Anita Anand is the J.R. Kimber chair in Investor Protection and Corporate Governance at the University of Toronto. @AnitaAnand2.
Historically, the main threat of regulatory reproach facing public companies was a visit from the securities commission. Now there is another wolf at the door: the proxy advisory firm. These firms play an important role in monitoring public companies, but the extent of their growing influence suggests that their activities call for regulatory oversight.
Proxy advisory firms – which include Institutional Shareholder Services (ISS) and Glass Lewis – communicate with corporations and shareholders on matters that require shareholder votes. They review the disclosure that companies issue in advance of shareholder meetings and provide recommendations on how shareholders should vote. They also have assumed a broader role in regulation, establishing metrics for evaluating companies’ governance practices, including board composition and ESG (environmental, social and governance) practices. On matters of concern for securities regulators, such as women on boards and climate change disclosure, they are an extra set of hands in the regulatory effort.
Proxy advisers can be valuable because they fill an information gap: institutional investors contract with these firms to carry out comprehensive reviews of voting proposals that the investors themselves have neither the time nor the resources to undertake. Over 1,700 mutual and pension funds rely on ISS alone, managing over US$26-trillion worldwide, according to the firm itself. Glass Lewis reports that it represents over 1,300 clients that manage a collective US$35-trillion in assets. In short, many institutional investors, including pension funds and mutual funds, review and perhaps follow proxy advisers’ recommendations when voting their shares.
Proxy advisers also influence boards’ decision making. More than 70 per cent of directors and executive officers have reported that their compensation decisions were influenced by guidelines published by ISS and Glass Lewis. ISS has explicitly stated that directors who make decisions that the advisory firm disapproves of may face serious repercussions, such as recommending that shareholders withhold their votes in director elections, at the next annual meeting.
Proxy advisers’ voting guidelines for each country are publicly available for any investor to consider, often setting standards for corporate-governance best practices. But little of advisory firms’ other work is public. Reports and specific recommendations are typically not available to nonclient investors. In other words, capital market participants may not know key pieces of information about how proxy advisers operate. Their voting guidelines might well leave shareholders and portfolio managers asking: how did the advisory firm reach its recommendation on this matter? How is the advisory firm being compensated?
In addition to selling proxy voting services to investors, some proxy advisory firms sell consulting services to companies, raising the obvious concern that these firms will recommend voting in favour of management proposals on which they have consulted, either to show the efficacy of their consulting business or as a “quid pro quo” arrangement. Proxy advisers currently address this concern by implementing firewalls between the two sides of their business, but the question arises as to whether these voluntary measures are sufficient to eliminate the conflict.
In 2015, the Canadian Securities Administrators (CSA) issued a policy that contains guidance in response to the concern that proxy advisory firms have become de facto corporate governance standard setters. The policy addresses four key issues: conflicts of interest, transparency and accuracy of vote recommendations, development of proxy voting guidelines, and communications with stakeholders. Although the policy includes concrete recommendations on how proxy advisers can adopt better internal practices, these are merely guidelines, with no mandatory force and no explicit periodic regulatory surveillance.
Securities regulators appear to be reluctant to regulate proxy advisers further, no doubt because these firms are in a contractual relationship with institutional investors who are sophisticated enough to “make their own bed.” But once institutions use the proxy advisers’ reports and the information (or at least some of it) becomes public, this information has an extensive impact on capital markets, impact that stretches well beyond the decisions that the clients themselves make. The breadth of this influence arguably means that securities regulators have a mandate to oversee their activities in order to maintain confidence in and protect the integrity of capital markets.
Proxy advisory firms make meaningful contributions to corporate governance. While there may be no need to impose a mandatory legal regime at present, securities regulators should at least audit them to review the adequacy of their disclosure and to understand the extent to which they are complying with the CSA’s policy. This type of oversight would allow regulators to identify pressing issues arising from their activities without curtailing the monitoring work carried out by these increasingly important market players. It would also allow regulators to consider whether additional oversight is required.