Proxy Advisory Firms and the Need for SEC Protection of Investors’ Fiduciary Interests

A trader works on the floor of the New York Stock Exchange shortly before the closing bell, March 17, 2020. (Lucas Jackson/Reuters)
The outsize influence of proxy advisers undermines the principle of value maximization at the heart of financial markets.

Opportunities to spend other people’s money are addicting, an eternal truth that now has emerged in full force in the context of corporate governance. Large, publicly-owned businesses, and public-pension funds managing the assets of many people, command substantial resources. The uses of those resources traditionally have been constrained by the fiduciary interests of the investors who own the firms or funds: Value maximization is the only appropriate criterion with which to evaluate business operations and investment choices.

In 2003, the Securities and Exchange Commission promulgated a regulation that appeared benign but that has engendered an unintended and adverse outcome: a duopoly of firms enjoying a position as the most powerful arbiters of corporate governance in America. Those firms, Institutional Shareholder Services (ISS) and Glass Lewis (GL), provide recommendations to investors and asset managers on how they should vote their shares in the many companies that they own. The two account for 97 percent of the market for proxy-advisory services. In short, despite lacking any statutory authority, they have become the de facto regulators of America’s public companies.

Because of subsequent staff interventions and interpretations, the 2003 regulation evolved from a simple requirement that investment funds provide transparency involving potential conflicts into an policy interpreted to mean that funds must vote on all proxy issues, that funds could avoid liability by retaining proxy advisers, and that the proxy advisers would bear liability only in extreme cases.

The “extreme cases” limitation on the potential liability of proxy advisers means that in practice they are effectively unconstrained by fiduciary responsibility considerations. So the personal preferences of the proxy advisers or their staffs — often oriented toward specific policy or political goals — can carry substantial weight in decisions on proxy matters, including executive compensation and corporate policies on a range of social and environmental questions. The climate “crisis” and the pursuit of “sustainability” are popular ones, and it is no surprise that many of the proxy advisers’ staff bureaucrats are enamored with them. Put aside the very large substantial climate uncertainties discussed in the scientific literature, including those outlined by the IPCC itself. The resulting impacts on business risks extending far into the future would be deeply speculative, and the definition of “sustainability” is vastly more ambiguous than commonly asserted.

In short, the voting recommendations flowing from proxy-advisory services have been shaped by incentives unrelated to the maximization of value for the shareholders, future retirees, and pensioners who participate in the funds. This effect is unlikely to be small: Recent research focusing on ISS finds that a negative recommendation results in a 25 percent reduction in support for the given proxy proposal.

Because the managers avoid liability by retaining proxy advisers, it is unsurprising that they have been induced to defer wholesale to their recommendations. And so the funds continue to vote on all proxy issues in accordance with those recommendations, a dynamic made easy by “robo-” (or automatic) voting. About which: Even in the case of funds that evaluate proxy advisers’ recommendations independently, acceptance of those recommendations has evolved into the default option in many cases, while rejection of the recommendations is the exception, a dynamic that research has confirmed empirically. Another study found that “175 asset managers with more than $5 trillion in assets under management have historically voted with ISS on both management and shareholder proposals more than 95 percent of the time.”

Automatic voting literally outsources the evaluation of proxy proposals to the proxy advisers, an outcome that disenfranchises pensioners in particular and shareholders more generally. This outsourcing inserts an external decision-maker between the fund management and those to whom that management has a fiduciary responsibility, thus reducing the transparency of decisions on proxy proposals. The proxy advisers have no obvious responsibility or incentives to respond to inquiries from investors, and communications between investors, managers, and proxy advisers are hardly frictionless.

The systematic deference manifesting itself in automatic voting yields an incentive for proxy advisers to adopt stances reflecting their personal policy and political preferences, as distinct from parameters driven by fiduciary responsibilities to the business and fund owners.

The SEC is in the final stage of a rulemaking process that has run several years. As that process concludes, it is essential that the rule require that proxy advisers’ recommendations be justified specifically in terms of the fiduciary responsibility to maximize returns, and that automatic voting be proscribed. A weaker solution will fail adequately to protect retail investors, pensioners and other savers.

A rule similar to that enforced by the Department of Labor (which regulates private pension funds under the Employee Retirement Income Security Act) would be highly appropriate: “ERISA fiduciaries may not sacrifice investment returns or assume greater investment risks as a means of promoting collateral social policy goals.” DOL recently proposed an update of that rule.

Value maximization implies the most productive use of the fund’s resources, thus maximizing the productivity of the economy as a whole. Because resources are limited always and everywhere, value maximization for the funds yields the greatest possible aggregate economic pie, the most favorable overall condition for the ability of ordinary individuals to improve their economic conditions.


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