Radar Guns and ISS
About thirty years ago a businessman from Europe moved to the United States for a couple of years to manage a recently purchased business. He developed a bad habit of getting speeding tickets and, on the advice of locals, solved that problem by purchasing a radar detector. He liked his radar detector so much that before he returned to Europe he acquired the distribution rights for his favorite brand. He quickly realized, however, that the local police did not use radar guns. So he purchased fifty or so radar guns, gave them to the police, and his business flourished.
Today, proxy advisors have devised an even better business model. Here is how it works: Develop a system of voting criteria in connection with annual meetings, but do not make the criteria transparent so that companies can readily comply with them. Claim that the criteria are proprietary or some other baloney like that. Just to make the process appear more purposeful, add in some criteria for which there is no empirical justification but that sound shareholder friendly. Then, sell advice to companies on how to fulfill the double top secret criteria.
In 2003, the SEC required institutional investors to begin reporting how they vote. Historically, institutional investors were unconcerned about voting, considering it unimportant to their economic interests, and almost always voted with management. As a practical matter, unless they were running an index fund, when they had a concern with management they “voted with their feet.” Once the SEC required them to report how they voted, however, they needed to look more serious, and substantially all of the significant institutional investors retained either ISS or Glass Lewis or one of their competitors in the proxy advisory field and began following their guidance. Just one problem: Except for proposals that related to economically significant events, the institutional investors still did not care much about their votes, and, as a result, did not care much about their proxy advisor or the quality of its recommendations. For the most part, they simply needed to provide the required disclosure. The byproduct of this is that most institutional investors have little motivation to require that the advice be of good quality or meaningfully beneficial to the shareholders. This said, many institutional investors, such as Fidelity, do thoughtfully decide on their own how to vote their shares.
We believe the current system results in a large number of votes being cast in a lemming-like manner. It also results in many companies finding it necessary to adopt practices, particularly practices with respect to compensation programs, that are inconsistent with the views of their directors and the best advice of their compensations consultants. But the companies need the support of the proxy advisors in order to receive approval of their proposals, so they cater to them. You need look no further than the recent stories about by GE and Northern Trust, one of the most respected companies in America and certainly the most conservative large financial institution in America, to identify ill-considered positions taken by proxy advisors and the extra effort required by these companies to get shareholder support – effort that would have been better focused on running their businesses.
Moreover, because of the sheer number of proxy statements that the proxy advisors must analyze over a condensed period of time (thousands over basically a three month period), their claim that every company and each proposal is analyzed based on the particular facts of the situation rings hollow. Indeed, while the process is opaque, we understand that most of the analyses are basic computer-driven check-the-box models that are prone to user error. Despite the heavy reliance by institutional investors on the ultimate recommendations of the proxy advisors, the proxy advisors often are unwilling (or unable given their business model) to correct errors or engage in productive dialogue over their recommendations. In addition, institutional investors lack the time or resources to actively engage with every company that wishes to convince them to disregard the negative recommendations of the proxy advisors.
We believe the current system is broken. The SEC should require proxy advisors to disclose their voting criteria with clarity. In addition, the SEC should prohibit proxy advisors from advising institutional investors while concurrently advising companies how to fulfill their criteria. The voting process needs to reflect the best interests of shareholders, not the best interests of the proxy advisors.