Do proxy firms need more regulation?

In an environment where big business has complained bitterly about over-regulation, three powerful business organizations – the Business Roundtable, the National Investor Relations Institute and the Society of Corporate Secretaries and Governance Professionals – have joined together to form the Shareholder Communications Coalition (SCC) in order to spearhead an effort to enact new regulation… of proxy advisory firms.

The coalition has issued a draft of regulations it wants the SEC to implement as soon as possible, reigniting a feud between issuers and proxy advisory firms that has been brewing for years. Essentially, the SCC is questioning both the way proxy firms operate and their integrity. Moreover, the proposed regulations suggest conflicts of interest that should prohibit proxy firms from serving as consultants to companies while advising institutional investors on governance issues. The proposed regulations also ask that proxy firms register as investment advisers, which would lead to more regulation and scrutiny. The SCC says its proposal is aimed at ensuring the accuracy, transparency and reliability of the work of proxy firms.

Niels Holch, executive director of the SCC, says the three member organizations reached a consensus and submitted a draft document to the SEC in spring 2010, which caused the regulator to agree to consider changing the rules governing proxy firms. The SCC proposed regulations focusing on four major areas regarding the practices of proxy firms: conflicts of interest, disclosure of their business practices, their ‘one-size-fits-all methodology’, and inaccuracies.

When proxy firms offer institutional investment advice to a pension fund, and then to a company that is affected by the votes of pension funds, it’s a clear conflict of interest, says Holch. Some compare it to the former practice of Big Four accounting firms selling consulting advice to their audit customers, which is now prohibited. ‘The SEC has indicated this will be one of the first rule-making proposals to arise as a follow-up to Dodd-Frank,’ Holch says.

Proxy firms fight back

Whether the SEC actually implements the proposed regulations remains to be seen, and the six major proxy firms – including RiskMetrics Group (which is part of ISS), Glass Lewis and Egan-Jones Proxy Services – aren’t taking matters lying down. The firms supply governance advice and other data to large institutional investors, mutual funds and pension funds. These investors use the information and recommendations to maximize their investments and ensure that CEOs, boards and corporate executives are operating in the best interests of shareholders. The proxy advisers argue that they are already regulated enough, and they defend the job they do as being fair and unbiased.

Sounding not the least bit defensive, Kent Hughes, a managing partner at Egan-Jones, says his firm welcomes discussions about transparency and conflicts of interest. Egan-Jones only operates as an institutional adviser and does not serve as a consultant to companies, thereby avoiding any conflicts of interest. Moreover, the company is quite explicit about the guidelines it employs to provide conclusions on shareholder proposals and other issues. At the root of these proposals, Hughes says, businesses would like to ‘inspect every element of what proxy firms advise and try to re-engineer conclusions.’

Robert McCormick, chief policy officer at San Francisco-based Glass Lewis, says companies are reacting to the feeling that proxy firms are exerting too much influence on pension and mutual fund voting, swaying shareholder resolutions. McCormick refutes that view, however, explaining that in analyzing 3,000 shareholder compensation proposals, his firm recommended against 17 percent of them, but only 1.5 percent failed. If his firm’s influence was so strong, he reasons, a higher percentage would have failed. His point is that most pension and mutual funds have their own voting policies and consider proxy data as only one factor in the mix. Ironically, proxy firms support management on the vast majority of occasions.

ISS declined to discuss the issue of conflicts of interest, but in its comment letter to the SEC, it stated: ‘We understand the potential for conflict that arises when ISS Corporate Services provides corporate governance advice to an issuer and ISS subsequently makes vote recommendations on the proposals in that same issuer’s proxy statement.’ It went on to say that establishing a ‘firewall’ between subsidiaries mitigates any potential conflicts.

What’s really going on here?

Industry observers disagree on the reasons why the SEC has decided to look at this issue now. The SEC actually announced its intensions on December 15, as part of chairman Mary Schapiro’s remarks made at the Transatlantic Corporate Governance Dialogue.

‘When boards believe that a recommendation has been based on incorrect information, those recommendations can act as a barrier to boards’ efforts to persuade investors to change their minds,’ Schapiro said. ‘As a result of the comments we’ve gathered, the Commission is considering how to provide guidance on how the federal securities laws should regulate the activities of proxy advisory firms.’

Some suggest the SEC is acting as part of its obligation under Dodd-Frank. Some say politics may be at play, since the five SEC commissioners (three Democrats and two Republicans) aren’t appointed unless they’re attuned to the political agendas of the two leading parties and the Senate. Others believe the business community has used some influence of its own to get the SEC to act. In the past, proxy advisory firms were viewed as neutral – like Switzerland – and dedicated to providing objective data. More recently, however, CEOs and corporations have come to view them as activists that take a strong point of view on shareholder resolutions.

‘These proposals are being driven by corporations, which are very concerned about the influence exercised by proxy firms,’ says Paul Hodgson, a senior research associate at GovernanceMetrics International. According to Hodgson, as the proxy firms provide guidance to corporations on say on pay, the corporations lobbied the SEC and basically said, ‘You’re regulating us – why aren’t you regulating them?’

Donald Kalfen, a partner at Meridian Compensation Partners who has written about these issues for trade magazines, says corporations simply ‘want to make sure that proxy recommendations are sound and as transparent as the other players have to be’.
To be sure, the debate over proxy firm influence is where things can turn really ugly.

Proxy advisory firm recommendations can mean negative votes that can potentially oust directors, or ‘no’ votes on governance proposals, compensation plans and other strategic policies supported by management. Negative recommendations can also mean a loss in stock value if investors shy away from companies with potential red flags.

Lynn Turner, a former chief accountant at the SEC, ex-managing director at Glass Lewis, former corporate board member and currently a consultant with economic research firm LitiNomics, says the SEC appears to be responding to business concerns that ‘asset managers were voting the shares or voting for proposals based on what the two or three large proxy firms told them to vote’.

Turner says many top executives ‘dislike the fact that proxy advisory firms do not always recommend that people vote in support of management. As a result, they’d like to see pressure put on proxy firms to change their voting.’ That’s why he surmises that business organizations are flexing their muscles now in an effort to diminish the influence that proxy firms exert on pension funds and mutual funds in swaying shareholder resolutions.

However, Turner also notes that larger asset managers like CalPERS often devise their own guidelines and are less influenced by proxy firms, although smaller asset managers may be more swayed by advisory firm recommendations. Even though smaller firms may rely on proxy firm data more, Turner says corporations that urge the SEC to regulate proxy firms may be blaming the messenger.

‘You have companies that don’t perform, but pay executives as if they are performing,’ Turner says. ‘In the vast majority of cases, the companies have been subpar performers when ISS and Glass Lewis have criticized them.’

No end to argument in sight

Unfortunately, there is little that both sides agree on in this dispute. The SCC claims that proxy firms are operating to their own advantage, not that of their clients. Its draft letter to the SEC alleges that ‘Proxy firms make recommendations and adopt policies that contribute to demand for their services.’

To eliminate potential conflicts of interest, the SCC is asking for full disclosure of proxy firms’ clients. ‘If relationships aren’t disclosed, you don’t know if they’re making independent evaluations,’ Holch says. However, this recommendation doesn’t apply to several firms, including Glass Lewis and Egan-Jones, which do not offer consulting services, and proxy firms want to know why they should be subjected to a rule that doesn’t apply to the entire group.

The SCC claims most proxy firms offer a one-size-fits-all methodology that applies to all their clients, and which fails to customize or individualize their research. Large pension funds and smaller mutual funds receive the same guidance, which can influence shareholder resolutions.

‘We’d like to see each investor, large or small, evaluate the facts and circumstances of each company,’ Holch says. But McCormick says that Glass Lewis already customizes results – ‘We look at shareholder proposals and board structure and treat everything on a case-by-case basis,’ he insists.

Various companies also accuse proxy firms of making errors. For example, in the SCC letter to the SEC, one unnamed company said that a proxy firm ran the wrong model to analyze the company’s equity plan, and that this contributed to ruining the plan. The proxy firm later apologized for its error, but this offered little consolation for the company.

A recent SCC survey revealed that 65 percent of firms had experienced at least one example of a vote recommendation based on inaccurate or incomplete information, and 44 percent of the time the proxy firm refused to correct the mistake. However, Turner says that when he was research director at Glass Lewis, management calls regarding accuracy were invariably about the interpretation of a fact or disclosure, or lack thereof, from the company.

Additionally, proxy firms argue, if most of the data they provide comes from corporate SEC filings, how can it be considered inaccurate? Kalfen notes that ‘a range of potential errors could creep into their analysis’ – some SEC data could be misinterpreted, drawn from incorrect filings or miscalculated, leading to errors that are often of omission rather than bias.

In response, McCormick says companies make a ‘market decision’ when choosing a particular advisory firm. ‘No one is forced to use anyone,’ he adds.

To minimize errors, the SCC has asked that proxy firms offer a draft of all reports 48 hours before issuance to make sure the numbers are accurate – not to review their overall evaluation. ISS spokesperson Ted Allen says ISS already provides drafts to S&P 500 companies 48 hours before publication so that they can fact-check the information. The SCC would like to see proxy firms introduce this practice across the board to all clients – but if such a policy were enacted, McCormick says it would undermine the independence of proxy firms. ‘It opens up proxy firms to being lobbied by the company for a particular vote,’ he says. ‘Inevitably it will turn to recommendations.’

Change on the way?

At this point, it’s too early to know whether any of these regulations regarding proxy firms will be implemented. The SEC asks for reactions and considers different viewpoints before moving forward, but Turner, the former insider, says that when the SEC announces the intention to issue guidance, it is already strongly considering implementation. He expects that 80 percent to 90 percent of what it recommends will be adopted.

As with any new regulations, there could be unintended consequences. The SEC could impose rules that force proxy firms to add even more scrutiny to their evaluation of publicly traded companies. And who’s to say that if the SCC gets the rules it wants enacted, institutional investors won’t come to rely even more on proxy firm recommendations, secure in the knowledge that their recommendations have been cleared by regulators? In short, increased regulation may ultimately increase the influence of proxy firms.

If some of these changes are enacted, Hughes says it could lead to proxy firms having to charge more for their services. More regulations will likely require proxy firms to spend more time delivering their services and to hire more staff to meet new standards, both of which will cost more money. They will also likely incur added costs for having to file new disclosures. If fees go higher, neither side will be happy.

If new rules are imposed, however, Hughes doesn’t see proxy firms changing the nature of how they operate. ‘We’re not going to come to different conclusions,’ he says. ‘That’s not realistic. Proxy firms are going to be objective and offer their best judgment.’
If the SEC authorizes new regulations, Holch says it will result in more balance and disclosure, and that would benefit everyone. He maintains that public companies must disclose a range of information, and so should proxy firms. Kalfen says any change that leads to a ‘more efficient marketplace, providing shareholders with information that is accurate and transparent’, is positive. He expects that proxy firms will continue to provide valuable information and will influence shareholders, but may face some additional controls.

Turner doesn’t expect the proposed changes to have an ‘earth-shattering’ impact on the market, and he suggests that rather than attacking proxy firms, CEOs and boards should spend more time on changing their performance. ‘That’s the best way to change votes,’ he concludes.