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Proxy Advisory Firms: Empirical Evidence and The Case For Reform
Proxy Advisory Firms: Empirical Evidence and The Case For Reform
with
David F. Larcker is the James Brian Tayan is a
Irvin Miller Professor of Accounting researcher with the
and director of the Corporate Corporate Governance
Governance Research Initiative Research Initiative at the
at the Stanford Graduate School Stanford Graduate School
of Business, and senior faculty of of Business.
the Arthur and Toni Rembe Rock
Center for Corporate Governance
at Stanford.
Messrs. Larcker and Tayan contributed substantial research and writing for this report under a grant from the Manhattan Institute.
2
Contents
Executive Summary...................................................................5
Introduction...............................................................................7
I. Shareholder Voting Overview..................................................8
II. Proxy Advisory Firms Overview..............................................9
III. Influence of Proxy Advisory Firms on Shareholder Voting ....11
IV. Proxy Advisory Firms’ Influence on Corporate Governance .. 13
V. Additional Issues Regarding the Proxy Advisory Industry.......16
VI. Regulatory and Legislative Initiatives...................................16
VII. Summary and Recommendations ......................................17
Endnotes.................................................................................20
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Proxy Advisory Firms | Empirical Evidence and the Case for Reform
4
Executive Summary
Institutional Shareholder Services (ISS), owned by the private equity firm Genstar, and Glass, Lewis & Co., a
portfolio company of the Ontario Teachers’ Pension Plan Board, control approximately 97% of the market for
proxy advisory services. The market, in short, is essentially a duopoly.
Proxy advisory companies have come under increasing scrutiny in recent years. Critics—including academic
researchers, the Manhattan Institute, and the U.S. Government Accountability Office (GAO)—have focused on
these firms’ influence as well as their objectivity and accuracy. In July 2010, the SEC issued a concept release on
the proxy voting system that highlighted concerns about proxy advisory firms, and a June 2014 SEC staff legal
bulletin attempted to clarify rules for proxy advisors. In December 2017, the U.S. House of Representatives voted
out a bill, the Corporate Governance Reform and Transparency Act of 2017 (H.R. 4015), which would impose
significant new regulatory requirements on proxy advisory firms.
Earlier Manhattan Institute research showed a positive association between ISS recommendations and share-
holder advisory votes on executive compensation, as well as votes on precatory (nonbinding) shareholder pro-
posals. Manhattan Institute research also showed a negative relationship between share value and public pension
funds’ social-issue shareholder-proposal activism—which is much more likely to be supported by proxy advisory
firms than by the median shareholder. This report seeks to inform further the state of knowledge about proxy
advisory firms with a more comprehensive review of the best empirical evidence. It finds that:
Key Findings
Proxy advisory firms lack transparency. The leading proxy advisors do not publicly disclose how they develop
their proprietary guidelines. They also do not disclose the results of any testing to demonstrate that their
recommendations are accurate and lead to positive future outcomes for shareholders. Proxy advisory firms do
not disclose the method by which feedback from corporate issuers and market participants is evaluated and
incorporated into their final guidelines.
Institutional investors are influenced by the recommendations of proxy advisory firms. Their influence is
most significant in proxy contests, the approval of company-wide equity compensation plans, and executive
compensation advisory (“say on pay”) voting.
Corporations are influenced by proxy advisory guidelines. Corporations make governance decisions to
increase the likelihood that they will receive a positive recommendation from these firms. This is particularly
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Proxy Advisory Firms | Empirical Evidence and the Case for Reform
the case in the design of company-wide equity compensation plans and say-on-pay voting. Research
generally shows that this influence is harmful to shareholders, with one notable exception: proxy advisory firm
recommendations in deciding proxy contests (contested director elections involving control of the corporation) are
shown to be beneficial to shareholders.
Proxy advisory firm recommendations may not be in the best interest of shareholders. Some proxy advisory
firms are not bound by fiduciary duties and might be subject to conflicts of interest or other governance issues
that limit proper incentives to align their recommendations with maximizing shareholder value. Empirical evidence
suggests that at least some proxy advisory firms’ recommendations are influenced by economic relationships with
issuing companies. Proxy advisory firms’ resource constraints also could negatively affect the accuracy of their
recommendations.
Regulation of the proxy advisory industry might be necessary. To be sure, there is conflicting evidence about how
proxy advisory firms’ guidance and recommendations affect shareholder value—with some evidence showing
positive rather than negative effects when it comes to proxy contests. It might be the case that proxy adviso-
ry firms use research teams with greater expertise, as well as more customization, when evaluating complex,
high-value proxy issues. Still, the generally negative impact of advisory firm recommendations, combined with a
lack of transparency and conflicts of interest, would make little sense in a properly functioning market: compa-
nies with a poor service record are driven from the market. Proxy advisory firms, however, appear to be insulated
from these forces. The dominance of ISS and Glass Lewis—despite evidence that their recommendations are
inaccurate and potentially value-destroying to shareholders—suggests that a market failure has occurred.
Two means of correcting this market failure suggest themselves: increasing regulatory standards to improve
advisory firms’ accuracy, transparency, and accountability; and reducing the regulatory demand for proxy ad-
visory services by eliminating the requirement that institutional investors vote all items on the proxy. H.R. 4015
would incorporate, at least in part, several of the policy reforms suggested in this report and deserves serious
consideration and debate.
6
PROXY ADVISORY FIRMS
EMPIRICAL EVIDENCE AND THE CASE FOR REFORM
Introduction
In the U. S., most common shareholders receive voting rights that protect their economic inter-
ests, alongside common-law fiduciary duties imposed on corporate boards and managers and, for
publicly traded corporations, the ability to sell shares in liquid markets. Although there are some
exceptions, voting rights in publicly traded companies are typically granted on a “one share, one
vote” basis, meaning that an owner of 100 shares receives 100 votes at the annual shareholder
meeting, while an owner of 1 million shares receives 1 million votes. Most shareholders exercise
these voting rights by proxy, by delegating their votes to other entities that cast ballots in cor-
porate annual meetings. Publicly traded corporations in the United States must distribute proxy
statements under rules promulgated by the Securities and Exchange Commission (SEC) under the
authority of Section 14(a) of the Securities Exchange Act of 1934.1
In recent years, market pressure and regulatory changes have increased shareholder voting power.
The Dodd-Frank Wall Street Reform and Consumer Protection Act gives shareholders the right to
vote on CEO compensation plans.2 Many companies now require majority voting standards for di-
rector elections, replacing decades-old systems relying on plurality voting. And the SEC has worked
to limit broker voting on director elections in situations when proxy voting instructions are not
received from individual shareholders, implemented in 2009 through New York Stock Exchange
Rule 452.3 These three changes, among others, have influenced the leverage that shareholders in
general—and institutional investors and their advisors, in particular—have on corporate elections.
Institutional investors dominate shareholder voting, because institutions own approximately 70%
of all publicly traded equity shares and because regulatory changes over recent decades have en-
couraged voting by institutional investors and discouraged voting by individual investors. At the
same time, voting requirements place significant burdens on institutional investors. To manage
their proxy voting, institutional investors rely heavily on third-party proxy advisory firms. The SEC
explicitly allows institutional investors to rely on proxy advisory firms’ voting guidelines to satisfy
their fiduciary obligations.
The proxy advisory market has come under increasing scrutiny in recent years. Critics of the proxy
advisory firm market have included the U.S. Government Accountability Office (GAO),4 former SEC
commissioners,5 academic researchers,6 and think-tank scholars.7 Critics have argued that proxy
advisory firms have sizable influence over corporate voting; that this influence extends to corporate
decision making; and that these advisory firms lack the incentives, legal requirements, and compe-
tence to develop voting recommendations aligned with shareholders’ interests.
The SEC has taken notice of concerns about proxy advisory firms. In July 2010, the SEC issued a
concept release on the proxy voting system that highlighted concerns about proxy advisory firms.8
And in June 2014, an SEC staff legal bulletin attempted to clarify rules for institutional investors
and proxy advisors.9
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Proxy Advisory Firms | Empirical Evidence and the Case for Reform
More recently, Congress has begun to consider legis- and changes to certain bylaw provisions. In addition
lative reforms intended to improve the functioning to proxy ballot items placed before shareholders by the
and transparency of the proxy advisory firm market. board of directors, shareholders of publicly traded com-
In December 2017, the U.S. House of Representatives panies can themselves introduce proposals for a share-
passed a bill, the Corporate Governance Reform and holder vote under SEC Rule 14a-8. Such rules are rather
Transparency Act of 2017 (H.R. 4015),10 which would lenient: currently, any stockholders owning shares
impose significant new regulatory requirements on valued at $2,000 or more for at least one year may in-
proxy advisory firms. troduce a shareholder proposal.15 Shareholder proposals
are generally opposed by the board of directors, rarely
Manhattan Institute research has shown a positive as- receive majority shareholder support,16 and are anyway
sociation between ISS recommendations and share- generally precatory (nonbinding).17
holder voting11 and a negative relationship between
share value and public pension funds’ social-issue
shareholder-proposal activism (which is much more Key Issues in Shareholder Voting
likely to be supported by proxy advisory firms than by
the median shareholder).12 This report seeks to inform Certain issues put before shareholders are quite con-
current reform efforts with a more comprehensive troversial. Some of these involve issues of corporate
review of the best empirical evidence on proxy adviso- control, i.e., who will be running the corporation. Others
ry firms. Part I summarizes key issues in sharehold- involve executive compensation issues, which are signif-
er voting and discusses evidence of how shareholder icant because executive pay has the potential to affect
votes affect corporate behavior. Part II overviews the shareholder value directly (if stock grants “dilute” the
proxy advisory firm market, including a discussion of holdings of existing shareholders) and indirectly (in that
the demand for such firms’ services, the current struc- compensation of senior executives is a major tool for re-
ture of the industry, and the way in which industry ducing agency costs, i.e., the misalignment of managers’
players develop voting guidelines. Part III assesses and shareholders’ incentives). The most controversial
the evidence on proxy advisory firms’ influence over shareholder voting issues include:
shareholder voting. Part IV looks at the research
about proxy advisory firms’ influence on corporate gov- • Contested Director Elections. In some cases, an activ-
ernance and compensation issues, including whether ist investor attempting to change the direction or to
such influence helps or harms shareholder value. Part seize control of a company will nominate its own slate
V briefly examines other issues that have been raised of directors as an alternative to the company’s pro-
about proxy advisory firms, issues about which there is posed slate. Shareholders will determine which set of
sparse empirical evidence. Part VI looks at regulatory directors controls the company, with the potential for
efforts, with a specific focus on H.R. 4015. Part VII very different strategic and economic outcomes.18
summarizes research findings and suggests guidelines
for reform. • Approval of a Major Acquisition or Sale. Takeover
offers and certain acquisitions require shareholder
approval. Investors will need to determine whether
acceptance of a deal is in their financial best interest.
I. Shareholder Voting
Overview • Approval of Employee Equity Programs. Companies
cannot issue employee equity awards, such as re-
stricted shares or stock options, without first gaining
Institutional investors and other diversified sharehold- shareholder approval to establish an equity program,
ers face a broad array of votes during corporate Ameri- because these programs dilute the ownership inter-
ca’s “proxy season”—the period between mid-April and est of current investors. The structure of these plans
mid-June, when most large publicly traded corpora- can be complicated, but they nevertheless provide
tions hold annual meetings. According to a 2010 report important incentives to employees and executives.
by the Investment Company Institute, Russell 3000 Shareholder approval or rejection of these plans will
companies faced more than 20,000 proxy ballot items have ramifications for employee motivation, work-
annually13—even before Dodd-Frank required executive place culture, strategy, and risk taking.
compensation advisory voting by shareholders.14
• Advisory Approval of CEO Pay. As mentioned above,
Some matters that require shareholder approval are the Dodd-Frank Act of 2010 gave shareholders an
usually mundane, such as the routine approval of the advisory vote on the compensation plans offered to
board of directors, ratification of the external auditor, named executive officers, including the CEO (“say on
8
pay”).19 While the results of this vote are nonbinding, II. Proxy Advisory Firms
they send an important signal about shareholder sat-
isfaction with CEO pay and performance. Overview
Shareholder voting is dominated by institutional in-
Impact of Voting on Corporate Decisions vestors. A 2017 report by Broadridge and Pricewater-
houseCoopers shows that institutional investors—such
Proxy voting serves as an important vehicle for share- as mutual funds, index funds, pensions, and hedge
holders to communicate their preferences to the board. funds—own 70% of the outstanding shares of publicly
While companies do not always take action in response traded corporations in the United States. Thus, “retail”
to shareholder votes—particularly when the vote is ad- (individual) investors own only 30%. Furthermore, in-
visory rather than binding—research suggests that cor- stitutional investors have significantly higher voting
porate directors pay attention to voting outcomes and, participation rates, casting votes that represent 91%
in many cases, incorporate the results of the vote in of the shares that they hold, compared with only 29%
their future decisions. This is particularly the case when for retail investors.26 The combination of these factors
shareholders register a strong “protest vote”—a material gives institutional investors a disproportionately large
vote in opposition to a proposed action.20 influence over voting outcomes.
Fischer et al. (2009) study the impact of protest votes Prior to the 1980s, institutional investors general-
in director elections. They find that a typical board ly paid little attention to shareholder voting matters,
nominee running unopposed receives 94% support. but the wave of hostile takeover actions in that decade
However, when a director receives significantly lower forced them to take at least occasional notice. Some
support (80% or less), companies are highly likely to institutional investors’ broader need to assess share-
take responsive action. Protest votes against directors holder voting issues, including proxy proposals, took
are associated with higher board turnover, higher man- on added significance in the late 1980s, when the U.S.
agement turnover, and increased corporate activity Department of Labor required retirement benefit
(such as a major asset sale or acquisition) in the year funds governed by the Employee Retirement Income
following the vote.21 Security Act (ERISA) to vote their shares according to
a “prudent man” standard.27 In 2003, the SEC clarified
There is some evidence that shareholder voting influ- that similar fiduciary duties attach to mutual funds
ences the design of compensation programs. Martin and other registered investment companies.28 And new
and Thomas (2005) find that when shareholders protest stock-voting rules for individual investors effectively
against executive-only stock option plans, directors made them less likely to exercise their voting rights: in
respond by reducing executives’ future salary.22 Simi- 2009, the SEC approved amendments to the New York
larly, Ferri and Maber (2013) study the impact of say- Stock Exchange (NYSE) rules that eliminated stock-
on-pay executive compensation advisory voting and find brokers’ ability to vote discretionarily the shares of
that companies that receive low levels of shareholder their individual investors for director elections;29 and
support are more likely to amend their executive com- in 2012, the NYSE applied the limitation to a broader
pensation plans in response.23 However, research in this array of issues.30
area is not conclusive. Armstrong, Gow, and Larcker
(2013) find that shareholder protest votes against equity
pay plans have little impact on future compensation.24 The Rise of Proxy Advisory Firms
Finally, the research shows that activist investors use the Two factors have opened the door for third-party
shareholder voting process to influence corporate poli- proxy advisory firms to play a substantial role in how
cies. Klein and Zur (2009) study a sample of 151 hedge institutional investors participate in proxy voting:
funds between 2003 and 2005. They find that hedge
funds have a 60% success rate in using their ownership Economic Demand for Proxy Advisory Firms.
position (including the threat of proxy contests) to meet The proxy voting process is costly and requires
their stated objectives. These include gaining board significant time, expertise, and personnel. While
representation, replacing the CEO, increasing cash large institutional investors—such as BlackRock
distributions (such as dividends or stock buybacks) to and the American Funds—can dedicate significant
owners, altering strategy, terminating pending acquisi- resources to developing proprietary proxy voting
tions, or agreeing to a proposed merger.25 These findings guidelines and researching company-specific issues,
indicate that shareholder voting is an effective means of most small and midsize funds lack the resources to
shaping corporate policy. conduct these activities. Third-party proxy advisory
9
Proxy Advisory Firms | Empirical Evidence and the Case for Reform
companies lower the research costs that smaller • ProxyVote Plus was established in 2002. Based in
funds would have to bear. Northbrook, Illinois, it provides proxy voting ser-
vices to 150 clients.37
Regulatory Demand for Proxy Advisory Firms. In
2003, the SEC began to require that registered insti- Proxy advisory firms also exist that specialize in non-
tutional investors (including mutual funds and index U.S. markets. Examples include Pensions & Invest-
funds) develop and disclose their proxy voting policies, ments Research Consultants (U.K.), Manifest (U.K.),
as well as disclose their votes on all proxy items.31 The Proxyinvest (France), GES Investment Services
rule was intended to create greater transparency into (Sweden), Nordic Investor Services (Sweden), and In-
the voting process and ensure that institutional inves- stitutional Investor Advisory Services (India).
tors act without conflict of interest. Furthermore, the
SEC clarified that institutional investors could satisfy Glass Lewis claims that its clients collectively manage
this obligation by relying on voting policies developed $35 trillion in assets.38 ISS does not disclose client asset
by an independent, third-party agency—such as a proxy size but discloses that its clients vote on 8.5 million
advisor. The use of a proxy advisory firm has become a ballots representing 3.8 trillion shares.39 Researchers
cost-effective means of satisfying institutional inves- at George Mason University estimate that these two
tors’ fiduciary and regulatory voting obligations. firms together have a 97% share of the market for
proxy advisory services.40
FIGURE 1.
FIGURE 2.
Some institutional data support this conclusion. rely on them exclusively to substitute for making their
Through survey reports, institutional investors state own decisions.51
that they refer to the voting recommendations of
proxy advisory firms but also that these recommen- Institutional voting data, however, suggest that proxy
dations have little influence over their actual voting advisors have a significant influence on voting behav-
practices. According to a survey by Rivel (2016), only ior, contradicting investors’ self-assessment of their
7% of institutional investors say that proxy advisory reliance on these firms. An extensive sample of the
firms are the “most influential” contributors to their voting record of 713 institutional investors in 2017,
policies. Instead, they state that generally estab- compiled for this report by the shareholder-voting data
lished best practices are the primary source of their firm Proxy Insight, shows that institutional investors
voting policies and decisions.50 McCahery, Sautner, are significantly likely to vote in accordance with proxy
and Starks (2016) reach similar conclusions. Using advisor recommendations across a broad spectrum of
a sample of 143 institutional investors, they find that governance issues.52 For example, 95% of institutional
just over half (55%) agree or strongly agree that proxy investors vote in favor of a company’s say-on-pay pro-
advisory firms help them make more informed voting posal when ISS recommends a favorable vote, while
decisions. However, the authors conclude that insti- only 68% vote in favor when ISS is opposed (Figure
tutional investors rely on the advice of proxy advisors 1). Similarly, when ISS recommends a favorable vote,
to complement their decision making, rather than equity plan proposals receive 17% more votes in favor
12
and uncontested director elections receive 18% more They do so because the CEOs recognize that some
votes in favor. Proxy contests receive 73% more votes institutional investors will simply follow ISS’s advice
in favor when ISS also supports the measure. Glass rather than do any thinking of their own.”54
Lewis also has influence over voting outcomes: its rec-
ommendations of favorable votes are associated with More recently, former SEC commissioner Daniel Gal-
16%, 12%, and 64% increases in institutional investor lagher expressed concern in 2013 that “it is important
support for say on pay, equity plan, and proxy contest to ensure that advisors to institutional investors . . . are
ballot measures. not over-relying on analyses by proxy advisory firms.”
He cautioned that institutional investors should not
Furthermore, voting data show that several large in- “be able to outsource their fiduciary duties.”55
stitutional investors often vote in near-total alignment
with proxy advisory firm recommendations (Figure 2). The evidence suggests that proxy advisors have a ma-
terial, if unspecified, influence over institutional voting
The Proxy Insight data suggest that while some institu- behavior and therefore also voting outcomes. An
tional investors might use proxy advisory recommen- against recommendation is associated with a reduction
dations to complement the information they collect to in the favorable vote count by 15%–30%.56
arrive at voting decisions, others rely to a very large
extent on the voting recommendations of these firms
as a substitute for their proprietary decision making.
And these are among the largest institutional inves- IV. Proxy Advisory Firms’
tors in the market; smaller funds with fewer resources
to develop proprietary voting guidelines (which give Influence on Corporate
them no competitive advantage in fund performance)
are more likely to rely on proxy advisory firms’ recom-
Governance
mendations. In fact, a number of small funds might
be considered auto- or robo-voters because they some- Empirical studies have also sought to examine the
time explicitly state in their voting policies that they extent to which proxy advisory firm recommendations
follow the recommendations of proxy advisors. influence corporate choices. This is a different ques-
tion from their influence on institutional investors’
A survey of 64 asset managers and owners with a com- voting patterns. The latter question seeks to measure
bined $17 trillion in assets supports this claim. That how heavily funds rely on proxy advisory recommenda-
survey, sponsored by RR Donnelley, Equilar, and the tions when casting votes; the former seeks to measure
Rock Center for Corporate Governance at Stanford the degree to which companies make governance deci-
University, finds that portfolio managers are only sions—pay structure, board structure, the adoption of
moderately involved in voting decisions. While 68% antitakeover defenses, etc.—explicitly with the voting
of funds report that portfolio managers play a role in guidelines of proxy advisory firms in mind and in order
establishing the proxy voting guidelines at their firms to win their approval.57
and 67% are involved in voting specific proxy items,
their actual engagement is quite low. Among large in- Here, the evidence suggests that proxy advisors have
stitutional investors with assets under management significant influence over corporate choices, particu-
greater than $100 billion, portfolio managers are in- larly compensation choices.
volved in only 10% of voting decisions.53 This demon-
strates that the individuals within investment firms A 2012 survey by the Conference Board, NASDAQ, and
that have the most detailed knowledge of specific com- the Rock Center for Corporate Governance at Stan-
panies are not very involved with proxy voting deci- ford University finds that 72% of publicly traded com-
sions. panies review the policies of a proxy advisory firm or
engage with a proxy advisory firm to receive feedback
Others have voiced qualms about the influence of and guidance on their proposed executive compensa-
proxy advisory firms. From his position as longtime tion plan. Companies reported making a broad range
vice chancellor (and now chief justice) of the Dela- of changes to their compensation program in response
ware Supreme Court, Leo Strine characterized the in- to proxy advisory firm policies:
fluence of proxy advisory firms in 2005: “[P]owerful
CEOs come on bended knee to Rockville, Maryland, 32% change disclosure practices.
•
where ISS resides, to persuade the managers of ISS
of the merits of their views about issues like proposed 24% reduce or eliminate certain severance benefits.
•
mergers, executive compensation, and poison pills.
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Proxy Advisory Firms | Empirical Evidence and the Case for Reform
contests between 1992 and 2005. In 55% of cases, ISS claims. One study, however, shows that conflicts of
recommends in favor of management’s nominations interest within proxy advisory firms are a legitimate
to the board; in 45%, they recommend in favor concern. Li (2016) finds that proxy advisory firms that
of the dissident slate. The authors find that ISS also engage in consulting arrangements with corporate
recommendations for the dissident slate increase the issuers exhibit favoritism toward management. The
probability of victory by 14%–30%. They also find author shows that when Glass Lewis initiates recom-
that ISS recommendations in these situations are mendations on companies that are both covered by
associated with positive shareholder returns. The and in consulting arrangements with ISS, ISS becomes
authors conclude that “proxy advice may facilitate tougher on management in future recommendations.
informed proxy voting.”69 Li concludes that the evidence “is consistent with our
theory [that] the incumbent is subject to conflicts of
interest by serving both investors and corporations.”72
V. Additional Issues
Regarding the Proxy VI. Regulatory and
Advisory Industry Legislative Initiatives
Market participants and researchers have raised ad- Proxy advisory firms are not subject to direct oversight
ditional concerns about the proxy advisory industry, by the SEC or other regulatory bodies in the United
beyond their direct influence over voting and corporate States. The following is a timeline of recent actions
behavior: taken by the SEC related to the proxy voting system and
the role of proxy advisory firms:
• Fiduciary Duty. Proxy advisory firms are not held
to a fiduciary standard that would require them to • July 2010. The SEC issued a concept release on the
demonstrate that their recommendations are in the U.S. proxy system. The report summarized concerns
best interest of shareholders and the corporation— about proxy advisory firms’ conflicts of interest, ac-
or, at least, no such standard that has been clearly curacy, and transparency. The report requested com-
articulated in rules or regulations or litigated in ments on potential solutions.
a court of law. This absence of fiduciary duties is
salient, given the evidence that at least some insti- • December 2013. The SEC held a proxy advisory firm
tutional investors use proxy advisory firms as a low- roundtable. Participants discussed issues facing the
est-cost option to meet their own fiduciary voting industry, including the use of proxy advisory firms.
obligations, without regard to voting accuracy.70
• June 2014. The SEC issued a staff legal bulletin that
onflicts of Interest. Some proxy advisory firms,
• C provided guidance on the responsibilities that invest-
such as ISS, receive consulting fees from the same ment advisors have in voting proxies and hiring proxy
companies whose governance practices they eval- advisory firms. The guidance sought to address con-
uate. The terms of these arrangements are not dis- cerns over conflicts of interest, but it largely omitted
closed, including whether paid clients are given questions of accuracy.
special access to information about the models un-
derlying the firm’s recommendations. • January 2015. To follow up on its legal bulletin, the
SEC began to look more carefully at how investment
• Resource Constraints. Proxy advisory firms might advisors and investment companies that retain the
have insufficient staff to accurately evaluate the services of proxy advisory firms use these firms’ ser-
full scale of proxy items on which they provide rec- vices, through the agency’s examinations of those ad-
ommendations each year. ISS, which is the largest visors and companies.73
firm, employs 1,000 individuals company-wide in-
cluding non-research (administrative) personnel. In December 2017, the U.S. House of Representatives
By contrast, Moody’s Corporation, which includes voted to approve H.R. 4015, “The Corporate Governance
the agency that rates credit instruments worldwide, Reform and Transparency Act of 2017.” According to its
employs 11,700 individuals.71 Small proxy advisory terms, proxy advisory firms would be required to:
firms are likely even more resource-constrained.
Register with the SEC under the Securities and Ex-
•
There is little research to evaluate the validity of these change Act of 1934.
16
information.”
EMPIRICAL FINDINGS
• Shareholder voting is dominated by institutional Develop procedures “sufficient to permit companies
•
investors. These investors are required by the receiving proxy advisory recommendations access in
SEC to vote all matters put forth on the proxy and a reasonable time (not less than three business days)
to report to shareholders how they voted each to the draft recommendations, with an opportunity to
matter. provide meaningful comment thereon, including the
opportunity to present details to the person responsi-
• Institutional investors are also required to develop ble for developing the recommendation in person or
proxy voting guidelines that are free from conflicts telephonically.”
of interest. The SEC explicitly allows institutional
investors to rely on the voting guidelines of third- Designate an ombudsman to receive complaints
•
party proxy advisory firms to satisfy this obligation. about the accuracy of information used in making
• Proxy advisory firms do not publicly disclose the recommendations.
processes by which they develop their proprietary
guidelines. They have not disclosed the results of Make public its “methodology for the formulation of
•
any testing—or that they, in fact, conduct testing— proxy voting policies and voting recommendations.”74
to demonstrate that their recommendations are
accurate and lead to positive future outcomes for This bill has not been introduced in the Senate.
shareholders. Proxy advisory firms do not disclose
the method by which feedback from corporate
issuers and market participants is evaluated and
incorporated into their final guidelines. VII. Summary and
• Institutional investors are influenced by the
recommendations of proxy advisory firms. Their
Recommendations
influence is most significant in proxy contests, the
approval of company-wide equity compensation The research literature shows mixed evidence on the
plans, and say-on-pay voting. degree to which proxy advisory firms influence firm
voting, as well as the impact that their policies and rec-
• Corporations are influenced by proxy advisory ommendations have on corporate behavior and share-
firm guidelines and make governance decisions holder returns. For the most part, proxy advisory firms’
to increase the likelihood that they will receive a influence on voting is shown to be—at a minimum—
positive recommendation from these firms. This moderate. In most cases, proxy advisory firms’ influ-
is particularly the case in the design of company- ence on corporate behavior and shareholder value are
wide equity compensation plans and say-on- shown to be negative. Nevertheless, conflicting evi-
pay voting. Research generally shows that this dence exists: at least in the case of proxy contests and
influence is harmful to shareholders. However, other shareholder votes implicating a potential change
proxy advisory firm recommendations in deciding of corporate control, proxy advisory firms appear to
proxy contests are shown to be beneficial to have a substantial impact on shareholder voting be-
shareholders. havior that positively affects shareholder value.
• Proxy advisory firms have no clear fiduciary duty
to the shareholders of the institutional investors The conflicting evidence is not irreconcilable. It might
whose votes they influence. They might not have be that proxy advisory firms customize their standards
proper incentive to act in the best interest of and use research teams with greater expertise when
shareholders. Some proxy advisory firms might evaluating complex issues such as proxy contests and
be subject to conflicts of interest. They might also mergers and acquisitions.75 When it comes to general
be resource-constrained, which could negatively issues common to the broad universe of companies—
affect the accuracy of their recommendations. such as compensation design and uncontested director
elections—resource and time constraints might compel
proxy advisory firms to employ more rigid and there-
Establish written policies and procedures reasonably
• fore arbitrary standards that are less accommodating to
designed to “address and manage any conflicts of in- situational information that is unique to specific com-
terest that can arise from such business.” panies’ situation, industry, size, or stage of growth.76
despite evidence that their recommendations are inac- • Maintaining adequate resources. Legislation or
curate and potentially value-destroying to sharehold- regulation could set minimal standards for proxy
ers, suggests a market failure. In a properly function- advisory firms’ staffing models to ensure that rec-
ing market, companies with a poor service record are ommendations are based on accurate and current
driven from the market. Proxy advisory firms, however, information.
are insulated from these forces.
• Improving reliability. Proxy advisory firms could
The reason for this market failure is that institutional be required to develop and disclose procedures
investors generally receive little competitive advantage for corporate issuers to comment on, respond to,
from being better or more informed voters regarding or object to draft recommendations before they
corporate governance.77 Because inaccurate voting from are made final.
a single institutional investor only very rarely affects the
risk and return of the investor’s portfolio even margin- •
Facilitating independent third-party review.
ally, there is little incentive to invest more resources in Many researchers can provide insights into
proxy advice. ISS is the dominant proxy advisory firm methods and models. Posting old data files to be
but is a relatively small operation: as reported by MSCI, analyzed by outside reviewers is a cost-effective
the publicly traded company that owned ISS before its way for proxy advisors to improve their services.
2014 acquisition by the private equity firm Vestal, it had Clearly, bond-rating agencies and other organiza-
just over $15 million in profits on $122 million in rev- tions engage in this type of activity and have ben-
enues.78 Thus, the evidence suggests that institutional efited from independent reviews.
investors largely use proxy advisory firms’ services as a
cost-effective method to satisfy their legal obligation to 2. Improved Transparency. Part of the problem
develop shareholder voting guidelines that are free from with assessing proxy advisory firms’ accuracy and
conflict and to vote all items on the proxy. They do not bias lies in their lack of transparency. Policymakers
appear to use their services to improve investment deci- could develop transparency requirements that do
sions. And even if proxy advisory firms are wrong, funds not compromise firms’ corporate trade secrets. Pos-
will continue to use their services. sible steps include:
Two means of correcting this market failure suggest • Process disclosure. Proxy advisory firms could be
themselves: required to disclose the processes by which they
develop their proprietary guidelines.
1. Increase regulatory standards. Congress and the
SEC could take steps to compel proxy advisory firms • Voting disclosure. Proxy advisory firms could be
to improve the quality of their product, increase required to freely publish their general vote rec-
transparency, and reduce conflicts of interest. ommendations after the proxy season has ended.
2. Reduce regulatory demand for services. Congress • Model disclosure. Proxy advisory firms could be
or the SEC could eliminate the requirement that in- required to disclose the details of their models to
stitutional investors vote all items on the proxy. This allow third-party researchers to test the accuracy
action would free investors to decide whether to pay of their recommendations.
for the voting recommendations of proxy adviso-
ry firms based on an evaluation of their price and onflict disclosure. Proxy advisory firms could
• C
value. be required to disclose issuers with which they
retain a commercial relationship. These data
These two reforms need not be mutually exclusive. would enable research on whether consulting
Specifically, in terms of recommendation 1, policymak- agreements affect the quality of proxy advisor
ers should consider regulations to achieve: recommendations.
19
Proxy Advisory Firms | Empirical Evidence and the Case for Reform
Endnotes
1 Pub. L. No. 73-291, 48 Stat. 881 (1934) (codified at 15 U.S.C. §§ 78a–78OO (2006 & Supp. II 2009)). The federal securities laws and regulations
governing proxy statements are principally designed to ensure corporate disclosures to shareholders to afford investment information and prevent
deception. See J.I. Case Co. v. Borak, 377 U.S. 426, 431 (1964) (“The purpose of § 14(a) is to prevent management or others from obtaining
authorization for corporate action by means of deceptive or inadequate disclosure in proxy solicitation.”)
2 See Pub. L. No. 111-203, 124 Stat. 1376, § 951 (2010).
3 See SEC Rel. No. 34-60215 (2009).
4 See U.S. Government Accountability Office (GAO), “Corporate Shareholder Meetings: Proxy Advisory Firms’ Role in Voting and Corporate Governance
Practices,” GAO-17-47, Nov. 15, 2016.
5 See, e.g., Nicholas Donatiello and Harvey L. Pitt, “Protecting Shareholders from Activist Proxies,” Wall Street Journal, May 28, 2015.
6 See, e.g., David F. Larcker, Allan L. McCall, and Brian Tayan, “And Then a Miracle Happens!: How Do Proxy Advisory Firms Develop Their Voting
Recommendations?” Stanford Closer Look Series, Stanford University Graduate School of Business (Feb. 25, 2013).
7 See, e.g., James R. Copland, “Politicized Proxy Advisers vs. Individual Investors,” Wall Street Journal, Oct. 7, 2012.
8 SEC Rel. No. 34-62495.
9 SEC, Staff Leg. Bull. No. 20, “Proxy Voting: Proxy Voting Responsibilities of Investment Advisers and Availability of Exemptions from the Proxy Rules for
Proxy Advisory Firms,” June 30, 2014.
10 H.R. 4015: Corporate Governance Reform and Transparency Act of 2017.
11 See James R. Copland with Yevgeniy Feyman and Margaret O’Keefe, “Proxy Monitor 2012: A Report on Corporate Governance and Shareholder
Activism,” Manhattan Institute, Fall 2012, pp. 22–23.
12 See Tracie Woidtke, “Public Pension Fund Activism and Firm Value,” Manhattan Institute Legal Policy Report No. 20, September 2015.
13 See Investment Company Institute, “Trends in Proxy Voting by Registered Investment Companies, 2007–09,” Research Perspective 16, no. 1 (November
2010).
14 Under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, publicly traded companies must hold shareholder advisory votes on
executive compensation annually, biennially, or triennially, at shareholders’ discretion. See Pub. L. No. 111-203, 124 Stat. 1376, § 951 (2010).
15 See 17 C.F.R. § 240.14a-8 (2007) [hereinafter 14a-8].
16 See, generally, James R. Copland and Margaret M. O’Keefe, “Proxy Monitor 2017: Season Review,” Manhattan Institute, Fall 2017. Although shareholder
proposals usually do not receive majority support, certain classes of proposals—including those seeking “proxy access” for shareholder board nominees
and those seeking to eliminate staggered board terms and elect all directors annually—are exceptions to the general rule and have typically received
majority shareholder support.
17 Although shareholder proposals are typically precatory, directors are nevertheless under significant pressure to respond to precatory proposals that
receive majority shareholder votes. ISS, for instance, considers withholding support for directors if boards have been “nonresponsive” to shareholder
proposals receiving majority support, even in a single year. See ISS, “United States Proxy Voting Guidelines: Benchmark Policy Recommendations,” Jan.
4, 2018, p. 9. In the view of ISS, responsiveness to a shareholder proposal “will generally mean either full implementation of the proposal or, if the matter
requires a vote by shareholders, a management proposal on the next annual ballot to implement the proposal.” Moreover, in determining “majority”
support, ISS excludes abstention votes, even if they are required to be included by company bylaws—thus putting pressure on boards to enact
shareholder proposals that technically receive less than majority shareholder support. See ISS, “U.S. Proxy Voting Research Procedures & Policies,” Jan.
4, 2018, p. 18.
18 In recent years, many companies have adopted proxy access rules more liberally, allowing investors to nominate directors on companies’ own proxy
ballots. It is too soon to assess empirically how these rules might operate in practice, in comparison with more traditional contested elections.
19 See Pub. L. No. 111-203, 124 Stat. 1376, § 951 (2010).
20 David Yermack, “Shareholder Voting and Corporate Governance,” Annual Review of Financial Economics 2 (2010): 103–25.
21 Paul E. Fischer et al., “Investor Perceptions of Board Performance: Evidence from Uncontested Director Elections,” Journal of Accounting and
Economics 48, nos. 2–3 (December 2009): 172–89.
22 Kenneth J. Martin and Randall S. Thomas, “When Is Enough, Enough? Market Reaction to Highly Dilutive Stock Option Plans and the Subsequent
Impact on CEO Compensation,” Journal of Corporate Finance 11, nos. 1–2 (March 2005): 61–83.
23 Fabrizio Ferri and David A. Maber, “Say on Pay Votes and CEO Compensation: Evidence from the UK,” Review of Finance 17, no. 2 (April 2013): 527–63.
24 Christopher S. Armstrong, Ian D. Gow, and David F. Larcker, “The Efficacy of Shareholder Voting: Evidence from Equity Compensation Plans,” Journal of
Accounting Research 51, no. 5 (December 2013): 909–50.
25 April Klein and Emanuel Zur, “Entrepreneurial Shareholder Activism: Hedge Funds and Other Private Investors,” Journal of Finance 64, no. 1 (January
2009): 187–229.
26 Broadridge and PricewaterhouseCoopers, “Proxy Pulse: 2017 Proxy Season Review,” September 2017.
27 See Letter from U.S. Department of Labor to Helmuth Fandl, chairman of Retirement Board, Avon Products, Inc. (Feb. 23, 1988); see also 73 Fed. Reg.
61731 (Oct. 17, 2008).
28 See 68 Fed. Reg. 6585 (Feb. 7, 2003) (“The duty of care requires an adviser with proxy voting authority to monitor corporate events and to vote the
proxies. To satisfy its duty of loyalty, the adviser must cast the proxy votes in a manner consistent with the best interest of its client and must not
subrogate client interests to its own” (internal citations omitted)).
29 See SEC Rel. No. 34-60215.
30 See NYSE, Information Memo No. 12-4, Application of Rule 452 to Certain Types of Corporate Governance Proposals (Jan. 25, 2012).
31 SEC, “Disclosure of Proxy Voting Policies and Proxy Voting Records by Registered Management Investment Companies,” 17 C.F.R., pts. 239, 249, 270,
274 (2003).
32 ISS has also participated in an industry that assigns governance ratings to individual companies, analogous to the practice of credit-rating agencies
assigning ratings to reflect the creditworthiness of individual companies. This industry has not gained wide reception in the market. For an early study
on the governance ratings industry, see Robert Daines, Ian D. Gow, and David F. Larcker, “Rating the Ratings: How Good Are Commercial Governance
20
Ratings?” Journal of Financial Economics 98, no. 3 (December 2010): 439–61.
33 ISS launched a proxy advisory service in 1986 and a voting service in 1992. In 2006, RiskMetrics purchased ISS for an undisclosed amount, and MSCI
acquired RiskMetrics for $1.55 billion in 2010. In 2014, private equity Vestar acquired ISS for $364 million. In 2017, Genstar acquired ISS for $720
million. See Institutional Investor Services, “About ISS.”
34 In 2006, Xinhua Financial of China acquired 20% of Glass Lewis for an undisclosed amount. Later that year, it acquired the remaining 80% for $45
million. In 2007, the Ontario Teachers’ Pension Plan of Canada acquired Glass Lewis for $46 million. In 2013, Alberta acquired a 20% stake in Glass
Lewis for an undisclosed amount. See Glass Lewis, “Company Overview.”
35 Egan-Jones Proxy Services, “Independent Proxy Recommendations and Voting Services.”
36 Segal Marco Advisors, “About Us: Who We Are.”
37 ProxyVote Plus, “About ProxyVote Plus,” 2013.
38 Glass Lewis, “Company Overview.”
39 Institutional Shareholder Services, “About ISS.”
40 James K. Glassman and Hester Peirce, “How Proxy Advisory Services Became So Powerful,” Mercatus on Policy Series, Mercatus Center at George
Mason University, June 18, 2014.
41 ISS, “2017–18 ISS Global Policy Survey Summary of Results,” Sept. 25, 2017.
42 ISS, “Executive Summary of 2016 Proxy Voting Guidelines Updates,” Nov. 10, 2015.
43 Larcker, McCall, and Tayan, “And Then a Miracle Happens.”
44 GAO, “Corporate Shareholder Meetings.”
45 Glass Lewis, “Guidelines: An Overview of the Glass Lewis Approach to Proxy Advice,” 2018.
46 The Glass Lewis Research Advisory Council is chaired by David Nierenberg, a venture capitalist. Other members include Charles Bowsher (former U.S.
comptroller general and former head of GAO), Kevin Cameron (cofounder of Glass Lewis), Jesse Fried (professor of law at Harvard Law School), Bonnie
Hill (consultant with experience on multiple corporate boards), Stephanie Lachance (corporate secretary at an investment firm), and Carla Topino (former
executive of Glass Lewis). See Glass Lewis, “Leadership: Research Advisory Council.” See also GAO, “Corporate Shareholder Meetings.”
47 Nadya Malenko and Yao Shen, “The Role of Proxy Advisory Firms: Evidence from a Regression-Discontinuity Design,” Review of Financial Studies 29, no.
12 (December 2016): 3394–3427.
48 Proxy Governance is now part of Glass Lewis.
49 Stephen Choi, Jill Fisch, and Marcel Kahan, “The Power of Proxy Advisors: Myth or Reality?” Emory Law Journal 59, no. 4 (March 2010): 869–918 .
50 Rivel Research Group, “Proxy Voting Protocols: Attitudes and Practices of North American Proxy Voters,” Corporate Governance Intelligence Council,
February 2016 (proprietary research on file with authors, available through Rivel).
51 Joseph A. McCahery, Zacharias Sautner, and Laura T. Starks, “Behind the Scenes: The Corporate Governance Preferences of Institutional Investors,”
Journal of Finance 71, no. 6 (December 2016): 2905–32.
52 Data and proprietary calculations made by Proxy Insight, for this report, are on file with the authors.
53 See Donald F. Larcker (Stanford University), Brian Tayan (Stanford University), Ronald Schneider (RR Donnelley), and Aaron Boyd (Equilar), “2015 Investor
Survey: Deconstructing Proxies—What Matters to Investors,” February 2015.
54 Leo E. Strine, Jr., “The Delaware Way: How We Do Corporate Law and Some of the New Challenges We (and Europe) Face,” Delaware Journal of
Corporate Law 30, no. 3 (2005): 673–96.
55 Daniel M. Gallagher, “Gallagher on the Roles of State and Federal Law in Corporate Governance,” Columbia Law School’s Blog on Corporations and the
Capital Markets, June 18, 2013.
56 In addition to the academic studies cited in this section of the report, James R. Copland coauthored a 2012 study assessing ISS recommendations’
influence over shareholder voting behavior in the context of precatory shareholder proposals filed under SEC Rule 14a–8 and executive compensation
advisory votes. See James R. Copland with Yevgeniy Feyman and Margaret O’Keefe, “Proxy Monitor 2012: A Report on Corporate Governance and
Shareholder Activism,” Manhattan Institute for Policy Research, Fall 2012. The authors’ econometric model found a 15% association between ISS
recommendations and shareholder-proposal voting and a 17.5% association between ISS recommendations and say-on-pay voting, each with a high
level of statistical significance.
57 Note that the issue of proxy advisory firm influence over corporate decisions is predicated on the board of director and management belief that these
firms influence institutional investor voting decisions. If proxy advisory firms had no influence over voting, they likely would also have no influence over
corporate choices.
58 David F. Larcker, Allan L. McCall, and Brian Tayan, “The Influence of Proxy Advisory Firm Voting Recommendations on Say-on-Pay Votes and Executive
Compensation Decisions,” Directors Note No. DN-V4N5, the Conference Board, March 2012.
59 David F. Larcker, Allan L. McCall, and Gaizka Ormazabal, “Outsourcing Shareholder Voting to Proxy Advisory Firms,” Journal of Law and Economics 58,
no. 1 (February 2015): 173–204.
60 The cost to access ISS equity plan models is $23,500–$29,500, according to its proxy filing disclosure, depending on the size of the company. Firms
are prohibited by the terms of the contract with ISS from disclosing to shareholders that they used ISS models to determine their plan design. See Ian D.
Gow et al., “Sneak Preview: How ISS Dictates Equity Plan Design,” Stanford Closer Look Series, Oct. 23, 2013.
61 Jennifer E. Bethel and Stuart L. Gillan, “The Impact of the Institutional and Regulatory Environment on Shareholder Voting,” Financial Management 31,
no. 4 (Winter 2002): 29–54.
62 Jie Cai, Jacqueline L. Garner, and Ralph A. Walkling, “Electing Directors,” Journal of Finance 64, no. 5 (October 2009): 2389–2421.
63 Choi, Fisch, and Kahan, “The Power of Proxy Advisors.”
64 Yonca Ertimur, Fabrizio Ferri, and David Oesch, “Shareholder Votes and Proxy Advisors: Evidence from Say on Pay,” Journal of Accounting Research 51,
no. 5 (December 2013): 951–96.
65 Malenko and Shen, “The Role of Proxy Advisory Firms.”
66 Larcker, McCall, and Ormazabal, “Outsourcing Shareholder Voting.”
67 Angela Morgan, Annette Poulsen, and Jack Wolf, “The Evolution of Shareholder Voting for Executive Compensation Schemes,” Journal of Corporate
Finance 12, no. 4 (September 2006): 715–37.
21
Proxy Advisory Firms | Empirical Evidence and the Case for Reform
68 David F. Larcker, Allan L. McCall, and Gaizka Ormazabal, “Proxy Advisory Firms and Stock Option Repricing,” Journal of Accounting and Economics 56,
nos. 2–3 (November–December 2013): 149–69.
69 Cindy R. Alexander et al., “Interim News and the Role of Proxy Voting Advice,” Review of Financial Studies 23, no. 12 (December 2010): 4419–54.
70 Donatiello and Pitt, “Protecting Shareholders.”
71 Moody’s Corporation, “Company Overview.”
72 Tao Li, “Outsourcing Corporate Governance: Conflicts of Interest Within the Proxy Advisory Industry,” Management Science (forthcoming) (published
online Dec. 16, 2016).
73 GAO, “Corporate Shareholder Meetings.”
74 As summarized by National Investor Relations Institute (NIRI), “U.S. House Approves Proxy Advisor Reform Bill,” Executive Alert, Dec. 21, 2017.
75 Scott S. Winter, “Trends in Shareholder Voting: The Impact of Proxy Advisory Firms,” American Bar Association Corporate Governance Committee, Oct.
12, 2010.
76 Gaizka Ormazabal, “The Role of Stakeholders in Corporate Governance: A View from Accounting Research,” Foundations and Trends in Accounting 11,
no. 4 (February 2018): 193–290.
77 For a more general look at voter ignorance problems, see Ilya Somin, Democracy and Political Ignorance: Why Smaller Government Is Smarter (Palo Alto,
Calif.: Stanford University Press, 2013); Bryan Caplan, The Myth of the Rational Voter: Why Democracies Choose Bad Policies (Princeton, N.J.: Princeton
University Press, 2008).
78 See MSCI, 2013 Annual Report, pp. 70–71.
22
May 2018
Abstract
Shareholder voting is dominated by institutional investors. The SEC requires
institutional investors to vote on corporate proxy matters but allows them to
discharge this duty by relying on the voting guidelines of third-party proxy
advisory firms.
Proxy advisory companies have come under increasing scrutiny and criticism in
recent years. This report seeks to inform current reform efforts with a review of
the best empirical evidence on these firms.
Key Findings
• Proxy advisory firms lack transparency. The leading proxy advisors do
not publicly disclose how they develop their voting guidelines or the results of
any testing to demonstrate that their recommendations are accurate.
• Institutional investors are influenced by the recommendations of
proxy advisory firms. Their influence is most significant in proxy contests,
the approval of company-wide equity compensation plans, and executive
compensation advisory (“say on pay”) voting.
• Corporations are influenced by the recommendations of proxy
advisory firms. Research generally shows that proxy advisory firms’
influence on the design of company-wide equity compensation plans and
say-on-pay voting is harmful to shareholders, but their recommendations for
deciding proxy contests (contested director elections involving control of the
corporation) are beneficial to shareholders.
• Proxy advisory firm recommendations may not be in the best
interest of shareholders. Proxy advisory firms have no clear fiduciary duty
to act in the best interest of the shareholders of institutional investors and
may be subject to conflicts of interest.
• Reform might be necessary. One avenue is by adopting standards to
improve proxy advisory firms’ accuracy, transparency, and accountability.
Another is to eliminate the requirement that institutional investors vote all
items on corporate proxy statements.