Hearings before the House Capital Markets Subcommittee revealed a growing consensus that proxy advisory firms have become the de facto standard setters for U.S. corporate governance and need to either adopt best practices and core principles or be regulated by the SEC. Subcommittee Chair Scott Garrett (R-NJ) emphasized that Congress must ensure that the proxy system works for US investors. The proxy system and the distribution of proxies have become quite complicated and many investors have come to rely exclusively on the recommendations of proxy advisory firms to vote their shares on proxy questions. Chairman Garrett analogized the growth in the influence of proxy advisory firms to the rise of the use of credit rating agencies before the financial crisis.
Proxy Advisory Firms. Chairman Garrett also mentioned that SEC staff interpretations have essentially allowed institutional investors to outsource their proxy voting duties to supposedly independent proxy advisory firms. The result is that proxy advisory firms currently wield an enormous amount of influence over the proxy voting process. The Chair also remarked on the conflict of interest issues around proxy advisory firms. They have no duty to provide advice in the best interests of shareholders and do not factor shareholder value into their recommendations. All that said, Chairman Garrett said that proxy advisory firms serve a valuable role in corporate governance, but should not be enshrined as sole guardians of proxy corporate governance.
Rep. Brad Sherman (D-CA) said that the real battle is between crony capitalism and free market capitalism, which demands that shareholders need good advice and freedom from frivolous lawsuits. Shareholders should not be deprived of proxy advice, he reiterated. Rep. Sherman fears that we are moving to the lowest common denominator on shareholder right, adding that Congress must ensure that shareholders have the information they need and have the protection that a well-drafted corporation statue can provide.
Rep. Robert Hurt (R-VA) noted that proxy advisory firms must be sufficiently transparent and accountable. As the SEC has acknowledged, he observed, there can be conflicts of interest when proxy advisory firms provide recommendations and other services, such as management consulting services.
Rep. David Scott (D-GA) said that, given the many recent failures of corporate governance, it is imperative that Congress examine all of the issues around which proxy advisory services make recommendations. He also queried why only two companies, ISS and Glass Lewis, handle 97 percent of the proxy advisory market. Rep. Scott is, like other members of the subcommittee, concerned about proxy advisory firms providing consulting services in addition to proxy voting recommendations, thereby leading to potential conflicts of interest. He questioned what policies and procedures proxy advisory firms employ to ensure that their recommendations are independent and not influenced by any consulting fees that they get from issuers. Rep. Scott further noted that the SEC has not taken any action in the wake of the staff study.
In his testimony, former SEC Chair Harvey Pitt said that proxy advisory firms exercise extensive but unfettered influence over corporate governance and indeed have become the de facto arbiters of U.S. corporate governance. They are powerful but unregulated, he added, and serious conflicts of interest permeate their operations.
Chairman Pitt emphasized that effective and transparent corporate governance encouraging meaningful shareholder communication is critical. Informed and transparent proxy advice can help corporate governance only if the advice being provided is solely motivated by the advancement of the economic interest of investors.
Eschewing federal regulation of proxy advisory firms, Chairman Pitt, testifying on behalf of the U.S. Chamber of Commerce, recommended the adoption of industry best practices and core principles. The Chamber has suggested best practices, he noted, and these are standards that the industry should embrace and follow. He urged the SEC and the institutional investor community to lend support to a code of best practices.
Chairman Pitt also testified that two 2004 SEC no-action letters, ISS and Egan-Jones, had the legal effect of permitting registered investment advisers to rely exclusively on a proxy advisory firm‘s general policies and procedures pertaining to conflicts of interest, as opposed to any specific conflicts a proxy advisory firm might have with respect to a particular issue or a particular company about which the proxy advisory firm might make a recommendation to determine if the proxy advisory firm was independent and could be relied upon to cast a vote for the investment adviser, without the adviser being deemed to have violated Rule 206(4)-2 of the Investment Advisers Act or any other provision of the federal securities laws. Earlier this year at a Chamber event, Chairman Pitt had said that, taken together, the two no-action letters create a regulatory environment in which portfolio managers believe that if they outsource the proxy vote they have avoided major problems under Rule 206(4)-6 and their own fiduciary obligations.
Picking up on Chairman Pitt’s point that many institutional investors have essentially outsourced their proxy votes to proxy advisory firms, Chairman Garrett asked who is the fiduciary duty owed to, to which Mr. Pitt replied the fiduciary duty remains with the institutional investors. They cannot divest themselves of it, he said, adding that the NALs are the vehicle by which they try to outsource the duty. To Chairman Garrett’s question of whether the proxy advisory firm has a duty to investors, Mr. Pitt responded that the firms have a duty akin to fiduciary duty, a duty of truthfulness, which is not the same as a fiduciary duty.
Testifying on behalf of the Society of Corporate Secretaries and Governance Professionals, Darla Stuckey, referring to the SEC concept release, said that proxy advisory firms are one of the few participants in the proxy voting process that are not generally required to be registered or regulated by the SEC. There is no accountability by proxy advisory firms even though, given the current structure of the proxy system, they control anywhere from 20-40% of the vote collectively on routine matters at widely held companies. When proxy advisory firm recommendations come out, large blocks of votes are cast almost immediately in automated voting decisions. These ripple out both from clients that follow the main policy of each advisory firm, she noted, and those that have so-called custom policies that are tweaked based on simplistic mechanical inputs.
While proxy advisory firms are not beneficial owners of any company’s shares, reasoned the corporate secretaries society, the two largest proxy advisory firms each effectively control a portion of the vote that is much larger than the Schedule 13D threshold (5%), and even larger than the 10% affiliate status threshold, yet they are not subjected to any kind of regulatory regime. The Society pointed out that proxy advisory firms may produce reports with material misstatements and omissions without any legal consequences for the firm.
Similarly, proxy advisory firms’ voting policies are also unregulated. There is no regulatory regime that governs the manner in which these firms develop their policies or form the recommendations they make. The policy development process at proxy advisory firms is not sufficiently transparent, contended the Society, and it is not clear who actually participates in the process.
The Society believes that proxy advisory firm voting influence undermines the integrity of the voting system for a number of reasons, including that proxy advisory firms are subject to conflicts of interest and make factual mistakes in their analysis, with the effect that their voting guidelines are erroneously applied to the company’s proposal and the voting recommendation is inaccurate. Proxy advisory firms are actually subject to four types of conflicts of interest, maintained the Society. The first occurs as a result of proxy advisory firms selling services to both institutional clients and issuers. The second conflict arises when proxy advisory firms make favorable recommendations on
proposals submitted by their own investor clients. The third conflict stems from proxy advisory firms’ interest in recommending certain proposals that are likely to expand their influence and future market. The fourth may arise when an owner of a proxy advisory firm takes a position on a proxy voting issue and the firm also issues a voting recommendation on that issue (this applies to Glass Lewis only since it is owned by a major public pension fund).
The Society recommended that proxy advisory firms be required to become registered investment advisors. In this way, the practices and procedures of such firms would be subject to SEC examination, which should provide additional discipline and accountability to the system. Once registered, proxy advisory firms would need to establish to an oversight authority that they are following their procedures and would need to provide factual support for the bases of their disclosures.
In his testimony, former SEC Chief Accountant Lynn Turner said that in today’s global markets an asset manager may invest in dozens of capital markets, and in thousands of public companies. For example, at Colorado PERA, the fund makes and manages
investments on a global basis in 7,000 to 8,000 companies. The proxies for these companies may involve the election of numerous directors, approval of compensation and acquisitions, shareholder initiatives submitted for shareholder approval, and any number of additional matters.
Many mutual or pension funds do not have unlimited staff who can read thousands of proxies and then research and submit an informed vote on the issues as required. Mr. Turner said that it would take well over a hundred staff, at a very significant cost to vote 8,000 proxies in a global market place. That would be a cost that would have to be passed on to investors, he noted, significantly increasing their fees, and reducing their investment returns, and ultimately, the amounts they are trying to save for retirement.
Instead, the funds rely, in part, on research they can buy from ISS and/or GL or others, along with their own research and proxy voting guidelines, to make a decision on how to vote.