The proxy advisory industry is broken. Things are so bad that even Congressional Republicans promoted legislation to regulate it. But there is a simple market solution to improving this function: technological disruption.
Shareholder voting rights are central to corporate governance, authorizing owners to weigh in to protect their economic interests. Some matters are momentous, such as contested director elections and corporate takeovers. All are potentially important, including those that seem mundane, like advisory votes on compensation plans or annual reelection of incumbent directors.
Despite rhetoric about shareholder democracy, the current proxy voting regime is failing. To start, share ownership today is dominated by institutions, not individuals (about 70% and 30%, respectively), and institutions have higher voting participation rates (voting about 91% of shares held versus 29% for individuals).
Among institutions, ownership is dominated by indexers, not decision makers. Today, only a minority of institutions do any homework before buying shares or casting votes. Indexers indiscriminately buy all stocks in a given basket. Many indexers cast votes almost as freely, relying heavily on preset general guidelines or recommendations of outside advisers —primarily Institutional Shareholder Services (ISS) or Glass Lewis, which control 97% of the proxy advisory market.
These two oligopolies, one owned by private equity and the other by two large Canadian pension funds, operate with lean staffs on low budgets. With just 1,000 employees at ISS and 1,200 at Glass Lewis, they cover a huge market: ISS has 1,700 institutional clients, while Glass Lewis’s clients together manage $35 trillion in assets. The two firms opine on hundreds of thousands of separate decisions annually — ISS addresses 40,000 annual meetings and Glass Lewis 20,000. (By comparison, Moody’s, the bond rating agency, employs 12,000.)
Measuring the exact influence of ISS and Glass Lewis is difficult, since some investors might vote the same way anyhow. But estimates range from swaying 6% to 33% of any given vote, which is significant considering that many proposals are decided by small margins. Evidence also shows that institutional investors are substantially more inclined to vote for proposals that advisers support than oppose — by margins ranging from 16%-27% on executive compensation to 64%-73% on directors in contested elections.
Two forces propelled proxy advisers to such prominence. The rising popularity of low-cost index fund investing has made it too expensive for indexers to do independent research. That stokes rising market demand. Since 2003, the Securities and Exchange Commission has let institutional investors meet their fiduciary duty to adopt and disclose proxy voting guidelines by relying on advisers. That created a governmental license for such firms, a recipe for market failure.
Under this government-sanctioned system, indexers not only avoid homework and responsibility for stock selection but for voting decisions. As indexers pushed their fees towards zero, they shifted from traditional market competition based on price to a novel form of competition based on virtue signaling: they woo customers by stressing social and environmental factors in their voting preferences. While advisers disclose little about how they develop their guidelines, they do stress surveying such indexer appetites.
Which begs the question: Are adviser recommendations good for shareholders? While the firms have never disclosed how their recommendations have worked out for shareholders, independent empirical research offers insights. On extraordinary matters, such as proxy contests and takeovers, where the proxy advisers do firm-specific analysis, recommendations tend to increase shareholder returns.
But on prosaic topics, including compensation plans and director elections, where the advisers’ recommendations tend to rely on general guidelines and check-the-box governance, recommendations tend to reduce shareholder returns. An intuitive explanation: when advisers deploy resources to engage specific questions, they do better than when relying only on preset general guidelines.
Proposed legal reforms start with rules for proxy advisers along the lines of those governing credit rating agencies, such as transparency and disclosure of conflicts. More severe interventions would impose fiduciary duties on advisors or mandate testing and disclosure of the value of their recommendations. Yet such oversight risks unpredictable side-effects. The SEC could repeal its authorization of indexers to rely on advisers. But that would create substantial costs for indexing that are part of its legitimate appeal.
Another alternative, fashioned by Maurice Lefkort of Willkie Farr & Gallagher, would move to pro-rata voting. Indexers could cast their votes in proportion to the votes of all other shareholders. As with their stock purchase decision, indexers incur no costs but freeride off resources invested by attentive shareholders. Lefkort acknowledges that the SEC would have to agree that the approach meets investor’s duties, which may prove difficult.
Here is a simpler, patented idea that I developed with Richard Brand of Cadwalader: a voting visibility database. Managed autonomously, a website would capture intended voting positions of active funds ahead of shareholder votes. Index funds would be able to consult the data to inform their voting. No legal changes are required.
While the precise upshot of a voting visibility database cannot be predicted, it would certainly offset the outsized influence of proxy advisers. By adding another resource to shareholder voting, the quality of shareholder voting would improve, elevating the ideal of shareholder democracy.
Lawrence A. Cunningham is a professor and director of the Quality Shareholders Initiative at George Washington University. His books include Quality Shareholders; Dear Shareholder; and The Essays of Warren Buffett. Cunningham owns stock in Berkshire Hathaway and is a shareholder, director and vice-chairman of the board of Constellation Software.