Now's the Time to Fix the Broken Proxy System

When the SEC passed a regulation in 2003 to constrain the conflicts of interest of mutual funds, the commissioners opened a gigantic can of worms. At a Roundtable today, a new Securities & Exchange Commission can start to put the lid back on.

The 2003 regulation produced a festival of unintended consequences, the main one being to outsource decisions on proxy voting – to the detriment of small investors, retirees, and businesses. Over the past 15 years, two proxy advisory firms that hardly anyone had heard of – Institutional Shareholder Services (ISS) and Glass Lewis (GL) –have become the prime arbiters of corporate governance, attempting to put their own political stamp on the American economy.

Meanwhile, ISS faces conflicts even worse than those the rule was intended to minimize, and both firms make proxy recommendations informed by deep ideological bias in areas such as the environment, labor union power, executive compensation.

One outrageous example of the arrogance of the firms is that GL has decided to pose as a super-regulator. In its published guidelines, GL states that it “will take note of instances where a company has successfully petitioned the SEC to exclude shareholder proposals.” If the SEC denies a vote on a proposal that GL believes is “detrimental to shareholders,” the proxy advisory firm will officially recommend rejecting members of the company’ governance committee. In other words, GL can effectively override a government agency.

What’s the remedy? In 2013, the Mercatus Center at George Mason University published our paper titled, “How to Fix Our Broken Proxy Advisory System.” Since then, under both Democratic and Republican Administrations, the SEC has taken steps to mitigate the damage.

In 2014, the SEC’s Staff Legal Bulletin No. 20 tried to clear up confusions, such as whether mutual fund managers have to vote on all proxy questions. And just two months ago, the SEC rescinded the Egan-Jones no-action letter, issued in 2004 by staff. That letter had limited the liability of proxy advisors.

The solution requires more than staff letters. The SEC should pass a permanent rule, and the Labor Department, which regulates pension funds, should do the same.

First, the funds should be the sole arbiters of whether to vote on proxy questions. The single test is whether the vote enhances the value of their clients’ investment. The funds would present a transparent policy to their clients. For example, it might be: “We will never vote shares because the costs outweigh the benefits,” or, “We will vote as recommended by management,” or “We will vote only in rare cases where we believe a proposal will substantially enhance shareholder value.”

Second, proxy advisors should enjoy no special protection from liability, and they must be free of conflicts. Currently, they are not. ISS sells consulting services, advising corporations on how to get positive proxy recommendations from…. ISS. In addition, ISS and GL earn substantial income by advising “socially responsible” or “ESG” (environmental, social, and governance) funds like Calpers, the $351 billion California public-employee pension giant. As a result, the proxy advisors have an incentive to favor proposals that are backed by these clients.

Third, the SEC and the Labor Department should affirm that funds are breaching their fiduciary duty when they vote to impose criteria other than clear value-enhancement on companies whose shares they own. In a 2016 paper, Alicia Munnell, a former Treasury Department official under President Clinton and now director of the Center for Retirement Research at Boston College, and her colleague Anqi Chen, concluded:

“While social investing raises complex issues, public pension funds are not suited for this activity. The effectiveness of social investing is limited, and it distracts plan sponsors from the primary purpose of pension funds – providing retirement security for their employment.”

There’s a backlash developing against funds that impose what they consider ESG standards on their investments. In an election last month, a Corona, Calif., police sergeant named Jason Perez defeated Priya Mathur, board president of Calpers. Mathur, according to Barron’s, was a “champion of Calpers’ focus on ESG investing.”

Perez said in an interview: “Calpers’ social investment focus and lack of returns received a lot of attention of labor up and down the state…. Everyone noticed the performance and [Calpers’] desire to concentrate on social issues.”

It would be a mistake for today’s Roundtable to take a narrow focus. Instead, it should be the kickoff for a thorough examination by the SEC of the role of the dangerous effects of ideological pressure on U.S. investment management in general. It’s a serious problem, but it can be fixed.