Corporate Governance Oversight and Proxy Advisory Firms: Do proxy advisors have too much power?

• Author: Brannon, Ike
• Position: SECURITIES & EXCHANGE

The Securities and Exchange Commission requires that investment management funds submit proxy votes for all companies in which they own shares. Because of the vast number of stocks held by the typical institutional investor, hedge fund, or mutual fund, most of these investors draw on the research of a proxy advisory firm, which provides them some guidance in their task and allows them to focus on managing their portfolio.

But while their clients want to maximize returns, the objectives of proxy advisory firms may not be completely aligned with that goal. The opacity with which these advisory firms operate makes it difficult for investment management companies--and individual shareholders--to discern that alignment.

Proxies have become increasingly contentious in recent years as political activists have taken to leveraging shareholder proposals to pursue fashionable political goals in a variety of ways. Proxy advisors have themselves become more political in their support of some of these goals. Accordingly, these activities have been receiving closer scrutiny--especially from Congress, which is currently debating legislation to increase transparency at these proxy advisory firms. The SEC has also declared its concern with political activism in proxy voting and may pursue further action in this area.

These days, some investors perceive that the growing importance of proxy advisors to investment managers may be problematic as the number of proxy votes multiplies. The worry many have is that political or social agendas that may be peripheral--or harmful--to long-run returns may be capturing undue priority, with potentially harmful ramifications for the interests of retail investors and other shareholders focused on value maximization. On such a basis, significant reform of the industry may be necessary

CONFLICTS OF INTEREST IN PROXY VOTING

Few individual investors are aware of the role that proxy advisors play in guiding the activities of institutional investors--or that they even exist, for that matter. But as the use of proposals for political advocacy accelerates, their role is growing in importance.

Ordinary-course management proxy items typically include the retention of existing board members, approval of new members, or the ratification of the CEO's pay package. However, companies are increasingly seeing proposals from shareholders that call on the company to take action on broader public policy proposals, both major and minor.

Proxy advisors are important because institutional investors--pensions, college endowments, and investment management companies--dominate shareholder voting. A recent analysis estimated that institutional investors control as much as 80% of the stock market. The SEC requires that institutional investors vote on corporate proxy matters but permits them to use recommendations from third-party proxy advisory firms. These frequently call on the company to take additional actions on environmental and social causes. The Economist magazine reported that there were 459 shareholder proposals submitted by early April of this year, a high proportion of which concerned climate change, racial and gender diversity, pay, and political spending. Given the increasing frequency of shareholder proposals that are tangential to the core activities of the company, the recommendations of proxy advisors are becoming more important every year.

There is nothing inherently wrong with companies seeking guidance from a third-party source. The sheer number of proxy items makes it difficult for institutional investors to perform this activity themselves. However, three potential problems bedevil the proxy advisory industry.

The first is a lack of transparency on proxy firms' methods and accountability for their recommendations. Proxy advisory firms have become, in some respects, akin to a self-appointed regulatory body, capable of making demands on public companies but without any actual statutory authority.

The second problem is that many in the investment community view proxy advisory firms as neutral arbiters, akin to referees in a sporting event. But in fact, these firms are for-profit enterprises with the potential for...