New Paper from Milken Institute Details Inherent Problems in Proxy Advisory Firms

June 21, 2019

Last week, nonpartisan think tank Milken Institute published a paper exploring the rise, impact, and implications of proxy advisors and how reforms could help improve the system.  Author Chester S. Spatt, a former chief economist of the Securities and Exchange Commission, writes that proxy advisory firms arose from a desire to address market failures in the corporate governance world, but have turned out to be problematic themselves, marred by inherent conflicts of interest, bias, and ideological leanings. This must change, argues Spatt: “The role of the proxy advisory firms is arguably among the most crucial for corporate governance, yet proxy advisory firms are subject to very little regulation.”

Why are Proxy Advisory Firms Important?

As we’ve detailed on our blog dozens of times in the past year, proxy advisory firms enjoy outsized influence as the unregulated intermediary between shareholder proposals and company management – and therefore hold more sway than individuals and groups that directly invest in the company. Spatt explains:

“While proxy advisory firms do not invest directly in public companies, their recommendations carry more clout than the votes of the largest asset managers or institutional investors. Empirically, the probability of changing the vote outcome is much greater for a proxy advisory firm than for a large institutional investor.” [Emphasis added]

The paper also points out that the very existence of recommendations from proxy advisory firms disincentivizes fund managers to do their own due diligence on proposals. This reinforces the power of the proxy advisors’ recommendations.

Inherent Problems: Conflicts of Interest, Bias, One-Size-Fits-All Recommendations

Proxy advisory firms operate in a system that allows for conflicts of interest, bias, and one-size fits all recommendations – all of which make it impossible to ensure their voting recommendations are fair and accurate.

The paper looks at conflicts of interest in the two biggest proxy advisory firms, ISS and Glass Lewis. ISS gives governance advice to clients, some of which are the same companies it provides shareholder voting recommendations for. One of Glass Lewis’s two owners is a Canadian labor union pension fund. Because unions typically have strong views and agendas, it would be in Glass Lewis’s interest to provide recommendations that advance its owner’s value – even if this recommendation is detrimental to Glass Lewis’s clients. In fact, the business models of proxy advisory firms have an inherent conflict of interest. It’s in their business interest to further the relationship with their clients: “A fundamental source of conflict that is inherent in the business model of any proxy advisory firm is the implicit incentive to stir controversy to increase the value of advice about proxy questions,” Spatt explains.

Proxy advisory firms’ votes and recommendations contain bias and ideological components. For example, ISS’s recommendations are usually to the left of most mutual funds. This is important because, as Spatt explains, “bias in the judgments of a proxy advisory firm, in conjunction with its tremendous influence, can create the possibility of poor or even misguided governance outcomes.”

Furthermore, proxy advisory firms make the mistake of assuming all investors are aligned, taking a one-size-fits-all approach:

“The approach of the proxy advisory firms does not directly distinguish how different investors, such as different types of mutual funds and ETFs, should vote. In effect, it is a one-size-fits-all approach, implicitly assuming unanimity among all the investors.” [Emphasis added]

In reality, the preferences of individual shareholders are not identical. And while it is the fiduciary duty of mutual fund managers to make sure they vote according to shareholder preferences, they typically just vote automatically in line with proxy advisory recommendations, a phenomenon called robo-voting.

Regulation is the Solution

Proxy advisory firms are just about the only institution in corporate governance without stringent regulations, the paper explains. Spatt explains that there are similar inherent conflicts of interest in auditing firms and credit rating agencies, but those are regulated under the Public Company Accounting Oversight Board and Dodd-Frank Act, respectively.

These examples prove that there are ways to change the system. Spatt explores a few of these solutions, beginning with best practice implementation. He explains that the lack of regulation all but ensures that proxy advisory firms will continue to operate how they want to, even if that way is not necessarily best; rather, regulation is a better solution: “While there are diverse perspectives on many matters, the proxy advisory firm often acts as if there is a generally accepted best practice. This is an important motivation for adequate regulation.”


The Milken Institute’s report makes it clear that keeping to the status quo will not make these problems within the proxy advisory industry go away. Spatt warns: “One of the lessons from the global financial crisis that has not been adequately reflected in our financial system is the potential risk to the system from incorrect regulatory judgments on a system-wide basis.” Luckily, all signs point to change, from hearings on Capitol Hill, to agendas at the Securities and Exchange Commission, and even new regulation abroad. The Main Street Investors Coalition awaits this much needed reform.

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