The complexity of the financial markets encourages people to support positions that would be unthinkable in most other situations. Such is the case with the Securities and Exchange Commission’s (SEC) proposed new regulations of proxy advisory firms.
The SEC requires institutional investors (such as mutual funds and public pension funds) to vote on all shareholder resolutions. Proxy advisory firms help institutional investors comply with these mandates by performing the required research and then providing recommendations regarding how an institutional investor should vote on specific shareholder resolutions.
While such services are useful, even essential for some fund managers, there are clear conflict of interest problems that must be addressed. These problems arise, in part, because proxy advisory firms engage in other consulting services for corporations, and the topic of these consulting services are also topics raised in shareholder resolutions. Take the issue of environmental, social and governance (ESG) programs as the example.
ESG is an imprecise term. With respect to corporate programs, ESG initiatives address social, environmental, or governance issues that are related to the corporation’s activities. Typically, companies implement ESG programs as a means to demonstrate their social responsibility and many ESG policies are raised via shareholder resolutions. As applied to investing, ESG imposes investment screens based on companies’ environmental activities, social impacts, and corporate policies (e.g. diversity). The goal of ESG investing is to explicitly account for issues that some people believe are important, and want to promote, sometimes at the expense of financial returns.
The two largest proxy advisory firms that control 97 percent of the proxy advisory market (ISS and Glass Lewis) also provide ESG advisory services to corporations. These programs illustrate that proxy advisors have a meaningful conflict of interest with respect to ESG programs that could be biasing their advice on shareholder resolutions.
These biases are problematic because ESG programs are neither universally good nor universally bad. In many instances, a corporate ESG program can enhance shareholder value. For example, consumers often demand that products are produced in a manner consistent with ESG criteria. In this case, the company is providing its customers with the products they desire in the manner they want it produced.
With respect to the proxy advisory firms’ role, 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).”
These results demonstrate that in order to understand whether a proposed ESG program is beneficial, the analysis must be an unbiased examination of the particular program and its value to the specific company considering implementing it. Due to the complete lack of transparency in how the two major proxy advisory firms establish their position on ESG programs it is unknown whether the proxy advisory firm has adequately conducted this due diligence.
Further, due to their internal ESG advisory programs, the major proxy advisory firms have a clear conflict of interest that could be biasing their analyses. As a result, institutional investors (particularly public pension funds) may be violating their fiduciary responsibilities when they adopt the ESG voting positions suggested by the two major proxy advisory firms.
It is, consequently, essential that investors receive full information regarding any positions the consulting services of ISS and Glass Lewis have taken on the specific ESG issue under consideration. Additionally, the proxy advisory firms should be required to provide the investment managers a comprehensive review of the methodology used to determine that the specific ESG issue under consideration enhances shareholder value.
And, the proposed SEC rule would make important strides in providing investors with this type of information.
Establishing more meaningful transparency requirements will meaningfully lessen the conflict of interest problem. With full transparency, investors relying on the advice of proxy advisory firms will be fully aware of any potential conflict of interest.
Further, the transparency rule will require proxy advisory firms to disclose the methodology behind their analyses. By eliminating the ability of proxy advisory firms to hide the methodology used to form their recommendations, the proposed changes will better ensure that proxy advisory firms’ recommendations are directly linked to enhancing shareholder value.
There are other positive reforms contained in the proposed rule. For example, the rule clarifies that investment advisors cannot blindly follow the advice of a proxy advisory firm. Investment advisers have a fiduciary responsibility to enhance shareholder value while adhering to the goals and objectives of the fund. It is inconsistent with this responsibility to outsource a fund’s voting decision to a third party without conducting adequate review of the recommended voting strategies.
It is important to note that, while the proposal is an important improvement, more reforms are necessary. For instance, eliminating the requirement that investment managers must vote on every proxy statement would remove the artificial demand for the services of proxy advisory firms that ultimately distorts the market. Consequently, it would enable institutional investors to focus on only those corporate proxy statements they deem material and therefore improve the competitive environment.
Transparency is essential for markets to work efficiently. The Securities and Exchange Commission’s proposed rule change regarding proxy advisory firms would significantly improve transparency in a market that is woefully opaque. As a consequence, the proposed rule is a positive step that would lessen the problems currently being imposed on investment advisers and their clients.
Wayne is a Senior Fellow in Business and Economics at the Pacific Research Institute and the Director of PRI’s Center for Medical Economics and Innovation. His research explores the connection between macroeconomic policies and economic outcomes, with a focus on the health care and energy industries. Wayne has over 25 years of experience advising Fortune 500 companies, medium and small businesses, and trade associations and he received my Ph.D. in economics from George Mason University.