Proxy Advisory Firms, Governance, Market Failure, and Regulation

Summary of Study

Bottom Line: Proxy advisory firms suffer from underlying market failures similar to the market failures that they were created to solve. Yet they are subject to very little regulation. Reform of proxy advisory firms -- in the form of legislative action, SEC rulemaking, SEC guidance, industry-led development of best practices, or some combination thereof -- is appropriate and necessary.

The role of the proxy advisory firms is arguably among the most crucial for corporate governance. The two proxy advisory firms heavily influence a substantial portion of the voting power of millions of individual shareholders, which is managed by thousands of asset managers. Unlike asset managers, however, proxy advisory firms face modest regulation.

Proxy advisors wield massive power. While proxy advisory firms do not invest directly in public companies, their recommendations carry more clout than the votes of the largest asset managers or institutional investors. Empirically, the probability of changing the vote outcome is much greater for a proxy advisory firm than for a large institutional investor.

This report explains the role and impact of proxy advisory firms, describes the economics of the proxy advising industry, identifies the underlying sources of market failure that suggest the potential need for regulation, and shows how the role and performance of proxy advisory firms can be enhanced.

Proxy-voting advice is fundamentally an information production process. The costs of producing information are largely fixed so that there are few cost savings from excluding recipients. Since it is difficult to exclude those who do not purchase the advice from receiving the benefits, proxy advice is a classic public good. Public goods lead to market failure because the non-exclusionary aspect prevents voluntary market exchanges. Due to economies of scale, the proxy advisory industry is arguably much closer to a natural monopoly and consistent with the observed oligopoly market structure.

Proxy advisor advice is not very diverse, and it can suffer from conflicts of interest. Proxy advisors, in some cases, sell consulting services to the same public companies they provide voting recommendations on, allowing them the opportunity to retaliate through their recommendations if the companies don't purchase their services. The transparency of proxy advisor client lists could offer assurance that proxy recommendations are not being distorted by conflicts of interest. Recommendations should be determined by cost-benefit analyses.

Proxy advisor regulation to fix underlying market failures should focus on the principle of transparency and the principle that cost-benefit analysis should underlie proxy recommendations. 

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