By Robert M. Krasne
How fiduciaries represent plan participants in corporate proxy matters is an important issue for the integrity of America's publicly traded companies and the vitality of our capital markets.
In this post-Enron environment, the investing public is looking for greater accountability of its corporate leaders. In that spirit, the Securities and Exchange Commission is requiring, starting later this year, registered management investment companies to disclose how they vote proxies related to the portfolio securities they hold. They are also required to disclose the policies and procedures that they use to determine how to vote proxies related to their portfolio securities.
The new SEC rule requiring disclosure and transparency has eroded the curtain of secrecy that prevented beneficial owners and the investment world from learning how investment managers vote proxies — or whether the proxies are voted at all. As fiduciaries managing assets of others, investment managers would be derelict to ignore or fail to exercise proxies — which are assets beneficially owned by their investors. Voting rights are assets, the value of which must be maximized for the benefit of the beneficial holders of the shares. Typically, ignoring the proxies is inconsistent with this obligation.
The SEC's rule does not address the manner by which managers are to exercise these voting rights; it merely exposes the voting practices to sunlight. A review of various managers' disclosures reveals an apparent safe harbor for managers through the use of guidance provided by businesses created to provide direction to institutional shareholders.
Among the most well known of these businesses is Institutional Shareholder Services Inc., Rockville, Md., which provides proxy voting and corporate governance services to institutional and corporate clients worldwide. Many of its institutional and corporate clients no doubt rely on ISS for fair and unbiased assessments of proxy issues before the 22,000 shareholder meetings ISS monitors annually. What those clients might not apprehend is that ISS faces substantial actual or apparent conflicts of interest. Indeed, if similar conflicts arose at one of the shareholder meetings it monitors, ISS would or should criticize the issuer.
In addition to providing proxy voting and corporate governance services to institutional and corporate clients who are seeking to satisfy their duty to their clients, ISS provides services to an unknown number of the companies that hold the shareholder meetings that ISS monitors. ISS, for example, has a proprietary, black-box option pricing model that issuers, for a handsome fee, can use to test various combinations of compensation plan features to determine what features will yield a positive vote recommendation from ISS. In other words, you can buy access to the party who ostensibly provides impartial recommendations. Furthermore, the recommendation is not transparent, but must satisfy an opaque proprietary model. The potential for conflict is significant. The failure to provide rational and compelling bases for recommendations is obvious.
ISS' business plan is built around the twin pillars of proxy services and corporate governance consulting. The accounting profession faced withering criticism for its dual business model focusing on both auditing and consulting. Accounting critics contended that the audit function was tainted by the provision of consulting services that were subsequently subject to review by the firm's auditors. ISS, which recommends how proxies are to be voted, might also be providing advice to the issuers on how to frame their referenda.
What is the likelihood of ISS recommending against a client to whom it sells consulting services? A short time ago, the same question would be asked of public accountants who also provided consulting services to their audit clients. Of course, rules were promulgated that now severely proscribe accounting firms' consulting work for audit clients. Perhaps such rules would be similarly wise for proxy service firms.
Another concern about ISS' proxy voting services is that the firm appears to use the same basic analytics and the same positions on issues with respect to all corporations or at least all industry groups. (It uses 25 industry groups for its compensation model). One size does not fit all, as companies, like the individuals who comprise them, are each different. Taking an inflexible position, i.e., recommending a blanket "yes" vote for proposals to destagger boards or redeem shareholder rights plans, might be correct in the vast majority of circumstances. However, ISS' reflexive position does not consider the rationale of the directors who believe retaining a staggered board or a rights plan is appropriate. ISS' approach is a disservice to shareholder democracy in a contested election — when both sides should receive a fair hearing.
This position places those investment managers who have determined to rely on ISS recommendations in a difficult position. As fiduciaries, they must look after the interests of their principals, that is, investors. They can rely on experts in whom they can reasonably repose confidence. Placing confidence in ISS, as it potentially serves two masters — both the fiduciary and the issuer — while not disclosing the underlying basis for its recommendation to the fiduciary, should be troublesome to a conscientious fiduciary.
Given the extraordinary clout that the investing public can wield through their managed investments, they can fundamentally change corporate practices through the exercise of their proxies. The SEC has recognized the importance of these proxies by requiring greater transparency for the voting process. For the investment managers to then abdicate their duty to exercise wisely the voting power of the shares they hold for the benefit of their investors by blindly relying on the recommendations of potentially conflicted, dogmatic advisers does not promote the corporate democracy that corporate America deserves.
Robert M. Krasne is principal of The Krasne Group Inc., Washington, a strategic business consulting firm, providing services to companies and individuals addressing corporate governance, strategic planning and other business-related issues.