Glass houses

Activist investing is now commonplace. Aided by regulatory advances and a changing attitude to ownership rights, shareholders are increasingly pushing for greater representation. More often than not, lurking behind the scenes is a proxy advisory firm, telling investors, the public and anyone who will listen how companies should be governed and how proxy votes should be directed. The presence of proxy advisors in corporate life has become almost as certain as death and taxes. But this may all be about to change as unrest grows over the influence of these firms and the way they conduct their business.

Ontario Teachers’ Pension Plan has used proxy advisory services for years – first Institutional Shareholder Services (ISS) and then Glass Lewis. That’s hardly unusual; these two biggest industry firms have thousands of institutional clients between them. 

What is unusual is seeing institutional investors look at pooling resources to create a commonly owned proxy advisory service. OTPP, with over $100 billion in assets, is working with about two-dozen other Canadian institutional investors on the project. For smaller institutions, the cost of research is an issue. For OTPP and other large investors, it’s the quality and independence of advice that matters most. 

‘The challenge we’ve seen is that it’s very difficult for the firms to remain independent,’ says Brian Gibson, senior vice president of public equities at OTPP, who is concerned about conflicts of interest. ‘They often … end up doing consulting work for the companies [they cover].’

The world of proxy advice is attracting increased criticism on a number of fronts. Critics complain that advisory firms have too much influence and take money both from investors and the companies whose proxy motions they rank. Yet many institutional investors have apparently given up their fiduciary responsibilities and effectively handed them over to the proxy advisory firms. The real question, though, is whether one party is at fault or if there is a systemic issue with the way institutional investors vote their shares.

According to Gibson, OTPP has nothing, per se, against proxy advisory services. Such companies can offer value to an institutional investor. ‘Exploring proxy proposals requires a lot of experience and judgment to analyze properly,’ Gibson says. Because of the organization’s size, OTPP does much of its own research, but smaller investors often don’t have the resources to devote to tracking the 8,000 US and more than 30,000 international companies that Glass Lewis or ISS does.

Hiring one of the firms lets the institution leverage work that is amortized over all the company’s clients – some 300 for the former and 1,700 for the latter. Even OTPP has some relatively small investments and cannot justify the intense level of research for every last one of them. ‘There was a meeting last year where the directors appointed two new members of the board but the nominating committee didn’t meet that year,’ says Catherine Jackson, the manager of corporate governance at OTPP. Digging up information like that requires time spent going over every bit of information tied to the corporations.

And there is little doubt that the proxy advisors, particularly ISS, have played an important role in changes in attitudes toward governance. ‘A few years ago they really helped to clean up some practices that were inappropriate,’ says Erik Beucler, managing consultant at executive compensation consultancy DolmatConnell & Partners. But as useful as a proxy advisory service can be, some serious questions about how they operate and their influence on the market have been percolating for the last few years.

Get your own house in order

For example, the two biggest firms, ISS and Glass Lewis, have seen some recent changes that have caused alarm among many investors and companies. Last year ISS was purchased by RiskMetrics Group, a risk management company. Now there is talk of a future IPO. If that happens, a publicly-held company, with all the pressures that come from the market, would be making recommendations about the governance of others.

Glass Lewis, on the other hand, was recently purchased by Chinese company Xinhua Finance, whose governance practices leave some questioning of propriety, particularly when a director stepped down after a Barron’s story brought up questions about his business dealings. Two top research executives also recently left the company, one publicly voicing his displeasure at the new ownership arrangements. (See sidebar.) The specter of governance problems is being taken seriously. A number of large institutional investors including the Missouri State Employees’ Retirement System, the Ohio Public Employees Retirement System and the Colorado Public Employees’ Retirement Association dropped ISS over the last few years because of concerns about conflicts of interest.

Paying for ‘performance’

Those concerns arise from inherent aspects of the ISS business model. On one hand, the company provides proxy voting advisory services. But it also has its CGQ – corporate governance quotient – in which it rates 8,000 US companies for governance practices. The number has become an important one for many investors, but many people find it problematic. Although ISS makes parts of its methodology available to anyone wishing to see it, not all of the details are there, so a company would not necessarily be able to tell how a change in practices would actually affect its CGQ. To get that information, a company must pay tens of thousands of dollars for ‘a premium CGQ subscription service, which is a web-based tool to help issuers with data analysis, benchmarking and peer analysis as well as understanding the impact of governance changes to their relative CGQ scores,’ according to a spokesperson. So ISS takes money for proxy advice and also takes money from many companies that are rated by it, although the company makes the point that ‘the majority of companies that have high corporate governance scores achieved them through positive governance practices without subscribing to CGQ.’

‘That’s like professors selling test scores,’ says Gary Lutin, an investment banker who advises shareholders on corporate control issues and a long-time critic of ISS. ‘The more important the passing grades are, the higher the value of the test scores.’ And the company also certifies director education programs, with companies that have sent their directors to an approved program getting a bump in their CGQs.

Are the indicators of good governance equivalent to good governance? ‘Look at Enron – no,’ Lutin says. ‘Good governance has devolved into a bureaucratic checklist process, as has legally defensive board practice. Going through a ritual is not the same thing as thinking about how to do things.’ For example, both Enron and Computer Associates, involved in considerable financial scandals, were once known for their ‘good’ corporate governance.

A need for new dilemmas

Lutin supports the emergence of Glass Lewis and says that he helped get them started, but in his opinion the firm, which has instituted its own corporate governance rating, has simply followed the same business model – because they are all for-profit companies that have to make money to survive.

But the process becomes grueling for the companies being rated. ‘The issue a lot of our clients are running into is that in order to stay relevant, ISS has to update its policies each and every year,’ says Beucler. ‘Because so many of the practices have been reigned in, they’re having to be more and more strict each year, making it harder and harder to meet the requirements.’ As an example, he mentions the annual run rate – equity-related awards granted in a year as a percentage of outstanding common stock – which must be within one standard deviation of the mean for all corporations. ‘As people started to work harder to get within one standard deviation, the mean fell,’ he says. The total they could grant kept dropping, even if the company was in an industry that traditionally used this form of compensation. ‘What eventually happens is you’ll be treating the GEs and ExxonMobils of the world the same as your small technology and life sciences companies.’

That may sound as though the proxy advisory services are solely at fault, but the situation is far muddier. Although the largest institutional investors may have the resources to perform their own research, that isn’t true for all organizations. Not all have the amounts of free money necessary to do their own research.

‘You can collect research on 3000 companies for just one client,’ Lutin says. ‘The cost for assembling the data on which you’d provide the voting recommendations is expensive. Most institutional investors need a cheap solution to their voting problem.’

And that’s the rub. Since the late 1980s the institutions have faced the mandate to pay attention to proxy votes. Yet most either don’t have the resources to pursue the necessary degree of research or they don’t want to spend the money. In either case, they lean too heavily on the proxy advisory services, particularly as the people who make the proxy decisions are generally different from those who buy the securities and have a stronger feel of an investment’s day-to-day activities and what the implications of a given vote might be.

Problems with authority

To make matters worse, the proxy advisory services have typically offered their opinions based almost entirely on governance issues. ‘It’s not that one would favor poor governance, but if a company doesn’t rank at the top of a list in terms of governance, but ranks at the top of the list for share performance and return to shareholders, what should the institutional investor do?’ asks Howard Steinberg, a partner with McDermott Will & Emery.

The advisory services say they don’t ask institutions to forsake their own research. But what should be an additional information service for institutional investors has, in many cases, become the primary decision maker. Some 15 to 20 percent of ISS clients automatically cast votes in accordance with ISS recommendations, according to then-CEO John Connolly in a January 23, 2006 Washington Post interview. According to various estimates, 40 percent of institutional investor votes conform with ISS.

Lutin thinks influence spreads much farther. ‘If ISS reported publicly as stating that something is good governance, it’s politically difficult for firms, even if they’re not using ISS, to go the other way,’ he says.

Granted, that’s not dictating corporate policy, and ISS notes, ‘we are also a registered investment advisor and therefore subject to the same SEC oversight as our 1700 institutional clients.’ Even so, proxy advisory services wield enormous influence, and not everyone agrees on how well under legal control the companies are.

Voice of reason?

According to a letter sent by the Society of Corporate Secretaries & Governance Professionals to the SEC on May 11 of this year, ‘The advent of the proxy advisory industry has had a material impact on issuers, since the recommendations of ISS and others now routinely have a material effect on voting results. Despite the significant role played by proxy advisory services in the corporate governance process, they are basically unregulated and unsupervised, and they often are not transparent with regard to standards, methods, compensation arrangements and conflicts of interest.’

Another fundamental question: if control over the governance concept benefits the marketplace,  ‘... whether it’s healthy for 30 or 40 percent of marketplace voting decisions to be based on the recommendations of commercial organizations whose economic objective is to maximize the commercial value of their voting influence,’ says Lutin. ‘I think there are real questions about the fundamental commercial model established by ISS and that others follow. Even if someone were pure, you don’t want 30 or 40 percent of the voting to be affected by them. You need an environment that encourages experimentation and not one that constrains it to [one party’s] idea of good governance.’

While the questions about the position of proxy advisory services in the voting process are common in the financial community, they are virtually unknown by individual investors that have their money in a pension or some other fund that is part of an institution’s portfolio. ‘Investors in the portfolios of the [institutional investors] are kind of in the dark,’ says Deborah Wallace, executive board consultant and principal of BrinkPoint Consulting. ‘There hasn’t been the kind of activism in this area that there has been elsewhere.’

A simple reason for the large amounts of quiet, is fear. According to many, both publicly-held corporations and institutional investors are afraid of bucking the status quo. Rightly or wrongly, they are concerned that being on the wrong side of the proxy advisory services could leave them lacking support when they need it for proxy measures. The advisory services have been successful in building their ‘good governance’ brands. To oppose them could be seen as anti-good governance.

One thing that might help is opening the field so that influence is not concentrated in so few hands. But it’s tough. OTPP can collaborate to create a service for a group, but a wider commercial offering isn’t easily launched. ‘Two guys from ISS and three guys from Glass Lewis can’t go out for drinks and decide to set up shop,’ Lutin says. ‘They have to get the venture capital guy, and if they get venture capital, they have to set up something that makes $40 million. The basic threshold for setting up in business is probably $15 million to $25 million by the time you figure out a three year phase.’

Some are optimistic the system is improving. ‘The positive trend is that an increasing number of institutions are taking back ownership of the voting decision marking, as opposed to what had happened for the previous decade or so, where many of them had passed the voting decisions on to ISS or some of the other proxy advisors,’ says Bill Ultan, senior managing director for consulting firm Morrow & Co. OTPP takes one approach to lessen dependence on proxy advisories, and some, like Lutin, are looking to open a software framework and data source so others could easily enter the advisory business and let the market pick the winners.

But for the time being, don’t throw away those CGQ scorecards, because the current system, and its problems, aren’t disappearing.