Paul Hodgson: SEC Commissioner Gallagher’s outsized rhetoric on proxy advisors

Rebutting the latest pot-shot at proxy advisors

An interesting posting by SEC Commissioner Daniel Gallagher appeared on the Harvard Law School blog on September 5. ‘Outsized Power & Influence: The Role of Proxy Advisers’ can be read here. Below, I summarise its essential argument and provide a rebuttal from the objective middle ground.

Gallagher blames a 2003 SEC release for the rise of the proxy advisor, which stated that an investment advisor’s fiduciary duty to its investors requires it to adopt policies and procedures designed to make sure that proxies are voted in those investors’ best interests. It is hard to understand this as a criticism, or a problem for that matter. Checking on these disclosed policies and procedures is exactly how an investor can determine whether the mutual fund is, in fact, voting stocks in accordance with what they believe is in their best interests. That same release also noted that a conflict of interest would be avoided if shares were voted on the recommendations of an independent third party.

He claims this release had two unintended consequences. The first is that mutual funds assumed it meant they must vote “every share every time.” To be honest, given the controversy surrounding broker non-votes and abstentions in recent high profile cases at Coca-Cola and Cheniere, voting every share every time might not seem a negative development. It is, however, impractical. More importantly, no proof is offered that this unintended consequence has actually occurred. The very substantial number of broker non-votes (shares that have not been voted at annual meetings) alone would seem to indicate that it has not.

The second “unintended consequence” is that funds “rotely relying” on proxy firms will “became a cheap litigation insurance policy”. “For the price of purchasing the proxy advisory firm’s recommendations, an investment advisor could ward off potential litigation over its conflicts of interest.” But it surely is a positive action for investment advisors to consult a proxy advisory firm about its voting decisions if this adds a third party, independent level of advice to its own decision making; particularly as this consultation adds another level of analysis in most cases rather than replaces it. I have yet to come across any institutional shareholder that votes any of its shares by rote. All of the institutional shareholders with whom I regularly speak subscribe to multiple proxy and other advisory services to inform their voting, as well as having dedicated governance staff conducting in-house research. None of them vote lockstep with any of these advisors.In a second 2004 letter to proxy advisor Egan-Jones, the SEC indicated that consulting on corporate governance for companies “generally would not affect the firm’s independence from an investment advisor.” This is the only criticism with which I have some sympathy since the existence of ISS Corporate Services – though hardly a key aspect of the firm’s business model as Gallagher appears to allege – and its use of precisely the same data and knowledge base as the shareholder services side of the firm does seem to me a conflict of interest and one which ISS would do well to jettison.

That said, it is only ISS that provides such services so to sully the entire industry over this one conflict is not appropriate. Later he returns to this issue and asks would proxy advisory firms be lenient “in formulating voting recommendations for companies that are their clients and harsh in crafting the recommendations for those companies that have refused to retain their services.” This single, admitted conflict of interest, albeit in the largest proxy advisory firm, does create such a risk, but has any research been undertaken that proves that ISS has been lenient on a corporate client and tough on a non-client? Has even a single instance been detected? Unsubstantiated statements such as the above are unhelpful at best.

Next Gallagher blames the SEC’s 2006 proxy disclosure regulations for making it even less likely that investment advisors will do their own research. While it is true that the amount of data and information that arose from the 2006 SEC disclosure regulations did increase, it increased significantly only in the area of executive compensation. However, this increase in volume was mostly limited to the largest corporations, those where investment firms were already paying close attention and would continue to do so, with or without the aid of proxy advisors. The length of smaller companies’ compensation reports increased rarely. The growth in data volume in other areas, such as director independence and security ownership, was significant only in a handful of companies, and again, those companies were already being closely scrutinised by investors. Related party transaction data actually decreased because the SEC raised the dollar thresholds at which firms must report relationships with directors and officers that lay outside their company duties.

He then points out that Say on Pay and Say on Frequency (a vote for how often to approve executive pay), and the SEC’s opening the floodgates to shareholder proposals make informed voting yet more difficult.

Again, there are problems with this argument. “Say on Frequency” votes are required only periodically, so it is not a burden at all. Furthermore, the “Say on Pay” vote actually decreased the number of executive remuneration stockholder proposals. Other ESG proposals have been on the increase, especially in the areas of political spending and climate change, and while this has increased the burden of decision-making on investors, it is hardly the fault of either the SEC, whatever Gallagher might say, or proxy advisors.

The blog then brings up the twin issues of “factual errors” and “‘cookie cutter’ approaches to governance” that do not capture individual company nuances. It is inevitable that, even with the best quality control, processing tens of thousands of vote recommendations will lead to some errors of fact. Yet these are few in number and since corporations should be aware of vote recommendations prior to the annual meeting they should also have an opportunity to correct any errors that might occur. But you cannot accuse proxy advisors of adopting “cookie-cutter” approaches to governance that might miss individual nuances and at the same time insist that they operate within fully-disclosed voting policies. Most investment firms have similar sets of policies and procedures that drive voting recommendations, but they do not always follow them if there are circumstances which suggest that would not be in the best interests of their clients.

Gallagher complains that corporations have “little access to proxy advisory firms in order either to correct a mistake of fact, or to explain why a generic corporate governance recommendation is the wrong result in the specific instance” and that it would be too time-consuming to do so anyway. This is simply not true. Appealing against a vote recommendation – which should routinely be reviewed by any corporation – is as simple as filing an additional proxy form with the SEC pointing out the mistake to shareholders and asking for it to be corrected.

He also complains of investment advisors ignoring companies trying to engage with them about what they feel is a mistaken vote recommendation. But I often come across investment advisors engaging deeply and freely with companies about their voting decisions. But, as with many of these criticisms, there is an implicit assumption that there are large numbers of investment advisors relying by rote on proxy advisory firms. This is an assumption that is not proved here and of which I am deeply suspicious.
The responses to these perceived problems championed by Gallagher are the 2010 Concept Release on the US Proxy System (the “Proxy Plumbing” release) and the December 2013 congressional roundtable.Very little of the concerns raised at the roundtable were properly substantiated and most were insignificant, except the already-noted potential conflict of interest raised by ISS’s corporate services.

In a surprising move, Gallagher then champions the European Commission, which recently drafted Article 3i (Transparency of proxy advisors) which would require proxy advisors to disclose data about the preparation of their recommendations, including their source and total staff involved, as well as any conflicts of interest. However, the transparency issue has already been dealt with in the US. All the major proxy advisors have been very open about the basis for their voting recommendations and pages and pages of their websites are devoted to disclosing and explaining them. Companies may take issue with them, but that is only possible because of this disclosure.

Also, the SEC released Staff Legal Bulletin No. 20 (SLB 20), which actually reiterates much of what was already stated in the SEC’s 2003 release, except for the following exceptions. First it clarifies that you do not have to vote “every share every time”; secondly, SLB 20 warns that investment advisors should not blindly rely on proxy advisors for advice but should demand that their voting recommendations are based on accurate information and, if determined to be inaccurate, they should be made to correct them.

If corrected information would change the voting recommendation then, of course, proxy advisory firms should be compelled to correct it and change their recommendation. But too often such “errors” are differences of interpretation rather than differences of fact. Glass Lewis may have a different approach to calculating run rates – the proportion of outstanding of equity used up each year in stock awards. But just because a company disagrees with GL’s approach does not mean that GL should change it.

Finally, SLB 20 also requires the disclosure of any significant relationship the proxy advisory firm might have with a company or the sponsor of a shareholder proposal. Again this is an appropriate regulation but one which is unlikely to affect any other firm than ISS.

Many of Gallagher’s criticisms smack of paranoia. Of course ISS should sell off its corporate services arm, of course proxy advisory firms make mistakes, of course some of their recommendations are wrong, but that does not mean to say that they are part of plot to destroy corporate America, or corporate anywhere else. They are simply part of the agency relationship between owners and managers and play no more significant part in that relationship than any other party.

Paul Hodgson is an independent governance analyst.