As we say “goodbye” to 2012 we say “hello” to another proxy season full of angst caused by the self-appointed czars of corporate governance, the proxy advisory firms. Although ISS and Glass Lewis have been making voting recommendations for more than a decade, over the past two years their power over voting outcomes has increased. When the Dodd-Frank Act was enacted in 2010 Congress was very clear that the Say-on-Pay votes were merely advisory and that directors would not be subjected to increased liability over a company’s executive compensation practice; however, the unintended consequence of Dodd-Frank was to strengthen the unregulated proxy advisory firm industry by allowing these firms to be the near-final arbiters of whether executive compensation should be approved by shareholders. Failure to comply with the arbitrary guidelines of ISS or the often unknowable guidelines of Glass Lewis can cause a company the potential embarrassment of a “failed” Say-on-Pay vote regardless of whether the independent directors at the company, who painstakingly analyzed various metrics in deciding what to pay the executive officers, determined the compensation to be in the best interests of the company and its shareholders. In fact, Matteo Tonello of the Conference Board suggests there is substantial evidence demonstrating that the proxy advisory firms have significant influence over the design of executive compensation programs, but no evidence that they have contributed at all to improved governance quality or increased shareholder value.
The SEC clairvoyantly expected a growing conflict between issuers and the proxy advisory firms when it issued its so called “Proxy Plumbing” release in 2010. That concept release, of course, focused on a broad review of the U.S. proxy system, which includes proxy advisors. While the SEC aptly noted the potential benefits that proxy advisors can bring to the table (e.g., assisting institutional investors with exercising their voting rights in an ever growing number of significant matters to be voted upon at meetings), the SEC sought comment focusing on two identified deficiencies of the proxy advisory firms: potential conflicts of interest and the lack of transparency. A third deficiency pointed out by James R. Copland of the Manhattan Institute is the concern of third parties implementing their agenda by steering the recommendations of the proxy advisory firms. For example, Mr. Copland cites the statistic that from 2006 through 2012 ISS has supported 1,266 shareholder proposals (63%), while a majority of shareholders supported only 212 of these same proposals (10%). Many of these shareholder proposals are put on the ballot through activists whose first priority is not necessarily to maximize shareholder return. Unfortunately, since the Proxy Plumbing release Congress has inundated the SEC with rulemaking initiatives from the Dodd-Frank Act and the JOBS Act. As a result, meaningful reform on the proxy system had to be put on hold despite the fact that proxy system reform may arguably better protect investors than providing disclosure on conflict minerals or having a new definition of independence for compensation committees.
The Canadian Securities Administrators (CSA), an association of the provincial and territorial securities regulators in Canada, has started to move the ball forward in Canada by soliciting input pursuant to a recent “consultation paper.” The consultation paper focuses on similar deficiencies identified in the U.S. namely, potential conflicts of interests, a perceived lack of transparency, potential inaccuracies in proxy advisory firms’ reports, and a “one-size-fits-all” governance solution. Depending on the feedback, the CSA could propose a new regulatory regime to combat these identified deficiencies. And because the CSA is not bogged down with Congressional rulemaking initiatives, the CSA could propose a workable solution soon.
While Canada may move first on the issue, I should note that the SEC hasn’t let this important issue drop. For example, Commissioner Paredes urged regulation of proxy advisory firms in a speech as recently as this past summer. In addition, then-SEC Chairman Mary Schapiro and then-Director of the Division of Corporation Finance Meredith Cross have noted in various speeches that the SEC was considering guidance on the issue. Furthermore, as a result of a suggestion from the Society of Corporate Secretaries and Governance Professionals, the SEC has created a liaison to help monitor the concerns of issuers with the proxy advisory firms.
So, while the SEC has been taking a proactive approach and carefully considering the issue, it is important to remember that the SEC’s mission is to “protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation” and, therefore, maybe proxy advisors should be given free reign. While issuers have increasingly voiced their concern over proxy advisory firms, are proxy advisory firms actually protecting the rights of investors? ISS’s stated mission is to “enabl[e] the financial community to manage governance risk for the benefit of shareholders.” Putting aside the complaints of the lack of transparency, potential conflicts of interest, and the large influence by third parties, I am not convinced that the proxy advisory firms assist long-term shareholders or retail shareholders. While, as Paul Rose, Assistant Professor of Law at Ohio State University points out, proxy advisors do provide certain benefits such as efficiently gathering data for all investors and providing “protection” against future claims of breach of fiduciary duty. The proxy advisory firms appear to be selling their product just fine despite the criticisms of the industry. Professor Rose suggests that, in fact, certain activist institutional shareholders are very much aligned with the proxy advisory firms’ desire to strengthen investors’ influence on issuers even if their interests are for short-term gain.
The success of proxy advisory firms may not be derived from the perceived benefits of their product at all, but rather from investment advisors not having sufficient resources to make reasonably informed voting decisions. Earlier this month, former SEC chairman Harvey Pitt suggested that the SEC consider repealing two 2004 no-action letters given to proxy advisory firms that, in his opinion, have created an environment where portfolio managers believe they can outsource their voting responsibilities. Robert A.G. Monks, a co-founder of ISS, appears to agree that it is not proxy advisory firms that are the problem, but rather investment advisors who shirk their fiduciary duties. Executive compensation attorney, Joseph Bachelder III, recommends that the SEC clarify whether a proxy advisor is a fiduciary under current regulation, and if they are not, have the SEC adopt a definition to encompass proxy advisory firms.
If in fact proxy advisory firms are not overall beneficial to investors, what can the SEC do? First, the advice from proxy advisors would be deemed “solicitations” under Regulation 14A (and therefore regulated) but for Rule 14a-2(b)(3), which generally provides an exemption for companies that provide advice pursuant to a business relationship. Thus, by amending Rule 14a-2(b)(3) the SEC could subject proxy advisory firms to regulation under the existing proxy rules and require further disclosure. Further, the SEC has stated that Rule 14a-9, which prohibits false and misleading statements, applies to proxy advisory firms. Consequently, the SEC could take action against proxy advisory firms now, although that would presume that the SEC could prove the information supplied by the proxy advisory firms is false and misleading rather than merely an “opinion.” While regulation does seem plausible and long overdue, I should note one caveat: regulation could have the unintended consequence of strengthening the proxy advisory firms. As the International Monetary Fund points out, when Congress began regulating the statistical ratings agencies the regulation effectively entrenched the private firms into the regulatory process. Essentially, regulation could give the proxy advisory firms legitimacy.
Given the need to balance the benefits that proxy advisory firms can provide and the desire for large institutional investors to access the information compiled by them with the need to ensure efficient markets and the need to protect all investors, I would support the approach set for in a recent comment letter submitted by David S. Rosenthal, Vice President-Investor Relations and Secretary of Exxon Mobil Corporation. His comment letter may have synthesized the solutions to the issue best with a rational well-measured approach. He suggests requiring proxy advisors to:
- Disclose their methodologies and to provide an explanation as to why their methodologies are appropriate (similar to how credit ratings agencies must disclose their methodologies pursuant to Section 932 of the Dodd-Frank Act);
- Ensure that all published information is accurate and not misleading; and
- Disclose the involvement of any third party in the formulation of their voting recommendations.
Mr. Rosenthal also recommends that the SEC remind investment managers of their fiduciary obligations in voting the shares.
We can only hope that Congress will leave the SEC alone long enough for the SEC to take up necessary and long overdue regulation of proxy advisory firms.