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What's Wrong with Proxy Advisory Firms? — Part II

By    |   Friday, 07 June 2013 01:46 PM

In testimony before the House Financial Services Committee's Subcommittee on Capital Markets and Government Sponsored Enterprises, chaired by Scott Garrett, R-N.J., a panel of seven experts presented diverse views on why reforms are needed in the role played by the two firms that dominate the proxy advisory sector, Institutional Shareholder Services (ISS) and Glass, Lewis & Co., (owned by the Ontario Teachers' Pension Fund), much as they are needed with respect to the role of Moody's and Standard & Poor's, the two firms that dominate credit ratings.

The witnesses made the case that these reforms should extend to the manner in which advisory services are employed by clients as well as to the practices of the dominant firms.

This article will present a closer look at the identities and views of the panelists on the complex issues raised by the activities of proxy advisory firms:

1. Harvey Pitt, for the U.S. Chamber of Commerce. Pitt is formerly the youngest general counsel of the Securities and Exchange Commission (SEC), who returned to the Commission as chairman coincident with the writing of rules in 2003 that required advisers to investment management companies to disclose their policies for voting proxies and how those proxies were actually voted.

Pitt explained that the SEC staff vitiated these rules by issuing two no-action letters in 2004 that permitted investment managers to outsource their fiduciary duties to investors by using "independent" proxy advisory firms, but this step brought its own conflicts, which are disclosed only in general terms. He complained that these no-action letters served to empower the two dominant companies and to encourage activists to promote causes that are expensive for companies to respond to yet offer no material benefits to their shareholders.

The Chamber's preferred solution is for a consensus in the industry to develop in favor of best practices and standards to replace the no-action letters, but Pitt acknowledged that since two firms dominate the business, they have no incentive to participate. He also stated that the difficulty of potential competitors in obtaining such no-actions for themselves constitutes a barrier to potential competition. Pitt stressed that there is no substitute for investors doing their own due diligence as to their proxy votes.

2. Timothy Bartl, president of the Center on Executive Compensation. Bartl challenged the legitimacy of the current proxy advisory model and complained that the research they provide is rife with inaccuracies regarding the calculation of executive pay and the selection of peer groups for comparison. He called a requirement for the proxy firms to register as investment advisers inadequate, because the activities of these firms are much different from those of investment advisers.

3. Niels Holch, executive director of the Shareholder Communications Coalition. The Coalition consists of the Business Roundtable, the Society of Corporate Secretaries & Governance Professionals and the National Investor Relations Institute.

The group calls for reform of the process of communication between companies and their shareholders. A high percentage of shares are not registered with the issuing companies and are held in street names, so that the companies do not even know who their shareholders are.

Holch noted that information technology has changed dramatically since the main body of proxy rules and regulations were adopted in 1985, so that it is much more practical to communicate directly with shareholders in real time.

He specifically called for the SEC to abandon the current shorthand system called NOBO/OBO that classifies investors as either Non-Objecting Beneficial Owners or Objecting Beneficial Owners. He complained further that the SEC has never acted on suggested reforms that were offered in response to the concept release issued in 2010.

4. Michael McCauley, Florida State Board of Administration. This state agency provides proxy administration services to all of the entities for which it is responsible, representing $170 billion in assets. To assist in this work, the agency subscribes to the proxy advisory research services, but it only follows their recommendations 67 percent of the time. It supports requiring the proxy firms to register as investment advisers.

5. Jeffrey Morgan, CEO of the National Investor Relations Institute. Morgan stressed that the activities of proxy advisory firms today "remain largely unregulated and unsupervised, while substantial concerns have been raised by companies and academics about: 1) a lack of transparency concerning their standards, procedures and methodologies, 2) the risk that their voting recommendations may be based on incorrect factual information, and 3) the inherent conflicts of interest posed by several of their business practices."

Morgan urged the subcommittee to call on the SEC to adopt rules to reform the practices of the proxy firms, and he noted that the European Union has called on the industry to adopt a code of conduct.

6. Darla Stuckey, senior vice president of the Society of Corporate Secretaries and Governance Professionals. Stuckey called the research provided by the proxy firms useful, but called for them to be required to register with the SEC as investment advisers.

Stuckey set forth four examples of four conflict of interest that make proxy advisory firms problematic for investors: 1) selling servicers to both institutional clients and issuers, 2) making favorable recommendations on proposals submitted by their own investor clients, 3) recommending proposals, such as annual say on pay reviews, that are likely to expand their influence and grow their market, and 4) taking positions that reinforce that of the parent entity, in the case of Glass-Lewis.

7. Lynn Turner. A former chief accountant of the SEC, and former employee of the Glass, Lewis proxy advisory firm, Turner — evidently a witness for the Democratic minority, which is permitted under committee rules to propose witnesses for hearing panels — played the role of primary defender of the existing model of proxy advisers.

He asserted that ISS has a transparent process, open to public comment, for determining how it votes, and that the proxy firms end up voting predominantly with management. He stressed that there are about a hundred votes per year that are especially significant because they involve interventions by activist investors where companies have underperformed their peers, to the detriment of shareholders.

Chairman Garrett concluded that it might be possible to get bipartisan agreement for Holch's proposal to enable direct access by public companies to their investors, but there would still be a lack of clarity as to the obligations of proxy advisory firms to investors, given the array of conflicts that have been identified, so the committee might be able to require disclosure of these conflicts or encourage the SEC to do so.

I would observe that since two of the panelists belong to Holch's Coalition (Stuckey and Morgan), the panel would have been more compact if Holch had spoken for all of them. In addition to the points Garrett made, the hearing may provide impetus for investors to arrange to register their shares with the issuing companies and to look for alternatives for exercising their proxy rights rather than allowing them by default to be voted by fund managers or, worst of all, by banks, which also have manifold conflicts, especially with respect to compensation or whether to split the roles of chairman and CEO.

For many shareholders, it might be preferable to remove the authority from the investment advisers and banks and simply abstain if they don't have the time and interest to study the issues presented by proxies.

The hearing could also serve to focus attention on the bizarre, non-transparent process by which the SEC staff can, in effect, govern and even nullify Commission rules by issuing no-action letters.

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In testimony before the House Financial Services Committee's Subcommittee on Capital Markets and Government Sponsored Enterprises, a panel of seven experts presented diverse views on why reforms are needed in the role played by the two firms that dominate the proxy advisory sector.
Friday, 07 June 2013 01:46 PM
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