The Economist reports:
Proxy advisory services used to be an obscure feature of corporate America. No longer. These geeky outfits, which review mountains of proposals put forward by shareholders on topics ranging from mergers and executive pay to climate change and diversity, then issue recommendations, can sway how their clients vote. ...
Two of them dominate the business. Institutional Shareholder Services (ISS), owned by Genstar, an American private-equity firm, provides proxy recommendations on over 40,000 shareholder meetings in more than 100 countries each year. Glass Lewis informs some 20,000 votes in 100 countries. It is owned by two Canadian asset managers. Between them, ISS and Glass Lewis control 97% of America’s proxy-advice market. ...
In August America’s Securities and Exchange Commission (sec) ruled that voting recommendations made by the advisers amounted to “solicitations” under proxy rules, a higher regulatory standard than the firms faced before. They would, for instance, have to prove compliance with anti-fraud provisions. iss filed a lawsuit in response. On November 5th the sec proposed more rule changes, “to improve the accuracy and transparency of proxy voting advice”. Among other things, these would raise the minimum share of votes required for shareholder proposals to succeed and let target firms review proxy recommendations twice before investors see them. ...
Joseph Grundfest of Stanford Law School sees nothing wrong with giving firms the chance to challenge the factual basis of recommendations: “As long as iss is accurate in everything it does, it has no additional legal liability.”
Nonsense, say critics of the new provisions, who liken them to slapping a tax on advice critical of management. Charles Elson of the University of Delaware argues the sec proposal is “a punitive solution looking for a problem”.
As longtime readers know, I respect and admire both Joe and Charles but on this occasion I definitely come down with Joe.
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]
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. Ironically, until the SEC finally acted, 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, 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”).
