July 3, 2019
Institutional Shareholder Services (ISS) recently released a myth vs. fact summary aimed at downplaying concerns over the lack of regulatory oversight on the industry, following the recent announcement that the Securities and Exchange Commission (SEC) intends to propose a rule regulating proxy advisors this year.
Here we explore the “facts” presented by ISS, many of which are misleading, taken out of context or simply false.
ISS Hides Behind Investment Advisers Act to Dodge Various Concerns
ISS claims its registration under the Investment Advisers Act addresses concerns that have been raised regarding conflicts of interest and a lack of oversight of proxy advisors.
Many key issues with proxy advisory firms such as conflicts of interest, a lack of transparency, and lack of fiduciary responsibility to investors are not addressed by current regulations.
Glass Lewis, the second largest proxy advisor agrees and told the SEC, “Glass Lewis believes that requiring proxy advisory firms to register as investment advisers under the Investment Advisers Act of 1940, as the framework stands today, would provide little or no protection to investors and issuers with respect to the areas of concern that have been raised.”
Conflicts of interest: At present, investors must trust that ISS maintains an appropriate “firewall” between their consulting services and their core ratings business, despite having almost no insight into how the business operates on a day to day basis. Glass Lewis has also acknowledged that this arrangement does not allow for sufficient independence, “We believe the provision of consulting services creates a problematic conflict of interest that goes against the very governance principles that proxy advisors like ourselves advocate.”
In no other part of the financial services industry is an organization able to sell products to the companies it assesses. Notably, the passage of the Sarbanes-Oxley Act of 2002 required the separation of those parts of financial institutions that provide ratings and those that conducted advisory work, also requiring disclosure of all relationships between those financial institutions and the companies they work for.
For its part, Glass Lewis also faces potential conflicts of interest. The business is co-owned by the politically active investor, the Ontario Teachers’ Pension Plan, and has faced accusations in the past that it has issued guidance that supports its owner’s agenda.
Transparency: Proxy advisors are not required to engage with companies or share information about the methodology underlying their recommendations. This is especially true for smaller companies, as ISS only provides draft reports to companies in the S&P 500, and Glass Lewis will only share its full reports for a fee. Small companies have limited resources to respond to a negative report and are less likely to secure a meeting with a proxy firm or investors.
Fiduciary Duty: Not all proxy advisors register as investment advisers and therefore do not acknowledge any legal obligation to shareholders. Given their influence over the outcomes of votes at public companies, this is problematic.
ISS Claims its Reports Have Limited Impact on Client Voting
ISS downplays the influence its recommendations have over shareholder voting, while emphasizing how often its recommendations are aligned with management.
REALITY: It is contradictory for ISS to claim that its reports provide significant value to clients but simultaneously argue that its clients regularly ignore their recommendations.
Furthermore, independent academic research suggests that ISS does have significant sway over voting decisions. An academic study published in the Review of Financial Studies found that a negative recommendation from ISS can lead to a 25-percentage point decrease in voting support.
Independently, a paper from the Stanford Graduate School of Business concluded that the impact may even be more pronounced than these calculations, since many companies will adapt their policies to appease proxy advisors before a shareholder proposal goes to a vote in an effort, “to avoid a negative SOP recommendation by proxy advisory firms, and thereby increase the likelihood that the firm will not fail the vote (or will garner a sufficient level of positive votes).”
ISS Claims it Isn’t Leading Proponents of Politically Motivated Proposals
ISS claims its support for environmental and social shareholder proposals, which can be hard to directly link to a company’s financial performance, is standard amongst investors.
REALITY: Research from law firm Sullivan & Cromwell shows that ISS supports the majority of environmental and social proposals. Specifically, ISS recommended in favor of 74 percent of social shareholder proposals in 2018, including 94 percent of political spending proposals and 87 percent of environmental proposals.
ISS issues at least five sets of specialty policy guidelines largely to cater to the needs of investors’ clients who are pursuing a social investing agenda. These reports have different objectives aside from pure value maximization, “’ISS’ Social Advisory Services division recognizes that socially responsible investors have dual objectives: financial and social upon which those voting guidelines are formed.”
ISS Claims its Custom Policies Take Companies’ Unique Characteristics into Account
ISS claims custom-designed voting policies and specialty reports available to clients are enough to properly account for each company’s unique characteristics but are still top-down governance guidelines instead of company-specific analyses.
REALITY: Anecdotal evidence from companies suggests that the analysis underlying recommendations provided by proxy advisors is not tailored to the characteristics of specific companies. For example, companies have noted the inclusion of incongruent peers in Glass Lewis’s peer group comparison, which ultimately lead to faulty recommendations.
The reason for the standardization may be due to a lack of resources. Proxy advisors do not have the staffing resources necessary to provide company specific analysis. For instance, ISS employs a total of 1,800 people, but only 370 employees are responsible for the research necessary to make recommendations for 10.2 million proposals annually.
ISS Ignores Supplemental Filings Analysis to Defend Against Errors
ISS claims to have a more than 99 percent (99.3%) accuracy rate for its research but fails to address serious issues filed by companies in SEC filings.
REALITY: A recent analysis of supplemental filings to the SEC by 94 different companies between 2016 and September 30, 2018 found 139 significant problems, including 49 issues that were classified as ‘serious disputes.”
Indeed, supplemental proxy filings likely only represent the tip of the iceberg when it comes to factual or analytical errors because companies have an extremely limited window to submit a response and expose themselves to the potential liabilities that come with an erroneous filing to the SEC.
ISS Fails to Address Complaint of Robo-Voting
ISS essentially ignores the accusation that it is engaging in “robo-voting” or automatic voting of their clients’ proxies.
REALITY: While some institutional investors are performing their own due-diligence that results in voting decisions which differ from that of proxy advisors, recent analysis indicates that many are not.
A review found that 175 entities, representing more than $5 trillion in assets under management, follow ISS 95 percent of the time. Companies have also observed a “spike” in voting after proxy advisors issue recommendations. A survey conducted by four major law firms of 100 companies’ experiences in the 2016 and 2017 proxy seasons found that almost 20 percent of votes are cast within three days of an adverse voting recommendation.
Additionally, language in the Taft Hartley guidelines appears to admit that ISS is the final arbiter of voting, dictating that investors utilizing these guidelines are less likely (or even unable) to deviate from the proxy advisors’ recommendations.