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The article below was published in Agenda, a Financial Times private subscription service for corporate directors, and is presented with permission.

For the article's referenced paper by Charles Nathan addressing the different communications requirements for investment (buy-sell) and voting (proxy) decisions, see


Agenda, April 26, 2010 article


The week's news from other boardrooms






Article published on April 26, 2010
By Kristin Gribben


The SEC will issue its long-awaited concept release before the end of June on suggested reforms of the proxy voting system that will touch upon, among other things, the relatively unchecked influence of the proxy advisory industry.

SEC Chairman Mary Schapiro has said the agency will look at a host of proxy voting reforms, including whether regulation of proxy advisory firms is needed. The concept release is also expected to deal with whether shareholders should remain anonymous to companies (NOBO/OBO classification), client-directed voting and voting mechanics (such as empty voting, over-voting and vote lending).

RiskMetrics Group dominates the proxy advisory industry, which companies and business associations would be thrilled to see the SEC scrutinize. But it appears the SEC is pushing for reform on its own, largely without corporate prodding.

The Shareholder Communications Coalition— which consists of five groups including the Business Roundtable and the Society of Corporate Secretaries and Governance Professionals— sent a wish list to the SEC of proxy voting reforms it would like to see. It didn’t include the proxy advisory industry. The group has campaigned for proxy voting reform since its formation in 2005 but has made little headway until now. All along, the associations involved in the coalition were planning to address reform of the proxy advisory firms as part of a separate campaign.

In announcing the pending concept release last November, Schapiro said that proxy advisory firms would be included. “Given the influence that these firms’ recommendations have on corporate voting outcomes, we’ll probe the need for rules to ensure that advisory firms are basing their research and recommendations on accurate and reliable information, and that they are providing adequate disclosure of any conflicts of interest they may have in providing voting recommendations,” she said at a Practicing Law Institute conference.

Shareholder activists, who are often aligned with proxy advisory firms, are likely to oppose too much intervention in that industry. Experts, however, say this might be an area where the Democratic commissioners part ways with shareholder activists.

Last month, the National Investor Relations Institute (NIRI) and the Society of Corporate Secretaries released a white paper on recommendations for reforming the proxy advisory industry, a copy of which was sent to the SEC.

The organizations want the SEC to require proxy advisory services to: a) register as investment advisers (three of the six proxy advisory firms are currently registered: Proxy Governance, RiskMetrics Group and Marco Consulting Group), b) disclose if they have a relationship with clients who are proponents of a proxy proposal on which the proxy advisors are issuing a recommendation, c) disclose their internal procedures, guidelines, standards, methodologies and assumptions, d) maintain a public record of all their voting recommendations and voting decisions, and e) allow public companies to review draft reports for accuracy and respond to comments or recommendations that they don’t agree with.

John White, director of the Division of Corporation Finance from 2006 to 2008 and a partner at Cravath, Swaine & Moore, says the SEC will likely incorporate the content of the NIRI and Corporate Secretaries paper in the form of questions in its concept release.

Concept releases are typically worded broadly in a way to solicit input from a variety of market participants. The SEC will then take the feedback it receives and formulate a proposed rulemaking that will go through another comment period before a rule is finalized. It’s a long process and new rules around the proxy voting system aren’t likely to be in place until the 2012 proxy season, observers of the process say.

The Power of Proxy Advisors

If reform means fewer investors voting in lockstep with third-party recommendations, that would be welcome news for directors. As evidence of proxy advisory firms’ influence, IBM says that in 2006 RiskMetrics Group (ISS at the time) issued a withhold vote recommendation for one of its directors because a family member of the director was employed by IBM in a non-officer capacity. The result was that 23% of the votes cast were withheld for the director. The next year, RiskMetrics changed its recommendation in support of the director’s reelection and the director received only 9% withhold votes. “The underlying facts had not changed nor had the make-up of IBM’s institutional shareholders changed significantly,” wrote IBM’s Assistant General Counsel Andrew Bonzani in a comment letter to the SEC last summer.

Charles Nathan, of counsel at Latham & Watkins, recently co-authored a paper about the difference between institutional investing and institutional voting that he hopes the SEC will take into account in its concept release and in future rulemakings that deal with proxy voting.

In the paper, Nathan explains why proxy advisory firms have gained so much influence. Investment firms are charged with a fiduciary duty to vote their proxies — a responsibility bestowed on them by the Employee Retirement Income Security Act (Erisa) of 1974. Until then, most institutional investors devoted little money or attention to proxy voting matters unless it was a vote on a major merger or acquisition. Following Erisa, most funds outsourced their voting obligations to proxy advisory firms because it is a cheaper way to vote than in-house. Thus began the division between the investment decision makers (namely portfolio managers) and investment voters (proxy advisory firms and the internal corporate governance staff at funds). Nathan says it’s important for the SEC to understand this divide when issuing rules on proxy voting because not all investors have the same goals.

It’s also imperative to keep this in mind specifically when regulating the proxy advisory industry, says White, the former SEC official. That’s because as more obligations are bestowed on proxy advisory firms, it will raise their costs, which are likely to be transferred to their clients, the institutional investors. Investment funds are conscientious about how much money they spend on proxy voting, and it’s unclear what the end result of reform will be.

A Check on Power

White says there was only limited discussion about reform of the proxy advisory industry when he was at the SEC, but since then these service providers “have just grown in power, influence and stature.” One way to check their power is to create more competition among the service providers, much as is being discussed about the ratings agencies, he says.

Another idea is for proxy advisory firms to self-regulate and limit any conflicts of interest. Some observers speculate that MSCI’s purchase of RiskMetrics Group last month might put an end to perceived conflicts of interest at RiskMetrics because the profits from its business advisory division might not be enough to offset the headache of regulatory scrutiny. The proxy advisor rates companies while simultaneously offering a service to help companies improve their scores. RiskMetrics has said it has several safeguards already in place to prevent any potential conflicts of interest.

Yet another option reportedly under consideration by at least one proxy advisory firm would be to turn itself into a nonprofit entity with nominal fees paid for by corporations instead of investors. Both Nathan and NIRI CEO Jeff Morgan say Proxy Governance has discussed this option. The proxy advisor did not respond to a request for comment.




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