The Securities and Exchange Commission’s (SEC) recent guidance represents a modicum of progress toward improving the accountability of the proxy advising industry. The intent, the Commission said, is to clarify the appropriate way for public corporations to engage proxy advisor services and would ultimately subject the industry to greater regulatory scrutiny.
Corrective action by the securities regulator goes some way towards addressing long-standing concerns about the quality and integrity of advice provided by proxy advisory firms. Firming up the operation of proxy processes should, in turn, protect the interests of retail investors.
Two companies--Glass, Lewis & Co. (Glass Lewis) and Institutional Shareholder Services (ISS)--constitute almost the entire proxy advising industry, accounting for 97 percent of the market for proxy advice. Low margins and natural barriers to entry make competition against the incumbents an unattractive proposition.
Despite their patchy track record, the role played by proxy advisors in guiding corporate decision-making means they operate as shadow regulators. Large institutional investors vote in line with the recommendations of the two main proxy advisors roughly 80 percent of the time.
Glass Lewis and ISS use their influence to push political agendas at the corporate level on a wide range of matters that have dubious and highly contested relationships with the profitable operation of the firm. For instance, Glass Lewis in considering its proxy advice will examine a corporation’s human rights policies and the adequacy of its diversity reporting, it will also interject itself into Northern Ireland and Holy Land labor relations.
There are myriad concerns about the performance of the proxy advising industry: Not only is there an ongoing pattern of errors in their advice, but there are also intractable conflicts of interest embedded in the multiple service lines they operate.
The corporate governance consulting aspect of their businesses directly conflicts with the provision of advice to institutional investors about how to vote on governance measures they have recommended to their clients. The nature of the conflict is so profound that it can only be fully resolved via a separation of proxy advising services from corporate governance consulting.
Defective proxy advice has been a major headache for listed companies and shareholders virtually since the advent of the industry. The U.S. Chamber of Commerce’s fourth annual proxy season survey revealed a diminished confidence in the advice provided by proxy advisors to corporate America. Over 80 percent of companies surveyed carefully monitored proxy advisor recommendations for “accuracy or reliance on outdated information.” At the same time, only 39 percent of corporations believed that advisory firms “carefully researched and took into account all relevant aspects of a particular issue.”
Neither have proxy advisors demonstrated responsiveness to companies’ concerns about their recommendations. The Chamber’s survey found that requests to meet with proxy advisor firms were denied in 57 percent of cases, and companies requesting previews of proxy advisor recommendations received them less than half the time.
In late 2018 the SEC staff hosted a roundtable discussion on proxy processes, followed by an extensive public comment process. These comments were used to form the new guidance issued last month, which builds on existing guidance issued by the Commission back in 2004.
While the SEC’s fresh guidance does not offer a comprehensive regulatory solution to the problems with the proxy advising industry, it should serve to make them more accountable. The new guidance clarifies the responsibilities of investment advisers when they engage the services of proxy advisors, and states that investment advisers have an obligation to monitor their use of proxy advisors.
The SEC’s guidance also clarified that a firm providing proxy voting advice is considered to be engaged in solicitation and therefore subject to federal proxy rules. The result of this interpretation is that proxy advice is prohibited from containing any false or misleading statements in relation to any material facts. Meeting that requirement can necessitate that proxy advisors explain the methodologies underpinning their advice and disclose their information sources, along with any material conflicts of interest.
Most importantly, the SEC guidance set out that investment advisers should consider the capacity and competency of proxy advisers to adequately analyze the matters for which the investment adviser is responsible for voting. In rendering this assessment, an investment adviser could consider “the adequacy and quality of the proxy advisory firm’s staffing, personnel, and/or technology.”
The new SEC ruling will ensure that proxy advisors and their analyses are given more scrutiny, which offers the prospect of some improvement in their performance and better outcomes for retail investors.
While the Commission’s updated guidance represents progress, its protocols for the engagement of proxy advisors do not amount to fundamental reform of the regulatory regime. Only legislative intervention can resolve the serious shortcomings that continue to bedevil the industry.
Time will tell if the Commission’s updated guidance will materially improve the performance of proxy advisory firms. While the enhanced regulatory guidance may offer some relief to long-suffering retail investors, the major reform of the industry will have to be delivered through legislative change or through major rule changes by the SEC.
Burchell Wilson is a consulting economist with Freshwater Economics.