May 2, 2024

Is the proxy advisory industry a net benefit or cost to shareholders?

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In Seven Questions About Proxy Advisors, from the Rock Center for Corporate Governance at Stanford, the authors, David Larcker and Brian Tayan, examine the proxy advisory firm industry—all two of them. Well, actually, as the paper observes, there are a large number of small players, but Institutional Shareholder Services and Glass Lewis “control[] almost the entire market.” It’s well-known that recommendations from ISS and GL are considered important—sometimes even a major aspect of the battle—especially in contests for corporate control and director elections. But, the authors point out, the extent of their influence on “voting outcomes and corporate choices is not established, nor is the role they play in the market. Are proxy advisory firms information intermediaries (that digest and distill proxy data), issue spotters (that highlight matters deserving closer scrutiny), or standard setters (that influence corporate choices through their guidelines and models)? Because of the uncertainty around these questions, disagreement exists whether their influence is beneficial, benign, or harmful. Defenders of proxy advisors tout them as advocates for shareholder democracy, while detractors fashion them as unaccountable standard setters.” The paper examines “seven important questions about the role, influence and effectiveness of proxy advisory firms.” The authors explore why there is so much controversy about the purpose, role and contribution of proxy advisory firms, asking whether “the proxy advisory industry—as currently structured—[is] a net benefit or cost to shareholders?”

SideBar

As the authors point out, this controversy is reflected in the SEC’s regulatory policy swings regarding proxy advisors, as well as the rounds of litigation in which, for example, the National Association of Manufacturers is both intervening in support of the SEC proxy advisor rules in one case and suing the SEC on its proxy advisor rules in another case.

In September 2019, the SEC published in the Federal Register a new interpretation and guidance directed at proxy advisors confirming that their vote recommendations were considered to be “solicitations” under the proxy rules and subject to the anti-fraud provisions, and providing some “suggestions” about disclosures that would help avoid liability. (See this PubCo post.) Not surprisingly, the proxy advisory firms were none too happy with the new interpretation and guidance, leading one, ISS, to sue the SEC. (See this PubCo post.) But the SEC was, at the time, considering new rules on the topic, and the case was held in abeyance until that process was complete. Then, in 2020, the SEC adopted amendments to the proxy rules that codified the SEC’s interpretation regarding proxy advisors and “solicitations.” The 2020 rules added to the exemptions from those solicitation rules two significant new conditions, viewed favorably by many companies and business organizations—one requiring disclosure of conflicts of interest and the second designed to facilitate effective engagement between proxy advisory firms and the companies that were the subjects of their advice. The case was then reactivated and both parties filed for summary judgment. (See this PubCo post).

In June, soon after assuming his position as SEC Chair, Gary Gensler directed the staff to take another look at the 2020 rules, and the staff announced that it would decline to recommend enforcement in the interim. Once again, the Court held the case in abeyance as the SEC contemplated new regulatory action that could have narrowed or eliminated the issues raised. In 2022, the SEC adopted new amendments to the proxy advisor rules reversing some of those key company-favorable provisions governing proxy voting advice that were adopted in July 2020. Importantly, however, under the 2022 amendments, proxy voting advice would still be considered a “solicitation” under the proxy rules and proxy advisors would still be subject to the requirement to disclose conflicts of interest. (The new amendments rescinded the second central condition that was designed to facilitate engagement between proxy advisors and the subject companies—the notice and awareness provisions—which some might have considered a core element of the 2020 amendments.) Because, when the SEC ultimately took action, it did not change the definition of the term “solicitation” from the 2019 interpretation and guidance and the 2020 amendments, and the SEC’s interpretation of that term was the subject of Counts I and II of ISS’s amended complaint, the case was again reactivated. NAM, which favored the 2020 amendments, intervened on the side of the SEC (and also became a defendant). Over four years later, in February 2024, the DC District Court held that the SEC’s rules regarding proxy advisory firms were invalid, stating that the “SEC acted contrary to law and in excess of statutory authority when it amended the proxy rules’ definition of ‘solicit’ and ‘solicitation’ to include proxy voting advice for a fee.” (See this PubCo post.) Now, both NAM and the SEC have filed notices of appeal with the DC Circuit. (See this PubCo post.)

As noted above, because NAM favored the 2020 amendments, NAM also has a separate case against the SEC before the Fifth Circuit challenging the 2022 amendments to the proxy advisor rules. In July 2022, NAM filed a complaint against the SEC, asking that the 2022 amendments—which, as noted above, reversed some of the key provisions in the 2020 rules, including the company-favorable condition that would have required company engagement—be set aside under the APA and declared unlawful and void. In September, NAM filed a motion for summary judgment, characterizing the case as “a study in capricious agency action.” In its complaint, NAM had contended that the 2022 rules were “both procedurally defective and arbitrary and capricious.” The SEC, NAM argued, “has come to a completely opposite outcome to that reached only two years ago, and it has done so on the basis of the exact same factual record that drove the SEC to adopt the 2020 Rule in the first place. The SEC does not—no doubt because it cannot—offer any compelling justification for why the exact same factual record requires a different result this time around.” In NAM’s subsequent motion for summary judgment, NAM contended that the 2020 rules represented a rulemaking compromise that was the result of a “decade of bipartisan policymaking”; new Chair Gensler, NAM argued, made “an abrupt about-face.” In December 2022, the Federal District Court for the Western District of Texas issued an Order granting summary judgment to the SEC and Gensler and denying summary judgment to NAM in that litigation. (See this PubCo post.) NAM appealed, and in August 2023, a three-judge panel of the Fifth Circuit heard oral argument on NAM’s appeal. Let’s just say that the panel didn’t appear to be particularly sympathetic to the SEC’s case, with Judge Edith Jones mocking the SEC’s concern with the purported burdens on proxy advisors as “pearl-clutching.” (See this PubCo post.) The decision has not yet been issued.

Now, the SEC and NAM have written jointly to advise the court of their appeal in the ISS litigation. The letter advises that, while this case “addresses the SEC’s partial rescission of a 2020 rule relating to proxy voting advice businesses,… [a]mong other things, that rule codified the SEC’s existing interpretation of the term ‘solicitation’ to include providing proxy voting advice for a fee….That codification was not affected by the 2022 rescission at issue in this case.” In the ISS case, the letter continues, “the district court recently held that the provision of ‘proxy voting advice for a fee’ does not constitute ‘solicitation’ under the Exchange Act,” and the court vacated that codified definition of solicitation that was added in the 2020 amendments. Given the appeal by both the SEC and NAM in the ISS case, the “district court’s decision in ISS is therefore subject to further review; indeed, both the SEC and the NAM agree that the district court’s decision in that matter is incorrect.”

Market role. The first question raised in the paper relates to “the market role for proxy advisors.” There seem to be several conflicting theories in the mix here. The authors point out that the descriptions from ISS and GL of their own services suggest that they act as “information intermediaries, with proxy firms offering the benefit of economies of scale to aggregate and analyze information that would be costly for individual investment firms to replicate on their own.” Others suggest that their role is really “issue-spotting”—identifying issues that their institutional investor clients can then then research and analyze. Other theories contend that they are “controversy creators,” because they benefit from highly contested proxy matters, and “agenda setters,” because “boards feel pressure to alter their governance practices to conform to the standards of proxy advisory firms,” even if they might otherwise adopt a different approach. In this way, they tend to “compel conformity.”

Influence. The second question addresses the source of proxy advisors’ influence. The extent of their influence is not entirely clear. Studies cited by the authors demonstrate effects on voting outcomes ranging from 2% (retail investors only) to 51% for institutional investors, with various other studies showing impact on voting outcomes of 17%, 18%, 25% and 27%. The question that the authors focus on here is whether the influence of proxy advisors reflects the quality of their recommendations or “distortions caused by the regulatory environment.” On the one hand, institutional investors may be using the services of proxy advisors because of their value as “a cost-effective means of making informed voting decisions.” On the other hand, they suggest, the demand for their services might be “artificially inflated” by SEC requirements for institutional investors “to vote all matters on the proxy and to make their votes public. To satisfy this obligation, institutional investors must develop proprietary guidelines or rely on guidelines developed by third parties.” Could it be that these investors purchase services from proxy advisors as “an inexpensive way of meeting a regulatory requirement to vote”? The authors ask “[w]hat explains the large swings in voting outcomes that seem to be associated with their recommendations? Are investors making ‘informed decisions’ based on information provided by these firms, or are they ‘blindly following’ recommendations? Would the influence of proxy advisors be lessened if institutional investors were not required to vote?”

Validity of recommendations. Third, the authors inquire how proxy advisors test the validity of their recommendations. The authors don’t really know. ISS provides some information about the steps involved in its policy update practices, such as providing for review and comment on draft policy updates, but GL apparently does not disclose this type of information. What neither discloses, however, is whether they use empirical analysis to evaluate whether guidelines are “associated with positive outcomes, such as increased operating- or stock-price performance or a lower incidence of governance failures.” As a result, the authors contend, it’s unclear whether proxy advisors’ policies benefit shareholders. Various academic studies examining this issue have shown very mixed results—some showing positive shareholder returns and some negative. One 2010 study, for example, showed that ISS governance ratings were “not predictive of future operating performance, stock-price performance, or governance failure.” Unfortunately, the authors lament, academic researchers no longer have access to ISS recommendations for further study.

Director evaluation. Fourth, the paper looks at how proxy advisors evaluate individual directors. It’s an intimidating task, given that, the authors indicate, there are about 40,000 directors of U.S. public companies; a real evaluation would require “knowledge of the skills, domain expertise, and boardroom contribution of each director,” not to mention “access to the individuals themselves or some insight into how board meetings are conducted.” Well, that’s not happening. And, on this question, proxy advisors don’t offer much insight into how they assess director effectiveness. According to the authors, GL says only that it “assesses directors on their independence and performance,” and ISS “on independence, board composition, responsiveness, and accountability.” The authors report on two studies showing that proxy advisors influence the vote in both contested and uncontested elections. And, in this new era of universal proxy, the authors expect that their influence will increase. (See this PubCo post.) What’s not known, however, is “[w]hether they are able to reliably weigh the merits of competing individual nominees.”

CEO pay. The fifth question is whether proxy advisors can detect “excessive” CEO pay. The authors suggest that, because the public tends to view CEO comp as just too high, CEO pay is an issue that has attracted the attention of various stakeholders, driving them to “pay considerable attention to the voting recommendations of proxy advisory firms.” The authors cite studies showing the impact of a negative recommendation on comp-related proposal at levels ranging from 20% to 30%. When it comes to executive pay, both ISS and GL have “elaborate models to inform their voting recommendations,” which include negative recommendations in the event of various “excessive” or “egregious” elements. Notwithstanding substantial disclosure about the proxy advisors’ recommendations, the authors argue that “we do not know how these firms determine which practices are excessive or egregious.” There does not appear to be a consensus among independent researchers about what pay levels are excessive or about other related issues. Maybe proxy advisory firms have figured it out, but “if so, these models have not been externally vetted.” Nevertheless, several studies showed that proxy advisors recommendations make a difference, including one study showing that 72% of public companies “review the compensation policies of a proxy advisory firm and a significant percentage of these make changes to pay structure in response,” and another study showing that 53% of companies “offer less pay to the CEO than they otherwise would in order to avoid a negative recommendation from a proxy advisory firm.” Studies also found elements of standardization across companies—associated with lower shareholder value—attributable in part to proxy advisor influence.

ESG. Question six is whether a proxy advisor’s views of ESG influence its recommendations. The authors observe that, until recently, proxy advisors focused on traditional corporate governance issues, with only “muted” support for environmental and social proposals. Now, ISS has entered into the business of issuing ESG ratings, which the authors view as “a phenomenally complicated undertaking.” The authors indicate that there is not even a consensus among professional researchers as to whether ESG ratings have predictive or informational value. The authors advise that there is now a “risk for issuers…that a proxy advisor’s view of ESG quality might influence its recommendations on proxy items in a way that is not in the interest of shareholders.” They cite as one example, among others, the 2021 proxy contest between ExxonMobil and Engine No. 1, in which “ISS backed three of the four directors put forward by Engine No. 1 because of their advocacy for ESG concepts, swinging the outcome of a closely run election just before a sharp upturn in traditional energy markets.” One study showed that “the proxy-maximizing incentives of proxy advisory firms are not aligned with those of investors and can encourage these firms to promote controversy or cater to ESG investors to increase own market share at the expense of beneficial owners.”

Independence. The last question is whether proxy advisors are independent, a question that the authors consider to be “unresolved.” As one potential conflict, they point to the receipt by some proxy advisors of consulting fees from the same companies that are the subjects of their vote recommendations, a relationship that could bias those recommendations, as demonstrated in research cited in the paper. The authors suggest that regulators should introduce as a safeguard a mandate for increased disclosure. (Note that, as discussed in the SideBar above, the most recent version of the SEC rules related to proxy advisors included, as a condition to the proxy advisor exemptions from the proxy solicitation rules, a requirement to disclose conflicts of interest.) Alternatively, proxy advisory firms could be designated as fiduciaries, comparable to some other participants in the financial services industry, or at least “require greater separation between the consulting and advisory businesses of these firms.”

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