After organizing a robust discussion about the proxy process and proxy advisor firms, the Securities and Exchange Commission recently approved new guidance around the proxy voting process. Now the Commission is considering changes aimed at increasing scrutiny of the proxy advisory industry. Having served as legal counsel to public companies for over 35 years, I believe these reforms can help reduce the burden the system places on businesses of all kinds, improving their governance and financial performance to the ultimate benefit of shareholders.
At present, proxy advisor firms are not subject to a fiduciary responsibility to the people whose money they represent and whose voting rights they help to exercise, the shareholders. In practical terms, this has led to a situation where the advisors are primarily driven by their own self-interest. As I warned the SEC, real harm arises when control ends up with an organization which has no true vested interest or fiduciary responsibility in the outcome of any vote and is only in the business of making money from the process.
A key aspect of the largest proxy advisory firm, Institutional Shareholder Services or ISS, is its consulting business. ISS consults for the same companies it also assesses on behalf of institutional investors. A common misperception is that this business model creates a conflict of interest within ISS, believing that the consulting fees directly impact the voting recommendations produced for the same firm. With a moment’s thought, it’s clear that proxy advisor firms can’t just sell their recommendations – doing so would fundamentally undermine their relationship with their investment adviser clients.
Instead, the real conflict created by this business model arises within public companies, not ISS. To maintain value in the consulting business, ISS keeps aspects of its policies confidential. For example, if a company wants ISS to support a request to increase the shares issuable under an equity plan, it can either try to guess at the right number or engage ISS. If they do engage ISS, the company submits a detailed spreadsheet on its plan, and receives back the maximum number of shares that will be supported. The ISS formula for equity plans is not disclosed to paying clients, but at least they avoid the high risk path of guesswork, hence the conflict: to pay or go it alone.
In addition to relying on opaque methodologies, ISS’s business model is enhanced by regularly changing policies, creating new products, and using relative ratings that force companies to continuously monitor their standing even when policies don’t change. These practices ensure companies never "finish" complying with standards and continue to need the assistance of consulting services. An example of these constant demands are ISS’s Environmental and Social Quality Scores introduced in 2018, which rank public companies based on hundreds of questions on environmental and social topics, allowing investors to identify “leaders and laggards in the industry.” For a business to score well on these measures, it must be rated as performing better than other companies.
Proxy advisor firms and questionable tactics
With relative and perpetually moving goal posts, many companies feel that they have no alternative but to pay ISS for services. Unfortunately, the objective is to mindlessly comply with "hot topic" governance policies delivering questionable benefits to stockholders. In my letter to the SEC, I highlighted policies broadly accepted as beneficial, but which on closer examination are either pointless (proxy access and majority voting), or harmful to the interests of most stockholders (opposition to forum selection clauses and controls on stockholder rights).
Thankfully, the recent SEC guidance should encourage institutional investors to review the practices of proxy advisor firms to ensure their actions are genuinely based on increasing shareholder value and not the advisor’s bottom line. And investors who rely on proxy advisor firms will have to demonstrate that the advisors are making voting determinations in the stockholder’s best interests.
In addition, the Commission should require additional disclosure of underlying methodologies from proxy advisor firms and should ensure that companies are able to easily explain to investors why they may disagree with certain recommendations. These changes will lessen the extractive nature of certain business practices and improve overall governance to the benefit of shareholders everywhere.