As annual general meeting season comes to a close, there is greater significance to the Securities and Exchange Commission's recent attention to the debate over the role of proxy advisers. The SEC is considering rules on proxy adviser regulation that stand to reshape the industry. Critics of proxy adviser reform question the need for action and argue that investors are not calling for reform. They are wrong.
Among institutional investors, the view is mixed. Certain fund managers such as Trillium Asset Management and Neuberger Berman have been vocal in their defense of the services that proxy advisers provide them. Others, most notably Blackrock, have called for greater accuracy in the data provided by proxy firms, as well as transparency over their operations. That view is shared by many retail investors. Recently, nearly 5,000 participated in a survey of their views on the role and influence of proxy advisers in an extensive study I helped to design. A clear majority voiced support for greater regulatory oversight of proxy advisers.
The power of these firms is unquestionable — and their recommendations shape the outcome of many annual meetings and transactions across capital markets. Hidden behind a veil of opacity, the leading proxy advisers, Institutional Shareholder Services and Glass Lewis, and their proponents argue they have no material influence over voting and merely provide independent research to thousands of institutional investors. Starboard Value, Rite Aid and Albertsons Cos. and a host of companies on the receiving end of negative recommendations are likely to disagree. Those anecdotes are supplemented by academic research.
SEC Commissioner Elad Roisman recently said that "asset managers disclose that they have adopted the proxy voting policies developed by proxy advisory firms." Certain funds not only tend to follow a proxy advisers' house policy but have internal policies in place that make it extremely difficult to vote in a way that diverges from recommendations. Emboldened, ISS and Glass Lewis have anointed themselves as quasi-regulators. The most egregious and recent example is Glass Lewis' statement that it would consider recommending against directors on boards that have excluded proposals under SEC rules. It seems Glass Lewis may view itself as a higher power than the regulator of U.S. capital markets. Worse, ISS has been known to threaten companies to use their "consulting services" in order to spur favorable recommendations. Unsurprisingly, a growing number of stakeholders are starting to voice their concerns over the duopoly that exists in the proxy adviser market.
If proxy advisers were simply a product of market competition, there would be no need for action. But the SEC created the market for these entities with a series of regulatory guidance letters 15 years ago, and early entrants took over the market. The power and prominence of ISS and Glass Lewis is inextricably linked to providing recommendations that allow institutional investors to meet their fiduciary obligations. Without the recommendations, their often-cited research may not be considered very valuable. Having put in place rules creating an artificial demand for proxy advisers, and encouraging investment advisers to use them, the SEC must take a level of responsibility over these entities.
Encouragingly, the SEC has now embarked on that journey to enhance investor protection by reviewing the role proxy advisers play in the U.S. proxy system. Providing clarification that institutional investors can elect when to vote or default to management would be a positive step to tackle the problems associated with existing rules. The SEC should also require added disclosure about how proxy advisers make recommendations, the expertise of those issuing recommendations and — failing an outright ban on clear conflicts of interests — far greater disclosure of their existence, including how they market consulting services to issuers under the soft threat of bad recommendations. And efforts must be made to ensure the accuracy of research being provided — by allowing companies to review draft reports and requiring proxy advisers to report on errors spotted by clients.
The efforts to enhance the quality of proxy adviser reports are likely to meet resistance.
One of the key aims of investment is generating sufficient returns to safeguard the future of investors. Institutional investors claim to discharge their fiduciary obligation by delegating voting decisions to firms who enjoy artificial demand for their services created by regulation, without having to meet any regulatory standards themselves.
Until the SEC can fully undo the damage done by the initial proxy adviser letters, it should be guided by the maxim that sunlight is the best disinfectant. It's time for regulators to force the hand of proxy advisers to provide real transparency to the market.
J.W. Verret is an associate professor at the Antonin Scalia Law School at George Mason University, Fairfax, Va. He also serves on the investor advisory committee of the Securities and Exchange Commission. This content represents the views of the author. It was submitted and edited under P&I guidelines but is not a product of P&I's editorial team.