A conflict of interests or just a good business model

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By Peter White – Peter.White@EthicalBoardroom.com

Proxy advisory firms – firms that vote shares for hedge funds or institutional investors that hold shares in many companies — have been the object of regulatory scrutiny recently.

“The Securities and Exchange Commission is planning to review recommendations for possible regulatory action targeting proxy advisory firms, then Securities and Exchange Commission Chair”, Mary Jo White said in March.

Similarly, the European regulator ESMA issued guidance for the proxy advisor industry in 2013.

The SEC has not made clear what rule changes it could have in store for firms like Glass Lewis and Institutional Shareholder Services, two of the largest proxy advisors in the world.  These firms help large institutional investors decide how to vote on critical company issues such as board elections and compensation. The issue is that clients of the firms allegedly influence their proposals for how large investors should vote, thus providing the clients with unfair influence.

In a House Financial Services Committee Hearing, held last year, Rep. Scott Garrett, committee chairman, made the case against the proxy advisors:

“Proxy advisory firms have no duty to make voting recommendations in the best interests of shareholders and have no financial interest in the companies about which they provide voting advice. By exploiting the proxy system to push special interest agendas, proxy advisory firms and activist shareholders have increased the costs of doing business for many public companies and disincentivised private companies from going public, all without a corresponding benefit to investor returns.

Proxy advisory firms have increasingly teamed up with unions, pension funds and other activist shareholders to push a variety of social, political and environmental proposals that are generally immaterial to investors and often reduce shareholder value.[1]

ESMA is less censorious, in its Final Report on The Proxy Advisor Industry.
The Report has found that there is no current market failure related to proxy advisors interaction with investors and issuers in the European Union which would require regulatory intervention.  However, ESMA has identified a number of concerns regarding the independence of proxy advisors, and the accuracy and reliability of the advice provided which would benefit from improved clarity and understanding amongst stakeholders.

ESMA proposes the development of an EU Code of Conduct that focuses on:

•    identifying, disclosing and managing conflicts of interest; and
•    fostering transparency to ensure the accuracy and reliability of the advice.

ESMA is still involved in discussions with several participants from the industry who are supportive of beginning work on a Code, these include Glass Lewis, Institutional Shareholder Service (ISS), IVOX, Manifest, Nordic Investor Services, PIRC and Proxinvest.

The Report sets out a framework for a Code, including the roles of the different stakeholder groups, the relationship with other corporate governance codes for issuers and the key principles concerning proxy advisors which ESMA would expect such a Code to cover.

ESMA has identified the following principles that are intended to offer guidance to the industry committee developing an industry-wide code:

1.    Identifying, disclosing and managing conflicts of interest
Principle – Proxy advisors should seek to avoid conflicts of interest with their clients. Where a conflict effectively or potentially arises the proxy advisor should adequately disclose this conflict and the steps which it has taken to mitigate the conflict, in order that the client can make a properly informed assessment of the proxy advisor’s advice.

2.    Fostering transparency to ensure the accuracy and reliability of the advice
Principle – Proxy advisors should provide investors with information on the process they have used in making their general and specific recommendations and any limitations or conditions to be taken into account on the advice provided so that investors can make appropriate use of the proxy advice.[2]

Proxy advisors are prepared to take on the guidance, and accept the code of conduct, but they do not accept the accusations of conflict of interest.

“Proxy advisors do not necessarily make recommendations,” insists a spokesperson for the London-based firm Manifest. “Only some proxy analysts make recommendations, not all. In any event, even if they do, recommendations are not binding on their readers, they are a point of view.” There is discretion to be asserted on the part of those being advised, the argument runs.[3]

In fact, it should be recognised that fund managers do not outsource their votes to proxy services, Manifest points out. “It is true that fund managers outsource a great number of services to support their professional activities, but that doesn’t mean they have outsourced their responsibility. If they have then there are remedies that should be enforced to ensure that doesn’t happen. BP outsourced exploration and extraction in the Gulf of Mexico, but that hasn’t absolved them of responsibility for the subsequent oil disaster. Are investors different? Yes, concepts of fiduciary responsibility are different between the US and UK/EU, however both markets have enforcement regimes for fund manager conduct of business,” Manifest says.[4]

Nor is it fair to accuse proxy analysts of operating behind closed doors.

Manifest say: “Clearly the corporate advisors are too busy criticising proxy analysts to bother reading our websites where they will find plenty of information about conflicts of interest, research methodologies etc. However, we would say at this point – proxy analysts serve their clients, the investors and asset owners. It is they that we are accountable to – as well as to the laws of the land, obviously. If issuers want to understand why shareholders vote the way they do, the answer is simple – pick up the ‘phone and talk to the investor.  Yes, it is true that not all of us serve just investors and asset owners, and to be fair to our competitor, they are quite clear about their business model. However, given ISS’s market share, it would seem to suggest that shareholders are happy to accept what critics call a “conflicted model.”[5]

So, do proxy advisors have undue influence, or are they being blamed for poor decisions by others? It is true that, when ISS told investors at JPMorgan Chase last year to get rid of Jamie Diamond, they simply refused. On the other hand, smaller issues may not get investor attention in the same way.