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A Turning Point in the Standoff With Proxy Advisers?

Stephen Davis and Jon Lukomnik | November 4, 2014

It’s fairly easy to get a CEO’s blood pressure spiking: just mention the two leading proxy advisers Institutional Shareholder Services and Glass Lewis. Some chief executives have accused these firms of fueling shareholder campaigns against them on a variety of topics, including pay practices, board independence, and how they should use their excess cash.  

In a recent informal poll at a meeting of the Business Council, U.S. chief executives singled out the two firms as most responsible, after shareholder activists, for short-term behavior in capital markets. Whether that is true or not is irrelevant; much of corporate America believes it. But there is reason to predict that, beginning with the 2015 proxy season, corporations here and in Europe will have new tools they can use to fight back against proxy advisers. And that development, for the first time in 30 years, could alter the dynamic of how proxies are voted, though perhaps less than some long-time opponents of the duopoly would like.

First, some background. It wasn’t always the case that proxy advisers were the boogeymen in C-suites that they are today. When ISS opened its doors in 1985 it found a market of institutional investors hungry for advice on how to do something many were just learning about: voting shares at portfolio companies. But the votes those investors were casting at U.S. annual meetings were, if we’re honest, mostly meaningless.

Director elections were conducted almost universally according to the plurality standard, meaning that candidates running uncontested could win with a single vote. Even stock markets labeled corporate board elections “routine” because ousting candidates was all but impossible. Moreover, the shareholder resolutions that took up oxygen in corporate governance debates of the time were nearly all non-binding, regardless of topic. So ISS and its later competitor Glass Lewis could recommend all the no votes they liked without much noticeable effect. The two were biting at the ankles of corporate power.

That’s now changed, thanks to the spread of majority rather than plurality voting in director elections and the Dodd-Frank Act, which mandated universal say-on-pay votes. Sure, say-on-pay is technically non-binding; and the overwhelming number of companies converting to majority voting provide a safety mechanism allowing them to re-install any director who fails to gain more than 50 percent yes votes. But the reality is that these issues are at the core of corporate authority, and lower-than-usual numbers for director elections and say-on-pay are seen as posing significant reputation risks for individual directors and their corporations. Moreover, with the swift rise of activist investors, ISS and Glass Lewis now have the clout to propel or break campaigns against boards or individual board members.

It’s no wonder, then, that CEO ire at the duo has intensified considerably in the last few years. Organizations, such as the U.S. Chamber of Commerce, have sought to concentrate corporate blowback with four major accusations against proxy advisory firms: inaccuracy of proxy analyses, insufficient fact-checking with corporations, conflicts of interest, and chronic use of one-size-fits-all models for making vote recommendations.

The Regulatory Response

Such charges mainly fed free-floating hostility among CEOs toward ISS and Glass Lewis. This year, however, critics extracted modest responses from regulators in Washington and Brussels for the first time—and they are preparing to leverage those into a multi-faceted assault on the two services in 2015.

The European Commission acted first, but with an unexpected set of collaborators. All six proxy advisers operating in the European Union joined with the ESMA—the European Securities and Market Authority—to bang together the industry’s first professional code of best practice. A threat was implied; had the firms balked, the Commission could have issued regulations, but the services decided to go along and delivered a list of standards in June.

Looking at the big picture, the more stubborn problem may be less ISS and Glass Lewis, and more the two extremes: corporations that still bristle at the idea that shareowners want to have a say, and funds that still automatically follow proxy firm advice.

The principles call for disclosure of how each adviser handles guideline development, staff training, conflicts of interest, and communication with corporations. But the measure corporations are most keenly interested in is the code’s promise of a complaint procedure they can use when they believe a proxy adviser has got something wrong. Details of this protocol are due in the next few months. Proxy advisers have told us they welcome the rules, saying the standards protect advisers who comply, and that there is nothing in the code that they can’t live with. Indeed, provisions largely reflect current practice.

Just days after release of the European code, the U.S. Securities and Exchange Commission chose to proceed with something close to regulation instead of pressing the private sector to self-police. And in this instance, the approach met with quiet corporate glee. Expect Staff Legal Bulletin 20, the new rules for proxy advisers, to become something of a household word in compliance and general counsel offices.

Among other standards, SLB 20 spells out that an investment adviser has a duty to watch any proxy firm it selects to test that it exhibits “the capacity and competency to adequately analyze proxy issues, which includes the ability to make voting recommendations based on materially accurate information.” Consider this the crack in the door. SEC Commissioner Daniel Gallagher urged corporations carefully to scour ISS and Glass Lewis reports for inaccuracies and to use SLB 20 as an invitation to bring complaints to the attention both of investors and to his personal office. The U.S. Chamber and prominent corporate law firms are likely to urge companies to do just that. In other words, with new complaint protocols now coming into place both in the United States and Europe, companies will now have their first-ever open channel to target proxy firms.

Open Season on Proxy Advisers

What does this mean for proxy season 2015? It is likely to trigger a tide of complaints aimed at discrediting the proxy advisory industry. Such an assault could hope to so tarnish ISS and Glass Lewis that institutional investors would regularly ignore their advice. Or instigators might also hope to lure the SEC into greater oversight of the advisers. Or they might want to compel each firm to give corporations time to respond to proxy analyses. Of course, the cynical might believe that attacks would be designed to cow ISS and Glass Lewis into less assertive stances; after all, the argument might go, corporates aren’t likely to raise as many complaints if they see rising ‘yes’ recommendations.

A benevolent consequence of a corporate offensive is also possible, however; complaints might drive the two advisers to pour more resources into analysis to improve quality. Do the math and you’ll find that ISS, for instance, now has on average one permanent analyst responsible for reports on 200 companies. Even with templates, boilerplate, and extensive use of technology, there is ample room for error. Expanding skilled staff would raise prices for clients, but there aren’t a lot of competitors out there ready to jump in with discount fees. Barriers to entry are high and it is hardly a high-profit industry.

As they ponder their shiny new weapons, though, corporate boards might want to resist an instinct to go for the jugular. Institutional investors generally appreciate the work ISS and Glass Lewis do for them. Shareholders might interpret attacks on their commercial allies as self-serving, defensive, and, worse, a way to avoid substantive engagement on governance issues or to distract from controversial executive compensation packages. In any case, most of the biggest institutional investors now have in-house governance teams who, while they tap ISS and Glass Lewis for research, make voting judgments independent of the advisers. Blackrock CEO Larry Fink, for one, has made that explicit.

Looking at the big picture, the more stubborn problem may be less ISS and Glass Lewis, and more the two extremes: corporations that still bristle at the idea that shareowners want to have a say, and funds that still automatically follow proxy firm advice. Those ‘robo-voters’ represent a minority of ballots cast, according to studies, but they remain a concern. And to solve it, the first place CEOs may want to look is their own backyard: their firm’s employee retirement plans. At that same Business Council meeting in October, an informal poll sought to discover what percentage of top CEOs were confident that their own plans were handling proxy voting thoughtfully, without excessive reliance on proxy advisors. The answer: 12 percent.