The Securities and Exchange Commission’s roundtable on proxy advisory firms in December was long overdue. In July 2010, the agency asked for public comment about these organizations in light of growing concerns that “proxy advisory firms may be subject to conflicts of interest or may fail to conduct adequate research and base recommendations on erroneous or incomplete facts.” Since then, silence.
Meanwhile, legislation including “say on pay” has increased the power of proxy advisory firms, especially the two biggest, Institutional Shareholder Services (ISS) and Glass Lewis and Co. Like the bond rating agencies of the last decade, these firms have been granted significant influence by the SEC in the shaping of corporate governance policies for all U.S. public companies. There is evidence that such influence may not be for the better, as far as shareholder value is concerned.
Proxy advisory firms have become prominent as the result of government regulations. In 2003, SEC rules and related actions allowed institutional investors to rely on advice from third-party advisory firms to fulfill their fiduciary obligations when they voted their shares.
In prior years, Department of Labor regulations had effectively established a mandate for all institutional investors to vote their shares on all proxy issues. But many institutional investment advisers lack the resources to consider thoughtfully the hundreds or thousands (or more) of proxy issues that come before them for a vote. As a result they rely largely—or in many cases nearly exclusively—on the advice of proxy advisory firms.
Research has consistently shown a strong correlation between recommendations of proxy advisory firms and proxy voting. The policies these firms prescribe also influence decisions by the directors of public companies. But our research, published in the Journal of Accounting and Economics, found that when public companies implement certain “best practices” promulgated by proxy advisers—in this case with regard to stock option exchange programs—their gains in shareholder value are on average 50% to 100% less than other firms.
The problem is that few proper rules of corporate governance can be properly evaluated without deep knowledge of a company and its management. Rule-based approaches, such as those developed by proxy advisory firms, tend to be based on “best practices”—better termed “one-size-fits-all best guesses”—that have little or no relation to the specific strategic, competitive or management situations facing individual companies. We are unaware of any evidence from proxy advisory firms that their policy choices benefit shareholders. Yet rule-based approaches are what the SEC has effectively prescribed for institutional investors.
Another concern, even more basic, is the current regulatory structure—which effectively requires all institutional investors to vote their shares, prove that their votes are not conflicted, and allows them to prove this by relying on proxy advisory firms. Does this system help or hurt shareholders? SEC Commissioners Daniel Gallagher and Michael S. Piwowar attempted to raise this fundamental issue at the roundtable. Unfortunately, there was little interest among the proxy advisers and institutional investors, who dominated the meeting, to pursue the matter.
Equally unfortunate, there was no direct representation of corporate directors on the panel, leaving out the very people the law requires to be responsive to shareholders. A thorough assessment of the impact of proxy advisers (and proxy voting regulation) on all shareholders cannot be obtained without understanding how corporate board members evaluate feedback from proxy voting and turn it into action.
We suggest that regulators rethink rules about when and how institutional investors are required to execute shareholder votes. Yes, investors should vote their shares if doing so is expected to increase shareholder value. But it is surely worth considering what would happen if institutional investors weren’t required to vote in every election. Individual investors have no such obligation.
The SEC should reconsider the entirety of the shareholder voting process, including the mandate that institutional investors participate in all corporate votes. Institutional investors should be free to make judgments about when it is in the interests of their shareholders to expend resources to research and vote proxies. They also must demand that proxy advisers ground their analyses and recommendations in sound, transparent research that ensures enhancement of shareholder value.
David F. Larcker is a professor at Stanford Graduate School of Business, senior faculty at the Stanford Rock Center, and the director of the school’s Center for Leadership Development and Research, where Allan L. McCall is a researcher. This piece was originally published in the Wall Street Journal in December and is republished with permission.