The democratic world, like the corporate world, relies upon an intricate set of checks and balances for its efficacy. In the political space, power-sharing helps prevent potential leviathans from encroaching on the rights of their electorate; in the corporate world, it precludes greedy company chiefs from lining their pockets with profits owed to shareholders.
The Enron scandal reaffirmed the necessity of diffused power, and interest in corporate governance surged as a swathe of new regulation came in to help protect investors. Now, more often than not, a proxy advisory firm will be lurking behind the scenes in the corporate space, telling investors, the public and anyone else who will listen how companies should be governed and how proxy votes should be directed.
The presence of proxy advisers in corporate life has become almost as certain as death and taxes. But this may all be about to change as unrest grows over the influence of these companies and the way they conduct their business. The US Government Accountability Office (GAO) published a report back in June on the back of ‘concerns about a group of roughly five firms that provide research and recommendations on proxy votes to their institutional clients’.
Some larger investors have also expressed concern. Ontario Teachers’ Pension Plan (OTPP) has used proxy advisory services for years – first Institutional Shareholder Services (ISS) and then Glass Lewis. Now, however, it is working with about two dozen other Canadian institutional investors on a project looking at pooling resources to create a commonly owned proxy advisory service. This is not an option for all shareholders, however, as smaller investors don’t have the resources to track the 38,000 or so companies covered by Glass Lewis and ISS.
Paying for performance
Some, like Brian Gibson, senior vice president of public equities at OTPP, question the business model used by the big proxy companies. ‘The challenge we have seen is that it is very difficult for the proxy firms to remain independent,’ he explains.
The GAO further acknowledges this criticism in a recently published paper entitled ‘Corporate shareholder meetings – issues relating to firms that advise institutional investors on proxy voting’. ‘Critics contend that corporations could feel obliged to retain ISS’ consulting services in order to obtain favorable vote recommendations,’ the paper points out.
On the one hand, ISS provides proxy voting advisory services. But it also provides its corporate governance quotient (CGQ), which rates 8,000 US companies for governance practices. The number has become an important one for many investors, but a number of people find it problematic. Although ISS makes parts of its methodology available to anyone wishing to see it, not all of the details are there, so a firm would not necessarily be able to tell how a change in practices would affect its CGQ.
To get that information, a company must pay tens of thousands of dollars for ‘a premium CGQ subscription service, which is a web-based tool to help issuers with data analysis, benchmarking and peer analysis as well as understanding the impact of governance changes to their relative CGQ scores,’ according to an ISS spokesperson.
So ISS takes money for proxy advice and also takes money from many companies that are rated by it. The company makes the point, however, that ‘the majority of companies with high corporate governance scores achieved them through positive governance practices without subscribing to CGQ.’ Not everyone is convinced, though. ‘That’s like professors selling test scores,’ comments Gary Lutin, an investment banker who advises shareholders on corporate control issues and a long-time critic of ISS. ‘The more important the passing grades are, the higher the value of the test scores.’
What’s more, ISS also certifies director education programs – and companies that have sent their directors to an ISS-approved program get their CGQs bumped up.
Power and influence
Another key concern is the bearing an ISS proxy recommendation has on the voting outcome. ‘You can see the influence on the voting in Hong Kong – a lot of it is driven by the ISS recommendations,’ notes Jamie Allen, secretary general of the Asian Corporate Governance Association. Some 15 percent to 20 percent of ISS clients automatically cast votes in accordance with ISS recommendations, according to former CEO John Connolly in a 2006 interview with the Washington Post. According to other estimates, some 40 percent of institutional investor votes conform with ISS.
‘There’s no denying that the ISS decision can sway the vote – as the case of HP showed,’ says Michelle Edkins, managing director of Governance for Owners. ‘But it’s unfair to criticize ISS for this.’ The advisory services say they don’t ask institutions to forsake their own research. ‘I would say many of our clients do their own research and use ISS as one element that goes into the mix, or they work with us to produce custom guidelines to meet their needs,’ explains Marc Goldstein, director of ISS’ research services in Japan.
But what should be an additional information service for institutional investors has, in many cases, become the primary decision-maker, which, in sensitive cases, can tip the balance significantly. ‘The level of influence of big advisory firms only really becomes a problem in high-profile cases – in other words, when investors should be taking the vote out of the template and making the decision by themselves,’ explains Edkins. ‘In essence, it is the proxy companies’ fault only because their clients rely on them too much.’
The big firms have also come in for criticism for discrepancies in their research budgets. The big advisers issue recommendations on some 30,000 firms outside the US, but have surprisingly few researchers stationed in some parts of the world. ‘Both ISS and Glass Lewis should have more resources on the ground in Asia,’ notes Allen. ‘The fact is that, with a lot of the issues and the people you are voting on, unless you have people on the ground [there], you miss the nuances.’
Much of the initial research on Asian companies conducted by ISS is carried out in Manila where ISS has nearly 200 staff across a number of different departments including data management, research, client services and technology. The team there provides support for the US and Australian offices. ISS also has offices in Melbourne, Singapore and Tokyo. In the Japanese market a team of four analysts out of a total of 15 conduct research on around 3,000 companies in the region. ‘We have always covered the biggest companies but we are starting to cover more smaller firms as our client base expands,’ adds Goldstein.
Get your own house in order
ISS and Glass Lewis have also seen some recent changes that have caused alarm among many investors and companies. Last year ISS was bought by RiskMetrics Group, a risk management company; now there is talk of a future IPO. If that happens, a publicly held company – with all the pressures that come from the market – would be making recommendations about the governance of others.
Glass Lewis was recently bought by Chinese company Xinhua Finance, whose governance practices leave some questioning the propriety of the deal, particularly when a director stepped down after a Barron’s story brought up questions about his business dealings. Two top research executives also recently left the company, one publicly voicing his displeasure at the new ownership arrangements (see Timeline to trouble).
Meanwhile, a number of large institutional investors – including the Missouri State Employees’ Retirement System, the Ohio Public Employees Retirement System and the Colorado Public Employees’ Retirement Association – have all dropped ISS over the last few years because of concerns about conflicts of interest. But are the indicators of good governance equivalent to good governance? No, says Lutin.
‘Good governance has devolved into a bureaucratic checklist process,’ he adds. Both Enron and Computer Associates, involved in considerable financial scandals, were once known for their ‘good’ corporate governance yet it is now common knowledge what was really bubbling under the surface.
While some accuse the big firms of setting too many arbitrary criteria for issuers, there is little doubt the proxy advisers – particularly ISS – have played an important role in improving attitudes toward governance. ‘A few years ago they really helped to clean up some practices that were inappropriate,’ points out Erik Beucler, managing consultant at executive compensation consultancy DolmatConnell & Partners.
‘The positive trend is that an increasing number of institutions are taking back ownership of the voting decision-making, as opposed to what had happened for the previous decade or so, where many of them had passed the voting decisions on to ISS or some of the other proxy advisers,’ adds Bill Ultan, senior managing director for consulting firm Morrow & Co. OTPP takes one approach to lessen dependence on proxy advisories, and some, like Lutin, are looking to open a software framework and data source so others could easily enter the advisory business and let the market pick the winners.
For the time being, though, don’t throw away those CGQ scorecards, because the current system and its problems are not going away any time soon.
