Proxy advisers wince in glare of regulatory spotlight

Financial Times

NOTE: The ACCF commends the EU for acknowledging the growing influence of proxy advisors in the shareholder proposal process, and addressing the lack of transparency in their recommendations. Also, while not requiring ESG factors to be integrated in institutional investors and asset mangers’ strategies, but rather using a “comply and explain” approach, an affirmative statement regarding their fiduciary duty to maximize returns should have been included in the adopted Shareholder Rights Directive II.  

EU rules come into force today and will draw attention to quality of advice

The glare of financial regulators is catching up with the proxy advice industry led by heavyweights Institutional Shareholder Services and Glass Lewis.

The influential third parties, which advise shareholders how to vote on topics from executive pay to board nominations, have so far avoided direct oversight while appeasing critics by committing to self-regulation.

But as the proxy advisers draw in more power they increasingly swim against the tide.

The Shareholder Rights Directive II, which comes into force in Europe today, will make proxy advisers answerable to financial regulators for the first time. In the US, the Securities and Exchange Commission is investigating the rules governing the proxy advisory system, which many expect to lead to greater transparency and oversight.

Regulators are acutely aware that an increasing number of institutional investors rely on proxy advisers for voting recommendations. The asset management industry’s meteoric growth, particularly the rise of passive funds, has broadened the shareholder register of many companies.

Some asset managers lack the time and resources to research investee companies in detail and outsource this to proxy advisers in a practice known as “robo-voting”. A report commissioned by the American Council for Capital Formation, a think-tank, last year found that almost a fifth of votes at annual meetings were cast within three days of an adverse recommendation by a proxy adviser, suggesting that many asset managers automatically follow proxy advisory firms.

This year, SEC commissioner Elad Roisman voiced concern about investors blindly adopting adviser recommendations. “It is incumbent upon […] asset managers to use their services responsibly,” he said.

Under the new EU rules, asset managers will have to disclose their use of proxy advisers on an annual basis. Proxy advisers, meanwhile, will have to disclose information on their processes, codes of conduct and any actual or potential conflicts of interest.

While Britain’s Financial Conduct Authority and its European counterparts will not have the power to regulate proxy advisers, they will be able to ensure proxy advisers comply with the requirements.

A corporate governance expert, who declined to be named, says the new regulatory regime potentially provides a basis for companies to complain about proxy advisers to regulators. “If there is an error, there [could now be] scope for redress for companies,” he says.

This could bring the tension between companies and proxy advisers into the open. Many corporates are critical of how proxy advisers operate, complaining that they adopt a “one size fits all” approach that does not take into account company-specific attributes.

They also accuse the groups of employing analysts that lack expertise and experience, saying that while bank equity analysts have to comply with a host of regulatory and professional requirements, analysts producing proxy reports are not held to the same standards.

Companies often berate proxy advisers for inaccuracies in their reports or question the methodologies they use but until now there has no means of appeal, says Peter Swabey, policy research director at the Institute of Chartered Secretaries and Administrators.

Companies’ concerns are not always justified. Mr Swabey adds: “It is very easy [for a company] to assume that shareholder dissent is based on an error [made by the proxy adviser] rather than someone disagreeing with what they’re doing.” However, the added disclosure that SRD II introduces “will bring clarity to whether this is the case”, he says.

Yet proxy advisers say that companies only object to their reports to suppress shareholder rights and protect management. Sarah Wilson, chief executive of Minerva, a UK proxy adviser, says: “There is no material evidence showing our research is inaccurate or defective.” She accuses companies of “shooting the messenger just because they don’t like the voting”.

Some proxy advisers are trying to deflect further scrutiny. Glass Lewis has launched a pilot service offering companies a right to reply. Six proxy advisers including ISS and Glass Lewis have submitted their joint code of conduct for review by an independent chair to reflect the SRD II.

Ms Wilson warns against the idea of more binding regulation for proxy advisers, suggesting that this could encourage companies to try to silence shareholders. She says Minerva has already been asked by some companies to provide research to them for correction before regulation. “To suggest our reports need correcting disrespects our clients,” she says, pointing out that investors are not obliged to follow proxy adviser recommendations.

The corporate governance expert says, however, that the sheer volume of work involved in preparing for annual meetings means that following proxy advisers’ advice is the only option for many asset managers.

While groups such as BlackRock, Vanguard and Legal & General Investment Management have substantial stewardship teams, allowing them to complement proxy advisers’ research, smaller managers or large managers that have small holdings in companies need proxy advisers.

He says the new regulatory obligations lay the ground for more binding rules for proxy advisers. “If there is evidence that the standards are not being met [ . . .] it opens up a case for further regulation.”

Others question whether the concentrated nature of the proxy adviser market will attract regulators’ attention. ISS and Glass Lewis of the US dominate the industry. There is particular scepticism in Europe, where companies are wary of ISS and Glass Lewis “trying to mandate US governance norms in countries where the market is simply not ready”, says Mr Swabey.

Ms Wilson says further scrutiny of competition in the proxy market is warranted, noting that this is a separate issue to questioning the quality of proxy advisers’ research.

ISS points to a 2012 inquiry by the European Securities and Markets Authority that found no evidence of market failure. It says: “While we would not oppose any further such reviews if competition authorities wished to undertake them, we do not believe further investigation is necessary.”

ISS disputes claims that its research is not tailored to different geographies. It says its recommendations are “based on a global set of market and regional policies, all tailored to take account of market-specific conditions”.