ValueWalk’s Q&A session with Jeff Patch, an analyst with Capital Policy Analytics, discussing what the company does, the state of the proxy firms, Netflix boycotting Georgia, companies pushing political issues, and ESG investing.
Can you tell us about your background?
I’m an analyst with Capital Policy Analytics, a Washington, D.C.-based economic research and consulting firm. My research focuses on how state and federal policies—regulation, legislation, law enforcement and oversight—impact investors, economies, markets, companies and taxpayers.
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Along with providing proprietary research directly to clients, we also write regularly on eclectic global legal, regulatory and political challenges that impact businesses and markets. For example, representative analyses include commentary on Reserve Bank of India data localization regulations’ impact on multinational financial and payments firms as well as the Malaysian prime minister’s meddling in foreign investment.
I started my career in journalism, first at papers such as the Des Moines Register in my home state of Iowa and later at Politico. While at Capital Policy Analytics, I have written news articles or analyses for The Federalist, The Weekly Standard, the Washington Examiner, Morning Consult and RealClearMarkets.com. I’ve also published commentary in The Washington Times, Crain’s New York Business and, of course, ValueWalk.
When did you start your firm and what does it do?
Ike Brannon founded the firm in 2012 to provide economic analyses to businesses, trade associations and individuals in the United States and abroad. It’s difficult to predict or prepare for how potential legislation or regulatory activity will impact the private sector—even for sophisticated executives and investors.
He spent nearly a decade in government, serving as the chief economist for the House Energy and Commerce Committee, senior adviser for tax policy at the U.S. Treasury, principal economic adviser for Orrin Hatch on the Senate Finance Committee, chief economist for the Joint Economic Committee and senior economist for the Office of Management and Budget.
Ike was also the chief economist for the 2008 presidential campaign of the late Sen. John McCain. That’s where we met. I worked with Ike to write op-eds and other materials for the campaign. We’ve teamed up on projects ever since as we share a similar economic perspective, tend to find the same issues interesting, and we've worked together enough to develop a solid writing and research rhythm.
Can you tell us about the current state of proxy firms?
Despite being subject to very little oversight, the influence of proxy advisory firms has grown significantly over the last decade, to the extent that they have become the de-facto regulators of America’s public companies.
The problem is that proxy advisors are increasingly recommending votes based on environmental and social policy concerns that may reduce profitability rather than what may be best for retirees financial returns.
The SEC requires investment management funds to submit proxy votes for all companies in which they own shares (some 600 billion shares will be voted on at roughly 13,000 shareholder meetings this proxy season). Fund managers depend on proxy advisory firms for guidance in voting their portfolios. This reliance has led to major problems.
Just two firms — Institutional Shareholder Services and Glass Lewis — control more than 97 percent of the market. With the rise of ESG-focused investing, a small but vocal subset of activist institutional investors are increasingly pushing public companies to take stands on political issues, no matter the impact on profits.
Activist resolutions and the voting recommendations that follow them often hurt average investors because they divert the focus and resources of companies away from increasing shareholder value and toward such hot-button political issues such as climate change.
Thankfully, the Securities and Exchange Commission has picked up on this situation and begun the process of enacting regulatory reform.
Last November, the SEC hosted a roundtable on the proxy process and opened up a comment period for investors, companies, academics and proxy advisory firms themselves to offer their suggestions for reform. Following the roundtable, Chairman Jay Clayton as well as Commissioners Hester Peirce and Elad Roisman have all expressed specific concerns with the current proxy process and the need for reforms to better protect retail investors. In May, the SEC added proxy advisory firms and shareholder submission thresholds to its semi-annual agenda.
What are your suggestions?
Proxy firms should have to register with SEC and clearly outline their methodologies. This would allow the SEC to create enforcement measures should firms choose to stray from their responsibilities as fiduciaries of investors.
To that end, the Commission should clarify that proxy advisory firms are subject to a fiduciary duty to their clients under the Investment Advisers Act and can be held accountable for breaching this duty.
Furthermore, the SEC should make it clear that an investment advisor’s use of proxy advisory firms is not sufficient to claim that it has fulfilled its fiduciary duty. They should still conduct their own basic due diligence of proxy firms’ guidance and voting recommendations.
What would the impact be on corporate governance? Would it have any effect on it?
While this is a relatively obscure issue, it’s an important one. That’s why the two biggest trade associations in Washington, D.C., the U.S. Chamber of Commerce and the National Association of Manufacturers, are running an educational and policy advocacy campaign on the topic on behalf of their members.
The goal of reformers is not to put proxy advisory firms out of business—they provide an important service to investors—but the quality and transparency of their guidance needs to improve to ensure markets function better for investors and public companies. In that same vein, we need regulations that ensure that proxy firm recommendations are free from conflicts of interest.
How do firms like ISS decide how to vote?
That is the million-dollar question. While some firms offer rough guidance, they are not required to do so—and many do not. Unfortunately, proxy advisory firms aren’t required to share the methodologies they use in their research and recommendations. This means that companies are often in the dark about how proxy firms arrive at their conclusions. There’s also a lack of transparency that potentially means conflicts of interest are not addressed.
The lack of transparency also puts companies at a disadvantage because they aren’t aware when proxy firms have relied on faulty logic or information to reach their voting recommendations. All these issues can have major impacts on companies and their shareholders.
What role do firms like BlackRock, StateStreet and Vanguard play here?
Passive investment funds managed by BlackRock, Vanguard and StateStreet have enjoyed an exponential growth in popularity among retail investors in recent years. These three firms have stakes in pretty much every listed company, resulting in a major concentration of power and voting rights.
As a result of their size, the trio has invested in building out their own internal teams to examine shareholder resolutions. Unfortunately, many other investors do not have the same resources and follow the recommendations of proxy advisory firms in virtual lockstep, without doing their own due diligence—the practice of robo-voting. This obviously raises significant questions about fiduciary duty.
It’s worth noting that some of these asset advisors have joined the call for more transparency among the proxy advisory industry. BlackRock has noted that there are no regulations or standards that proxy firms are required to follow when preparing their voting reports and suggested that the industry could improve the quality of its guidance.
What about activists like Paul Singer or Carl Icahn?
Activist investors like Icahn and Singer have the same agenda as management—value maximization—but a different view on how to achieve it.
In contrast, many of the new breed of activists now want to use the corporate governance system to advance social or political initiatives. Independent research has shown that’s not the priority of the majority of retail investors. Their main investment objective is to maximize the value of their holdings
Not insignificantly, independent research has shown that ISS has been active in actively promoting these kinds of social issues.
What role (or lack of one) do boards of directors play in this battle? Are they just there to collect a nice paycheck and do little?
Most boards do a good job—both in terms of setting company strategy and providing due diligence over management’s execution.
But directors are sometimes the collateral damage of proxy advisers’ activism. Several times they have recommended against a director because of erroneous and arbitrary reasons. In 2016, ISS recommended voting against the director nominees put forth by Bed Bath & Beyond Inc., claiming that their participation on the company’s compensation committee made them unfit for election. Bed Bath & Beyond was ultimately able to show that ISS had not voiced specific concerns against the nominees but instead defaulted to its policy for an automatic recommendation against all members of the compensation committee in the absence of a compensation committee chair (instead of basing its recommendations on the credentials of the nominees).
This isn’t an isolated event. Every year companies are forced to spend resources defending their director nominees against often baseless proxy advisor activism.
Why is this a priority for the SEC? They are understaffed and dealing with a lot of important issues like fraud. What makes you think they should tackle proxy reform now?
Just because this is a relatively obscure issue doesn’t make it an unimportant one and investors and companies alike have been raising concerns about the proxy process for the last 20 years. Each time a proxy firm issues an erroneous piece of guidance, it can impact company performance and, in return, the value of retail investors’ savings.
Research from the Spectrem Group has shown that retail investors overwhelmingly care about this issue and want to see reform. It’s something that fits with Chairman Clayton’s agenda to protect Main Street investors.
Some potential quick fixes for corporate governance malpractices: what are some suggestions?
Beyond addressing proxy advisory firms another easy fix would be to look at shareholder resolutions, specifically the ownership requirements needed to introduce a resolution and what percentage of votes are needed to reintroduce a proposal that has already been rejected.
The thresholds to introduce a recommendation have not been amended to track inflation in decades, and as a result, activist shareholders with tiny ownership stakes—who may have very little interest in the financial performance of the business—can put issues up for consideration. Last proxy season a shareholder with only 12 votes introduced a resolution for Elon Musk to be removed from Tesla.
Likewise, so-called zombie resolutions can be reintroduced year after year, despite being overwhelming rejected by a large majority of shareholders. Companies then have to invest significant resources in considering and responding to the same proposals the following year.
In both cases the current regulatory framework is not acting in the interests of the majority of shareholders.
Do you think Jay Clayton is focusing on the right aspects?
Chairman Clayton has demonstrated that he understands the significance of tackling proxy advisors. He’s made multiple speeches and comments on the need for reform and protecting America’s retail investors. His office brought the roundtable last fall to fruition, along with the request for comments from stakeholders.
In the roundtable he made it clear that his priorities were in the right place: “The question on the table is: can we improve the [proxy] system and for whom? I believe the answer is long-term, main street investors—those who put 50, 100, 200 dollars away a month.”
It’s critical that middle class Americans—both working and retired—have confidence in our financial system, and these reforms would be a step in the right direction.
Has the Financial Industry Regulatory Authority or the Commodity Futures Trading Commission weighed in on any of these issues?
Ultimately, as proxy issues impact public companies and their shareholders, the SEC is the sole federal agency that can amend the current regulatory regime. As FINRA regulates brokers and broker-dealers while the CFTC regulates futures and options markets, proxy issues are outside their mandates.
You mention companies pushing political issues. What are your thoughts on that matter? Why would corporations want to alienate potentially half of their audience when pushing divisive political stunts? Is it to appeal further to a highly engaged smaller audience or is it more than about money?
This is less about corporations themselves pushing a particular set of political issues. That’s up to company management and the strategy they choose to set. It’s an appropriate use of company resources if they can justify their overall strategy to the board of directors and their shareholders.
Firms with consumer exposure assume more risk when taking a public stance on issues of political or cultural controversy, as Nike infamously experienced recently after pulling a shoe design with the iconic Betsy Ross flag after former NFL quarterback Colin Kaepernick claimed offense. The impact of such decisions isn’t easily predicted. Nike experienced a wave of negative publicity but it hasn’t materially impacted the firm’s stock price. Private companies have less to worry about general public sentiment than public companies, but a company’s brand—it’s reputation—is often a significant source of value.
My concern is about a small group of investors, supported by proxy advisory firms, hijacking the corporate governance process to exploit their own political agendas at the expense of the majority of investors.
Are any of these tactics like Netflix boycotting Georgia illegal?
Those tactics aren’t illegal, but investors have the right to question the merits of those decisions and whether they create value for shareholders or amount to meaningless virtue signaling.
Company leaders also have to worry about hypocrisy and maintaining a consistent standard for consumers and investors. Many firms and celebrities that lambasted social policies such as abortion restrictions in certain states seem to have no problem doing business globally in places like Europe (where abortions are also restricted), Africa (where homosexuality is severely punished in many countries) and Asia (where in China, for example, human rights are fundamentally restricted). It’s possible for companies to criticize the decisions of elected officials while not punishing the citizens who they represent.
BlackRock and CalPERS seem to want companies to further push partisan left-wing legislation. Why?
Environmental, Social and Governance (ESG) investing has become a fashionable practice for investors and activists alike. ESG practices aren’t bad in and of themselves, but fund managers and proxy advisors should only pursue them when investors have knowingly consented and invested in funds where these objectives have been clearly stated. Their fiduciary duty must come first at all times.
In recent director elections, CalPERS pensioners sent a clear message that they do not support pursuing political or social objectives above wealth maximization. Board president Priya Mathur, campaigned on prioritizing the political and social objectives of investments, lost her reelection bid to a candidate who argued that the fund should be solely focused on increasing investor returns.
How do you expect to actually impact these trends? SEC rules? Public pressure?
A combination of both of these things is going to be most impactful, and we’re already seeing that happen. In order for the SEC to act on this issue, they needed to see that the public and stakeholders are concerned. Through the comment process, it’s been made very clear that retail investors are concerned about proxy advisors and would like to see more oversight, and the SEC has now announced reform considerations on its agenda.
What about taking stakes in big public asset managers to change policy at those firms?
That would be pretty difficult, if not impossible. Many of those entities are not open to outside investors, and fundamental change can only come from responsible federal oversight.