Stephen Choi, Jill Fisch, Marcel Kahan, the Power of Proxy Advisors: Myth or Reality?

• Citation: Vol. 59 No. 4
• Publication year: 2010

THE POWER OF PROXY ADVISORS: MYTH OR REALITY?

Stephen Choi^*Jill Fisch^**Marcel Kahan^***

ABSTRACT

Recent regulatory changes increasing shareholder voting authority have focused attention on the role of proxy advisors. In particular, greater shareholder empowerment raises the question of how much proxy advisors influence voting outcomes. This Article analyzes the significance of voting recommendations issued by four proxy advisory firms in connection with uncontested director elections. We find, consistent with press reports, that Institutional Shareholder Services (ISS) is the most powerful proxy advisor and that, of the others, only Glass, Lewis & Co. seems to have a meaningful impact on shareholder voting.

This Article also attempts to measure the impact of voting recommendations on voting outcomes. Unlike prior literature, it distinguishes correlation from causality by examining both the recommendation itself and the underlying factors that may influence a shareholder's vote. Using several different tests, we conclude that popular accounts substantially overstate the influence of ISS. Our findings reveal that the impact of an ISS recommendation is reduced greatly once company- and firm-specific factors important to investors are taken into consideration. Overall, we estimate that an ISS recommendation shifts 6%-10% of shareholder votes. We also determine that a major component of ISS's influence stems from its role as an information agent, aggregating factors that its subscribers consider important.

INTRODUCTION

Proxy advisors-private firms that analyze corporate elections and advise investor clients on how to vote their shares-are recent and potentially powerful new players in the corporate governance world.¹Institutional investors, which hold an increasing percentage of the shares of U.S. companies,²wield substantial voting power but often lack the appropriate incentives to cast informed ballots with respect to their portfolio companies.³

Instead, many institutional investors employ the services of proxy advisors to assist them in exercising their voting rights.⁴The services of proxy advisors include providing research, helping investors develop voting guidelines, handling the mechanics of the voting process, and offering recommendations on each issue on a company's agenda.⁵In some cases, institutional investors may even subcontract their voting decisions to proxy advisors.⁶

As a result of their capacity to influence voting, proxy advisors are regarded as very powerful.⁷The popular, business, and academic media describe ISS (Institutional Shareholder Services, a division of RiskMetrics), the proxy advisor with the largest client base,⁸and Glass, Lewis & Co., which has the second largest client base,⁹as "influential,"¹⁰"powerful,"¹¹and having great "clout."¹²Commentators have claimed that ISS alone is able to influence shareholder votes by 19%,¹³13.6 to 20.6%,¹⁴30%,¹⁵and even "a third or more."¹⁶The collective power of proxy advisors arguably is even greater. As a result of this influence, management and shareholder activists alike frequently lobby ISS to endorse their respective positions. As related by Delaware's Vice-Chancellor Leo Strine:

[P]owerful CEOs come on bended knee to Rockville, Maryland, where ISS resides, to persuade the managers of ISS of the merits of their views about issues like proposed mergers, executive compensation, and poison pills. They do so because the CEOs recognize that some institutional investors will simply follow ISS's advice rather than do any thinking of their own. ISS has been so successful that it now has a California rival, Glass Lewis.¹⁷

Similarly, commentators have observed that "boards may do what they believe ISS wants them to in order to keep their seats, whether or not their belief is justified."¹⁸

This influence is troubling in light of the limited accountability of proxy advisors. Proxy advisors do not have a financial stake in the companies about which they provide voting advice; they owe no fiduciary duties to the shareholders of these companies;¹⁹and they are not subject to any meaningful regulation.²⁰Moreover, it is not clear that the proxy advisory industry is sufficiently competitive and transparent to subject advisory firms-ISS in particular-to substantial market discipline.²¹Institutional investors, for the reasons outlined above, may lack sufficient interest in voting to scrutinize advisors' recommendations carefully. In addition, ISS has, until recently, enjoyed a near-monopoly position and still remains the dominant firm providing voting advice.²²

The ability of proxy advisors to influence investor voting becomes particularly significant as the importance of shareholder voting increases. With respect to director elections, most U.S. companies have shifted in recent years from plurality to majority voting.²³Under plurality voting, the nominees who win the most votes are elected, regardless of the number of votes that are "withheld."²⁴Thus, in an uncontested election, a single vote in favor is enough to assure a nominee's election. By contrast, a majority standard requires a nominee to receive a majority of the votes cast.²⁵Under this standard, shareholders can prevent the election of a nominee even without nominating a competing candidate; the voters simply must cast a sufficient number of "withhold" votes. As a consequence, the shift to a majority standard substantially increases the importance of shareholder voting in uncontested elections.

Over the same time period, a large number of companies dismantled their staggered boards.²⁶The percentage of S&P 500 companies with staggered boards declined from 55% in 2005 to 40% in 2007.²⁷In companies with staggered boards, typically only one-third of the board is up for election in any given year.²⁸With a non-staggered board, the whole board is up for election. Dismantling the staggered board increases the number of directors up for election each year, thereby increasing the opportunity for shareholders to exercise their franchise. Indeed, the move from the typical three-year staggered board to non-staggered, annual elections triples the potential impact of the shareholder vote.

Finally, the New York Stock Exchange (NYSE) has adopted a rule that eliminates discretionary broker voting in uncontested director elections.²⁹

Historically, brokers who did not receive voting instructions from the beneficial owners of shares in their brokerage accounts were permitted to vote these shares in their discretion.³⁰Brokers generally exercised their discretion to vote the shares in favor of the slate nominated by the company-the so- called management slate.³¹These discretionary broker votes are estimated to amount to about 19% of the votes cast at annual meetings.³²Under the revised NYSE rules, companies will lose a sizeable block of automatic votes in favor of their nominees, shifting power to those shareholders who do vote.³³The effect of broker voting is illustrated dramatically by the Citigroup 2009 annual meeting in which broker votes comprised 46% of votes cast.³⁴Had the NYSE rule been in effect, two of the Citigroup nominees would not have won re- election.

As the Citigroup annual meeting demonstrates, the number of directors who receive a large percentage of withhold votes has increased. According to Georgeson, Inc., one of the leading proxy solicitation firms,³⁵a record 612 directors at S&P 1500 companies received withhold votes in excess of 15% in the 2008 proxy season.³⁶Thirty directors failed to receive a majority of the votes cast (up from fifteen in 2007).³⁷Additionally, the number of contested elections, though still relatively small, continues to increase. For 2008,

Georgeson reported an all-time high of fifty-six contested solicitations, following a previous all-time high of forty-six contested solicitations in 2007.³⁸

In comparison, between 1995 and 1999, the number of contested solicitations averaged twenty-five per year.³⁹

In addition to voting in director elections, shareholders vote on shareholder proposals introduced pursuant to Rule 14a-8 of the Securities Exchange Act.⁴⁰

As institutional activism increases, the character of these shareholder proposals has shifted from social policy issues⁴¹to proposals dealing with core economic and governance questions,⁴²such as executive compensation,⁴³shareholder nomination rights,⁴⁴and other corporate governance matters.⁴⁵These proposals are receiving increasing attention and support from shareholders. The number of proposals receiving majority shareholder support at S&P 1500 companies has increased from twenty-five in 2001 to eighty-six in 2008.⁴⁶

More importantly, boards have become more responsive to proposals receiving majority support. The number of implemented proposals rose from three in

2001 to forty-three in 2008.⁴⁷As a result of these increases, shareholder power to introduce proposals is beginning to have a noticeable effect on the governance of U.S. corporations.

Two regulatory initiatives have the potential to increase the significance of shareholder votes even more. Under the first initiative-so-called "proxy access"-shareholders are likely to gain some ability to introduce candidates for the board of directors in a company's proxy statement. Although shareholders have traditionally been able to mount an election contest by nominating competing candidates, a company is not required to include the challenger's nominees on the company proxy statement, and the challenge requires an independent (and costly) proxy solicitation. For many years shareholders have sought the power to compel the inclusion of their nominees on the company's proxy statement.⁴⁸After several unsuccessful attempts to persuade the SEC to adopt a rule providing for proxy access, institutional investors began to seek proxy access by introducing amendments to individual companies' bylaws.⁴⁹Although these efforts were upheld in court,⁵⁰in 2007, the Republican-controlled SEC amended...