Last week, the Securities and Exchange Commission (SEC) took an unimpressive measure to address a growing problem in the way American companies are governed. SEC staff issued guidance in connection with proxy advisory firms (PAs). PAs have become an increasingly important driver of a range of corporate decisions on issues from executive compensation to board composition. These PA firms do not represent the interests of investors and may have conflicts that pit their interests in direct opposition to shareholders. The SEC staff's guidance fails to get to the heart of the PA issue.
As explained in a recent Mercatus Center policy brief, PAs wield deep influence in the corporate world for several reasons. Institutional investors, such as mutual funds and pension funds, hold large swathes of company stock. Government has imposed certain obligations on the managers of these large funds. Among other requirements, if fund managers vote the shares on behalf of the fund, they must vote them in the best interests of the fund. Regulators have told managers that one way to satisfy this requirement is to rely on a PA, which provides voting recommendations. The impetus to rely on PAs for voting advice has grown as the number of votes has increased because of pressure from activist investors and measures like the Dodd-Frank say-on-pay provision. Say-on-pay requires companies to hold periodic advisory votes on their executive compensation packages.
There are several problems with widespread reliance on PAs. Because the government endorses reliance on PAs, the firms are well on their way to becoming the next credit rating agencies — private companies operating with a tacit government mandate and thus free of the healthy competitive market pressures that would keep them on the straight and narrow.
The PAs themselves do not have large enough staffs to give detailed attention to each of the many votes on which they make recommendations. PAs employ general guidelines, which they tailor to some degree to the circumstances of a particular company or client, but time and resource constraints limit the amount of tailoring that is feasible. The general guidelines, rather than being built on clear evidence of what would enhance the value of a corporation, are crafted without procedural rigor through, for example, surveys and roundtables with investors, companies and other interested parties.
What makes the situation more complicated is that the PAs have conflicts of their own. Institutional Shareholder Services provides consulting services to companies and gives voting recommendations to shareholders of those same companies. Glass Lewis, the other large PA in the United States, is owned by activist investors.
As a result of the widespread reliance on proxy advisers whose voting recommendations are the product of suspect procedures, many shares of many companies are being voted in ways that may not enhance the value of those companies and could actually detract from their value.
Participants at an SEC roundtable on the subject discussed the fact that investment advisers feel compelled to vote shares, even if the matter at issue is not important for the value of the company. In fact, the law does not compel universal voting of shares with active analysis. The staff guidance issued last week touches on this point by telling investment advisers that they and their client "may agree that the time and costs associated with the mechanics of voting proxies with respect to certain types of proposals or issuers may not be in the client's best interest." According to the guidance, an adviser, with its client's agreement, can abstain from voting, vote as management recommends, or vote only on particular issues of importance to the client.
Acknowledging that non-active voting arrangements are legal is helpful, but the acknowledgement is inarticulately expressed. Moreover, it is embedded in guidance that is mostly about how to rely more on PAs. The end result, it seems, will be the further entrenchment of PAs. Investors will bear the additional costs of the procedures set forth in the guidance.
A better solution would have been a clear statement from the SEC — not its staff — that investment advisers should only expend resources to vote if doing so is of economic value to their clients. Making such a statement would not be a radical departure from past policy; it would simply confirm a statement made by the SEC about a decade ago that investment advisers are not required to vote every proxy. Staff pronouncements in the intervening years obscured that message, so the commission needs to restate it clearly and unequivocally. Staff guidance that tells advisers how to rely on PAs more effectively is no substitute.