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The House Committee on Financial Services’ April 29th hearing titled “Exposing the Proxy Advisory Cartel: How ISS & Glass Lewis Influence Markets” examined “the role and influence of proxy advisory firms…in shaping corporate governance and shareholder voting outcomes.”
It’s about time.
Proxy advisory firms exist because the SEC requires institutional investors to vote on all matters put forth in proxy statements, or the measures voted on during shareholder meetings. For most institutional investors keeping up with all the issues raised during shareholder meetings is overwhelming, so they turn to proxy advisory firms for help. Proxy advisory firms help institutional investors manage this herculean task. They do the leg work and advise institutional investors on how to vote on the thousands of shareholder resolutions that arise every year.
Two proxy advisory firms – ISS and Glass Lewis – control 97% of the market. Given the sheer volume and importance of proxy statements every year, these two firms have acquired tremendous influence over corporate governance.
Unfortunately, inefficiencies plague the proxy advisory market. As the Environmental, Social, and Governance (ESG) issue exemplifies, these inefficiencies weaken corporate governance to the detriment of effective management.
While the pressure to implement ESG programs has lessened as of late, numerous ESG programs continue to be raised via shareholder proposals that include requirements to report on companies’ greenhouse gas emissions. When it comes to ESG proposals, the two major proxy advisory firms establish their position without adequate transparency and use a one-size-fits all approach despite the vast differences that ESG programs can have on different companies.
As a result, their ESG recommendations can be detrimental for many companies. For instance, when examining the influence of the proxy advisory firms, the American Council for Capital Formation concluded that the ESG recommendations from the proxy advisory firms particularly “disadvantages small and mid-sized companies, in favor of larger companies that have the resources to comply”.
The proxy advisory duopoly also has an irreconcilable conflict of interest because both ISS and Glass Lewis sponsor their own ESG programs. ISS has a program known as ISS ESG that, according to their website, provides “ESG screening, ratings and analytics designed to enable investors to develop and integrate responsible investing policies and practices into their investment strategies.” Glass Lewis has formed a strategic partnership with Sustainalytics and actively incorporates ESG principles into its proxy voting recommendations.
Put differently, the major proxy advisory firms that control 97 percent of the proxy advisory market have a pre-ordained belief that pro-ESG proxy statements should be supported. This inherent bias in favor of ESG programs is troubling given ESG’s actual performance.
Several studies document that ESG-related proxy measures typically harm financial returns. One study in the Journal of Financial Economics examined the impact from activist public pension funds on the market values of a sample of Fortune 500 companies finding that increased activism by public pension funds is negatively correlated with stock returns. Further, the firms receiving proposals from activist public pension funds promoting social agendas were valued 14 percent lower than similar companies without such agendas. Another study by the Manhattan Institute found that public pension shareholder activism pushed by proxy advisory firms negatively impact share value.
The claim that shareholders voted for the proxy measures, therefore the corporation is simply listening to the desires of its owners, also rings hollow. The majority of “shareholders” voting on these proxies are institutional investors that are simply voting the recommendations from ISS and Glass Lewis. These impacts are worsened when the institutional investors automatically adopt the proxy advisory firm’s recommendation without further scrutiny – a practice referred to as robo-voting.
The empirical results indicate that ESG programs are detrimental to corporate performance and rarely achieve their lofty aims. The proxy advisory firms’ predisposition to view these programs positively illustrates an important disconnect between the advice from proxy advisory firms and the potential financial interest of the specific company. The ESG issue exemplifies why fundamental reforms to the proxy market are warranted.
The overarching goal of the reforms should be to better align the interests of the proxy advisory firms with the interests of fund shareholders. Specific reforms should include ensuring that proxy advisory firms act in a manner that promotes fund managers’ fiduciary responsibilities to shareholders, creating greater transparency regarding the proxy advisory firms’ biases and conflicts of interest, and creating greater transparency regarding the methodology the proxy advisory firms used to determine their recommendations.
While currently plagued with misaligned incentives, proxy advisory firms play an essential role in the financial markets; but the market must be structured correctly. Fixing the flaws that pervade the current market is an opportunity that the 119th Congress should not let slip away.
