I Smell A Rat: Recommendations From Proxy Advisory Firms Are Full Of Errors

by: Jared Whitley

Summary

Proxy advisory firms wield an enormous amount of power over the shareholder voting process.

A new study reveals that proxy recommendations are full of errors.

Unless proxy advisory firms are reined in, they will continue to wreak havoc on investors' returns.

A friend and I were at a local restaurant when we saw a very well-fed rat scurry across the floor. We complained to the server, who merely shrugged. We quickly decamped to the Applebee’s across the street.

While it may be unrealistic to think that rodents are nonexistent in a restaurant, I subscribe to the age-old adage that for every one rodent in sight there are twenty nearby in hiding.

A new American Council for Capital Formation (ACCF) study about errors in proxy advisory voting reminded me of this dictum. The first-of-its-kind study seeks to quantitatively determine whether proxy advisors impose a real cost to ordinary investors. Unsurprisingly, the study finds numerous problems in recommendations made by proxy advisory firms.

Proxy Advisers came to be what they are today through a requirement made by the Securities and Exchange Commission that investment management funds submit proxy votes for all companies in which they own shares. Given the vast number of stocks typically held in managed funds, most investors rely on a proxy advisory firm for guidance so they can focus on managing their portfolio. What’s more, there are two firms that comprise approximately 98 percent of the market, Glass Lewis and Institutional Shareholder Services (ISS). As finance has become increasingly complex, proxy advisory firms have become more powerful in a climate filled with never-ending litany of environmental, social, and governance guidelines being touted by activist investors.

Proxy fights represent a way for politically engaged entities to pursue their favored policies, often negating the interests of actual shareholders - making money. The needs of retail investors to prepare for retirement or buy a home be damned.

The SEC is currently evaluating the proxy process, and numerous voices from academia and business are voicing the need to constrain the proxy advisory firms.

The ACCF study asked 100 companies about their experiences during the 2016 and 2017 proxy voting season, and 35 of those companies reported 93 separate adverse proxy advisor recommendations.

A supplemental survey of 94 companies tallied 139 significant complaints over the last three years. Of these complaints, 39 were regarding factual errors, 51 comprised analytical errors, and 49 were “serious disputes” – problems that consisted of, for instance, a “one-size-fits-all” application of advisors’ general policies as well as a recommendation for bylaw changes that would be illegal under the issuer’s state law of incorporation.

As far back as 2010 the SEC expressed concern that "proxy advisory firms may … fail to conduct adequate research and base [their] recommendations on erroneous or incomplete facts." Demonstrative of this problem was one complaint where Willis Towers Watson had to push back on ISS for criticizing its compensation plan, complaining that its recommendations included “a litany of factual errors” and ignored the fact that Willis Towers is widely seen as an industry leader on compensation.

Thousands of recommendations are made every proxy season, so 139 complaints may not sound like a lot. But given that this study is the first to investigate problems created by proxies, its results have many in the financial community imagining that for every one error we see, there are 20 more we don’t see.

Moreover, every company said they need more time than proxy advisors typically provide– 100 percent said they need at least three business days to respond to recommendations while 68 percent said they needed at least five days. Smaller companies don’t have the resources to jump through every hoop as fast as proxies demand, but ISS and Glass Lewis make a habit of giving far less – sometimes only 12 hours.

The compressed timeline is compounded by the phenomenon of robo-voting, where investors have to automatically follow proxy advisors’ recommendations. Asset managers must override the voting system if they do not want to vote exactly in line with proxy guidance – which, again, puts particular stress on smaller organizations.

The ACCF study raises questions over whether asset managers are meeting their fiduciary duty to investors.

Proxy advisory firms have grown to be more powerful than they should ever be, and the duopolistic market enhances the two firms’ power. Substantive reform is called for to ensure that the interest of investors--and not the stakeholders of proxy advisory firms--are being met.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.