The market for proxy advisors has grown significantly in the past decade, enriching those who run proxy advisory firms.
The growing importance of proxy advisory firms has prompted market participants, journalists and scholars to examine ways in which their influence could be problematic. The usual litany of complaints includes conflicts of interest, transparency, methodology, and responsiveness to investor interests.
But little attention, if any, has been paid to the source of demand for proxy advisors. Some of those who have looked into the proxy advisory business think the answer is obvious: institutional investors are the biggest users of proxy advisors, and the role of institutional investors in the markets has been growing rapidly. The larger the share of equities held by institutions, the larger the role for proxy advisors.
Of course, this only moves the question on step backward: why are institutional investors increasingly purchasing proxy advisory advice?
The reliance by institutions on advisors is a bit surprising. Sophisticated mutual fund managers and pension fund managers might be expected to be in the best positions possible to make their own determinations about the wisdom of voting for board candidates or executive pay recommendations. Given the well-documented flaws in the proxy advisory business, why aren’t institutions internalizing this process?
Part of the answer may be complexity. Corporate proxies are becoming increasingly complex, as investors are asked to vote on more questions and those questions themselves are increasingly complex. Some sources of the new questions and new complexity:
- hedge fund activism—largely enabled by ‘shareholder friendly’ regulations—has increased the number of proxy contests, while raising the possibility that the interests of the activists may depart from long-term shareholders;
- regulatory increases in shareholder power to vote on corporate governance matters has enhanced the importance of proxies while introducing complex questions of optimal governance that are highly contested even among the best informed experts in the field; and
- the shift to require that directors receive a majority of the votes even in uncontested elections,—which is likely the result of enhanced shareholder say in governance matters—has allowed for a powerful ‘none of the above’ strategy to be employed by opponents of management.
In addition, proxy questions that are not yet mandatory but that have been under consideration may drive demand in anticipation of the questions. These include the ability to cast a vote on executive pay and further proxy access rules.
It may be that as the questions become more numerous and complex, the costs of internally evaluating them—which include opportunity costs for talent diversion as well as error costs—outweigh the agency costs of using proxy advisors. Or, at least, this could be the perceived balance of costs that—whether accurate or not—would increase demand for proxy advisors.
To put it differently, although the rise of proxy advisory firms appears at first glance to be a consequence of a market phenomenon, this appearance is probably deceptive. Securities regulations that have increased the complexity of proxy questions are very likely increasing the demand for proxy advisors. Which is to say that the demand for proxy advise is not driven by some internal market process but by regulatory intervention in the markets.
This consequence is wholly unintended. As far as I’ve been able to discover, no one has advocated for increased proxy access or say on pay provisions on the grounds that they would increase the demand for proxy advisory services. Indeed, I doubt many realized that this would result from changes to securities regulations that were intended to be ‘shareholder friendly.’
In fact, there’s something a bit ironic about this result. Reforms to securities regulations that were ostensibly intended to empower shareholders or further ‘shareholder democracy’ have instead resulted in increasing domination of proxy questions by a small clique of advisors. That those advisers have often been advocates of these reforms should at least raise an eyebrow about how unintended this consequence really was.
Another source of demand for proxy advice has been the regulation put in place by the SEC in 2003 that required mutual funds to adopt written policies and procedures to ensure that securities were being voted in the best interests of clients. Of course, the easiest way for mutual fund managers to protect themselves against accusations that they have violated their duty is to abandon this field, giving it over to third-party advisory firms. It’s harder for an investor to challenge the proxy voting decisions of a mutual fund manager when those decisions are made by a well-respected proxy advisory firm.
Note that there’s an irony—or, perhaps, perversity—to the dynamic here. A regulation that appears, on its face, to require mutual fund managers to carefully consider whether they are voting on proxy questions in the best interests of their clients, instead has resulted in them outsourcing this decision to firms who are even further removed from client influence and whose interests may conflict with clients. (In passing, let’s note that the largest proxy advisory firms are supporters of these mutual fund rules.)
The rise of proxy advisory firms, in other words, appears to largely be the unintended and unanticipated consequence of regulations aimed at investor protection. This suggests, at the very least, that we should be wary that the proxy advisor’s rise may be accompanied by unintended and unanticipated costs.
In fact, there are frightening parallels between the rise of the proxy advisors and the role played by credit ratings agencies. Like the proxy firms, the ratings agencies saw the demand for their services grow largely due to demand driven by regulation. Because the demand was not driven by genuine market demand for analysis, ratings agencies were able to profit while providing poor credit analysis. Similarly, proxy firms have business-lines increasingly locked-in by regulation.
We should at least worry that their advice might fail just like the advice of the credit ratings agencies failed.
Questions? Comments? Email us atNetNet@cnbc.com
Follow John on Twitter @ twitter.com/Carney
Follow NetNet on Twitter @ twitter.com/CNBCnetnet
Facebook us @ www.facebook.com/NetNetCNBC