Every year, corporation after corporation submits proposals to its shareholders for ratification. Many of those proposals involve executive compensation. In its proxy materials, corporations present the strongest case possible for its proposals but rarely inform shareholders of any of the downside.
Enter Institutional Shareholder Services Inc., a Bethesda, Md., for-profit firm. ISS decided it could provide a useful service and also earn a profit by analyzing a corporation's proxy proposals and then advising institutional investors as to whether a given proposal should be approved or rejected. Institutional investors would support ISS' efforts by paying it fees to obtain the fruits of its analyses.
Over the years, ISS has become very sophisticated in analyzing a company's proxy proposals to the point that, today, you need an extensive knowledge of finance and mathematics to understand the many algorithms ISS employs. ISS' sophistication is generally credited to one of its vice presidents, Gary Lyons.
So long as ISS received its income solely from advising institutional investors, no conflict of interest could be discerned. But over time, ISS began to take fees from the very companies whose proxy proposals it was evaluating. The process could well have started quite innocently, for example, by a company whose proposal was nixed by ISS calling ISS to ask it what it would have to do to avoid being publicly embarrassed in the future. But, however innocent the origin, it was not long before ISS began to see consulting with companies as a new and potentially lucrative business.
In interviewing some leading executive compensation consultants, corporate compensation directors and corporate secretaries, I was astounded at the anger at ISS they uniformly expressed, hurling such adjectives as "blackmail," "extortion," and "working both sides of the street."
Of course, some of their remarks have to be taken with a grain of salt. When an executive compensation consulting firm claims to perceive a conflict of interests at ISS - a new type of competitor - one must recognize the consulting firm making the statement also has a conflict of interests.
It is less easy to dismiss the criticisms of corporate compensation directors and corporate secretaries. They have no apparent conflict of interests. One of them told me that one day, shortly after his company's proxy statement had been released, he received a fax from ISS informing the company ISS was going to recommend to its institutional shareholder clients that the company's proposed new long-term incentive plan be rejected. Then, 20 minutes or so later, another fax came from ISS offering, for a fee, to help the company design plans that would not run afoul of ISS' voting guidelines and, for all practical purposes, assure the plan would receive ISS' seal of approval.
Although he does not deny the incident took place, ISS President James Heard states such behavior would violate ISS' policy. Mr. Heard is well aware of ISS' potential conflicts of interests. That is why he has set up ISS' consulting activities with corporations as a separate division of the company, headed by Mr. Lyons. "I realize that there is the potential for an appearance of conflict of interest, but we have taken steps to deal with the issue," Mr. Heard told me. Among those steps, Mr. Heard notes ISS analysts who recommend approval or disapproval of particular proxy proposals work in a different division of ISS and do not report to Mr. Lyons; and ISS informs companies for which it works on a fee-paying basis that its activities will not result in pre-approval by ISS.
"From my perspective," Mr. Heard continues, "it's all right for ISS to be in the business of rendering services to corporations, as long as everyone understands what we are about, as long as we treat everyone the same way and as long as everyone can see we are disclosing these relationships to our institutional clients."
Has Mr. Heard really solved the conflict of interests issue? Not in my opinion. The Chinese wall Mr. Heard has erected seems to be made, at least in part, of papier-mache. Although the analysts who make recommendations to institutional shareholders do not report to Mr. Lyons and presumably make their decisions independently, it is Mr. Lyons who developed the computer program the analysts use for their decisions.
In the past few weeks, I had occasion to view ISS' work firsthand. My client, the California Public Employees' Retirement System, had been approached by a major corporation that is planning to ask its shareholders to approve a new long-term incentive plan. The corporation sent California Employees' a draft of its proposal and asked whether it could be counted on to vote favorably. The system turned the plan over to me for analysis. I found the plan to be markedly deficient in a number of respects.
After receiving my comments and considering the matter itself, the retirement system informed the company it would vote against the proposal. That action sparked a counteroffensive by the company, culminating in its chief executive officer flying to Sacramento to meet with Dale Hanson, California Employees' chief executive officer. In the meeting, the company's chief executive sought to denigrate my analysis of the proposed plan, and his principal line of offense was that ISS had pre-approved the company's plan.
For my part, I wrote Mr. Heard, expressing puzzlement at how ISS could have seen the plan as being acceptable; some of its features looked to be in direct conflict with ISS' guidelines. I did not hear from Mr. Heard for a month. During the interim, he might have called the company, reminding it that ISS' work with it did not carry its pre-approval. In any event, not long after Mr. Heard received my letter, the company made a point of telling me it had made an overstatement when it informed California Employees, in an earlier letter, that "(ISS') review included a comprehensive examination of the entire plan and they have stated they will recommend shareholders approve the plan."
Subsequently, Mr. Heard answered our letter. He stated quite emphatically: "(Company X) is among the companies that have participated in the corporate governance audit program that we offer to corporations to familiarize them with ISS voting policies .*.*. and to take these policies into account in drafting proposals that may be submitted to shareholders for approval. The purpose of our corporate audit program is to educate companies about our policies, not to preapprove proposals that may appear in the company's proxy statement. *.*. (R)epresentation by (Company X) .*.*. that ISS has preapproved its compensation plan, or other proposal to be submitted to shareholders, is simply inaccurate."
Admittedly, the above is only a single case. But ISS was paid a fee by this company, and the company seemed to think ISS had offered its approval to the company's planned design. Upon reflection, I wonder whether Mr. Heard's assertion that ISS does not offer pre-approval to a corporate client is, for all practical purposes, meaningless.
Suppose as a compensation director at a company I hire ISS. If I know for certain my new plan will not conform to ISS' policies, isn't it rather dangerous for me to trumpet that my plans have been pre-approved by ISS? After all, a simple phone call will establish me to be a liar. Alternatively, if I don't know whether my plan will conform to ISS' policies, why did I hire ISS in the first place? Finally, if I know my plan does conform to ISS' policies, does it matter whether ISS has for the record, not given its approval? Isn't it reasonable for me to assume ISS' eventual approval is a mere formality?
So when Mr. Heard says representations of pre-approval are "simply inaccurate," I wonder whether Mr. Heard's statement, though perhaps technically correct, is itself for all practical purposes inaccurate.
ISS is performing a valuable service for its institutional clients. Those clients ought to be willing to pay ISS what it takes for ISS to do quality work and at the same time earn a reasonable profit. It should not be necessary for ISS to seek fees from the companies the plans of which it is trying, objectively, to evaluate.