How Proxy Advisory Services Became So Powerful
This policy brief outlines the regulations that give PAs their power and the nature and adverse consequences of that power, and offers suggestions for reforms.
Proxy advisory firms (PAs) have become a powerful force in American corporate governance. These firms counsel pension plans, mutual funds, and other institutional investors about how to vote the shares of corporations they own. They have built their businesses, in large part, on demand generated by regulatory requirements and expansive staff interpretations of those requirements. This policy brief outlines the regulations that give PAs their power and the nature and adverse consequences of that power, and offers suggestions for reforms.
Sources of Proxy Advisory Firms’ Power
Two firms dominate the PA industry in the United States. Institutional Shareholder Services (ISS) and Glass Lewis share approximately 97 percent of the market. These firms weigh in on issues such as the composition and operation of corporate boards, disclosure and compensation practices, and companies’ policies on recycling, renewable energy, and political contributions. The firms’ power derives from the growth in the proportion of shares owned by institutions, the growing number of proxy votes, and—importantly—the regulatory push toward reliance on outside proxy advice.
In 2011, institutional investors owned approximately 60 percent of publicly traded equities, up from well under 20 percent in the 1960s. Institutions with large, diversified portfolios can face hundreds of thousands of votes, mainly concentrated during the popular annual meeting months of March through June. Unions, pension funds, and individual shareholders push for votes on a range of issues from climate change to political spending. Dodd-Frank’s provision mandating advisory executive compensation (“say-on-pay”) votes every one to three years further increases voting volume.
But regulation is the main impetus to vote proxies—and to rely on PAs. In the absence of regulatory encouragement to use PAs, institutional investors might rationally choose not to vote, to vote consistently with management, or to vote only on key matters. Critical to the rise of ISS is the 1988 “Avon Letter,” where the Department of Labor underscored the fiduciary importance of voting shares in the interests of pension plan beneficiaries under the Employment Retirement Income Security Act of 1974. Another boon to PAs was a 2003 Securities and Exchange Commission (SEC) requirement that investment advisers vote proxies in their clients’ best interest. The SEC allowed “an adviser [to] demonstrate that the vote was not a product of a conflict of interest if it voted client securities, in accordance with a pre-determined policy, based upon the recommendations of an independent third party,” meaning a PA. Two subsequent staff letters further incentivized investment advisers to “cleanse” themselves of conflicts of interest in voting their clients’ shares by using PAs—even ones paid by the companies about which they were giving advice.
Seemingly forgotten is a note in the SEC’s 2003 rulemaking that “we do not mean to suggest that an adviser that does not exercise every opportunity to vote a proxy on behalf of its clients would thereby violate its fiduciary obligations to those clients under the Act.” This important caveat recognizes that voting can be unduly costly, but investment advisers act as if the caveat does not exist. Investment advisers vote to satisfy a perceived regulatory mandate rather than to enhance the value of their clients’ portfolios. PAs are central to that compliance exercise.