Fixing the Broken Proxy System

Proxy season has begun, and it’s expected to be a hot one. More than half of publicly listed U.S. companies will hold annual meetings between now and the end of June. There will be votes on more than 200,000 questions, ranging from approving auditors to disclosing political contributions.

Proposals directly from shareholders will increase, and, with the implementation of the Dodd-Frank Act, every company has to subject its executive compensation plan to an up-or-down vote, nicknamed “say on pay.”

If you think all this voting constitutes something akin to democracy, think again. Two small firms -- and one in particular -- will have an inordinate impact on how votes are cast. Few of their shareholders know it, but mutual funds and other institutions pay these firms to advise them, in effect outsourcing proxy decisions. The two companies -- Institutional Shareholder Services Inc., with more than 60 percent of the market, and Glass Lewis & Co., with almost all the rest -- have become the most powerful arbiters of corporate governance in the U.S. today.

Between them, ISS and Glass Lewis influence the votes of one-fourth to one-half of the shares of a typical mid- or large- cap company. A Stanford University study found that opposition by a proxy adviser to a management proposal results in a “20% increase in negative votes cast.” That figure actually underestimates the power of ISS and Glass Lewis because corporations trying to avoid a negative recommendation from a proxy advisory firm will shape their policies accordingly.

Rule Interpretation

The firms gained their exalted position because of a staff interpretation of a Securities and Exchange Commission rule adopted in 2003, which itself followed a Labor Department ruling 15 years earlier. Mutual funds are now required to set up a transparent process for proxy voting and to vote on all proxies -- tens of thousands of them in the case of large funds.

The simple solution for the funds was to hire ISS or Glass Lewis and enjoy virtual immunity from liability if they follow these advisers’ recommendations. Meanwhile, the SEC gave the proxy advisers protective treatment not granted to similar financial gatekeepers, such as auditing firms.

The system isn’t working. Proxy advisory firms lack the resources to examine questions in depth and with regard to the nuances inherent in the management of specific corporations. Instead, they use “one size fits all” rules that have produced such absurdities as recommending a vote against Warren Buffett as a director of Coca-Cola Co. (KO) because, as an audit committee member, he lacked independence. Why? Some of the subsidiaries of Buffett’s holding company, Berkshire Hathaway Inc. (BRK/A) -- including International Dairy Queen Inc. -- bought Coca-Cola products, thus creating what ISS guidelines consider a conflict of interest. Berkshire bought Coca-Cola shares in 1988 and had amassed $10 billion worth of stock, making Coca-Cola, at the time, its single-largest investment. Buffett was re-elected to the board anyway (he stepped down from the post in 2006).

The proxy advisers also have incentives that aren’t aligned with those of investors -- not to mention corporate directors, who themselves own shares and risk lawsuits as well as diminished reputations for poor decisions.

In addition, proxy advisers suffer from conflicts of interest. Some of their largest clients are giant pension plans run by unions and politically motivated individuals, with strong social, labor and environmental agendas that are often reflected in ISS recommendations. Other clients are public corporations -- “issuers” -- themselves. ISS, for instance, advises issuers on governance policy (including how to get proxy questions approved) and at the same time counsels institutions on how to vote.

Flawed Advice

As a result, the advisers’ advice isn’t very good. A lack of transparency makes research difficult, but studies of say-on- pay and exchange offers (also called options repricing) show that ISS’s recommendations, which favor strong limits on compensation, deplete the value of shareholdings to a significant degree.

The July 2012 Stanford Graduate School of Business study titled “The Economic Consequences of Proxy Advisor Say-on-Pay Voting Policies” looked at ISS and Glass Lewis recommendations on compensation policies and issued these stark conclusions:

“First, proxy advisory firm recommendations have a substantive impact on say-on-pay voting outcomes. Second, a significant number of firms change their compensation programs in the time period before the formal shareholder vote in a manner consistent with the features known to be favored by proxy advisory firms apparently in an effort to avoid a negative recommendation. Third, the stock market reaction to these compensation program changes is statistically negative. Thus, the proprietary models used by proxy advisory firms for say-on- pay recommendations appear to induce boards of directors to make choices that decreaseshareholder value.”

Specifically, the researchers found that, in their study of more than 2,000 companies, the “average risk-adjusted return” on the implementation of the recommendations “is a statistically significant -0.42%.”

ISS also backs other governance policies -- such as independent chairmen and “golden parachutes” -- for which support in the academic literature is mixed, at best.

In a classic case of unintended consequences, the 2003 SEC rule led to a result that was almost precisely the opposite of what many of its supporters, including Chairman Harvey Pitt, had wanted. Instead of eliminating conflicts of interest, the rule simply shifted them to the advisory firms. Instead of encouraging funds to assume more responsibility for their proxy votes, the rule pushed them to assume less. Instead of providing informed, sensitive voting on proxies, the incentive has been to outsource decision-making to two small organizations that most investors have never heard of.

Reasonable Solutions

The good news is that this broken proxy system can be fixed.

First, let mutual funds and other institutions themselves decide when it makes sense to spend resources analyzing and voting on a proxy question. The test should be whether the vote enhances the value of a fund’s investment to a significant degree and whether the benefits of the voting process exceed the costs.

Second, end the preferential regulatory treatment that proxy advisers currently enjoy in the law. Institutional investors would remain free to purchase proxy advisory services if those services are valuable on their own merit. 

Finally, end extraneous proxy requirements such as say-on- pay votes. Let shareholders and directors decide the matters that should be put to votes, if any, beyond those already required under state corporate law.

All three steps are reasonable, nonpartisan and relatively easy to accomplish. They will return efficiency to the system and put the authority for shaping corporate governance where it belongs -- in the hands of corporate directors, managers and shareholders.