The SEC, under former Chairman Jay Clayton, issued a rule that improved the proxy advisory services market by promoting transparency and holding proxy firms more accountable for inaccuracies. Rather than implementing the necessary improvements to these reforms, Chairman Gary Gensler intends to roll-back the progress already made.
Proxy advisory firms exist because the SEC requires institutional investors to vote on all matters put forth in proxy statements, or the measures voted on during shareholder meetings. For most institutional investors keeping up with all the issues raised during shareholder meetings is overwhelming, so they turn to proxy advisory firms for help.
Two proxy advisory firms – ISS (an arm of Genstar, a private equity firm) and Glass Lewis (an arm of the Ontario Teacher’s Pension Plan Board and the Alberta Investment Management Corporation) – control 97 percent of the market. Given the sheer volume and importance of proxy statements every year, the influence of these two firms is large and growing.
One purpose of the new rule was to ensure that proxy advisory firms disclose relevant conflicts of interest, which was an important clarification. Not only do proxy advisory firms have significant conflicts of interest, but they also do not abstain from providing investors guidance on issues where meaningful conflicts of interest exist.
The issue of ESG (or Environmental, Social, and Governance) investing exemplifies this problem. ESG investing prioritizes environmental and/or social criteria, not just financial criteria, when selecting investments.
Many advocates claim that ESG investing enhances profitability, but as I wrote about here, there are also reasons to be skeptical of this claim. A 2016 paper by Munnell and Chen similarly found that ESG portfolios offer lower returns and raise significant fiduciary concerns.
Since ESG questions are often raised via the proxy process, many recommendations provided by ISS and Glass Lewis address this issue. Both proxy advisory firms typically support ESG proxy questions, but such support is unsurprising given that both firms also provide ESG advisory services.
ISS has a program known as ISS ESG. According to their website, “ISS ESG solutions (ISS-ethix, ISS-climate and ISS-oekom) provide ESG screening, ratings and analytics designed to enable investors to develop and integrate responsible investing policies and practices into their investment strategies.”
Glass Lewis has formed a strategic partnership with Sustainalytics, which Glass Lewis describes as “the leading independent provider of global governance services”. According to Glass Lewis, the firm “features data and ratings from Sustainalytics in the ESG Profile section of our standard Proxy Paper reports. The goal is to provide summary data and insights that can be efficiently used by clients as part of their process to integrate ESG factors across their investment chain, including effectively aligning proxy voting and engagement practices with ESG risk management considerations.”
Due to these programs, there is a clear conflict of interest when these firms advise clients on ESG-related proxy questions. And the evidence indicates that these types of biases have consequences.
Research by the Manhattan Institute found “a positive association between ISS recommendations and shareholder voting and a negative relationship between share value and public pension funds’ social-issue shareholder-proposal activism (which is much more likely to be supported by proxy advisory firms than by the median shareholder).”
Given the clear bias these firms have toward supporting ESG programs, it is in the interest of investors that both firms clearly disclose their conflicts of interests. Chairman Gensler is seeking to repeal this sensible reform.
He is also seeking to repeal essential anti-fraud provisions that hold proxy advisory businesses to the same standards that are applied to other public companies.
As the American Council for Capital Formation (ACCF) noted, “institutions often vote in line with ISS and Glass Lewis recommendations. Notably, when proxy advisors recommend voting in favor of a proposal, large institutional holders support the resolution 80 percent of the time. And some funds automatically vote with the proxy advisors nearly 100 percent of the time, in a troublesome practice known as robo-voting.” A 2021 study in the Harvard Law School Forum on Corporate Governance found that “114 institutional investors voted in lockstep alignment with either ISS or Glass Lewis in 2020”.
These robo-voting trends are troubling because, as the ACCF also noted in a submission to the SEC, during the 2020 proxy season, there were “at least 42 instances where companies believe proxy advisors have issued recommendations based on erroneous information or flawed analysis.” These errors and flawed analyses were not unique to 2020 and have continued at a similar rate this proxy season, despite the Clayton SEC’s attempts to address them.
The two proxy advisory firms’ broad influence on how institutional investors vote, coupled with the large number of documented quality issues with respect to their analyses, indicates that rolling back the rule that required stricter quality standards is unwise.
The rule implemented under Former Chairman Clayton took important steps toward promoting transparency and improving accountability. While more reforms were still necessary, repealing this rule, as Chairman Gensler is considering, is a major step in the wrong direction. If repealed, investors, particularly beneficiaries of large public and private pension funds, will suffer the consequences of lower returns and less financial security.