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Public companies command vast resources and influence. Tech giants are soaring to record high market capitalizations, and corporations are increasingly wielding cultural as well as economic power by weighing in on social issues. Those who guide these public giants enjoy enormous power. One might think that attaining such power is quite difficult. Yet two little known companies—Institutional Shareholder Services (ISS) and Glass Lewis—can command this kind of influence without owning a single publicly-traded share.
ISS and Glass Lewis are the leading proxy advisory firms, which investment management funds pay for guidance on how to vote their shares (i.e., how to exercise voting rights associated with their shares to influence corporate policy). Together the two firms control 97% of the proxy advisory market. And their clients listen. A recent study showed that 175 of ISS’s clients, representing more than $5 trillion in assets, voted as the firm instructed 95% of the time. Empirical research shows these recommendations have outcome determinative effects on shareholder votes, changing key corporate policies.
How have proxy advisory firms come to wield such vast influence? Two reasons:
1. Rational Apathy: Investment management funds are rationally apathetic about voting their shares. Voting comes with a steep opportunity cost—taking time away from finding ways to generate investor returns. Investment management funds prefer to not deal with shareholder votes. And many would simply not cast their ballots at all, but for federal regulations mandating otherwise.
2. Federal Regulations: The Securities and Exchange Commission (SEC) requires investment management funds to vote their shares. Investment management funds, not wanting to deal with this hassle, developed a simple solution to this problem–-paying proxy advisors to vote their shares. Many investment management funds don’t even give proxy advisory firms’ recommendations a cursory review. They just automatically vote according to their recommendations. With proxy advisory firms’ clients owning 70% of outstanding publicly traded shares, they exercise vast influence.
Proxy advisory firms’ influence is increasing agency costs for the average shareholder. Shareholders bear agency costs when, contrary to their interest, management doesn’t maximize value creation. Proxy advisory firms drive up agency costs when casting votes directing managers to engage in corporate policies damaging value creation. Critics accuse proxy advisory firms of voting on behalf of special-interests with whom they have relationships, such as labor-union pension funds and other politically oriented investment vehicles, rather than average shareholders. Many have called on the SEC to curb proxy advisory firms’ influence.
The SEC heard this call. In July, the Commission adopted rules and interpretive guidance addressing proxy advisory firms’ influence. The most significant regulatory changes are the new requirements that (1) proxy advisory firms must simultaneously give their advice to their clients and the companies they’ll be voting on, and (2) proxy advisory firms must notify their clients if a company responds to their voting advice.
These regulatory changes will help address some concerns about proxy advisory firm influence. They will help weed out conflicts of interest proxy advisory firms may have when making vote recommendations. They will also provide investment management funds with another perspective on how to vote: companies will now put out more solicitations. This counterbalance may give investment management funds a better perspective on what the best voting option is for long-term shareholder value.
Yet these changes do not address the underlying issues causing proxy advisory firms to have so much influence: rational apathy and federal regulations. Investment management funds that didn’t care to look at proxy advisory firm voting advice are not now going to start looking at additional company solicitations. Proxy advisory funds haven’t gained vast influence because investment management funds don’t have enough information to vote. They’ve accumulated such influence because investment management funds don’t want to vote. And as long federal regulations force them to do so, they will continue outsourcing their vote casting to proxy advisory firms.
Hence, a more complete check on proxy advisory firms is simple: repealing federal regulations requiring investment management funds to vote their shares.
Critics argue such a reform will decrease overall vote totals in shareholder elections. However, this change will give the ballots of voters with rational incentives to vote—i.e., owners of many shares interested in long-term company health—greater weight, thereby reducing agency costs and increasing shareholder value. Furthermore, proxy advisory firms will need to work harder to attract clients no longer forced to use their services due to federal regulations. Such a competitive development could make way for more nimble competitors to ISS and Glass Lewis, breaking up the duopoly in the proxy advisory market.
The SEC checked proxy advisory firms’ influence slightly in July. Repealing federal regulations mandating investment management funds to vote their shares can provide a more thorough and longer-lasting check.