ISS And Other Proxy Advisory Firms’ Conflicts Of Interest: Analyzing The Insufficiency Of The 2020 Securities And Exchange Commission Rule Change

 

Dan Daskal

 

Proxy advisory firms provide institutional investors with a host of crucial services, including corporate governance research and recommendations, proxy voting advice, and proxy voting and distribution services. These firms’ ability to facilitate informed proxy voting at an affordable cost assists institutional investors in complying with the SEC’s 2003 rules requiring investment advisors to implement policies designed to ensure they vote shares in their clients’ best interests.[1] Institutional Shareholder Services (“ISS”) dominates the proxy advisory firm market with an estimated 63% market share as of 2017,[2] while Glass, Lewis & Co. (“Glass Lewis”) serves as its largest competitor with an estimated 28% market share as of 2017.[3] The convergence of the market concentration of the proxy advisory industry,[4] the rising proportion of shares held by institutional investors,[5] certain institutional investors’ increasing reliance on proxy advisory firms’ voting recommendations[6] and management’s incentive to respond to such recommendations[7] has resulted in increased scrutiny of these firms’ influence over shareholder voting and corporate governance policies.

These concerns have been exacerbated by the conflicts of interest faced by proxy advisory firms. [8] The SEC publicly acknowledged the need to reform the proxy advisory industry in 2010 with its “Concept Release on the U.S. Proxy System.”[9] The SEC recognized several conflicts of interest, including “when owners or executives of the proxy advisory firm have significant ownership interests in, or serve on the board of directors of, issuers with matters being put to a shareholder vote on which the proxy advisory firm is offering vote recommendations.”[10] Certain firms, such as ISS, also provide both “proxy voting recommendations to investment advisers and other institutional investors and consulting services to corporations seeking assistance with proposals to be presented to shareholders or with improving their corporate governance ratings”[11] as well as providing “corporate governance ratings on issuers to institutional clients, while also offering consulting services to corporate clients so that those issuers can improve their corporate governance ranking.”[12]

The SEC’s 2020 Final Rules[13] regulating proxy advisory firms aim to address these issues by implementing heightened disclosure requirements for proxy advisory firms. The SEC amended Rule 14a-1(l)(iii) to codify its past guidance that proxy voting advice constitutes a proxy solicitation.[14] Proxy advisory firms generally rely on Rules 14a-2(b)(1)[15] and (b)(3)[16] to exempt them from proxy filing and information requirements; however, the relevant portion of Final Rule 14a-2(b)(9)(i) provides that the 14a-2(b)(1) and (b)(3) disclosure exemptions will not be available unless:

The proxy voting advice business includes in its proxy voting advice or in an electronic medium used to deliver the proxy voting advice prominent disclosure of: (A) Any information regarding an interest, transaction, or relationship of the proxy voting advice business (or its affiliates) that is material to assessing the objectivity of the proxy voting advice in light of the circumstances of the particular interest, transaction, or relationship; and (B) Any policies and procedures used to identify, as well as the steps taken to address, any such material conflicts of interest arising from such interest, transaction, or relationship.[17]

Requiring heightened disclosures by proxy advisory firms ensures that their clients are made aware of the conflicts and have the opportunity to properly evaluate them. When selecting a proxy advisory firm, institutional investors can compare firms’ conflicts disclosures and place as much weight on them as they see fit. These disclosures may therefore incentivize proxy advisory firms to improve their management of conflicts or eliminate them altogether in order to appease clients; however, for this to happen, institutional investors would need to both closely monitor the conflicts disclosures and place a great deal of weight on them. Institutional Investors may be under-incentivized to react to any disclosed conflicts as a result of the costs of switching proxy advisors[18] and the “certification effect”[19] of relying on the recommendations of a firm such as ISS. Along with high monitoring costs, these factors reduce the likelihood that they will switch to a different proxy advisory firm even if they are unsatisfied with the conflicts. As such, the disclosure requirement will likely be insufficient in mitigating proxy advisory firms’ conflicts of interest. Any future proposals for reform, nonetheless, must weigh the costs of implementation with the benefits to shareholders.

 

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[1] See Sec. & Exch. Comm’n, Proxy Voting by Investment Advisers, Release No. IA-2106 (Feb. 11, 2003).

[2] Chong Shu, The Proxy Advisory Industry: Influencing and Being Influenced 1-2 (USC Marshall School of Business Research Paper, 2020), https://ssrn.com/abstract=3614314 [https://perma.cc/5M3Z-GCBP].

[3] Id. at 2.

[4] Id. at 1-2.

[5] See Jacob Greenspon, How Big a Problem Is It That a Few Shareholders Own Stock in So Many Competing Companies?, Harv. Bus. Rev. (Feb. 19, 2019, updated Feb. 22, 2019), https://hbr.org/2019/02/how-big-a-problem-is-it-that-a-few-shareholders-own-stock-in-so-many-competing-companies [https://perma.cc/U4N2-NPZ9] (“Overall, institutional investors (which may offer both active and passive funds) own 80% of all stock in the S&P 500.”).

[6] Shu, supra note 2, at 18 (“In 2017, 29 investors combined managing over $200 billion of assets almost entirely follow ISS recommendations. From 2007 to 2017, the fraction of robo-voting ISS customers grows from 5 percent to 23 percent.”).

[7] David F. Larcker et al., Outsourcing Shareholder Voting to Proxy Advisory Firms, J. L. & Econ., 173, 203 (2015) (“[M]any boards of directors change their compensation programs before formal shareholder votes in a manner that better aligns the programs with the recommendation policies of proxy advisory firms.”).

[8] See, e.g., Clifton A. Pemble, President and CEO of Garmin Ltd., Comment Letter, SEC - Amendments to Exemptions from the Proxy Rules for Proxy Voting Advice, File Number S7-22-19, 3 (Jan. 27, 2020)

We have noticed that in some instances the consulting side of a firm's business rated us poorly on governance and compensation practices (much to our surprise and contrary to all available evidence, and for reasons they wouldn't divulge unless we agreed to pay them a large fee), while at the same time the proxy advisory side of the business recommended that shareholders vote for all of our governance and compensation related proposals. If there is no correlation at all between a firm's ratings and their voting recommendations, as seems to be the case for Garmin, then what does that say about the reliability or sincerity of the ratings and/or the voting recommendations?

[9] See Sec. & Exch. Comm’n, Concept Release on the U.S. Proxy System, Release No. 34-62495, 108–9 (Jul. 14, 2010).

[10] Sec. & Exch. Comm’n, Concept Release on the U.S. Proxy System, Release No. 34-62495, 117 (Jul. 14, 2010).

[11] Id. at 116; see also The ICS Story, ISS Corp. Solutions, https://www.isscorporatesolutions.com/our-story/ [https://perma.cc/44WV-6ASK] (last visited Nov. 21, 2020); Gary Retelny, President and CEO of Institutional Shareholder Services, Comment Letter on SEC Staff Roundtable on the Proxy Process, 13 (Nov. 7, 2018), https://www.sec.gov/comments/4-725/4725-4629940-176410.pdf [https://perma.cc/V9VD-ETP4] (ISS maintains a “firewall” between ISS and ICS).

[12] Id. at 117.

[13] See Sec. & Exch. Comm’n, Exemptions from the Proxy Rules for Proxy Voting Advice, Release No. 34-89372, 58-68 (July 22, 2020).

[14] See 17 C.F.R. § 240.14a-1.

[15] 17 CFR 240.14a-2(b)(1).

[16] 17 CFR 240.14a-2(b)(3).

[17] 17 C.F.R. § 240.14a-2(b)(9)(i).

[18] Tamara C. Belinfanti, The Proxy Advisory and Corporate Governance Industry: The Case for Increased Oversight and Control, 14 Stan. J. L. Bus. & Fin. 384, 413 (2009) (“As the first mover in the proxy advisory industry, ISS benefits handsomely from consumer switching costs. In terms of the proxy advisory industry, the costs of switching proxy advisors entail the hassle of getting up to speed with a new rating and proxy voting system, and the immense task of switching voting platforms.”).

[19]Tao Li, Outsourcing Corporate Governance: Conflicts of Interest Within the Proxy Advisory Industry, 64 Mgmt. Sci. 2,953 (2018) (explaining that ISS’s “‘certification effect’ could be valuable in case a lawsuit occurs”).