A Proxy Adviser's Two Sides
By Dean Starkman
Washington Post Staff Writer
Monday, January 23, 2006
From a nondescript office park near the Shady Grove Metro stop,
Institutional Shareholder Services Inc. runs a global operation with
offices as far-flung as London and Manila.
ISS, the world's leading adviser to big shareholders on corporate
elections, has a client roster of 1,600 institutions that together own
$23 trillion worth of stocks -- about half the world's stock-market
value. Nearly all pay for ISS's views on corporate elections, known as
Corporate chieftains routinely travel to Rockville to lobby for ISS
support on controversial ballot proposals -- as did Hewlett-Packard
Co. chief executive Carly Fiorina and dissident shareholder Walter B.
Hewlett in 2002 when they faced off over the company's deal to buy
Compaq Computer Corp. Last fall, News Corp. chairman and chief
executive Rupert Murdoch took part in a lengthy conference call with
ISS executives to explain why his company's new anti-takeover device
was good for shareholders.
As an important shareholder watchdog of corporate behavior, ISS has
long been criticized by corporate managers who take issue when ISS
recommendations do not go their way. Many executives chafe at ISS's
close scrutiny of their company's corporate governance.
But these days, ISS is taking criticism from all sides.
Academics, shareholder advocates and, lately, some clients are
complaining that ISS compromised its role as chief arbiter of
corporate behavior by tolerating its own conflict of interest.
The questions center on ISS's growing business of selling services to
the same corporations it scrutinizes. For example, ISS ranks
corporations according to how well they score on its
corporate-governance test. But it also sells services that
corporations use to improve those scores.
"If your governance is not getting a good grade, you go see them and
they tell you how to get a good grade," said Ira M. Millstein, a
securities lawyer and partner at New York's Weil, Gotshal & Manges LLP.
"If that's not a conflict, I don't know what is."
In 2004, the head of Missouri's $8 billion public pension fund dropped
ISS over concerns about corporate consulting fees, according to a
series of letters exchanged in 2004 and obtained by The Washington
Post. In the letters, Gary Findlay, executive director of the Missouri
State Employees' Retirement System, said ISS couldn't provide enough
assurance that its loyalty was solely with shareholders.
"I see no merit in further wasting your time or mine regarding this
issue," Findlay wrote. "From this point forward, we will . . . engage
an organization that at least has the appearance of undivided loyalty
to . . . clients."
ISS spokeswoman Cheryl Gustitus said Findlay never spoke to ISS to
learn about the company's safeguards against potential conflicts.
Findlay declined to comment.
Other pension funds have come forward with concerns. Last year, the
$69 billion Ohio Public Employees Retirement System chose a new rival,
San Francisco-based Glass, Lewis & Co., over ISS and cited the
Rockville company's corporate business as a key reason. "The thing
that tipped us was [ISS's] actual or perceived conflicts due to the
corporate consulting," said Cynthia Richson, the Ohio system's
corporate governance officer.
In November, the board of the $34 billion Colorado Public Employees'
Retirement Association terminated its contract with ISS after 16 years
and hired Glass Lewis, noting in a statement that the San Francisco
firm, among other things, "was free of any appearance of conflict."
ISS executives say the concerns are unwarranted. President and chief
executive John M. Connolly said in an interview that the company has
no conflicts and goes to great lengths to separate the sales of
services to corporations from the researchers who issue
recommendations. He said ISS does not consult but offers access to
tools and research data to corporate clients.
"Everything we do is for the interests of institutional clients,"
Connolly said in an interview. "We are not here to grow at any cost."
The services ISS sells help further the cause of shareholders by
helping companies improve their governance, he said. The sales account
for only 15 percent of ISS's revenue, he said.
Connolly said that despite 30 client defections, ISS had a 94 percent
renewal rate by its customers last year and added 424 clients.
In some ways, the scrutiny of ISS is a result of its remarkable rise.
Its roots date to the once-scruffy shareholder-rights movement of the
late 1960s and early 1970s, when campus protesters pushed universities
to justify investments in companies involved in nuclear power,
weapons, and apartheid-ruled South Africa.
The corporate landscape at the time was dominated by imperial chief
executives and rubber-stamp boards. Most institutional investors --
including pension funds, foundations and mutual funds -- either
routinely sided with management in corporate votes or didn't vote at
all. Shareholder activists were seen as gadflies or pie-in-the-sky
ISS founder Robert A.G. Monks, a former money manager who once ran for
the Republican nomination for U.S. Senate from Maine, said he was
inspired to start the company in the late 1970s by a paper company
polluting the Penobscot River. After a stint in the Reagan
administration as head of the Labor Department's Pension and Welfare
Benefits Administration, he founded ISS in 1985 to help shareholders
exert more control over the companies they owned.
In 1988, Monks's former office at the Labor Department ruled that
pension-fund managers who ignored proxy votes exposed themselves to
legal risk. The edict -- the first in series of government mandates
requiring money managers to pay closer attention to proxy votes --
boosted the fledgling proxy advisory business.
ISS took off in the mid-1990s after Canadian media giant Thomson Corp.
bought the company and invested heavily in an electronic system to
cast institutions' ballots. The ISS "agency voting" system collects
ballots, marks them (with ISS recommendations, if the client chooses)
and delivers them to vote-tabulation companies without money managers
having to see them.
"That's where the explosion came from," said ISS's executive vice
president, Patrick S. McGurn, who worked at an ISS rival before
joining ISS in 1996.
ISS, meanwhile, rode the rise in the power of the institutional
investor. In the 1980s and 1990s, tens of millions of Americans
invested in stocks for the first time, mostly through pension plans
and mutual funds. In 1985, institutional investors controlled 46
percent of a U.S. stock market worth $2.2 trillion; today institutions
control 63 percent of a market worth $17 trillion, according to the
With institutions demanding a more systematic approach to proxy
voting, ISS over the years drew up policies that defined good
corporate governance. Its Corporate Governance Quotient, or CGQ,
includes 63 features that all corporations should have, including some
now considered commonplace: that boards include formal nominating and
compensation committees, that boards be controlled by a majority of
independent directors and that "independence" be strictly defined.
Corporations complained that ISS imposed a "politically correct"
governance model that had little to do with whether the corporations
made money for shareholders. "You have centralized decision-making
about what governance should look like," said Gary Lutin, principal of
New York investment bank Lutin & Co. and a longtime ISS critic. "Who
anointed these guys?"
Activist shareholders applauded. ISS supporters say the company has
played a major role in defending shareholder interests against the
worst corporate abuses -- insider deals, anti-takeover devices,
excessive pay and cronyism. "It does a serious job on behalf of its
clients," said Damon A. Silvers, associate general counsel for the
AFL-CIO, which supports shareholder initiatives. "It has been a target
of a long history of unfair attacks by various people acting on behalf
of the corporate community."
By the end of the 1990s, ISS was a Goliath. Its current clients
include the $1.1 trillion Fidelity Investments and hundreds of smaller
funds, including the $48 billion Virginia Retirement System.
ISS has 500 employees, including 290 researchers who prepare reports
on 33,000 corporations worldwide, including 8,000 in the United
States. A plaque listing clients covers a wall in the reception area
of ISS's headquarters.
ISS recommendations have been credited for tipping some blockbuster
corporate battles, including Hewlett-Packard's Compaq acquisition and
a vote in 2004 that forced Michael D. Eisner to quit the chairman's
post at Walt Disney Co. ISS also provides recommendations for votes at
small and mid-size companies, and for social initiatives pushed by
activist shareholders -- such as whether corporations should be forced
to abide by the Kyoto Protocol on global warming (ISS says generally
yes) or be asked to label genetically modified foods (ISS says no).
Shareholders and executives alike puzzle over the influence of ISS
recommendations on shareholder votes. Susan E. Wolf, vice president at
Schering-Plough Corp. and chairman of the Society of Corporate
Secretaries and Governance Professionals, said some organization
members think ISS controls a third or more of their shareholder votes.
Millstein agreed, adding: "That's scary."
A 2002 study published in the academic journal Financial Management
found that ISS recommendations unfavorable to management were
associated with lower vote totals of 14 to 21 percent, depending on
ISS executives play down the influence of their recommendations. "ISS
doesn't control any percent of the vote," said Martha L. Carter, ISS's
director of research. "It's our clients who do."
In an interview, Connolly acknowledged that 15 to 20 percent of ISS
clients use a service that automatically votes according to ISS
recommendations, although the clients can override it. He said such
clients represent a small portion of any shareholder vote. He said
most of ISS's biggest clients vote according to their own criteria,
using ISS to research whether companies measure up.
In 2001, a group led by New York merchant bank Warburg Pincus LLP
bought the company, made a series of acquisitions and revved up the
The next year, ISS began a long-planned service that sells information
to corporations on how to improve governance ratings. A corporation's
CGQ is stamped on the front of ISS's reports to money managers. A low
rating is considered embarrassing. ISS sells corporations access to a
Web site that shows how changing certain governance policies -- for
example, eliminating related-party deals -- would boost their CGQs.
Companies can find out free what their CGQs are and what changes would
boost their scores but must pay for the Web-based tool that calculates
the value of each change. They can also buy comparative data on
Another corporate product allows companies to calculate whether
stock-based executive compensation plans exceed ISS standards.
Some academics accused ISS of misusing its influence by creating a
governance test and then selling the answers. "This starts to resemble
the protection schemes of bullies," Jeffrey A. Sonnenfeld, a professor
at the Yale School of Management, wrote in 2003.
And business groups said their members felt squeezed to buy ISS
products out of fear of receiving unfavorable recommendations on
crucial proxy votes. "The U.S. Chamber gets a number of calls from
members who feel strong-armed," said David C. Chavern, vice president
of the U.S. Chamber of Commerce.
Lately, some of ISS's clients have begun to object.
In one of his letters to ISS, Findlay, of the Missouri retirement
system, compared ISS to the big accounting firms of a few years ago,
which sold consulting services to corporations while at the same time
auditing their books.
"I would have thought you might have reevaluated your business plan
given the upheaval in the accounting community," Findlay wrote.
Last month, Millstein denounced ISS's business model at a conference
celebrating ISS's 20th anniversary held at the Ronald Reagan Building
and International Trade Center. "Anybody who can't see a conflict
between consulting and standard-setting has trouble with their
eyesight," Millstein said during a discussion with Connolly. "We who
are on the other side are saying, 'How do they get away with this?' "
In the interview, Connolly said he had invited Millstein to the
conference and was happy with the exchange of views. But he disagreed
with the lawyer, a longtime advocate of better corporate governance
who was legal adviser to the outside directors at General Motors Corp.
in 1992 when they forced Chairman Robert C. Stempel to resign.
ISS executives noted that the company's corporate services sales
division is physically separate from its shareholder research
division, using separate office equipment and computer databases to
prevent shareholder staffers from stumbling upon the names of
corporate clients. Bonuses for those who provide research for
institutional investors are calculated from a different pool than
bonuses for those on the corporate sales side, Connolly said.
While Connolly acknowledged the failure of such "Chinese walls" in the
accounting industry and on Wall Street, "we believe we've protected
ourselves," he said.
He added that ISS, as a registered investment adviser, is regulated by
the Securities and Exchange Commission, which he said has inspected
its procedures and found no significant problems. In 2004, the SEC
issued a legal ruling that said investment firms could rely on ISS and
other proxy advisers if the firms properly checked out the advisers'
conflict procedures. The agency, however, said it took "no position"
on whether ISS's conflicts procedures were impartial.
ISS executives say that the heart of the company is good governance
and that the cause is served both by its fee-based products and the
amount of free governance resources for corporations that ISS
provides. And some corporate executives, while not thrilled with the
system, say they don't feel pressured to buy an ISS product to win its
"I've never heard of a corporation that thought that paying for the
consulting actually got them a better result," said Margaret M. Foran,
senior vice president for corporate governance at Pfizer Inc. She said
companies can improve their scores only by making changes, not by
buying the ISS product.
The question keeps coming up.
Last month, at a meeting that included Connolly and McGurn, officials
of a building-trades union accused ISS of retreating from full support
of a union-backed shareholder measure that would make it easier to
remove corporate directors, according to a source who spoke on the
condition of anonymity because the meeting was supposed to be private.
Union officials accused ISS representatives of compromising what had
been a clear endorsement of the initiative, instead leaving open the
possibility that ISS might approve corporate alternatives case by
"Are you going to charge for that?" asked Ed Durkin, director of
corporate affairs for the United Brotherhood of Carpenters and Joiners
of America, according to the source and later confirmed by Durkin.
McGurn, in an interview, said that the answer was an "unequivocal no"
and that the company sells services for only matters, such as
compensation plans and governance, that depend on written policies,
not on the judgment of analysts. In any case, McGurn said, the union
officials were mistaken. ISS had not changed its policy and would
almost certainly back most of the unions' shareholder proposals, he
In an interview, Durkin said union officials "remain watchful" of
ISS's stand on the question but are satisfied that "it isn't based on
any consulting business that could raise conflicts."
"Is there a perception that there is a conflict?" Connolly said in an
interview. "It sounds like there is. Can I assure you there is no
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