Why You Should Be
Worried About Proxy Advisory Firms
Tuesday, 26 Oct 2010 | 8:53 AM ET
The market for
proxy advisors has grown significantly in the past decade, enriching those
who run proxy advisory firms.
Coolidge | Iconica | Getty Images
importance of proxy advisory firms has prompted market participants,
journalists and scholars to examine ways in which their influence could be
problematic. The usual litany of complaints includes conflicts of
interest, transparency, methodology, and responsiveness to investor
attention, if any, has been paid to the source of demand for proxy
advisors. Some of those who have looked into the proxy advisory business
think the answer is obvious: institutional investors are the biggest users
of proxy advisors, and the role of institutional investors in the markets
has been growing rapidly. The larger the share of equities held by
institutions, the larger the role for proxy advisors.
Of course, this
only moves the question on step backward: why are institutional investors
increasingly purchasing proxy advisory advice?
The reliance by
institutions on advisors is a bit surprising. Sophisticated mutual fund
managers and pension fund managers might be expected to be in the best
positions possible to make their own determinations about the wisdom of
voting for board candidates or executive pay recommendations. Given the
well-documented flaws in the proxy advisory business, why aren’t
institutions internalizing this process?
Part of the answer
may be complexity. Corporate proxies are becoming increasingly complex, as
investors are asked to vote on more questions and those questions
themselves are increasingly complex. Some sources of the new questions and
- hedge fund
activism—largely enabled by ‘shareholder friendly’ regulations—has
increased the number of proxy contests, while raising the possibility
that the interests of the activists may depart from long-term
increases in shareholder power to vote on corporate governance matters
has enhanced the importance of proxies while introducing complex
questions of optimal governance that are highly contested even among the
best informed experts in the field; and
- the shift to
require that directors receive a majority of the votes even in
uncontested elections,—which is likely the result of enhanced
shareholder say in governance matters—has allowed for a powerful ‘none
of the above’ strategy to be employed by opponents of management.
In addition, proxy
questions that are not yet mandatory but that have been under
consideration may drive demand in anticipation of the questions. These
include the ability to cast a vote on executive pay and further proxy
It may be that as
the questions become more numerous and complex, the costs of internally
evaluating them—which include opportunity costs for talent diversion as
well as error costs—outweigh the agency costs of using proxy advisors. Or,
at least, this could be the perceived balance of costs that—whether
accurate or not—would increase demand for proxy advisors.
To put it
differently, although the rise of proxy advisory firms appears at first
glance to be a consequence of a market phenomenon, this appearance is
probably deceptive. Securities regulations that have increased the
complexity of proxy questions are very likely increasing the demand for
proxy advisors. Which is to say that the demand for proxy advise is not
driven by some internal market process but by regulatory intervention in
This consequence is
wholly unintended. As far as I’ve been able to discover, no one has
advocated for increased proxy access or say on pay provisions on the
grounds that they would increase the demand for proxy advisory services.
Indeed, I doubt many realized that this would result from changes to
securities regulations that were intended to be ‘shareholder friendly.’
In fact, there’s
something a bit ironic about this result. Reforms to securities
regulations that were ostensibly intended to empower shareholders or
further ‘shareholder democracy’ have instead resulted in increasing
domination of proxy questions by a small clique of advisors. That those
advisers have often been advocates of these reforms should at least raise
an eyebrow about how unintended this consequence really was.
Another source of
demand for proxy advice has been the regulation put in place by the SEC in
2003 that required mutual funds to adopt written policies and procedures
to ensure that securities were being voted in the best interests of
clients. Of course, the easiest way for mutual fund managers to protect
themselves against accusations that they have violated their duty is to
abandon this field, giving it over to third-party advisory firms. It’s
harder for an investor to challenge the proxy voting decisions of a mutual
fund manager when those decisions are made by a well-respected proxy
Note that there’s
an irony—or, perhaps, perversity—to the dynamic here. A regulation that
appears, on its face, to require mutual fund managers to carefully
consider whether they are voting on proxy questions in the best interests
of their clients, instead has resulted in them outsourcing this decision
to firms who are even further removed from client influence and whose
interests may conflict with clients. (In passing, let’s note that the
largest proxy advisory firms are supporters of these mutual fund rules.)
The rise of proxy
advisory firms, in other words, appears to largely be the unintended and
unanticipated consequence of regulations aimed at investor protection.
This suggests, at the very least, that we should be wary that the proxy
advisor’s rise may be accompanied by unintended and unanticipated costs.
In fact, there are
frightening parallels between the rise of the proxy advisors and the role
played by credit ratings agencies. Like the proxy firms, the ratings
agencies saw the demand for their services grow largely due to demand
driven by regulation. Because the demand was not driven by genuine market
demand for analysis, ratings agencies were able to profit while providing
poor credit analysis. Similarly, proxy firms have business-lines
increasingly locked-in by regulation.
We should at least
worry that their advice might fail just like the advice of the credit
ratings agencies failed.
© 2010 CNBC, Inc.