Editor’s Note: Radhakrishnan Gopalan is a professor of finance at Olin Business School at Washington University in St. Louis. Todd Gormley is an associate professor of finance there, and Todd Milbourn is the Hubert C. & Dorothy R. Moog professor of finance. The opinions expressed in this commentary are their own.
Increasingly, investors are relying on proxy advisory firms to help them decide how to vote their shares during shareholder meetings. The research these firms provide can help a pension fund decide whether to vote its shares in favor of appointing a certain board member, or an asset manager to vote her stake for or against a corporate takeover.
But the proxy advisory industry’s rapidly growing popularity poses a problem. The industry is currently dominated by two key players — Institutional Shareholder Services and Glass Lewis — giving these firms immense power over some crucial votes in Corporate America. The growing reliance on this industry and the concentration of power within it has increased calls for greater regulation. Indeed, the SEC needs to regulate proxy advisers and require more transparency and accountability from the industry.
Proxy advisers’ booming growth is thanks to a 2003 SEC rule that requires institutional investors to disclose and offer a rationale for their votes in shareholder meetings. Often, institutions, particularly smaller ones with fewer assets under management, find it more cost-effective to use proxy advisers’ recommendations to justify their votes than to have an in-house research department that analyzes and offers recommendation on proposals.
Proxy advisers belong to a class of institutions that produce financial research for investors, which include auditors, credit rating agencies and security analysts. These industries tend to be dominated by a few key players (Moody’s, S&P and Fitch in the credit rating industry, for instance) because of how expensive it is to set up shop — which deters new entrants.
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An important disciplining device that keeps these institutions on the straight and narrow is their focus on reputation. When institutions do a poor job (inflated ratings or voting recommendations based on sloppy analysis, for instance), their ultimate concern becomes about tarnishing their reputation. And that concern gets greater the more one has to lose — i.e., the large market shares with fat profit margins associated with a concentrated industry. This focus on reputation deters competition, as the market is less likely to trust new, potential “fly-by-night” operators that lack these incentives.
Research on the credit rating industry shows that increased competition isn’t always beneficial for investors. The same could be true for the proxy advisory industry if increased regulation pushes the industry toward greater competition. But there are areas where the entire industry could benefit from stricter oversight.
The first is in terms of proxy advisory firms’ recent foray into corporate governance consulting, which is a troubling trend. This new line of business provides potentially significant conflicts of interest, i.e., hire us to consult on your governance, and you will get favorable recommendation on your shareholder proposals.
Such conflicts of interest are not new. They arose when auditing firms branched into consulting, which contributed to the Enron and WorldCom accounting scandals and subsequently leading to regulation prohibiting such practices. The SEC needs to use its power to eliminate such conflicts of interest. That might entail forcing the proxy advisors to divest their consulting businesses altogether.
The second area the SEC needs to regulate is in ensuring greater transparency about the rationale for these advisers’ recommendations. This will serve two purposes. First, companies often complain that proxy adviser recommendations are based on faulty data. Whether these complaints are legitimate or simply reflect companies’ unhappiness with the adviser’s recommendation is unclear. But what is clear is that greater transparency will allow companies to more easily challenge faulty data, if it exists.
Second, greater transparency will shed light on whether proxy advisory firms are using a “one-size-fits-all” policy to arrive at their recommendations. For example, advisers may think that classified boards — wherein not all directors are due for election in a year — is bad for shareholders, and because of this, always recommend against proposals that classify a board. But, research shows that optimal governance arrangements are often much more nuanced and that one size does not fit all. Greater transparency will allow firms to challenge recommendations based on such policies and put forth their arguments as to why their case is unique.
Given the ever-increasing reliance on the few players in the proxy advisory industry, we believe we are past due for some increased oversight, accountability and transparency in this space.