Who says Congress isn’t popular? Well, Congress may become much more popular with public company executives if Congressman Patrick McHenry (R-NC) can make good on his recent promise to challenge the power of proxy advisory firms if the SEC doesn’t act. In a recent keynote speech at an American Enterprise Institute conference on the role of proxy advisory firms in corporate governance, Rep. McHenry stated that proxy advisory firms are a significant issue on Capitol Hill.
As I have blogged about before, there are some real questions as to whether proxy advisory firms actually serve investors’ interests. While ISS and Glass Lewis are entitled to create a business model based on providing services to institutional investors, there has been either a market or regulatory failure that has forced public companies to consider corporate governance policies promulgated by two unregulated proxy advisory firms before making business decisions. Public companies should be making decisions based on what makes sense for their company and their shareholders and not based on trying to meet arbitrary policies of ISS or Glass Lewis (policies that seem to be continuously tweaked to keep the proxy advisory firms services relevant). To be fair, ISS and Glass Lewis claim that their policies aren’t arbitrary at all, but rather their policies reflect their clients’ views. Of course, for that to be the case, all of their institutional investor clients would need to have a monolithic view toward corporate governance.
Because institutional investors may own hundreds or even thousands of positions in public companies, institutional investors do not have the ability or the resources to research all of the issues facing each of those holdings. That is where ISS and Glass Lewis step in to provide guidance to these institutional investors. While some institutional investors have robust voting policies and attempt to make educated and informed voting decisions, many other large investors blindly follow the instructions from their proxy advisory firm.
You may be asking yourself: How can large institutional investors such as mutual funds blindly rely on a third party for voting guidance? How can fiduciary duties be delegated? The ability for large institutional investors to essentially outsource the voting process is largely believed to stem from two no-action letters that the SEC issued in 2004 that imply that portfolio managers can outsource their fiduciary obligations with respect to voting.
Representative McHenry suggests three solutions to curb the excessive power wielded by proxy advisory firms. First, Rep. McHenry suggests that the SEC immediately withdraw the no-action letters. The withdrawal has also been suggested by former SEC Chairman Harvey Pitt and more recently by current Commissioner Gallagher. Thus, the thought of withdrawing the no-action letters may be picking up steam.
Second, Rep. McHenry recommends that the SEC develop ways to increase competition. Currently, proxy advisory firms operate as a duopoly – 97% of the proxy advisory business is held by ISS and Glass Lewis. I think increased competition would work well to curb the influence of proxy advisory firms in general, except I am not sure how feasible it would be. Going through thousands of proxies during the short proxy season takes significant resources. Thus, the business model of the proxy advisory firms really relies on having a large number of clients to make the research cost effective.
Third, to meet their fiduciary duties, mutual funds must generally vote at each election for every issue on the ballot. The SEC has made it clear that investment advisers may “not ignore or be negligent in fulfilling the obligation it has assumed to vote the client proxies.” Rep. McHenry suggests that investment advisers be given a wider latitude on deciding on what issues it should vote. I think this suggestion could be very helpful in reducing the importance of proxy advisory firms. Although there would likely be less shares voted overall, the shares that are voted would be by shareholders who had more at stake on the issue rather than by shareholders without an economic stake in the issue (and therefore more likely to follow a proxy advisory firm’s recommendations blindly).
Whether Congress can actually pass any legislation to enact Representative McHenry’s suggestions is up for debate. But, it is possible that his rhetoric may be more directed at nudging the SEC to act on its own. Back in December, the SEC held a roundtable to discuss the proxy advisory firm issue. And in March, Chair White noted that she expected the Commission to act on the Staff’s recommendation on possible action targeting proxy advisory firms. While the Staff has yet to publicly release its report on recommendations regulating proxy advisory firms, the report is due out soon. Hopefully, the 2015 proxy season will be marked by a reigning in of the proxy advisory firms.