Does the investment community rely too heavily on proxy advisory firms to inform their votes? The Securities and Exchange Commission seems to think so.
In August the SEC issued new guidance, likely a precursor to upcoming regulation. The potential result? An increased administrative burden that could dramatically raise the costs associated with proxy voting—and with it the very real potential to discourage investors from holding companies accountable.
What is a proxy advisory firm?
Each year, shareholders cast proxy votes on thousands of company matters, from board nominations, executive pay, and auditor ratification to mergers and proxy contests. Casting an informed vote requires gathering all the relevant facts as well as understanding the company’s peer group and best governance practices.
For example, in assessing whether a company’s CEO compensation plan is doing its job in retaining and incentivizing the CEO in light of the company’s performance, investors typically find it helpful to understand what competitors are paying for similar performance. After all, that should be a decent yardstick for what the CEO might make if she were to jump ship to a competitor. Proxy advisors make that assessment easier by aggregating compensation market data and making it digestible.
As with basic stock or credit research, rather than each investor conducting this due diligence individually, it’s more efficient for experts to assemble the information and make it available for purchase to investors to use as they see fit in their proxy-voting decisions. This is where proxy advisory firms add value. Although some provide only governance research, others also provide voting recommendations based on investor preferences.
For example, some investors might want to vote against the election of a non-independent director on the compensation committee and ask the proxy advisor to alert them when this occurs. However, the investor still has complete discretion over which proxy advisors to work with and how to use the research to make a voting decision. This arrangement is an efficient, market-based solution, similar to the research and decision-making process seen in other parts of the investment industry.
Why is the SEC looking to further regulate proxy advisory firms?
Similar to equity or credit research, there can be a natural tension between research providers and the companies being researched. Proxy advisors have at times been a thorn in public companies’ sides. They may recommend votes that management disagrees with, and companies worry the advisory firms could have an outsize influence on proxy votes.
As a result, some of these public companies have long lobbied the SEC to cast its regulatory eye on proxy advisory firms. But governance research should be evaluated based on whether it provides value to the investors who pay for it, not whether it pleases the companies being researched.
While the new guidance isn’t earth shattering, there’s a looming threat of burdensome regulation in the coming months. In the past a few ideas to further regulate the advisors included a proposal to force them to allow companies to review the research before proxy advisors could publish it to their paying investor clients. That would reduce the already very limited amount of time investors have to digest the analysis before the shareholder meeting.
Another idea was to make proxy advisory firms liable for research “mistakes.” Unfortunately critics often appear to confuse factual mistakes with disagreements of opinion. With so much uncertainty on what’s coming, we’re wary that the SEC might break a system that’s currently working. And this could have big ramifications not only for proxy advisors but also for institutional and individual investors alike.
What are the implications of additional proxy advisor regulation?
Additional regulation would make it much more expensive for proxy advisory firms to operate—and, realistically, those costs would be passed on to investors. Plus, with only two firms making up the vast majority of the proxy advisor market, this could further consolidate an already small playing field and pose additional barriers to entry for new proxy firms. So if public companies and the SEC are worried about too few voices having too much influence, additional regulation doesn’t figure to help matters. It means institutional investors risk having access to less diversity of opinion on proxy measures. And when was the last time you heard anyone say less independent research was a good thing?
And finally, this will harm individual investors as well—the exact market players the SEC intends to protect. Since the 1950s, individual investors have increasingly opted to leverage institutional investors to manage their assets instead of directly holding individual stocks. They hire these larger entities to be stewards of their capital and represent their interests. It’s therefore paramount for institutional investors to be able to make informed and cost-effective voting decisions as they fulfill their fiduciary duty to the end investor.
The bottom line
In an era when more and more investors want to practice active ownership and gain visibility into company business practices, the independent research proxy advisors provide is crucial. This is why Parametric and more than 50 other investors signed a letter from the Council of Institutional Investors outlining our concerns to the SEC and requesting that no additional regulatory requirements be imposed. The SEC and a number of public companies appear to believe they’d be doing the right thing by further regulating proxy advisors. We respectfully disagree.