A report by Bloomberg suggests that the answer might be yes:
Managers likely will see developments in the Securities and Exchange Commission’s work in this area “around the end of proxy season this year,” said Dalia Blass, director of the agency’s Division of Investment Management. She was speaking at the Investment Company Institute’s Mutual Funds and Investment Management Conference in San Diego.
The agency is looking at how to promote voting practices that are in the best interest of managers’ clients and whether they should vote all proxies, Blass said. The commission also is examining how managers should handle possible proxy advisory firm conflicts of interest and evaluate the advisers’ recommendations, especially when companies disagree with the advice, she said. Proxy firms include Glass, Lewis & Co., in addition to Institutional Shareholder Services Inc.
It's about time. As I wrote in my book, Corporate Governance after the Financial Crisis
In arguing that institutional investors have incentives to be rationally apathetic, we emphasized the costs entailed in monitoring and responding to problems at portfolio companies. These costs could be reduced if activist investors could make use of economies of scale by developing standardized voting procedures on recurring issues and standard responses to common types of managerial derelictions. We in fact observed just such a response very early in the evolution of institutional investor activism as many institutions adopted standard voting practices on issues such as takeover defenses.
Significant savings, however, would require collective action. Only by clubbing together in monitoring their portfolio companies, could institutions truly achieve economies of scale. As long as they were obliged to act individually, the size and high rate of turnover of their portfolios made achieving real economies of scale impractical.
The emergence of Institutional Shareholder Services (ISS) offered a solution to these problems. ISS was founded in 1985 to provide proxy advisory services to institutional investors.[1]The premise was that institutions could outsource to ISS the tasks of monitoring corporate governance at portfolio firms and making decisions about how to vote their shares.
ISS got a major boost in 1988 when the Department of Labor announced that ERISA pension plan fiduciaries had a fiduciary duty to make informed decisions about how they voted shares of portfolio companies. In response, pension plans began to rely on ISS for analysis of issues upon which a shareholder vote would be required and advice as to the best voting decision. A similar 2003 SEC ruling that mutual funds and other investment company advisors must adopt policies designed to ensure that shares of portfolio companies are voted in the best interests of their clients added a whole new class of institutions that outsourced their proxy decision making to ISS.
Today, ISS services some 1700 institutional investor clients, which collectively manage some $25 trillion in equity securities. The goal of reducing the expenses of activism through economies of scale thus seems well within reach.
ISS has proven highly successful at influencing shareholder voting. By some estimates, an ISS recommendation can effect a swing of 15 to 20% in a proxy vote.[2]Although competitors have entered the market for proxy advisory services, ISS remains the most powerful player in that market. Only one other advisory service, Glass, Lewis & Co., has a measurable effect on the outcome of shareholder votes and its impact remains minor compared to that of ISS.[3]
The shareholder empowerment provisions of Dodd-Frank are widely expected to further enhance ISS’s influence, especially with respect to executive compensation. Institutional investors will look to ISS for guidance on both the say when on pay and say on pay votes. The biggest effect of Dodd-Frank on proxy advisory services, however, is likely to come indirectly via NYSE Rule 452.
The NYSE rule deals with voting of shares held in brokerage accounts. The typical retail investor account is set up with the broker as the legal owner of the shares and the investor as the beneficial owner thereof. Under state law, the brokers therefore are the ones who vote the shares. Under federal law, brokers are obliged to request voting instructions from their client. Many retail investors, however, fail to provide instructions. In such cases, Rule 452 permits the broker to vote the shares in its discretion with respect to routine matters. As to non-routine matters, however, a broker without instructions must abstain.
In the past, brokers routinely voted as management recommended. As a result, management often had a substantial base of support on many issues. A 2009 amendment to Rule 452 significantly altered the environment, however, by changing the treatment of an uncontested director election from a routine to a non-routine matter. As a result, the number of retail investor-owned shares voted in director elections has fallen, increasing the proportion of institutional investor votes as a percentage of those being cast, and thereby enhancing the effect of an ISS recommendation.
Dodd-Frank § 957 will have a similar effect in a potentially wide range of issues. At a minimum, § 957 requires that votes on executive compensation be deemed non-routine. The proportion of votes coming from institutional investors therefore will rise with respect to both say on pay and say when on pay decisions. Because § 957 directs the SEC to undertake a rulemaking proceeding to determine whether there are “other significant matters” that should be deemed non-routine, which proceeding is expected to be completed by late 2012, ISS’ influence likely will continue to grow. Indeed, it seems fair to say that Dodd-Frank does more to empower ISS than it does shareholders.
Despite its success (or, perhaps, because of it), ISS has been controversial. Some critics argue that ISS is too rigid and mechanical in its advice. Martin Lipton complains, for example, that ISS routinely recommends against reelection of a board’s nominating committee if those members allow the firm’s CEO to provide recommendations or advice:
It would be a totally dysfunctional process if input and advice from the CEO were prohibited until after the committee meets and makes its decisions. There is nothing in the NYSE rule or “best practices” that warrants restricting the CEO from voicing advice or opinion until after the committee has acted. [4]
A related example of excessive rigidity on these issues came in 2004, when ISS urged its clients to oppose reelecting Warren Buffett as a director of Coca-Cola because Buffett did not satisfy ISS’ strict definition of director independence. Shortly thereafter, CalPERS announced that it would oppose Buffett’s reelection on the same grounds. Critics of the ISS and CalPERS positions pointed out that Warren Buffett is probably the most respected investor of all time, with a long record of integrity. At the time in question, Buffet’s Berkshire Hathaway Company owned almost 10% of Coke’s stock, which meant that his personal financial interests were closely aligned with those of other shareholders (albeit not perfectly). Buffett qualified as an independent director under the NYSE’s listing standards. As I argued at the time, if “Buffett doesn’t qualify as independent under the ISS and CalPERS standards, the problem is with the standards not Mr. Buffett.”[5]
Critics link this sort of check the box mentality back to the very reason for outfits like ISS to exist; namely, the cost associated with making informed voting decisions about numerous issues posed on the proxy statements of the thousands of publicly traded companies. The globalization of institutional investor holdings has compounded the problem by forcing ISS to stretch its resources to include many foreign issuers. In 2009, for example, ISS had to prepare voting recommendations with respect to more than 37,000 issuers around the world. The constantly growing number of voting recommendations that must be made, most of which are concentrated into the three to four month annual meeting season, reportedly forces even ISS to automate decision making to the fullest possible extent and, accordingly, to rely one one-size-fits-all standards instead of giving careful consideration to the specific needs and circumstances of each individual firm.
Finally, there is the question of accountability. Although both the SEC and the Department of Labor are considering regulation of the proxy advisory business, as of this writing they remain essentially unregulated. Ironically, market forces are the only thing holding ISS accountable; i.e., the same forces most shareholder power proponents claim do not work when it comes to holding management accountable.
Taken together, these concerns raise serious issues as to whether shareholder activism is an appropriate solution to the principal-agent problems of corporate governance. The view that institutional investor activists will carefully scrutinize portfolio companies to reach informed voting decisions is exposed as a fiction. Instead, shareholder activism depends on the whims of a single proxy advisor who offers limited transparency and is largely unaccountable, essentially unregulated, and poorly informed.[6]
[1]ISS was acquired by RiskMetrics Group in 2006. For purposes of semantic consistency, however, I shall refer to it as ISS throughout.
[2]David Larker & Bryan Tayan, RiskMetrics: The Uninvited Guest at the Equity Table 2 (Stanford Grad. Sch. Bus. Closer Look series CGRP-01, May 17, 2010), http://ssrn.com/abstract=1677630.
[3]Stephen Choi. et al., The Power of Proxy Advisors: Myth or Reality?, 59 Emory L.J. 869 (2010). On the other hand, this study also argues that “popular accounts substantially overstate the influence of ISS” and that “ the impact of an ISS recommendation is reduced greatly once company- and firm-specific factors important to investors are taken into consideration.” Id.
[4]Martin Lipton, ISS Goes with Form over Substance, Harv. L. Sch. Forum Corp. Gov. & Fin. Reg. (Mar. 17, 2011), http://blogs.law.harvard.edu/corpgov/2011/03/17/iss-goes-with-form-over-substance/.
[5]Stephen M. Bainbridge, Directors Cut?, ProfessorBainbridge.com (April 29, 2004), http://www.professorbainbridge.com/professorbainbridgecom/2004/04/directors-cut.html.
[6]See Choi & Fisch, supra note 639, at 318 (explaining that the trend of pension funds delegating decisions to ISS “raises a substantial concern that the effectiveness of institutional activism will be limited by fund agency problems, including the economic incentives of those exercising delegated governance powers”).
