The US Society  of Corporate Secretaries and Governance Professionals (SCSGP) has called for the SEC to regulate proxy advisory agencies “to change certain of their current procedures”, in order to “make the processes and methodologies utilized by the proxy advisory firm more transparent, accountable and reliable”.

In a letter to the Secretary of the SEC, Elizabeth Murphy dated 27^th December 2010, they express concern along with evidence to supporting it, about the level of ‘influence’ that ISS in particular exerts over corporate America.

There’s statistical evidence supporting their suspicion that many investors are inclined to simply follow the voting advice they’re given even when there’s an identified error in the analysis(especially, they claim, hedge funds) rather than respond to issuers who reach out to them. Anecdotal evidence points to a correlation between the timing of the publishing of an ISS report and an uptick in voting decisions received, whilst simultaneously observing a significant swing in the voting patterns towards ISS vote recommendations. There are also systemic factors which re-inforce the practice, such as fund managers being required by their clients to justify why they don’t follow the proxy advisor’s vote recommendation. This effectively forces the manager to use the proxy advisor if they want to win investment mandates.

As unintended consequences go, it’s a pretty black and white example. Investors buy into the concept that there is value to be had (or protected) in using shareholder voting rights, so they build into their management mandates the requirement that these rights are made use of. But they go way beyond this by specifying not just how these rights are to be exercised, but effectively that they must be exercised by a specific third party (which may not be of the choosing of the fund manager). They are in fact taking away from their appointed managers the ability to freely make those valuable decisions on the back of which their investment mandates are evaluated. It’s a crazy world where investors require their fund managers to use a specified voting service but allow their custodians (who have even less economic interest in the quality of voting decisions than the SCSGP claim proxy advisors do) to impose one on them.

The level of influence doesn’t impact just investors. Because of the degree to which they claim investor opinion is dictated by proxy advisors, issuers feel obliged to seek to make proposals that will secure a positive voting recommendation from proxy advisors, rather than consulting with investors about what they want. The nearest issuers can feel sure they will get an ISS blessing is by subscribing to ISS advisory services simply to access the assessment methodology to understand what is ‘permissible’ and what is not.

In short, even to a lay-person reading the SCSGP letter, it seems clear that issuers feel ‘bullied’ by proxy agents and their recommendations.

The letter cites a number of regulatory proposals they would like to see implemented, including:

• Requirement for procedures for managing conflicts of interest
• Disclosure of the methodology behind voting recommendations
• Disclosure of data collection and analyst training methods and reports produced per analyst
• Provide issuers with at least 5 business days to review draft reports prior to publication
• Disclose consultation, engagement and appeal processes employed with issuers prior to and after report publication
• Include issuer responses in the research reports, including where the issuer disagrees with the recommendation and whether a recommendation has been changed after issuer review
• Report the number of incidents where disagreement with an issuer over factual statements have occurred
• Disclose remuneration research models to prevent the necessity of issuers to have to buy consulting services in order to get a favourable recommendation on stock plans

The requests are accompanied by some lengthy criticism of their members’ experiences of being the subject of research by ISS and, to an extent, Glass Lewis. Some of these criticisms may be justified, others arguably less so.

In addition to the conflicts of interest related to selling consulting services to issuers, it is claimed by the SCSGP that it’s ISS’s commercial interest to promote those consulting services which leads them to make voting recommendations and adopt policies to that end. But then again, we might expect ISS to support their own consulting standards with their voting recommendations because, well, that’s what they believe and define good governance to be.

A slightly more complex (and valid) potential conflict of interest concern is where a shareholder who is a client of the proxy advisor tables a shareholder resolution. There’s onus on the advisor to ensure that they don’t appear swayed by the investor client viewpoint (though one wonders where the line might be drawn where both the investor and issuer are clients of the proxy advisor).

Aside from conflicts of interest, there’s also the problem of mistakes. We all make them, but they should all be acknowledged and rectification sought.

However, the SCSGP claims that two thirds of factual mistakes that affect recommendations are not corrected nor the recommendation amended. That’s dangerous especially in respect of those clients who blindly follow the recommendation, but also those for whom ISS is the only source of information used. However, at least it is possible for large issuers to ascertain an ISS mistake and attempt to remedy the damage – issuers claim they have no right of reply or access at all to Glass Lewis reports (as is the case for small and mid cap companies with ISS reports too).

Other typical areas of complaint about mistakes included insufficient time or opportunity to review them, irrelevant or misleading (formulaic) peer groups.

The conclusion of the complaints is that “persons having the fiduciary responsibilities of share ownership need to exercise more responsibility in decision-making with respect to the voting process”.

So, in the final analysis, what are the issues here?

Well, issuers clearly want better access to the research process. Given the complaints they cite and the all-pervasiveness of influence that they fear, that’s understandable. But if they want proxy advisory to become a regulated industry, then that may put an end to issuer approval of draft research reports altogether – after all, it is explicitly prohibited to circulate draft broker reports to the issuer in question. Where that comparison falls short is that single broker houses may not be deemed to be anywhere near as influential on their own as ISS seem to be. That’s because there’s healthy competition between brokers for custom. A genuinely competitive proxy advisory market would certainly force the process and transparency improvements the SCSGP calls for, and would certainly be a positive development.

The timescale issue is a different problem. Part of the reason why there’s so little time for issuer review of analyst reports is that the analyst teams are deluged with 80% of their work during 20% of the year. This also goes some way to explaining the shortfall in quality the SCSGP complains of and certainly exposes all but the most robust research systems and methodologies. Much mud has been thrown in the ‘we need more time’ debate from both sides of the fence. But if issuers didn’t have their AGMs largely at the same time of year, they’d stand a much better chance of getting the correct attention to detail they feel they deserve, as well as the time to be able to engage with their investors when they disagree with a proxy advisory recommendation.

There is an obsession with following proxy advisor recommendations in some parts of the market which is, in our view, fundamentally incompatible with the values that the SCSGP so succinctly sum up with their assertion that “persons having the fiduciary responsibilities of share ownership need to exercise more responsibility in decision-making with respect to the voting process”.

That should put issuers in direct contact with investors (that is when they don’t hide behind Reg FD); and investors and their managers resume ownership of their decisions. Analysis becomes more objective, and research service competition then focuses on quality rather than policy positioning and frankly, bucket shop pricing models. Stewardship and decision-making becomes more transparent, and there’s then no need for additional, complex, protracted regulatory intervention. After all, fund managers don’t simply follow their brokers buy/sell recommendations blindly so why are proxy decisions so different?

These issues are inevitably very complex. The settling in of the Stewardship Code, forthcoming market and regulatory reactions to the stewardship debate, as well as the complexity of the relationship between the different parties and interests in the proxy advisory process will certainly demand careful attention. Yet these very real challenges must be addressed and surmounted – we can’t afford to not find an answer.



Last Updated: 16 January 2011