The Agency Cost Case for Regulating Proxy Advisory Firms

Summary of Study

Bottom Line: The securities commissions in Canada and the United States have made a mistake by not regulating proxy advisors. The need for new rules relating to the proxy industry flows out of the core rationales for securities regulation, namely to remedy certain kinds of market failures inherent in proxy advisors' day-to-day operations.

The case for regulatory intervention in the market for proxy advice can be stated as follows:

  1. There is significant evidence of informational failures in the market.
  2. There is evidence these failures arise systemically as a logical consequence of the conflicts of interest of the agents that make up the market.
  3. There is evidence of significant externalities in this market, suggesting the full value of good proxy advice is not captured by market participants and that high-quality advice is therefore underproduced.

Both investment managers and proxy firms bear few of the costs of poor governance and operate under incentives to keep proxy advice as inexpensive as possible.

Empirical evidence drawn from the academic studies performed on this market show significant problems with the content of proxy advice, including mistakes in what produces good corporate governance and frequent errors in voting recommendations. The evidence also reveals problems in the process by which the advice is delivered, including insufficient information for advisors to comply with their own voting guidelines, conflicts of interest, opacity, and an apparent inability to correct errors.

Securities regulation should address these market failures with the application of traditional disclosure tools to the market for proxy advice. For instance, proxy advisors should provide all issuers with a copy of their recommendations several days before those recommendations are to be sent out. Securities regulators should permit companies to provide a response to the voting recommendations of the advisors and require the advisory firms to include it in the voting recommendations they deliver to their clients.

These regulations would allow a company, which feels the recommendations are incorrect and material, to have an opportunity to explain the facts the advisors have missed, the mistakes it has made, and the reasons why the board made the decision it did.

Providing issuers with access to the proxy advisors’ reports would go some distance to remedying the problems inherent in the proxy process. If a proxy advisor knows in advance it will have to defend its recommendation, the advisors will do better at justifying their conclusions.

Since mistakes, errors in judgment, failures to anticipate consequences, and the actual rationale for voting recommendations will be exposed by the issuers’ responses, access to proxy reports should make it much easier for institutional investors to form opinions on the relative quality of the proxy advisors’ work.

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