US Chamber Event : Examining the Role of Proxy Advisory Firms

AT TODAY’S U.S. Chamber of Commerce event entitled “Examining the Role of Proxy Advisory Firms,” the current and future role of proxy advisors was discussed.

In opening remarks, Tom Quaadman of the Center for Capital Markets Competitiveness (CCMC) stated that the Securities and Exchange Commission (SEC) has failed to promulgate rules to regulate the behavior of proxy advisory firms. He noted that two companies, Institutional Shareholder Services (ISS) and Glass Lewis & Co., account for 97 percent of the market for proxy advisor services. He raised concern that their large influence may lead to setting de facto standards for corporate governance. He added that the U.S. Chamber of Commerce plans to release suggestions on the treatment of proxy advisors at some point next year.

First Presentation

David Larcker of Stanford University’s Graduate School of Business discussed the role proxy advisory firms have in executive compensation.

The study noted that the proxy advisory industry is a classic duopoly structure, with two main firms controlling the market, and seeks to meet the “natural demand” for data collection and “expert evaluation” services. He mentioned that there is much criticism of these two firms targeted at their ownership structure, data errors in reports, and conflicts of interest related to their consulting services.

Larker stated that a key goal of the study was to find out if the advisory firms were actually creating any shareholder value through the recommendations that they make to investors. He also questioned whether the recommendations were based on rigorous research and if there was any “back-testing” performed to validate them.

The study found that proxy advisory firms recommendations do, indeed, affect the voting of investors and showed that many investors voted “in lock step” with the recommendations in “say on pay” decisions. He cited that 20 percent to 30 percent of the overall vote was affected by the proxy advisors. Larker added that proxy advisor policies and consulting practices influence corporate behavior and affect compensation plan design.

Larker said the study shows that recommendations adopted from proxy advisory firms “do not appear to increase shareholder value.” He added that implementation of plans that exclude directors and officers show lower stock performance, lower operating performance, and higher employee turnover. He concluded that the results provide very little insight into the benefits of proxy advisory firms.

Larker proposed that organizations create a partnership with them to pull together empirical research on proxy advisors. He added that the results be published for free use by all concerned parties.

When asked how companies are responding to the voting decisions, Larker stated that directors and owners are taking the votes personally and are clearly responding to the recommendations put forth by the advisory firms.

Panel I

Robert McCormick of Glass Lewis & Co. stated that his firm takes a multifaceted approach to developing policies. He said Glass Lewis & Co. analyzes current market practices and rules, studies a broad range of academic research, and engages with clients informally to understand their point of view. He noted that this approach allows them to tailor their decision making to the specific market they are studying. McCormick added that the market share and overall power of proxy advisory firms, namely ISS and Glass Lewis, “may be overstated.”

Patrick McGurn of ISS stated that his firm conducts a multi-tiered process over the course of six months that includes; 1) looking at the previous proxy season; 2) surveying market participants; 3) holding roundtables with institutional investors, corporations, and advisors; 4) developing draft policies; 5) holding a review and comment period; and 6) looking for unintended consequences before releasing the policy recommendation.

Asked if he saw anything wrong with Professor Larcker’s assessment, Durkin stated that he agreed with the need to perform “back-testing,” but said it should test if voting policies are adding corporate value rather than shareholder value. He expressed concern with the advocacy role that proxy advisors take in their communications to investors. He stressed the “onus is on investors” to make up their own minds and not “cede their power” to the proxy advisors. He believes that proxy advisors “just create more processes” and do not provide real executive compensation reform.

McCormick stated that investors are making up their own minds on voting decisions using data provided by the advisory firms. He noted that 70 percent of the total vote in a decision is independent of proxy advisor influence. He stated that quality of data is very important to his firm and that in many cases supposed errors in the data could be attributed to differences in interpretation.

McGurn stated that it is not proxy advisors’ role to be activists. He said companies look to his firm to provide data, and thus allow them to spend more time on the discussion and decision making process.

Smith agreed with Durkin that the influence a proxy advisor has depends on the composition of the investors. She said that her company directly communicates with their institutional investors to increase their level of knowledge and provide a balanced view. She said that decisions are made in the best interests of shareholders. She also noted that engaging with investors has given insight into what disclosures may be included in future reports.

The panel was asked if proxy advisory firms’ behavior tends to be a one-size fits all approach. McGurn said that his firm takes a case-by-case approach, focusing on the performance at each company using qualitative analysis based on a quantitative approach. He added that investors want information that is concise and easy to follow. He also mentioned that voting is a form of communication in which investors can change the behavior of board members.

McCormick stated that all criticism of his firm has been external rather than from the companies they work with.  He also noted that back-testing to assess effect on shareholder value is difficult, but that looking it qualitatively over the long term is important.

Second Presentation

Edward Knight of NASDAQ OMX stated his view that the public company model is “somewhat broken” and requires fundamental re-thinking. He notes that the current initial public offering (IPO) market limits innovation and job growth as companies that get acquired tend to cut employment and reduce innovation. He added that the Jumpstart Our Business Startups (JOBS) Act has not increased the number of IPOs and has actually made it easier for companies to stay private.

Knight said that proxy advisors should be subject to regulation in a similar way that public companies are, requiring more transparency. He said that a revamp of the proxy advisory system could improve confidence and align the incentives of companies, shareholder, and advisory firms to make the best decisions and increase shareholder value. He noted that there is a problem with companies “giving in” to corporate governance standards recommended by proxy advisors without sufficient debate on the details.

He concluded that the proxy advisory firms need defined goals and that regulators should develop “rules of the road.”

Panel II

Harvey Pitt of Kalorama Partners said that regulation of proxy advisory firms should be similar to that of credit rating agencies. He noted that proxy advisors have a significant impact on the market especially when advising on mergers and acquisitions . He said there is a need for a clear definition of obligations and fiduciary rules.

Sara Lewis of Lewis Corporate Advisors said that proxy advisory firms have “changed the conversation” in the boardroom and that compensation committees feel “pressured to conform” to the proxy advisors outlines. She said that boards are in a better position to know what is best for their company than the proxy advisor. However, she noted the advantages of proxy advisory firms include having more robust conversation on compensation and making companies maintain strong dialogue with their investors.  Smith stated that voting recommendations will be driven by the market and what voters want to achieve.

Frank Hatheway of NASDAQ OMX, said that robust empirical analysis and transparency needs to be improved in advisors’ recommendations. He added that there seems to be a movement towards making data available to third parties, which is encouraging.

Moderator David Hirschmann, of CCMC noted that the job of proxy advisory firms continues to become more demanding and must be done over a shorter period of time and asked what implications this may have. Lewis responded that errors have profound implications, but they are bound to happen. She noted that advisory firms can go back and change information or recommendations but that many investors may have already voted.

Pitt said that core fiduciary principles are needed and that proxy advisors should have to verify that their recommendations are based in facts. He also noted that the overwhelming nature of the voting process is a burden to many companies. He stated there has been a lack of effort from the Department of Labor to look at these issues from a litigation perspective and that the likelihood of SEC action is “slim to none,” even though the SEC stated that it will be reviewed next year. He views the lack of action on the part of the SEC as a part of the problem and feels that they should articulate the responsibilities of a proxy advisor in a pragmatic way.

Smith concluded that institutional investors should spend more time evaluating and reviewing proposals put forth by proxy advisory firms. She also said there is a need for more open and honest discussion between proxy advisors, companies, and investors.