The SEC needs to put more teeth in its guidance and clarify its standards.
May’s showdown at DuPont Co., in which shareholders rejected an activist campaign to install four new board members, brought proxy advisory firms’ bias back into the news: All three of the company’s largest institutional shareholders ignored the proxy recommendations to vote for candidates whose primary qualification was loyalty to the activist. Unfortunately, their rejection of proxy advisory positions is the exception, not the rule; the present system of proxy voting serves neither companies nor shareholders.
A Stanford University study of institutional investors released in February demonstrated that, for the average asset manager with $100 billion or more under management, the portfolio managers who make the investment decisions are involved in only 10% of voting decisions. Who is making voting decisions if those who are investing are seldom involved?
Voting decisions are often effectively controlled by proxy advisory firms — namely, Institutional Shareholder Services and Glass Lewis. There is considerable evidence that a “no” recommendation from such firms translates into about a 30% “no” vote by institutional shareholders. Add to this that regulation prohibits the 20% or more of shares held in the name of the brokerage firm, known as “street name” securities, from being voted in most matters of consequence. Simple arithmetic means that companies need 80% of the remaining votes to overcome “no” recommendations from proxy advisory firms.
While proxy advisory firms claim they merely advise and do not make voting decisions, their influence is unmistakable. Research released last year from Stanford University’s Rock Center for Corporate Governance found that many large money managers side with ISS more than 95% of the time when the proxy advisory firm and management disagree about pay practices.
Proxy advisory firms have no financial interest in shareholder votes. They rarely understand the companies on which they report, their competitive situations or their strategic challenges. They use opaque processes, and they often solicit consulting fees from the same companies on whose issues they advise, without disclosing specific arrangements. Most important, proxy advisory firms claim no duty to the shareholders whose votes they effectively control. How does this serve shareholder or corporate interests?
The situation has been exacerbated over the years by two factors. One is the increasing size and scope of index funds and exchange-traded funds, many of which rely almost entirely on proxy advisory firm recommendations. Another is the increased number of matters that require shareholder votes thanks to the 2010 Dodd-Frank law and certain Securities and Exchange Commission rules.
The decoupling of proxy voting from the investment process, and in many cases from investor interests, might be less troublesome if it increased shareholder value, but it doesn’t. Research from 2009, also conducted by Stanford’s Rock Center, found that governance ratings by proxy advisory firms have no ability to predict future performance, and that their proxy voting policies are negatively correlated with shareholder value. Proxy advisory firms have offered no research showing that their recommendations do enhance shareholder value.
The SEC took steps toward improving proxy voting by issuing 2014 Staff Guidance. However, since portfolio managers are involved in only 10% of voting decisions, it is likely that more needs to be done. The SEC should put teeth in the guidance in three ways.
First, while SEC rules now explicitly reaffirm that proxies be voted in the economic interests of shareholders, the standards should be more precise. The agency’s Staff Guidance allows asset managers to comply by “periodically sampling proxy votes to review whether they complied with the investment adviser’s proxy voting policy and procedures.” This is not enough; a judgment must be made each time as to what is in the interests of shareholders for that company at that time.
Second, determining what best serves shareholders cannot be outsourced to a third party claiming no fiduciary obligation to shareholders; that must be defined by the asset manager. Many asset managers say that proxy recommendations are only one input into their decision-making, but the data do not always bear this out. Other asset-management firms consider proxy voting an integral part of the investment process and dedicate substantial resources to it. Accurate disclosure should be a requirement, not an option.
The criteria used by proxy advisory firms in arriving at recommendations must be more transparent. Voting should not be based on these firms’ opinion about what constitutes good governance, but rather on enhancing shareholder value. Additionally, proxy firms must be free from conflicts.
Finally, the SEC should be clear that if asset-management firms have not taken steps to ensure that votes enhance shareholder value, they should not vote their shares. Decisions on how to vote proxies should not be based — solely, or even principally — on third parties who have not demonstrated that their recommendations are in the best interests of company shareholders and funds, and disavow any duty to act in their interests.
Proxy voting has the potential to improve corporate governance, and shareholders should be able to influence the companies they own. This cannot happen when neither investors nor their fiduciaries control voting outcomes. The SEC should clarify that its Staff Guidance is not intended to permit third parties to impose their unproven preferences about governance onto American companies and their shareholders.
Nicholas Donatiello is a lecturer at Stanford Graduate School of Business. Harvey L. Pitt, a former SEC chairman, is the CEO of the global business consultancy Kalorama Partners, LLC.
Originally published in the Wall Street Journal, on May 28, 2015.