Proxy Advisory Firms: At the Heart of Corporate Governance
Proxy advisory firms play a very important role in corporate governance through their guidelines and vote recommendations to shareholders, which influence considerably the decisions made by companies on such issues as the selection of directors, the design of corporate compensation programs, and merger and acquisition activity. In a white paper for the Milken Institute, “Proxy Advisory Firms, Governance, Market Failures, and Regulation,” I’ve examined the role and power of advisory firms and their significance in corporate governance in light of the current regulatory debate.
Proxy advisory firms have increased in importance with the greater emphasis on corporate governance in the last two decades, such as the required disclosure of mutual fund proxy votes. Because information generated by the advisory firms applies to many shareholders of a company and to a degree across companies, there are tremendous economies of scale associated with these efforts. Hence, traditional competition in information production fails; in fact, the market is currently dominated by two firms, Institutional Shareholder Services (ISS) and Glass Lewis. These two firms consequently have considerable influence and power concerning governance decisions in the United States.
The resulting market failure and the power of the proxy advisors suggests the potential value of enhancing regulation of these firms—especially in light of the more extensive regulation of such financial intermediaries as the mutual funds themselves, credit rating agencies, and auditors. In this case, regulation might include greater emphasis on transparency and cost-benefit principles in developing guidelines and proxy vote recommendations as well as ensuring that companies have sufficient opportunity to respond to apparent errors. This seems particularly important given the impact of the recommendations on society’s corporate governance agenda and the overall impact of such recommendations on the economy. The particular regulatory and supervisory remedies might be achieved through a variety of alternative approaches including legislative action, SEC rulemaking, SEC guidance, or industry-led development of best practices.
Several studies have explicitly criticized the recommendations from proxy advisory firms as not providing value-maximizing advice for the shareowners. Instead, these recommendations reflect ideological or other biases. It is interesting that larger asset managers, who invest the most in stewardship (relative to smaller asset managers), are much more supportive of management recommendations than the proxy advisory firms. This suggests that the objective underlying proxy advisory firm recommendations is not necessarily shareowner value maximization. Proxy advisory firms may in fact have alternative goals. For example, controversial proxy battles enhance the value of the proxy advisory firm’s recommendations.
Of course, smaller asset managers, who are not able to invest much in stewardship, are more likely to closely adhere to the recommendations—giving the proxy advisory firms considerable influence on governance outcomes. This can occur not only through the actual votes, but also in the prepositioning of companies (in designing compensation programs, for example) to avoid adverse recommendations on particular issues or even director elections. In that sense the proxy advisory firms act as quasi-regulators, playing a central role in the underlying governance decisions of the firm.
While not recommending an overhaul of the function of proxy advisory firms, some adjustments to regulatory oversight would provide better protection for companies and shareowners.