3.5.2 Proxy Advisers

Proxy advisers play an increasingly prominent role in corporate governance. Earlier in the Chapter, ISS 's recommendation to vote in favor of the acquisition of ABN Amro by Fortis was mentioned as a possible explanation for why Fortis shareholders approved the deal. ISS's recommendation is also seen as the explanatory factor for why Hewlett-Packard shareholders approved the controversial acquisition of Compaq in 2002.1 But instead of relying on anecdotal evidence, we can rely on a growing body of systematic evidence revealing ISS 's influence on voting outcomes. For instance, a study using a sample of over 40,000 director elections found that directors who received a negative ISS recommendation received nineteen percent fewer votes.2 This suggests a significant influence.

How do proxy advisers affect voting efficiency? Or, more precisely, how do proxy advisers affect the operation of the various mechanisms of voting efficiency? To answer this question, we first need to take a closer look at the impact of proxy advisers on individual voting behavior.

While empirical evidence is scarce, one study has found that mutual funds have tended to vote in line with ISS recommendations across the board during the five recent proxy seasons.3 Although this finding suggests that mutual funds tend to follow ISS 's recommendation instead of their independent judgment—which, as we have seen, could affect voting efficiency—it does not provide conclusive evidence that they do. Because ISS typically consults with mutual funds prior to issuing its recommendations, we cannot exclude the possibility that it tailors its recommendations to track mutual funds' voting preferences.4

Even if ISS recommendations merely track mutual fund preferences, however, they may still compromise voter independence, for two reasons. First, mutual fund managers consulted by ISS are unlikely to be unanimous in their beliefs. ISS's recommendation would thus deviate from at least some fund managers' beliefs. Some of these managers may be inclined to change their beliefs once ISS has issued its recommendation, assuming the recommendation is based on superior information, or simply to avoid criticism.5

Second, shareholders who are not subscribed to ISS 's advisory services may also learn of ISS's recommendation prior to deciding on how to vote. Especially when votes are contentious, such as in proxy contests or takeovers, ISS 's recommendations typically receive much attention from the financial press. Shareholders who learn of a recommendation through this channel again may be inclined to base their voting decision on that recommendation.6 In each case, shareholders would ignore their own beliefs.

Notice that a trade-off emerges between independent voting and informed voting. While ISS's recommendations may reduce voter independence they may also raise average competence, just as recommendations of other types of opinion leaders may do. Some evidence suggesting that ISS recommendations raise average competence is provided by a recent study that documents significant abnormal returns around ISS recommendations in proxy contests.7 To explain these returns, the authors test the hypothesis that ISS recommendations are informative about the value that a dissident team would bring to a firm if victorious, and find that they are.8 Apparently, the market perceives ISS as being extraordinarily competent. If this is correct, ISS recommendations can promote informed voting.

Whether it can be inferred from the market's response that ISS is in fact extraordinarily competent is questionable. Investors may not accurately perceive the information content of a recommendation.9 A somewhat similar problem exists with respect to the judgments of credit rating agencies. Investors' responses to downgrades can be quite dramatic, as evidenced by the sharp declines in share prices following the rating agencies' downgrades of debt issued by southern European countries such as Greece this past spring.10This raises concern as to whether the market's response is proportionate to the information content of such a downgrading. Indeed, David Beers, head of sovereign ratings of Standard & Poor's, a major credit rating agency, was recently quoted as saying that "[p]eople's perceptions are that a downgrade from AAA means that minutes later you default, but in fact it means only a slight increase in default risk."11

Skepticism is also warranted when we turn our attention from ISS's proxy advice to its corporate govemance ratings, which may indirectly influence voting behavior on, for example, proposed by-law amendments. The main thrust of criticism is that ISS's one-size-fits-all rating methodology fails to account for firm-specific characteristics.12 Indeed, empirical evidence suggests that govemance ratings have failed to adequately predict risks associated with govemance structuren fust as credit rating agencies have failed to adequately predict risks associated with financial structures.13

The trade-off between the various mechanisms of voting efficiency may also indirectly involve conflicted voting. There is concern that ISS's consulting services to issuers may compromise its objectivity in rating their govemance structures or in issuing proxy advice with respect to these issuers.14 As to the rating of govemance structures, the concern is mitigated by the recent lasinch of ISS's "Govemance Risk Indicators," which are both transparent and absolute.15 But there remains widespread unease about potential agency problems deriving from the fact that ISS is a for-profit organization that issues proxy advice to its clients without having an economie interest in the outcome of the vote.16

The preceding analysis has three implications for policymakers such as the SEC, which in its recent concept release also addresses the question of whether and how to regulate proxy advisors.17 First, to promote informed voting, policymakers could require increased transparency of proxy advisers' methodologies, just as they are requiring increased transparency of credit rating agencies' methodologies.18 Second, to promote independent voting, policymakers may wish to encourage institutional investors to make independent judgments rather than exercising their voting rights solely on the basis of proxy advice, just as they have cautioned investors against overly relying on credit rating agencies.19 Third and finally, to prevent conflicted voting, policymakers could consider restricting the ability of proxy advisers to provide consulting services to issuers, just as they have restricted the ability of auditors to provide consulting services to issuers.20 A less far-reaching option would be to require proxy advisers to take strict measures to avoid conflicts of interest, possibly similar to the measures the recent Dodd-Frank Act requires of credit rating agencies.21

Taking these steps is critical in light of pending reforms. Consider the reform in the area of executive compensation, for which proxy advisers have strict policies. Not only do shareholders in U.S. firms now have broader powers with respect to executive compensation, the issue will also be qualified as a non-routine matter, meaning brokers may vote only when instructed.22 Since retail investors are the least likely to instruct their brokers, the vote of institutional investors will probably increase in relative weight. And given that institutional investors are the ones retaining proxy advice, it is ever more important that they vote on an informed and independent basis.23 Should they fail to do so, Lest some portfolio firms would risk losinge talent to rival firms because they are unable to offer competitive pay, the fear expressed by Countrywide's former CEO at the beginring of this Chapter.