers' interaction with investors and issuers in the European Union, which would require regulatory intervention. ESMA, however, identified a number of concerns regarding the independence of proxy advisers, and the accuracy and reliability of advice.

ESMA recommended that the proxy advising industry should develop an EU Code of Conduct that focuses on:

Identifying, disclosing, and managing conflicts of interest

Proxy advisers should seek to avoid conflicts of interest with their clients. Where a conflict effectively or potentially arises the proxy adviser should adequately disclose this conflict and the steps which it has taken to mitigate the conflict, in order that the client can make a properly informed assessment of the proxy adviser's advice.

Transparency to ensure accuracy and reliability

Proxy advisers should provide investors with information on the process they have used in making their general and specific recommendations and any limitations or conditions to be taken into account on the advice provided so that investors can make appropriate use of the proxy advice.

Disclosing general voting policies and methodologies

Proxy advisers should, where appropriate in each context, disclose both publicly and to client investors the methodology and the nature of the specific information sources they use in making their voting recommendations, and how their voting policies and guidelines are applied to produce voting recommendations.

Considering local market conditions

Proxy advisers should be aware of the local market, legal and regulatory conditions to which issuers are subject, and disclose whether/how these conditions are taken into due account in the proxy adviser's advice.

Providing information on engagement with issuers

Proxy advisers should inform investors about their dialogue with issuers, and of the nature of that dialogue.

Source: European Securities and Markets Authority.

Corporate governance activist James McRitchie quoted concerns about the proxy advisory industry he received from a hedge fund manager: “I think the proxy advisory business is essentially a scam. Like the CCO business for mutual funds and investment advisers, the demand is largely created by regulators. Without regulation, who would pay for a proxy adviser?”

McRitchie advocates a new model where all shareowners vote on, and pay for, proxy advisory services through company funds voted on the company proxy. Recommendations from several proxy advisers would be made available to all shareowners. Since all shareowners pay for the advice, advisers could be paid substantially more for company analysis than under the current model, which depends on relatively few subscriptions for funding.

Where the Conflicts Are

Despite the many concerns aired by critics of the industry, proponents of proxy advisory firms also had their say, as did representatives of both ISS and Glass Lewis.

While the focus at the roundtable was on proxy advisers, a “more profound instance of regulatory privileging” takes place with auditor demands, said Damon Silvers, director of policy and special counsel for the AFL-CIO. “If you are going to start going heavy at these issues of concentration and gatekeepers, this is about the last place to start,” he said. “The really serious problems lie elsewhere, where you not only have concentration, you have a profound conflict about who is paying for what.”

Nell Minow, co-founder and board member of GMI Ratings, served as ISS' first general counsel and its second CEO. Like Glass Lewis, it actually entered the proxy advisory space indirectly. While unsuccessfully promoting other consultation services, many institutional investors expressed a desire for help with proxy analysis, she recalled.

“The reason this product has become so popular and universal is that there are these complex issues, particularly with regard to compensation,” she said.

Minow bristled at comparisons to ratings agencies. “The ratings agencies are paid by the people they rate, and that is a conflict of interest,” she said. “These products are paid for by the people who buy them—that is not a conflict of interest. I would hope the SEC supports independent analysis to protect investors. The reason proxy advisers are so influential is because they provide advice that people think is important.”