Tags: Garrett | proxy | SEC | advisory

What's Wrong with Proxy Advisory Firms?

By    |   Thursday, 06 June 2013 03:04 PM

Wednesday, the same day the Securities and Exchange Commission (SEC) was struggling with the regulation of money market mutual funds, the House Financial Services Committee's Subcommittee on Capital Markets and Government Sponsored Enterprises, chaired by Scott Garrett, R-N.J., held a hearing titled "Examining the Market Power and Impact of Proxy Advisory Firms."

A large panel of witnesses represented associations with an interest in this issue, former SEC officials and in the case of the U.S. Chamber of Commerce, both. Today's article will discuss the broad question of how best to regulate proxy firms to make them more responsive to the interests of shareholders and to minimize conflicts of interest, while tomorrow's article will discuss the complaints of the panelists in more detail.

Interestingly, the Chamber of Commerce and the Financial Services Roundtable (FSR), which normally agree on issues, diverge on this one, with the Chamber opposing new regulation and the FSR supporting it.

In opening remarks, Garrett observed that many investors don't understand how the proxy system works and that it is dominated by two companies, Institutional Shareholder Services (ISS) and Glass, Lewis & Co., which combined control 97 percent of the business and vote from 20 percent to as much as 40 percent of all proxies.

This duopoly raises many of the same issues as the duopoly of Moody's and Standard & Poor's controlling the credit rating business. In this case, the SEC has not looked at its regulatory scheme for 20 years, during which the volume of proxies has grown and technology has changed dramatically.

As this article was written, Fred Tomczyk, head of TD Ameritrade, has criticized the SEC for neglecting important market structure issues while it has been preoccupied with the implementation of Dodd-Frank.

Garrett referred to rules the SEC issued in 2003 that require mutual funds and their advisers to set rules and procedures reasonably designed to ensure that proxies are voted in the best interest of the clients, but, he added, just the following year, the SEC staff, rather than the Commission, interpreted the rules "in a manner that now allows mutual funds and investment advisers to effectively outsource their fiduciary obligations when voting their clients' proxies to supposedly independent proxy firms."

Garrett noted that once this is done, there is no duty that the entity voting the proxy must vote in the client's best interest. He complained that the proxy advisory firms have been voting for issues like say on pay that are not in the best interest of investors. He asserted that this trend is contributing to an increase in the cost of doing business and a decline in the willingness of companies to go public. (I do not see the latter as a problem except for companies dependent on a flow of fees from initial public offerings.) Garrett raised the question of whether regulatory changes are needed in order to increase the transparency and accountability of the proxy system.

With the regular ranking Democrat, Carolyn Maloney (D-N.Y.) absent to attend the funeral of her friend Sen. Frank Lautenberg, D-N.J., Brad Sherman, D-Calif., assumed the role of senior Democrat and challenged Garrett to stand for free-market capitalism rather than crony capitalism.

He criticized Delaware and Nevada for enabling corporations to ignore the wishes of shareholders, and he also chided corporate managers for entering into what he called a bizarre alliance with trial lawyers to oppose the movement to require companies to divest investments in Iran. Sherman declared that advocates of free-market capitalism should support shareholder rights and measures to promote jobs, disclosure of campaign contributions and divestment of investments in countries that engage in terrorism.

Garrett shot back that if Sherman opposes crony capitalism, he should support reform of Fannie Mae and Freddie Mac.

David Scott, D-Ga., referred to a concept release the SEC staff issued in 2010 that addressed a lack of transparency and accuracy in proxy advisory services, but the SEC has taken no action in the intervening three years. Just as the credit rating agencies are marked by conflicts of interest when they are paid by issuers and sell consulting services as well as ratings to them, proxy advisory firms sell proxy advice and consulting services to clients, and this creates conflicts that affect shareholder interests, particularly when the consulting services relate to the calculation of parameters that affect the pay of top executives.

The Chamber of Commerce representative, Harvey Pitt, testified that rather than adopt new regulations, more effort should be made to develop best practices that all of the parties involved in the proxy system should follow, while the FSR called for proxy advisory firms to be required to register as investment advisers under the Investment Advisers Act of 1940. However, while this would require proxy firms to meet standards prescribed in the regulation, it would not impose a duty to act in the best interest of shareholders.

Therefore, Timothy Bartl, president of the Center on Executive Compensation, contended that the functions are so different from those of investment advisers that a separate regulatory scheme is needed for proxy advisory firms.

My view is that the whole field of so-called corporate governance is problematic, because public companies tend to be run by their CEOs as autocrats, as demonstrated most recently when dissident shareholders were unable even to wrest one of the top positions at JPMorgan Chase from Jamie Dimon.

However, since the reach of the proxy process is expanding, and the SEC might one day return to this issue, it deserves further discussion.

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The House Financial Services Committee's Subcommittee on Capital Markets and Government Sponsored Enterprises, chaired by Scott Garrett, R-N.J., held a hearing Wednesday titled "Examining the Market Power and Impact of Proxy Advisory Firms."
Thursday, 06 June 2013 03:04 PM
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