Proxy advisory firms have come under increasing scrutiny in recent months for the disproportionate influence they have over shareholder votes at America’s public companies. A November 2018 roundtable at the Securities and Exchange Commission underlined the need for greater transparency and oversight, and in May the agency officially added the issue of proxy advisory firms to its regulatory agenda – a good indication that the Commission intends to act.
Now a new layer of evidence has revealed another concerning aspect of the industry: the fact that certain proxy advisors are providing their investor clients with what effectively amounts to recommendations “for hire.”
Institutional investors have traditionally relied on firms such as Institutional Shareholder Services, the largest and most influential proxy advisor, for third-party recommendations on how to cast their shareholder votes in order to fulfill a 2003 SEC guidance document, arguably misinterpreted, that requires investors to vote their securities in every company they own.
With some of the largest passive investors owning stock in tens of thousands of companies, the SEC attempted to minimize the burden of this rule by creating a safe harbor that enables investors to claim that they have insulated themselves from liabilities derived from any potential conflicts of interest around their votes by using “independent third parties.”
Together these actions artificially established an entirely new industry by creating a clear incentive for investors to outsource the analysis of the various management and shareholder resolutions. In effect, using a proxy advisor became the lowest cost, lowest risk solution for many investment managers.
Over time the industry has steadily evolved, and ISS has developed an increasingly comprehensive and complex array of solutions to meet its clients’ needs.
In addition to its core benchmark report, which may be used by different clients to implement custom policies aligned to their investing preferences, the company also produces up to five “specialty” reports aimed at responding to the preferences and agenda of different investor types. In contrast to their benchmark report, the recommendations in these specialty reports simply reflects the expectations of the clients to whom they are issued.
ISS positions these reports as responding to the specific needs of different types of investors, stating they include “special policies for socially responsible investors, faith-based investors, Taft-Hartley funds and their external asset managers, and public employee pension funds.” In turn, investors receive recommendations in-line with their predetermined voting preferences, while still being able to claim the use of an independent, third-party expert.
Critically, an analysis of these reports demonstrates that ISS frequently issues different recommendations on votes at the same companies.
For example, based on a sample of 10 of the largest U.S. companies, ISS’s Taft-Hartley reports recommended voting against management 47 percent of the time on average in 2019, according to an analysis conducted by FTI Consulting. By comparison, in its benchmark reports, ISS proposed voting against management only 10 percent of the time, the analysis found. Depending on the report an investor chooses to use, voting guidelines vary drastically.
Clearly this situation represents a problematic development.
While there is nothing inherently wrong with investors choosing how to vote the securities they own, investors shouldn’t be able to do so while still claiming they have cleansed themselves of any potential conflicts through the use of a third party who, in theory, is providing independent guidance.
Put another way, ISS is effectively providing “pick and choose” governance for its customers. Investors can simply select a recommendation that meets their preferred result and still cast their votes in-line with an “independent, third-party report.” Rather than providing genuinely independent analysis, ISS has created guidance for hire.
This failing is compounded by a lack of transparency. Unlike benchmark reports which are at least seen by S&P 500 companies, companies are not provided with the opportunity to review the facts, findings or recommendations within specialty reports. And in fact, many have no idea they even exist.
Perhaps unsurprisingly, anecdotal evidence suggests that these specialty reports are rife with errors, misinterpretations and speculative, unqualified statements. Without oversight, there is no way for companies to check if reports are accurate, significantly magnifying the extent of the problem.
ISS has always argued it is simply an “independent provider of data, analytics and voting recommendations to support our clients in their own decision-making.” The facts tell a different story. By creating “pick and choose” recommendations, investors get to select the recommendation they prefer and still avoid any issue around conflicts of interest.
When the SEC created its dual mandates around the voting of securities, the aim was to ensure that funds were meeting the interests of their retail investors, by playing an active part in the corporate governance process. The situation we find today, where investors have the opportunity to pursue a subjective agenda free from any concerns over conflicts, shows just how far we have come from that lofty goal. It is time the Commission act to ensure that proxy firms actually put the interests of America’s individual retail investors first.
Tim Doyle is Vice President of Policy and General Counsel at the American Council for Capital Formation. He has written extensively on corporate governance issues.
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