To Accelerate the Trump Boom, Rein In Proxy Advisors
The Securities & Exchange Commission is usually all over undisclosed conflicts of interest. But it took the financial-market regulator 14 years to reverse one decision in which it had essentially declared that undisclosed interests were nothing to worry about. This month (EDS: Sept. 13) the SEC rescinded earlier staff guidance that essentially told money managers that they didn’t have to worry about any conflicts of interest at the companies that advise them on how to vote shares that they own. It’s a first small step toward greater accountability in the little-noticed, but increasingly important corner of the investing world known as proxy advisory.
Proxy advisors issue recommendations on how institutional investors should vote their shares. These investors need this advice in part because federal rules require these investors to vote—and require them to have good reasons to vote the way they did. These requirements have given rise to an industry known as proxy advisory. And two companies—Glass Lewis and ISS—dominate the field of counseling shareholders on how to vote their shares, as well as actually processing the votes on behalf of their clients.
The funny thing about shareholder democracy is that most shareholders don’t seem to care about it. Last year, just 29% of retail shareholders voted their shares, according to PWC. Despite this lack of enthusiasm from actual stockholders, shareholder democracy seems to be one of those things that nobody is against. It sounds so nice, and like Mom and apple pie, so American. And with most of us owning shares directly or indirectly, we’re a nation of shareholders.
On the face of things it seems only right that we, as owners of these companies, should have a say in how they’re run. But like any democracy, the shareholder kind is easily captured by special interests, especially when retail shareholders, for the most part, don’t vote.
Institutional shareholders—mutual funds, pensions funds and the like—do vote, because they have to. In 2017 institutional shareholders voted 91% of their shares. And our stock markets, once dominated by retail shareholders, are more and more controlled by large institutional investors, creating greater opportunity for mischief in the name of democracy.
The House of Representatives last December passed a bill, H.R. 4015, to regulate proxy advisors. The Senate Banking Committee has held hearings on the bill but has not yet sent it up for a vote. As midterms near and the year winds down, there’s a danger that the “Corporate Governance Reform and Transparency Act” will die in the Senate, and an opportunity to bring greater transparency to this shadowy corner of the corporate governance landscape will have been missed.
In the world of stock ownership, “proxies” are votes cast on behalf of shareholders who do not show up in person at a company’s annual meeting. These days, that’s almost every shareholder in almost every publicly traded company in the U.S.
Institutional Shareholder Services was founded in 1985 to advise institutional investors on how to cast their proxy votes. Three years later, they were given a great gift by the federal government—the first of many in the history of the proxy-services business. That year, the federal Department of Labor issued what is known as the “Avon Letter,” which advised institutional investors and pension-fund managers under the DOL’s jurisdiction that they had a fiduciary duty to vote their proxies in a way that protected the interests of their beneficiaries. In 1994, the DOL issued an “Interpretive Bulletin” on proxy voting. Importantly, the bulletin states that the fiduciary must “not subordinate the interests of the participants and beneficiaries in their retirement income to unrelated objectives.”
The bulletin also required institutional investors to keep records of their proxy votes and to develop and maintain institutional policies that would govern their voting decisions.
In 2002, the SEC got in on the act under Harvey Pitt, expressing its view that investment advisers under its jurisdiction “must exercise its responsibility to vote the shares of its clients” in a manner consistent with its fiduciary duties.
For ISS, these burgeoning requirements were a gold mine. Today, ISS and its younger competitor, Glass Lewis, run a tidy business helping institutional investors comply with voting and record-keeping requirements, and through their proxy-advisory services, also help those investors by providing the government’s required rationale for voting the way they do.
ISS says there no barriers to entry into proxy services, and yet ISS and Glass Lewis together are reported to control 97% of the proxy-advisory market. ISS calls that number “conjecture,” and told the Senate Banking Committee that “this is not a statistic we have verified or can confirm.” Be that as it may, they are widely recognized as by far the biggest players in this government-fueled market for proxy services.
In parallel with the government’s push not only for proxy voting, but for the whole panoply of proxy services—record-keeping, research and voting policies—another major shift was happening in American financial markets. And this too redounded to the benefit and increased the importance of the proxy advisors. In the 1980s, institutional investors owned, on average, between 20% and 30% of a publicly traded company’s stock. By 2010, that number had risen to 65%. According to one estimate, institutional ownership of the 1,000 largest companies on the U.S. markets is more than 75%.
Thirty years ago, when ISS got its start, a diversified stock portfolio might hold dozens of different stocks. Today, with high-speed algorithmic electronic trading and index funds dominating the markets, large institutions hold the stock of thousands of companies. All of them have proxies that must be voted, which range from the mundane to wildly controversial.
The biggest institutions may have the biggest capacity to research and come to judgments on those voting decisions, but they also own stakes in the largest numbers of companies, and there may be no institutional investor in existence that can stay on top of all them.
This situation is compounded yet again by the government-mandated proliferation of issues on which shareholders can or must vote. The 2010 Dodd-Frank financial regulation law required all publicly traded companies to present executive compensation to shareholders for a vote. Other reforms in recent years have made it easier for special interests to put pet issues to a vote of shareholders. A favorite of the “corporate social responsibility” crowd are various motions to require disclosure of environmental or climate-change risks that a company may face.
Nobody ever asked shareholders—institutional or otherwise—if they wanted a “say on pay” or a report—prepared at shareholders’ expense—about climate change. Say-on-pay was a populist issue given currency by outrage over the high pay of bank executives who’d been bailed out during the 2007-2008 financial panic. It has since become a mostly pro-forma exercise in ratifying decisions by the board.
There are, to be sure, close-fought proxy battles. Late last year, an activist shareholder, Nelson Peltz, fought for a seat on the board of Procter & Gamble, over the objections of management. The resulting vote was so close it made Florida in 2000 look like a landslide. P&G appeared to have prevailed, but the margin was so slim that P&G put Peltz on its board anyway. ISS and Glass Lewis both recommended a vote in favor of Peltz.
But close or not, controversial or not, institutional investors have to vote, have to have a reason why they voted the way they did, and a record of both how they’ve voted and their policies around voting. The SEC even has forms for these things. If you happen to be an investment manager trying to outperform your benchmark—but not an activist like Peltz, for example—you might well conclude that most of that is a nuisance most of the time. And you’d gladly pay the proxy advisors to make it go away, so you can focus on picking stocks or getting in front of macro trends, or whatever it is you to do to make money for your investors.
On the other hand, if you manage an index fund invested in hundreds or thousands of companies, and your raison d’etre is matching the return of the market or some sector, every incremental piece of overhead cuts into your investors’ returns after fees, so employing a small army to research proxy votes and make and implement informed decisions about most of them isn’t a good option.
In either case, if the proxy advisers suggest you oust Elon Musk as chairman of Tesla—as happened earlier this year—you’ll probably notice, and you may or may not listen. (61% of Tesla’s stock is owned by institutions.) But on a thousand other things, you’re probably content to go with the flow. Indeed, research from the American Council on Capital Formation shows that the largest institutional investors vote in line with the proxy advisors’ recommendations more than 80% of the time, and in some cases upward of 90% of the time. The alternative—having a research shop devoted to monitoring the myriad votes of thousands of companies—is expensive, difficult, and risky, unless being an activist is what your fund is set up to do.
And recently, Glass Lewis and ISS have taken an increasing interest in environmental and social issues. The ACCF noted in its recent paper on the subject that Glass Lewis and ISS have both become more likely to favor shareholder proposals requiring greater disclosure and reporting regarding risks and “mitigation initiatives.”
A number of companies already voluntarily report out on environmental and political risks, if they are material and germane to their businesses. Some activists and activist investors are pushing for more, and disclosure often seems like a low-cost concession. Certainly those who push most forcefully for disclosure of environmental risks (and climate change is the chief target here) tend to argue that disclosure both protects investors and may even help long-term performance by nudging companies onto a more sustainable path.
But a recent study by Harvard’s Joseph P. Kalt and Lexecon Senior Managing Director L. Adel Turki found “no statistically significant impact on company returns one way or the other” from increased disclosure of climate-change-related risks. They didn’t find any harm in them, but nor did they discover any benefit from greater corporate disclosure of climate-change risks. A null result sounds uneventful, but providing these disclosures, researching them, collating and justifying the data that underlie them—all these things cost money and take time. And it just so happens that ISS runs a nice side business setting up these systems for public companies.
But if they do not improve performance or enhance returns, they are hard to justify if you have a fiduciary duty—to your shareholders, as management, or to you investors and beneficiaries as an investment manager or adviser.
And going back at least to the Department of Labor’s 1994 Interpretative Bulletin, a fiduciary’s duty to vote is a duty to vote in line with your beneficiaries’ financial interest, and not to subordinate those interests “unrelated objectives.” It is precisely these unrelated objectives that critics of the proxy advisors worry about. ISS’s current “voting policies” state that ISS will generally recommend voting in favor of “resolutions requesting that a company disclose information on the financial, physical, or regulatory risks it faces related to climate change on its operations and investments or on how the company identifies, measures, and manages such risks.” This is a change from earlier guidance.
Support for climate-change disclosure will certainly help keep the environmental activists off of ISS’s back, but per the Kalt/Turki paper, it’s far from clear—from a fiduciary perspective—that such a position is justified.
ISS says that its consulting and proxy advisory arms are firewalled, that the proxy researchers don’t even know who the consulting clients are, there are safeguards in place, and so on. All of this is no doubt true, and may even be effective. But none of it avoids the perception that buying these services from the folks who decide whether to recommend a vote for or against management on some of these issues might not be a bad idea anyway.
Remarkably, despite their own calls on companies to disclose more, to appoint more independent directors and to look at possible conflicts of interest on corporate boards, they themselves are lightly regulated. HR 4015 isn’t a perfect bill. But at least it would impose standards for disclosure, transparency and conflicts-of-interest on an industry that increasingly acts as a kind of shadow regulator of corporate governance.
Washington has been a busy place this year, and corporate governance may not seem sexy in light of everything else happening on the hill. But the “Trump economy” has largely been a story of successful tax and regulatory reform. Reining in the proxy advisors would be one more step in the right direction.
