Will Proxy Advisory Firms Be Reined In by the SEC? Some Takeaways from the SEC’s Roundtable

A version of this article originally appeared in Corporate Governance

Advisor’s March/April 2014 issue.

Introduction

The SEC’s Division of Corporation Finance held a roundtable (the Roundtable) on December 5, 2013 to discuss topics related to the growth of the proxy advisory industry and current issues relating to their services.  The Roundtable was part of the SEC’s review of whether reform of the industry is required and, if so, whether the reform should take the form of SEC rulemaking or guidance, or industry initiatives.[1] Roundtable participants included representatives from institutional investors, investment advisers, issuers, academia, law firms, consultants, associations and the two main proxy advisory firms in the US, Institutional Shareholder Services Inc. (ISS) and Glass Lewis & Co. LLC (Glass Lewis).

This article summarizes the Roundtable discussions and some of the takeaways for issuers.

Part I.  Background

Growth of the Proxy Advisory Industry

The proxy advisory industry has grown significantly over the last three decades.  The growth is frequently attributed in part to a significant growth in assets managed by institutional investors, such as investment advisers, pension plans, employee benefit plans, bank trust departments and mutual funds.  It is also attributed to regulatory developments, such as:

• the 1988 “Avon Letter” issued by the Department of Labor;[2]
• passage of the Sarbanes-Oxley Act of 2002 (and the governance failures that led to it);
• the SEC’s adoption in 2003 of Rule 206(4)-6 under the Investment Advisers Act of 1940 (the Advisers Act);[3]
• amendment in 2010 of NYSE Rule 452 so as to prohibit discretionary voting by brokers in director elections; and
• adoption of say-on-pay rules required under the Dodd-Frank Wall Street Reform and Consumer Protection Act (2010) (Dodd-Frank).

These regulatory developments have led to a more shareholder-centric model of governance with increased voting burdens for institutional investors.  Proxy advisory firms have responded by providing institutional investors services regarding matters such as issue analysis and vote recommendation, vote execution, research on governance issues, and mitigation of conflicts of interest.

The two largest proxy advisory firms, ISS and Glass Lewis, collectively account for 97 percent of the market in the US.[4]  ISS is a division of MSCI Inc., a US, publicly traded company, and is a registered investment adviser under the Advisers Act.  Glass Lewis was formed in 2003, is owned by the Ontario Teachers’ Pension Plan and is not a registered investment adviser under the Advisers Act.

Regulation of Proxy Advisory Firms

There are two principal ways that proxy advisory firms may be subject to federal securities laws:  under federal proxy rules and under the Advisers Act.

The activities of proxy advisory firms fall within the broad definition of “solicitation” under the proxy rules.  The furnishing of proxy voting advice is therefore generally subject to the information and filing requirements under the proxy rules.  However, Exchange Act Rule 14a-2(b)(3) exempts the furnishing of proxy voting advice from most of the proxy rules[5] if certain criteria are met, including that the adviser discloses to the advice recipient any significant relationship with the registrant or its affiliates, or the proponent of any matter on which advice is given, and any material interest of the adviser in such matters.[6]

Activities of proxy advisory firms also expose them to regulation under the Advisers Act.  A person is an “investment adviser” subject to regulation under the Advisers Act if the person, “for compensation, engages in the business of advising others .  .  .  as to the value of securities or as to the advisability of investing in, purchasing, or selling securities, or who, for compensation and as part of a regular business, issues or promulgates analyses or reports concerning securities.”[7]  In falling within this definition, proxy advisory firms are subject to the antifraud provisions under Section 206 of the Advisers Act, and owe fiduciary duties to their clients pursuant to Section 206, regardless of whether or not they are registered with the SEC.[8]  Proxy advisers that are registered as investment advisers with the SEC[9] are subject to additional regulations, including SEC filing obligations;[10] the requirement to adopt, implement and review various policies and procedures;[11] and certain record-keeping obligations.[12]

Part II.  The Roundtable

The Roundtable first considered factors related to the growth, nature and impact of the proxy advisory industry.  The Roundtable then considered two specific issues that have frequently been cited as concerns about the industry:  conflicts of interest by proxy advisory firms and the accuracy and transparency of the vote recommendation process.  One of the Roundtable participants also described an initiative in Europe to implement a comply-or-explain code of conduct for proxy advisory firms.

1.  Growth, Nature and Impact of the Industry

Factors Contributing to the Use of Proxy Advisory Firms

The discussion regarding the growth of the proxy advisory industry focused on the types of market demand and regulatory changes described in Part I above.

Rule 206(4)-6:  There was a recognition that Rule 206(4)-6 under the Advisers Act and the Egan-Jones[13] and ISS[14] “no-action” letters that followed it increased the demand for proxy advisory firm services.  Repeal of the no-action letters is one potential tool available to the SEC if it determines that the influence of proxy advisory firms needs to be curtailed.  Rule 206(4)-6 requires registered investment advisers to adopt policies and procedures reasonably designed to ensure that proxies are voted in the best interests of clients.[15]  The no-action letters made it easy for investment advisers to satisfy this requirement by relying on the voting recommendation of proxy advisory firms.  The Roundtable participants were divided as to whether the Rule itself, or the no-action letters, were primarily to blame.[16]  There is considerable doubt that merely retracting the no-action letters, without amending the Rule, would be an effective way of reversing the regulatory incentive to use proxy advisory firms that the Rule and no-action letters created.

Change in Governance Norms:  Several participants expressed the view that changes in governance norms have created an increased demand for proxy advisory firms.  For example, the large increase in the number of shareholder proposals, including as a result of the recent adoption of Dodd-Frank, increased the workload on portfolio managers.  The shift to majority voting also contributed to the growth of the proxy advisory industry by expanding their influence.  The shift allowed proxy advisory firms to influence a greater range of actions that had traditionally been within the responsibility of the board through the threat of “withhold” recommendations in director elections for noncompliant directors.

Market Demand:  Several participants expressed the view that growth of the proxy advisory industry was driven more by the business demands of institutional investors than any regulatory incentive.  One of the early ISS employees[17] stated that ISS only began providing proxy advisory services in the 1980s because prospective clients asked it to.  The CEO of Glass Lewis stated that Glass Lewis had similar origins.  Glass Lewis started operations in 2003, which was a time when institutional investors were starting to develop more robust proxy governance programs.  They asked Glass Lewis for help developing and implementing these programs.

Data Regarding the Influence on Proxy Voting

One participant[18] cited data showing a significant correlation between ISS recommendations and vote outcome.  The data was from studies that examined the roles of ISS vote recommendations in uncontested elections, and showed the following:

• for management proposals, a negative ISS vote recommendation is associated with about 13.6–20.6 percent fewer votes for management;
• for individual directors, a negative ISS vote recommendation translates to 14–19 percent fewer votes;
• for say-on-pay proposals, a negative ISS recommendation is associated with about 24 percent fewer votes.

The studies, however, are subject to varying interpretations.[19]  While the data could indicate that big ISS clients simply outsourced their votes to ISS, other possible explanations include that ISS brought new information that influenced institutional investors, or that the views of ISS on corporate governance matters were consistent with the views of many of ISS’ clients.  This latter explanation is supported by the similarity among voting policies of many of the large institutions.[20]

The data also does not convey the complete story regarding the impact of proxy advisory firms.  Some participants pointed out that it does not take into account the impact the proxy advisory firms have on boards of directors.  Boards often factor the voting policies and potential reactions of ISS and Glass Lewis into their decision-making processes.

A representative of Glass Lewis provided data illustrating the extent to which Glass Lewis’ clients follow the Glass Lewis recommendation.  The representative said that of Glass Lewis’ 900 voting institutional clients, 80 percent have custom voting policies.  However, the degree of customization of these varies, and some may be very similar to the Glass Lewis policy.  Of the clients that follow the Glass Lewis policy, these clients deviate from Glass Lewis’ recommendations some of the time.[21]

The Use of Proxy Advisory Firms by Institutional Investors

Large Institutions:  A representative of BlackRock gave a description of BlackRock’s relationship with proxy advisory firms, which the representative viewed as comparable to that of other large institutional investors and investment advisers.[22]  The following are some of the key points:

• Research and Data Services:  BlackRock uses proxy advisory firms primarily to synthesize and normalize the data, which is a very important service given that on some days BlackRock may be voting on as many as 30 meetings.  The data is one of many inputs in the proxy voting decision.[23]
• Voting Decisions:  BlackRock makes its own decision how to vote on a case-by-case basis.  The underlying voting principle is to achieve a voting outcome that best supports and promotes the economic interests of BlackRock’s clients.  Issuers should feel free to contact BlackRock directly with regard to voting issues.
• Voting Policies:  BlackRock does not defer to ISS or Glass Lewis voting policies.  It has its market-specific policies for every major market in the world posted on its website.  It reviews the policies every year and also works with proxy advisory firms on their policy formation processes, including with respect to developments from the prior proxy season and anticipated issues for the following proxy season.
• Choice of Proxy Advisory Firms:  BlackRock uses both ISS and Glass Lewis research globally and subscribes to additional market specific research in those markets where it exists.
• Voting Platform:  BlackRock uses ISS to help implement its voting, which is administratively challenging given the large number of US and international shareholder meetings.[24]

The BlackRock representative expressed a view that institutional investors could address misinformation about the investors’ use of proxy advisory firm services through measures such as:

• posting on their websites information about how the investors use the investors’ policies, how they use the services of ISS and Glass Lewis, and what in-house resources the investors have; and
• including high-level summary statistics of voting patterns in Form N/PX filings

Small Institutions:  According to a representative of the Investment Adviser Association, smaller investment advisers tend to rely more heavily on the research and recommendations of proxy advisory firms.[25]  However, they retain ultimate fiduciary responsibility for proxy voting and the ability to override the recommendations of the proxy advisory firms.  There are also thousands of investment advisers that do not use proxy advisory firms at all.

Institutional Investor Oversight of Proxy Advisory Firms:  There was a general recognition that investment advisers have a duty to exercise due diligence in selecting a proxy advisory firm and voting policies, as well as an obligation to exercise oversight of their performance.  The large institutions have the resources to exercise greater oversight.  For example, according to the BlackRock representative, BlackRock participates in ISS policy reviews, provides feedback to ISS when it disagrees or sees errors in ISS’ analyses, annually reviews ISS’ performance on operational matters, reviews ISS conflicts to see they are appropriately mitigated and considers ISS performance enhancements for the upcoming year.

Competition among Investment Advisory Firms

There are significant barriers to entry in the proxy advisory industry, according to the former President and COO of Proxy Governance Inc., which ceased operations in December 2010.[26] Barriers to entry are due to factors such as:

• Significant Coverage Obligations:  There are 40,000 securities globally, and to attract even a medium-sized institutional investor, a proxy advisory firm would have to cover about 10,000 securities, including 4,000 in the US and 6,000 outside the US.  Moreover, securities outside the US are much more difficult to deal with than US securities.
• Low Margin Business:  Net income is about 10 percent of revenue, and EBITDA is about 25 percent.  That will not attract quality risk capital.
• High Technology Costs:  Significant technology is required on the research side in order to upload and analyze the quantitative information and present it to an analyst, who then has to factor in qualitative information and make a decision.  Proxy advisory firms also need very robust voting platforms.  The platforms must have the capacity for the clients to put in their own voting policies, because clients rarely follow proxy advisory firms across the board.
• High Switching Costs:  Most large- and medium-sized institutions have developed their own technology to integrate with the systems of their existing proxy advisory firms.  Switching to a new proxy advisory firm is burdensome and takes six to nine months to complete.

2.  Specific Issues Regarding Proxy Advisory Firms

The Roundtable focused on two types of issues that are commonly raised in connection with proxy advisory firms:  conflicts of interest and the accuracy and transparency of their recommendations.

Conflicts of Interest of Proxy Advisory Firms

Several areas were raised as presenting conflicts of interest, the principal ones being as follows:

• ISS Both Makes Proxy Voting Recommendations to Institutional Investors and Advises Issuers on How to Ensure the Recommendations Are Favorable:  There was a general recognition that it presents a conflict of interest for ISS (i) to generate revenue from institutional investors, through the ISS voting recommendations, by judging issuers’ corporate governance, and (ii) to also generate revenue from issuers by advising the issuers on what governance steps the issuers need to take so as to avoid an adverse ISS judgment.  Some participants thought this should be prohibited, and some thought that ISS should give greater disclosure regarding this type of conflict.  A representative of ISS at the Roundtable defended the practice in light of ISS’ strong firewalls between its advisory side and its corporate side.[27]
• Proxy Advisory Firms Make Voting Recommendations on Shareholder Proposals Made by the Firms’ Clients or by Parties Promoted by the Firms’ Clients:  For example, if CalSTRS (or one of its affiliates) puts forward a shareholder proposal at an issuer’s annual meeting, ISS will issue a voting recommendation to ISS clients as to whether or not to vote in favor of the CalSTRS proposal.  However, CalSTRS is a client of ISS, and so ISS will have an incentive to support the CalSTRS proposal.  There was a general recognition that this creates a conflict and should at least warrant disclosure.[28]  The conflict also calls into question availability of the proxy rule exemption for proxy voting advice (Rule 14a-2(b)(3)), which requires disclosure to the advice recipient of any significant relationship with the proponent of the shareholder proposal.  While both ISS and Glass Lewis typically disclose these conflicts in their reports, there is an issue as to whether their disclosures are sufficient.[29]
• The Customers of Proxy Advisory Firms Have Too Much Influence over the Firms’ Voting Recommendations:  Participants disagreed as to whether this created a significant conflict.  One Roundtable participant noted that proxy advisory firms have changed recommendations as a result of pressure from their custom­ers.  Other participants, on the other hand, stressed that institutional investors and proxy advisory firms are approached by parties on both sides of voting issues and there is nothing inherently wrong with that.[30] Moreover, Glass Lewis has been criticized in the past for not being willing to discuss voting issues with interested parties.[31]
• The Ownership Structure of Proxy Advisory Firms Presents Conflicts:  ISS is owned by a public company and Glass Lewis by a government pension plan.  Conflicts issues arising from ownership structure present similar issues to those described above relating to passing judgment on proposals of clients.[32]

The general view was that where conflicts could be addressed by disclosure, generic disclosure was insufficient and language concerning the specific conflict was required.

Accuracy and Transparency of Proxy Advisory Firm Reports

The three principal concerns about ISS and Glass Lewis voting recommendations were:

• Recommendations Are Based on One-Size-Fits-All Policies and Firms Lack resources to Tailor:  The notion that proxy advisory firms neither sufficiently tailor recommendations to specific issuers nor have the resources to be able to do so was a concern of many Roundtable participants.  One person noted that the disclaimer on ISS reports states that the ISS research team analyzes proxy issues and completes vote recommendations for more than 40,000 meetings in more than 100 worldwide markets, through the work of more than 200 analysts fluent in more than 25 languages.  Those figures indicate that each analyst has a huge amount of work to do, and thus it is inevitable that mistakes will be made.
• Issuers Are Not Provided Sufficient Time or Opportunity for Input:  ISS typically issues its reports about two weeks after issuers mail their proxy statements, which leaves two to three weeks for issuers to address inaccuracies in the ISS reports.  ISS also tries to provide S&P 500 issuers with 24–48 hours to comment on reports before they are released.  Glass Lewis typically does not provide issuers the ability to comment prior to release.  Both firms will consider updates to reports to correct inaccuracies that are pointed out after the reports are issued.  There was a concern that this process runs the risk that inaccu­rate information is disseminated in reports and issuers have insufficient time to correct the inaccuracies without postponing their shareholder meetings.[33]
• Voting Policies Are Adopted Without Sufficient Empirical Evidence that They Enhance Shareholder Value:  The ISS policies do not appear to be driven by empirical analysis, but are based on an outreach to clients and nonclients.  The ISS representa-tive described the voting policies as being as inclusive and global as possible.  Policies are updated by an internal policy board based on annual surveys that clients and nonclients are welcome to respond to, as well as roundtables held around the world.  Draft policies are provided for comment before being finalized.  Summaries of finalized policies are posted on the ISS website.  The representative described the extent to which the views of the various constituencies are included in its policies as “a little bit art, a little bit science.”

3.  Eu Code of Conduct

Ms. Rabin of Glass Lewis described how Europe, Australia and Canada had issued consultations that focused wholly or partly on the proxy advisory industry.  In February 2013, the European Securities Market Authority (ESMA) published a final report (the ESMA Final Report) on its findings and recommendations resulting from its consultation.  The ESMA Final Report found no clear evidence of market failure regarding how proxy advisory firms interact with investors and issuers, and so ESMA decided not to introduce binding regulations.  However, it found areas where a coordinated effort of the proxy advisory industry would foster better understanding and assurance among other stakeholders.  At the time of the report’s publication, ESMA announced the formation of a drafting committee containing proxy advisers, including Ms. Rabin.  Other members included representatives from ISS Europe, IVOX in Germany, PIRC and Manifest in the UK, and Proxinvest in France.  The drafting committee prepared a set of principles that were released for public consultation on October 28, 2013, with the consultation period ending on December 20, 2013.[34]

The code (the Code of Conduct) is a comply-or-explain model.  The draft Code of Conduct released in October of last year consisted of just three principles:

• Principle One (service quality):  “Signatories aim to offer services that are delivered in accordance with agreed client specifications.  Signatories should have and publicly disclose a research policy and, if applicable, ‘house’ voting guidelines.”
• Principle Two (conflicts of interest manage-ment):  “Signatories should have and publicly disclose a conflicts-of-interest policy that details their procedures for addressing potential or actual conflicts of interest that may arise in connection with the provisions of services.”
• Principle Three (communications policy):  “Signatories should have and publicly disclose their policy (or policies) for communication with issuers, shareholder proponents, other stakeholders, media and the public.”

The Principles are supported by guidance that provides additional background and context.  The Code of Conduct is expected to be finalized and put in place in March 2014.  The participants in the process have indicated that they intend to implement the finalized Code of Conduct on a worldwide basis.  ESMA has reserved the right to review the Code of Conduct in two years and has made clear that it will act if the code has not worked.

SEC Commissioner Gallagher stated his belief that the Code of Conduct was a positive step, but he referenced the ineffectiveness of the 2003 IOSCO code for ratings agencies, which was also a comply-or-explain model.  He stated that the Code of Conduct should therefore not be the end of the debate.

Part III.  Takeaways from the Roundtable

The Roundtable discussion indicated a common recognition that proxy advisory firms provide important services for institutional investors.  It seems clear that the proxy advisory industry is here to stay.  However, many participants, representing both issuers and investors, expressed concerns about conflicts of interest in the industry.  Issuer representatives were also very vocal about risks associated with proxy advisory firms disseminating inaccurate information shortly before meeting dates, particularly given the large percentage of votes that the firms’ clients represent.  It seems likely that some reform of the industry will be undertaken.

Timing and Scope of Reform Initiatives

The Roundtable served more as a forum for airing views than reaching consensus on the appropriateness and details of reform.  However, there were some indications that any reform in the near term is likely to be through a self-regulatory initiative.  The SEC is unlikely to adopt rules in the near future, and if it does adopt rules they are likely to be quite narrowly tailored.

         Self-Regulatory Initiative:  As made clear by Mr. Pitt, the SEC has a very full agenda, and this initiative is not very high on its priorities list.  Moreover, it is unclear that something as simple as retracting the Egan-Jones and ISS no-action letters would have a beneficial impact.  A self-regulatory initiative appears the most likely near-term option, particularly given that one is already underway in Europe.  The effectiveness of the Code of Conduct will depend significantly on the policies that proxy advisory firms adopt under it.

         Scope of SEC Action:  If the Code of Conduct fails to address the types of concerns expressed in the Roundtable, the SEC may take action when its agenda is less crowded.  Given the value of the services that proxy advisory firms provide to institutional investors, and the risk that heavy regulation could increase barriers to entry and further entrench the two dominant firms, SEC regulation is likely to be quite tailored.  For example, many of the conflicts of interest concerns could be addressed through mandatory disclosure, which could be accomplished within the framework of the Advisers Act.  Some of the concerns about accuracy could be addressed through requiring reports to be made available to issuers and filed with the SEC, perhaps on a confidential basis, in a specified period of time before their issuance.  This could be accomplished under either the Advisers Act or Exchange Act Rule 14a-2(b)(3).[35]

The Roundtable discussion also made clear that issues associated with proxy advisory firms are part of larger problems relating to the proxy voting process.  Many of the participants stressed the ultimate responsibility of institutional investors in the proxy voting process.  Rules clarifying the institutional investors’ voting responsibilities, as well as their due diligence and oversight obligations vis-à-vis proxy advisory firms and inability to broadly outsource voting responsibilities to the firms, are potentially part of the solution.  Many other issues were also discussed in the SEC’s 2010 Concept Release on the U.S. Proxy System.[36]

Practical Issues for Companies

Issuers do not need to sit idly by and wait for the SEC’s regulatory agenda to free up and for the impact of the Code of Conduct to become clear.  The Roundtable discussion indicated a few steps that issuers can take in the meantime:

• Outreach to Institutional Investors:  Issuers have significantly increased their engagement with institutional investors in connection with proxy votes over the last few years.  Institutions represented at the Roundtable expressed a willingness to engage in discussions with management.  Representatives of large institutions emphasized that the proxy advisory recommendations were only some of the inputs used in determining how to vote.  Issuers should continue with the outreach to their larger institutional shareholders and actively develop their relationships with these institutions so that the institutions have a better understanding of the issuers’ business operations, growth plans and governance processes.
• Review Proxy Advisory Firm Reports:  Both ISS and Glass Lewis indicated that they are willing to correct errors in their reports even after the reports have been released.  The factual accuracy of these reports is one of the topics in the crosshairs for regulatory action.  Issuers should promptly review reports for accuracy and pressure the proxy advisory firms to correct errors.
• Respond to Proxy Advisory Surveys:  Mr. Retelny of ISS indicated that ISS attempts to be as inclusive as possible in obtaining feedback to its policy updates.  He stated that in its 2013 survey, ISS received feedback from approximately 150 institutions and 350 corporations.  Many corporations are therefore already participating in the ISS survey.  While it is unclear how much influence they have had, more corporations should try to become involved in the process.  At a minimum, increased participation by corporations cannot harm the prospects for having their views heard, but decreased participation can.  Moreover, Mr. Retelny indicated that ISS is reaching out to corporate directors in order to obtain their input.  Corporate directors should therefore also be encouraged to get involved in the process.
• Policing Conflicts:  Conflicts of interest are also one of the main areas that the SEC is considering for regulatory action.  Issuers should actively pressure proxy advisory firms to fully disclose any conflicts that they become aware of.  Institutional investors also appeared sensitive to the issue of proxy advisory firm conflicts.  Issuers should also bring such conflicts to their attention.
• Code of Conduct:  Issuers should familiarize themselves with the Code of Conduct when it is adopted, and with the policies that proxy advisory firms adopt under it.  In the event of shortcomings of the policies or violations under them, these can be pointed out to both the SEC and ESMA as evidence that the Code of Conduct is insufficient and a regulatory solution should be actively pursued.
• Engagement in Regulatory Process:  The SEC is still in the process of analyzing the proxy advisory industry and the need for regulation.  ESMA has publicly stated that it will review the development of the Code of Conduct within two years after publication of the ESMA Final Report and may reconsider pursuing a regulatory strategy instead of a voluntary code at that time.  Issuers who have specific examples of the failures of proxy advisory firms should consider communicating their views to the SEC and ESMA so that they can be taken into account in regulatory deliberations.  Views can be communicated directly or through industry associations, such as the Business Roundtable.[37]