The Troubling Case of Proxy Advisors: Some Policy Recommendations

Abstract

The changing times created a business opportunity. As institutional investors and fund managers came to collectively own a large majority of all shares in circulation, their fiduciary obligation, or duty to vote their proxies created a logistical problem.Proxy advisors, firms specializing in analyzing the information and issuing voting recommendations to their clients, institutional investors and fund managers of all stripes, came about to tap into this market niche.The outcome was somewhat unexpected. Proxy advisors now stand in a bully pulpit from which to harangue corporate management and boards of directors on all matters of governance and compensation; neither investors, nor investment advisers, they enjoy a franchise to "make recommendations" to investors on how to discharge their fiduciary responsibility as shareholders.Their influence has grown in spite of repeated criticism of their performance, because investors seemed to find these "advisors" useful in discharging what could be an onerous responsibility. Neither regulated, nor supervised, proxy advisers rely on a business model that makes it virtually impossible for them to handle with care and responsiveness the sheer volume of reports they have to produce in a very short period of time. In the case of ISS, the firm is also vulnerable to conflicts of interests.Their role in defining what is proper governance, what is an effective board and how should executives be compensated gives them an undue, unhealthy influence on the functioning of private corporations.Eventually, the chorus of critics got the attention of the securities regulators in the USA, in Canada, in France, which set up consultation processes to determine what, if anything should be done.The litany of issues raised about proxy advisors is troublesome:• Lack of transparency as to the process by which they arrive at formulating their recommendations;• Inaccuracies in their analysis and unresponsiveness to corporate demands for corrections;• Conflicts of interest, in particular for ISS, by their offering of several services to the samecorporations which are the subject of their proxy recommendations;• More subtle criticisms focus on their definition of good governance and the lack of (or very weak) empirical evidence that their kind of governance has any influence on the performance of companies;• Proxy advisors have a vested interest in raising the bar of good governance from year to year to justify their continued employment;• The influence of proxy advisers on corporate governance makes some, many, boards of directors overly preoccupied with ensuring favorable recommendations from proxy advisers, by taking pre-emptive steps to ensure that their policies on governance and executive pay will not trigger a negative score when fed into the proxy advisers’ standardized algorithm; their business model is problematic. Because their clients, institutional investors, collectively own shares in all publicly listed companies, they have to provide advice for all these corporations.In Canada, some 1570 companies are listed on the TSX and another 2,200 are listed on the TSX Venture. The financial year of roughly 84% of companies listed on the TSX ends on December 31st. For some 80% of TSX listed companies, there were less than 50 days between the date the Management Information Circular is received by shareholders and the ultimate date for proxy voting. (IGOPP research, 2012). These statistics create a fundamental issue for these service providers and raise basic questions about their business model. How can they cope with this mass of data and come up with fair and thoughtful recommendations for thousands of corporations in a matter of a few weeks in the spring of each year;Surprising and puzzling is the role these proxy advisors are now playing in all cases of mergers, acquisitions, proxy contests and all other litigious matters. Proxy advisers offer their opinion on almost all litigious, contentious issues. As these issues often come about as a result of the actions of some activist hedge funds, a proxy advisor’s favourable opinion, from ISS particularly, is a highly prized input to the argumentation of activist funds. The potential for conflicts of interest is decoupled in these highly charged confrontations with huge sums of money at stakes. This policy paper makes recommendations to institutional investors as the prime clients of proxy advisors and to securities commissions as the protectors of the integrity of financial markets.RESPONSIBILITY OF INSTITUTIONAL INVESTORSLarge institutional investors bear a singular responsibility for this state of affairs. They carry the fiduciary responsibility to vote proxies in the interest of their stakeholders, a responsibility they cannot farm out to proxy advisors. Most large institutional investors maintain adamantly that they do not sub-contract this responsibility but merely use proxy advisors as information gatherers and providers of opinions.Even for that limited role, large institutional investors, as clients of proxy advisory services, should demand that they be given full information on their business model: part-time vs. full-time employees, location of employees, extent of work performed in foreign countries, training of employees, proficiency of the staff, the ways the advisory service copes with the logistics of having to formulate opinions/recommendations on thousands of proposals within a very short time period.As clients of these advisors, they should demand explicit statements of conflicts of interest whenever these advisors are involved in M&A transactions, proxy contests or other litigious matters. They should insist that proxy advisors disclose at the time of their recommendation whether the advisor has, currently or within the recent past, been engaged by any participant in the relevant M&A transaction or proxy contest, whether any of the interested parties subscribe to the proxy advisory firm’s services, and the aggregate fees paid by the interested parties to the proxy advisory firm.Finally, institutional investors should state their disagreement with some of the proposed guidelines of proxy advisors. Certainly they should make clear that they do not consider the ISS proposed guidelines on executive compensation appropriate or useful and that they will not give any weight to voting recommendations based on these metrics.Canadian institutional investors should object vigorously to ISS basing some of its guidelines on poorly designed studies carried out in the American context. CANADIAN REGULATORSThe consultation document produced by the Canadian Securities Administrators has provided an excellent summary of the issues as well as some potential remedies. We urge the Canadian regulators to examine the recommendations made in this policy paper as they proceed to set a course forward concerning the proper supervision of proxy advisors.Indeed, it is a recipe for troubles to co-locate two businesses within the same corporation, one advising institutional investors on how to vote on issues of momentous significance to corporations, the other one advising corporations on how to meet the standards of "good" governance set by proxy advisors. Canadian regulators should certainly prohibit ISS from offering its corporate services to corporations about which ISS issues proxy voting recommendations to its institutional clients.At a minimum, Canadian regulators should demand that ISS provide to its institutional clientele the list of clients of ISS Corporate Services, Inc. for which proxy voting advice is put forth by ISS.Furthermore, whenever proxy advisors get involved in takeover situations when they are actually advising their clients and the shareholders at large as to the adequacy of the bidder’s price for a transaction, regulators should subject them to the regulatory framework applicable to financial advisers and investment bankers offering an "opinion" on the advisability of a transaction.Finally, Canadian regulators should demand that proxy advisors set standards for the training, expertise and experience of analysts preparing proxy advisors’ reports. All in all, the business of proxy advisors, though seemingly filling a need, brings forth a host of issues, which, if they are not dealt with vigorously and effectively, may well result in a warped system of governance and a serious failure of accountability.