A Few Thoughts On The “Putting Investors First Act Of 2023”- Part 1

I support several provisions of the bill including registration of proxy advisors with the SEC, disclosure of conflicts of interest but I am opposed to provisions that make it harder to disagree with management unfriendly proposals and ones that make proxy voting harder and unduly expensive.

Rep. Steil (R-WI) has introduced a bill titled, “Putting Investors First Act of 2023” in the 118^th Congress. The bill is intended to regulate proxy advisory firms and shareholder proposals. There is a lot going on in the bill. There is also a fair amount of history associated with these rules. In brief, the Jay Clayton SEC proposed proxy rules, which can be broadly viewed as friendly to issuers (companies). The Gensler SEC reversed some of these rules to make them friendlier to institutional investors. Much has been written on these proposals and counterproposals in the public domain. Instead of rehashing those arguments, I focus on the Steil bill and present my perspective, mostly informed from a combination of academic work and as a consumer of financial statements and corporate governance reports.

In the paragraphs that follow, I reproduce the key provisions of the bill and offer commentary.

1.0 Registration of proxy advisor with the SEC

The bill asks that:

· A proxy advisory firm will have to register with the SEC and the advisory firm is required to (i) certify that the advisory firm is able to consistently provide proxy advice based on accurate information; (ii) state the procedures and methodologies that the advisor uses in developing proxy voting recommendations; (iii) the organizational structure of the advisor; (iv) whether or not the advisor has in effect a code of ethics, and if not, the reasons therefor; (v) any potential or actual conflict of interest relating to the provision of proxy advisory services; (vi) the policies and procedures in place to publicly disclose and manage conflicts of interest; (vii) information related to the professional and academic qualifications of staff tasked with providing proxy advisory services; and (viii) any other information and documents concerning the advisor that the SEC might think is appropriate in the public interest or for the protection of investors.

· The SEC is required to accept or deny such registration or place limitations on the advisory firm’s activities after review.

Comments:

This sounds similar to the process that the PCAOB uses to register auditors but looks less onerous than the process by which a credit rating agency becomes an NSRSO. Clearly, the number of auditors listed with the PCAOB far outnumbers the agencies approved as NSRSOs suggesting that auditor registration is relatively easier. Having said that, the top two proxy advisors, ISS and Glass Lewis, reportedly control 90 plus percent of the market and the registration process is arguably meant to bring them into the regulatory fold. The other three proxy advisors, which hold a much smaller share of the market, include Egan Jones Proxy Services, Segal Marco Advisors, and ProxyVote Plus. Absence of significant competition among proxy advisors, contrasted with the competition among hundreds of asset managers, also increases the need for some kind of regulation.

Registration seems like a good idea to me partly because it is ironic that an industry devoted to assisting institutional investors “govern” companies is itself highly opaque and unregulated. An interested user who visits the ISS website will find next to no information about their revenues, segments under which the revenue is earned (corporate governance, ESG, market intelligence, fund services, securities class action services, media, economic value added and ISS corporate solutions), and how ISS arbitrates between conflicts in the provision of such services across both sides of the market they service (corporate customers and institutional investors looking to govern such corporate customers). We also do not know from the website who are their corporate and institutional customers and the number of employees that work for ISS’ various segments, how profitable the proxy business is relative to their consulting business, how and whether one segment subsidizes the other, among other things.

Some academic evidence suggests that ISS does not necessarily incorporate enough economic rigor in its recommendations. For instance, in two of my papers (here and here), we show that ISS’ recommendations on CEO compensation practices do not reflect whether CEO’s pay actually tracks firm performance. Larcker, McCall, and Tayan (2013) question the extent to which final policy guidelines are based on the extensive body of peer-reviewed, third-party research on governance. This also suggests that proxy advisor recommendations potentially “crowd out” or discourage production of information of sound governance and compensation practices for specific companies in the marketplace. Otherwise, the academic work on governance would have been adopted faster by institutional investors.

A 2016 GAO report concludes “some corporate issuers told GAO that firms continue to apply policies in a one-size-fits-all manner, which can lead to recommendations not in the best interest of shareholders. Corporate issuers also stated that they often do not understand the rationale for some vote recommendations and would like to discuss them before they are finalized. Proxy advisory firms told GAO that to maintain objectivity and satisfy research reporting timelines for clients, they limit the breadth of such discussions.”

At the very minimum, there is enough skepticism in informed circles about the process by which proxy advisors take decisions and whether decisions were associated with better governance practices that led to greater future cash flows, lower risk and greater shareholder value added. Such skepticism can be potentially mitigated by requiring proxy advisors to be more transparent at least in terms of registration and disclosure of conflicts of interest.

What about increased compliance costs?

Having said that, critics will argue that (i) registration and greater compliance will lead to higher costs; and (ii) institutional investors, who buy the services of the proxy advisors, do not seem to be unduly troubled by conflicts of interest or perceived under-performance of proxy advisors.

Regarding costs, I have not seen good estimates on how much incremental costs we are talking about. Transparency about both the costs paid by institutions to proxy advisors and the revenue earned by such advisors would help address this objection, especially if the increased costs will lead to better accountability and higher quality recommendations from proxy advisors.

Regarding the relative lack of pushback by institutional investors, here is my hypothesis. The current regulatory system requires institutional investors to develop proxy voting guidelines and disclose their votes. Most institutional investors are in the business of selling low-cost funds, not in the business of conducting detailed fundamentals-oriented research on a firm’s governance practices. Fundamentals research is expensive and does not scale well and is not well suited to top-down quantitative models that are used extensively in valuation research. This logjam opens the market for information intermediaries such as proxy advisors. The hope is that a good information intermediary can do the research on behalf of multiple asset owners and hence defray the large, fixed costs of such work across numerous clients. No wonder, institutional investors seem relatively satisfied with what proxy advisors do as most do not have the means or the incentives to do deep research on idiosyncratic governance arrangements of companies they own.

The economics of this business are perhaps no different from that of credit rating agencies. But the system works only if we impose guardrails on such information intermediaries. There are perhaps only two solutions to this logjam. We could let institutional investors voluntarily pass on voting all resolutions on the proxy or even some of these resolutions and make that policy public stating clearly that they do not have the resources to either hire a proxy advisor or conduct the governance research themselves. Or we impose sensible regulation on the proxy advisors that will perhaps serve the holy grail of both improving the transparency, quality, and potential accountability of their work.

2.0 More disclosure by proxy advisors:

· The SEC is required to issue rules to require the management and public disclosure of any conflicts of interest relating to the offering of proxy advisory services.

· Each registered proxy advisor shall annually disclose to the SEC and make publicly available the economic and other factors that a reasonable investor would expect to influence the recommendations of such proxy advisory firm, including the ownership composition of such proxy advisory firm.

Comments:

This is another reform I support but perhaps not for the implicit assumptions underlying the Steil bill. Tao Li, in a 2016 paper in Management Science, suggests that the conflict of interest, if anything, favors management. Hence, tighter rules around public disclosure of conflict of interest, especially when proxy advisors sell services meant to improve governance ratings and simultaneously rate corporate governance or put out recommendations on how institutional investors may want to vote on proxy proposals, are necessary, in my view.

3.0 Improve due process at the advisor:

Each registered proxy advisory firm will have to (i) have staff and other resources to produce proxy voting recommendations that are based on accurate and current information; (ii) implement procedures that permit companies that are the subject of proxy voting recommendations to have access in a reasonable time to data and information used to make recommendations.

Comments:

ISS’ website states that they employ 3000 employees and they service 3400 clients. I am not sure how many firms, across the globe, are covered by ISS. FactSet reports that they have ISS’s ESG ratings for 7.300 companies. We could perhaps assume that ISS issues proxy recommendations on these 7,300 firms. It would be useful to know many of their employees work on analyzing corporate governance practices and compensation plans per company. This is non-trivially difficult because governance arrangements can be idiosyncratic and subtle, depending on the context of the industry and the country they operate in. On top of that, one uniform recommendation on a proposal ignores the diverse preferences of hundreds of asset managers. Some asset managers care about ESG issues, others worry purely about short term value creation, some care about long term value creation, some about tax efficiency of their investments and so on.

The second provision of the bill asks for systems that give companies enough time to process the proxy advisor’s recommendations. This is logistically complicated. The timeline from the issuance of a proxy statement with various shareholder resolutions to issuance of proxy advisor recommendations and the holding of the annual meeting can be tight. Ordinarily, a shareholder proposal must be filed at least 120 calendar days (four months) before the proxy meeting. If the company intends to exclude a proposal from its proxy materials, it must file its reasons with the SEC no later than 80 calendar days before it files its proxy statement. The proxy advisor presumably begins their work after the proxy statement has been released. The time gap between the release of the proxy statement and the annual meeting is usually 45 days. This timeline may have to be relaxed to accommodate the bill’s requirement.

There is another point of symmetry that often gets overlooked in these discussions. While it might be a good idea for proxy advisor to vet their recommendations with the companies before publishing their opinions, there is no requirement to vet their recommendations with the proponents. It’s just as easy to misrepresent the shareholder proposal as it is to misrepresent the company’s situation. And, I am told that while ISS will often check with the company, proponents often can’t even get ISS to talk with them. Symmetry demands that ISS/Glass Lewis should ideally vet their recommendations with both parties.

In sum, my bigger worry is whether increased engagement with the corporate issuer might, on the margin, force proxy advisors to be excessively deferential to management. The system, as of now, is arguably already tilted in favor of management. ISS’ own data states, “the percentage of companies with failed say-on-pay votes increased to 3.2 percent, up from 2.6 percent in 2021, representing the highest failure rate since say-on-pay votes began in the US.” Surely more than 3.2% of pay packages in corporate America do not reflect pay for performance, as suggested by several papers (see here and here).

4.0 Provide companies a chance to respond and appoint an ombudsman:

The registered proxy advisor will have to provide (i) the issuer a reasonable opportunity to provide meaningful comment and corrections to such data and information, prior to the publication of proxy voting recommendations to clients; and (ii) employ an ombudsman to receive complaints about the accuracy of information used in making recommendations from the subjects of the proxy advisory firm’s voting recommendations and seek to resolve those complaints in a timely fashion and prior to the publication of proxy voting recommendations to clients; (iii) if such ombudsman is unable to resolve such complaints prior to the publication of proxy voting recommendations to clients, include in the final report of the firm to clients a statement detailing its complaints, if requested in writing by the company.

Comments:

I agree with the idea of giving the company a reasonable opportunity to respond to a proxy recommendation, subject to the comment about the tight timelines discussed earlier. But an ombudsman sounds like overkill. Enacting an ombudsman provision will simply force proxy advisors to become even more deferential to management. Management has a chance to explain their opposition to a proxy advisor’s recommendation in their proxy statement in any case. And, we do not seem to have an ombudsman in governing other information intermediaries such as sell-side analysts, credit rating agencies or auditors.

5.0 Provide clients more data:

Proxy advisors will provide to clients receiving proxy advisory firm recommendations that (i) information demonstrating that draft recommendations (other than recommendations relating to an issuer-sponsored proposal or recommendations consistent with that of the majority of the board of directors of the issuer, or in effect the “management unfriendly” recommendations) are in the best economic interest of shareholders; and (ii) a certification by the CEO, CFO and the primary executive responsible for overseeing the compilation and dissemination of proxy voting advice that the draft recommendations, other than the “management friendly” recommendations, (a) are based on internal controls and procedures that are designed to ensure accurate information; (b) do not violate applicable State or Federal law; and (c) prioritize economic returns to shareholders.

Comments:

This provision raises on the onus on the proxy advisor to justify “management unfriendly” recommendations. I have some sympathy for requiring proxy advisors to add commentary on the model they have in mind that links their recommendation on a proposal to the company’s future cash flows or risk or even the risk of the whole portfolio of stocks owned by universal owners such as pension funds who hold indexed companies for decades. But I do not support any provision that makes it more difficult to highlight management unfriendly positions given the growing disconnect between owners who supply capital and managers who deploy that capital.

More in part 2.