The system for proxy voting by
mutual funds and other institutions that own shares in publicly traded
companies in America is badly broken. The source of the disrepair is
regulation. Among the unintended consequences of rules enacted with the
best of intentions is the harm inflicted on retirees and other investors.
The good news is that, with small changes, the system can be fixed.
A rule enacted by the Securities
and Exchange Commission in 2003, which followed actions by the US
Department of Labor 15 years earlier, required institutions to adopt and
disclose policies for proxy voting that were intended to minimize
conflicts between the institutions’ interests and those of their
An SEC staff interpretation led
to a result almost the opposite of what many of the rule’s supporters
intended. Institutions could easily protect themselves from legal
liability by shifting responsibility to proxy advisory firms, which
acquired increasing power over corporate governance, to the detriment of
shareholders. The rule resulted in outsourcing decision making to advisors
with little particularized knowledge and no incentive to maximize value.
The proxy advisory firms themselves face the same conflicts of interest
that the rule was intended to minimize. The problem is compounded by a
market for proxy advice that is dominated by two firms. To fix this broken
system, it is necessary to return the responsibility to determine the need
for a vote to shareholders and directors.
OUTSOURCING PROXY ADVICE
Now that mutual fund
shareholders are required to vote on all proxies, the simple solution is
to hire an advisor and enjoy virtual immunity from liability if they
follow these advisors’ recommendations. Meanwhile, the SEC has given the
proxy advisors protective treatment that has not been granted to similar
• Two small organizations that
most investors have never heard of, Institutional Shareholder Services
(ISS) and Glass Lewis & Co., LLC, have come to dominate not just the field
of proxy advice but the landscape of corporate governance in America.
• ISS, which controls more than
three-fifths of the market, renders millions of decisions for more than
1,000 institutions that vote on proxies, affecting their holdings in 5,000
THE INFLUENCE OF PROXY ADVISORS
Proxy voting by institutions has
become increasingly important in determining how American businesses are
run, both because those institutions now hold three-quarters of the equity
assets of the 1,000 largest public corporations
and because shareholder activism has increased, with the encouragement of
• For example, the Dodd-Frank
law requires public companies to hold “Say-on-Pay” shareholder votes on
executive compensation plans. While these votes are nonbinding, corporate
directors risk lawsuits if they ignore shareholder opposition. ISS has
been especially active in recommending “no” votes on many pay plans.
• Between them, ISS and Glass
Lewis influence the votes of one-fourth to one-half of the shares of the
typical mid- or large-cap company. A Stanford University study found that
opposition by a proxy advisor results in a “20% increase in negative votes
cast.” That figure underestimates the power of ISS and Glass Lewis since
corporations trying to avoid a negative recommendation from a proxy
advisory firm will shape their policies accordingly.
IMPACT OF PROXY ADVISORS ON
It is essential to evaluate
whether the policies these powerful proxy advisory firms advocate actually
enhance shareholder value—the aim of good corporate governance.
• A lack of transparency makes
research difficult, but studies of Say-on-Pay and exchange offers (also
called options repricing) show that ISS’s recommendations deplete
shareholder value to a significant degree.
• ISS also backs other
governance policies—such as independent chairs and golden parachutes—for
which support in the academic literature is mixed, at best.
The ultimate result is lower
returns for investors, including retirees.
REASONS FOR POOR-QUALITY ADVICE
BY PROXY ADVISORY FIRMS
Lack of resources to examine
proxy questions in depth and with regard for the nuances inherent in the
management of specific corporations, misaligned incentives, and the very
conflicts of interest that the SEC tried to avoid yield suspect
recommendations by the advisory firms.
• Their use of
“one-size-fits-all” guidelines has produced such absurdities as
recommending a vote against Warren Buffett as a director of Coca-Cola.
The proxy advisors are not
shareholders and do not bear the cost of bad decisions. Their incentives
are therefore not aligned with those of investors, who are directly
affected by loss in value of their investment from bad decisions, or
corporate directors, who themselves own shares and risk lawsuits and
diminished reputations for poor decisions.
• In addition, proxy advisors
suffer from the conflicts of interest that the SEC tried to avoid. Some of
their largest clients are giant pension plans run by unions and
politically motivated individuals, with strong social, labor, and
environmental agendas. Other clients are public corporations—“issuers”
—themselves. ISS, for instance, advises issuers on governance policy
(including how to get proxy questions approved) and at the same time
advises institutions on how to vote.
THE THREE STEPS NEEDED TO FIX
THE CURRENT SYSTEM:
• Limit proxy voting
requirements of mutual funds and pension funds so that those institutions
will be the sole arbiters of when it makes sense to vote using active
analysis of the question at hand. The test should be whether the vote
enhances the value of their investment to a substantial degree and whether
the benefits of the voting process exceed the costs.
• End the preferential
regulatory treatment that proxy advisors currently enjoy in the law.
Institutional investors would remain free to purchase proxy advisory
services if those services are valuable on their own merit.
• End extraneous proxy
requirements such as Say-on-Pay votes. Let shareholders and directors
decide the matters that should be put to votes, if any, beyond those
already required under state corporate law.
CENTER AT GEORGE MASON UNIVERSITY - 3351 Fairfax Drive, 4th Floor,
Arlington, VA 22201