Proxy Advisory Services: Making Glass (Lewis) Transparent -- And ISS Too

Originally posted at WLF's Legal Pulse blog

With 2014 and many corporations’ annual meetings just around the corner, more and more publicly-traded companies find themselves girding for costly proxy fights over corporate governance issues.  The small cadre of firms that provide proxy advisory services increasingly hamper management’s ability to prevent proxy battles, and to win those it can’t forestall.  Entities like Glass Lewis & Co. and Institutional Shareholder Services (ISS) provide advice to their institutional money manager and investment adviser clients that increase the percentage of shareholders voting against management’s recommendations.

But it is not at all clear that this proxy voting trend serves shareholder interests.  The Securities and Exchange Commission (SEC) has been studying these firms (which together control some 97% of the proxy services market )and their grip over proxies.  As Edward Knight, General Counsel of NASDAQ OMX (the public company that owns NASDAQ) points out: “[T]here is evidence that the Firms not only increase the costs of being a public company, but also create disincentives for companies to become public in the first place.”  Perhaps, as an October petition filed with SEC by NASDAQ OMX urges, it’s time the SEC stopped studying and started acting to make the methodology behind such influential proxy voting advice more transparent.

A Creature of Regulation.  The current problem began when, in an effort to curtail potential conflicts of interest, SEC imposed a new rule in 2003—the “Proxy Voting by Investment Advisers” rule—that required entities such as institutional investors and investment advisers to disclose “the policies and procedures that [they use] to determine how to vote proxies.”  To satisfy this new requirement, investment advisers began turning to third-party firms that offer advice on proxy voting.  When a 2004 SEC no-action letter clarified that relying on such firms creates a veritable safe harbor, the reliance on these firms grew and their impact blossomed.

Thanks to a second 2004 no-action letter, SEC has also instructed proxy advisory firms that they can provide advice to public companies on corporate governance issues—including how to win proxy votes—at the same time that they make proxy voting recommendations to investment advisers.  As James Glassman and J.W. Verret wrote in a Mercatus Center analysis last April, “Instead of eliminating conflicts of interest, the rule simply shifted their source.  Instead of encouraging funds to assume more responsibility for their proxy votes, the rule pushes them to assume less.”  Such concerns, voiced both by public companies and SEC Commissioners, led SEC to publish a “Concept Release on the U.S. Proxy System” that elicited over 300 comments.

Opaque and Conflicted.  Many of those comments, as well as Mercatus’s analysis and NASDAQ OMX’s petition, criticize the advisory firms for using “one-size-fits-all” formulae and ratings to determine whether investors should approve a public company’s governance proposals. Because ISS and Glass Lewis keep the models and methods they use to reach their recommendations secret, companies can neither effectively evaluate how investors might vote nor challenge an advisory firm’s conclusion if they believe it to be flawed.

Proxy advisory firms are vulnerable to at least two kinds of conflicts of interest.  The first, where Glassman and Verret train their focus, relates to the ideological agendas of clients.  Those agendas, which can include demands that businesses cast aside their First Amendment rights or radically alter their environmental policies, can be directly at odds with shareholders’ primary interest in growing share value.  And yet the proxy advisers often follow the lead of their clients and advance those ideological agendas.

The second conflict arises out of the advisory firms’ work for both sides of proxy battles.  The NASDAQ OMX petition summarizes this conflict well:  “At the same time it [ISS or Glass Lewis] evaluates companies against its own non-transparent corporate governance guidelines, it profits as a consultant to help these same companies obtain higher governance ratings and/or provide to institutional investor clients voting recommendations regarding these companies’ shareholder proposals.”

A Troubling Anecdote.  A July 19, 2013 comment on the SEC’s 2010 Concept Release effectively illustrates these transparency and conflict concerns.  In the comments, the general counsel of Axcelis Technologies related that company’s attempt to earn ISS’s recommendation on an Equity Incentive Plan for Axcelis employees.  Even though Axcelis set the percentage for the cap on plan grants at a level that had met ISS’s previous standard, ISS recommended against approval of the proxy containing the plan just nine days before the company’s annual meeting.  A frantic back-and-forth between Axcelis and ISS ensued.  Axcelis believed that ISS’s reasoning and conclusions regarding Axcelis’s cap were deeply flawed.  But because ISS refused to share its methodology, Axcelis was forced to offer a lower cap on its proxy statement just three days before its annual meeting, an outcome that reduced the shares employees could receive.

One week after the meeting, the Axcelis general counsel received a call from an ISS representative.  In a voicemail, the representative referenced the Equity Incentive Plan cap debacle, and suggested that “going forward . . .you do have the ability to work with us prior to filing a proxy” to determine what ISS might recommend to its investor clients.

The Accidental Regulator?  So it is that federal regulation has caused two relatively small proxy advisory firms to be de facto appointed as corporate governance regulators.  Advisory firm representatives proclaimed at a recent SEC roundtable on the proxy process that their work is sufficiently transparent and enough safeguards are in place to prevent conflicts of interest.  Those representations did not reassure some companies at the roundtable, who understand that these private firms answer only to their clients. SEC will be taking comments related to what was discussed at the roundtable until January 10.

Count us equally skeptical.  If the proxy advisory firms are going to act like regulators, then the same transparency and accountability we demand of actual regulators is needed.  NASDAQ OMX’s petition, which has already garnered support from numerous public companies, deserves serious consideration.  At a minimum, SEC should revisit the 2004 no-action letter that allows firms like ISS to contact companies like Axcelis with an implicit offer—hire us to help you prevent problems that we can cause—they can’t refuse.  Otherwise a rule that was meant to buttress fiduciary duty will continue undermining it instead.