The GMI Blog

Why We Should Not Regulate Proxy Advisory Firms

The Securities and Exchange Commission has invited comments on a wide range of topics concerning the proxy system, with tomorrow the last day to file.  This is my comment on why the Commission should not regulate proxy advisory firms:

Comments regarding proxy voting system reform
File Number S7-1410

Ladies and Gentlemen of the U.S. Securities and Exchange Commission:

I am delighted that the SEC is looking at the proxy system to consider updates that reflect changing technology and circumstances, and hope we can move to a system that recognizes the essential role that investors must play in providing oversight to minimize the agency costs and perverse incentives inherent in capitalism.

For too long, the system has been designed for the benefit of issuers, and it is not too strong a statement to say that the devastation of the financial meltdown could have been mitigated or even prevented if investors had been able to prevent the perpetuation of boards selected, compensated, informed (and misinformed) by insiders.

With regard to the list of items on which the SEC has invited comment, I would like to object in the strongest possible terms to the possible regulation of proxy advisory services. As the original general counsel and for one year CEO of ISS, I have observed this industry from the beginning. Having left ISS in 1990, and having been a proponent and dissident who has failed to gain the support of the ISS analysts more often than I have been successful, I have had the opportunity to develop some objectivity.

The core founding principle of our democracy is freedom of expression. The recent Citizens United decision by the Supreme Court emphasized the importance of unfettered speech, justifying corporate participation in the political process explicitly through its accountability to investors because "shareholder objections raised through the procedures of corporate democracy can be more effective today because modern technology makes disclosures rapid and informative" (citation omitted). The core founding principle of our economy is to allow the market to determine the value of goods and services. Infringement of either free expression or the free market should only be done in the most extreme circumstances and no such justification is present here.

ISS developed the proxy advisory business because as we were trying to sell another product entirely institutional investors kept telling us that what they wanted was an independent assessment of management and shareholder proposals. At the time, many of them subscribed to the IRRC reports, which analyzed proposals but did not give recommendations. In those days of hostile takeovers and management entrenchment, they wanted advice that was as knowledgeable and as objective as what they were receiving from securities analysts and other independent advisors.

When I left ISS in 1990, both our employees and our clients were in the low two digits. The fact that it became such a powerful international presence in the two decades that followed demonstrates just how badly its customers wanted those products. The fact that two other substantial competitors have entered the market shows that there are very low barriers to entry. The firms often disagree with each other. They are transparent and highly competitive about their different approaches, and each does not hesitate in sales calls to explain in detail why their product is superior. Most clients choose the firm that best suits their own policies; the rest prefer to do business with more than one and compare the recommendations to assist them in arriving at their own decision. This is exactly what markets do best and there is no reason to interfere.

The issuers claim that these firms are too influential. Of course, they do not complain that they are too influential when they support management recommendations in the overwhelming majority of cases. They only complain that they are too influential in those selected occasions when they oppose managements' recommendations. Do not confuse correlation with causation. Clients follow the advice of proxy advisory services because they like and trust the recommendations even, it is fair to say, because in those instances the issuers are proposing matters that are not in the shareholders interest. And it is absurd to suggest that the proxy advisory services take a one size fits all approach. That is demonstrably not true. The SECs own rule-makings and the stunning conformity and lowest-common-denominator benchmarking approach of the issuer community is far more one size fits all than the proxy advisors, who provide detailed and highly specific analysis of matters like executive compensation that are tailored by sector, market-capitalization, and other factors.

There is no reason to suspect that sophisticated institutional investors are abdicating their obligation as professionals and fiduciaries to consider these issues as carefully as they do their buy-sell-hold decisions, also based in part on the opinions of independent analysts like the proxy advisory firms. Indeed, the data show that while clients do often follow the recommendations on routine matters (which means voting with management), the more high-profile and controversial a proposal or proxy contest, the more likely that clients are to read the analysis and come to their own conclusion, often departing from the proxy advisory services recommendation, demonstrating the independence of their judgment. Just as two investors can look at the same data and make different conclusions about whether to buy, sell, or hold, they can look at a proxy advisory recommendation and make a different decision about whether to vote yes, no, or abstain.

The arguments made by the other side show such a stunning statistical illiteracy that they are either disingenuous, ignorant, or both. Issuers seem stung to discover that investors may not believe management is acting in their best interests and believe that the answer is not to change their behavior or improve their communication but to smother outside analysis of their proposals. If issuers object to the recommendations made by the proxy advisory firms, the answer is for them to respond directly and substantively in their communications with their shareholders, not to cut off outside assessment.

An ABA assessment of ISS recommendations noted that they supported dissident candidates two-thirds of the time, suggesting that this reflected an anti-management bias. On the contrary. Given that proxy contests occur only in a fraction of a percent of companies each year and by definition those are companies with the most severe performance issues, the fact that ISS supports management one-third of the time demonstrates that they take a very measured approach. Overwhelmingly, proxy advisory firms support management candidates. And overwhelmingly, their clients have shown that the firms pass the ultimate market test of credibility and legitimacy by buying their products.

No one has shown any evidence that the proxy advisory firms have been anything but transparent about their approaches and the way they deal with conflicts of interest as indeed it is in their best interest to do so in seeking sales. Some of them meet the stringent standards of registration as investment advisors. There is no reason to regulate their analyses and recommendations.

If the SEC has any concerns about institutional investors failing to meet fiduciary standards in exercising their share ownership rights, including not just proxy voting but making decisions about initiating shareholder proposals, running dissident candidates for the board, and filing lawsuits, the Commission should address those issues directly. As the Court noted in Citizens United, the remedy is not to restrict speech but to consider and explore other regulatory mechanisms. I would support the UK approach of putting the burden of proof on institutional investors to show why they have not been actively engaged in exercising those rights, and I would support a vigorous enforcement program to address the issues of conflicts of interest we have documented in the repeated failure of institutional investors to vote against value-destroying compensation plans (even when proxy advisory services tell them to do so). But any regulation of proxy advisory services is contrary to our commitment to freedom of expression and the free market, and it is a pity that the issuer community, which would rather cut off exactly the kind of information the market needs to be efficient than make a substantive response, needs to be reminded of this.

Again, I appreciate the Commission's examination of this and other topics relating to the proxy system and request that before issuing a proposed rulemaking the Commission hold hearings to explore these matters more thoroughly. I welcome the opportunity to answer questions on this comment or any of the other issues under consideration.

Nell Minow
Chair, The Corporate Library
56 Northport Drive
1st floor
Portland, Maine 04103

 

 

Why the Proposed Rules Would Mean Less (and Less Irrational) Financial Regulation

Thanks to the Consumer Federation of America for this chart.

Nell Minow - Editor

David Stockman Schools Banks on Supply-Side Economics

David Stockman, the one-time head of the Office of Management and Budget who famously was taken to the woodshed by his boss, President Ronald Reagan, for telling the truth about the fragility of the budget numbers, has a bracing op-ed in the New York Times reminding bankers what capitalism really means. I wish he had made the point that the boneheaded monetary policies he decries were a direct result of the well-funded influence of the financial institutions, along with the unraveling of most of the statutory and regulatory protections.  But everything he says is literally right on the money and this piece should be hung on the wall at every government office in the executive and legislative branches with oversight (or failure to exercise oversight) on the financial markets and institutions.

The economy desperately needs less of our bloated, unproductive and increasingly parasitic banking system. In this respect, the White House appears to have gone over to the supply side with its proposed taxon big banks, as it scores populist points against the banksters, too.

Not surprisingly, the bankers are already whining, even though the tax would amount to a financial pinprick — a levy of only 0.15 percent on the debts (other than deposits) of the big financial conglomerates. Their objections are evidence that the administration is on the right track.

Make no mistake. The banking system has become an agent of destruction for the gross domestic product and of impoverishment for the middle class....

The baleful reality is that the big banks, the freakish offspring of the Fed’s easy money, are dangerous institutions, deeply embedded in a bull market culture of entitlement and greed. This is why the Obama tax is welcome: its underlying policy message is that big banking must get smaller because it does too little that is useful, productive or efficient.

To argue, as some conservatives surely will, that a policy-directed shrinking of big banking is an inappropriate interference in the marketplace is to miss a crucial point: the big Wall Street banks are wards of the state, not private enterprises. During recent quarters, for instance, the preponderant share of Goldman Sachs’ revenues came from trading in bonds, currencies and commodities.

But these profits were not evidence of Mr. Market doing God’s work, greasing the wheels of commerce and trade by facilitating productive financial transactions. In fact, they represented the fruits of hyperactive gambling in the Fed’s monetary casino — a place where the inside players obtain their chips at no cost from the Fed-controlled money markets, and are warned well in advance, by obscure wording changes in the Fed’s policy statements, about any pending shift in the gambling odds.

Nell Minow - Editor

Fed gets in on the act: bank pay regulations

I tell you, who’d be head of HR at a bank nowadays? Who’d be on the compensation committee? It’s got to be a nightmare. Serve ‘em right, I hear you say. Well…

In an October 22 press release the Federal Reserve announced that it would conduct a horizontal review of compensation practices at each of the 28 large complex banks it oversees to detect whether they are using risk-appropriate compensation.

In addition, it will review compensation practices at 1000s of regional and community banks.

The press release says, in no uncertain terms:

Flaws in incentive compensation practices were one of many factors contributing to the financial crisis. Inappropriate bonus or other compensation practices can incent [sic] senior executives or lower level employees, such as traders or mortgage officers, to take imprudent risks that significantly and adversely affect the firm. With that in mind, the Federal Reserve's guidance and supervisory reviews cover all employees who have the ability to materially affect the risk profile of an organization, either individually, or as part of a group.

This is all part of financial regulation but, and I’ve said it before, why weren’t they doing this before? It’s not as if there weren’t any warning signs. A simple subscription to Board Analyst would have been enough.

The Fed suggests a set of principles:

• risk-adjusted pay
• deferred pay
• longer performance periods
• reduced sensitivity to short-term performance

Not exactly revolutionary, but of course, the Fed actually has the authority to mandate companies to follow these principles – unlike The Corporate Library which has been writing about this for a while – so that should help.

The guidance also extends to internal controls and corporate governance because it is clearly recognized that without those controls and effective risk management professionals, as well as strong, qualified boards with active oversight, the Fed cannot possibly oversee all of these compensation arrangements all the time.

So, we’ve got 30 days to comment on these principles, to flood the Fed with fodder for thought. Docket No. OP–1374. E-mail regs.comments@federalreserve.gov. They’re on the right lines, but we don’t want any Pay Czar-like waverings.

Paul Hodgson — Senior Research Associate

SEC Staff Reverses Two Controversial Interpretations of Rule 14a-8's Ordinary Business Exclusion

In Staff Legal Bulletin 14E released last week, the Staff of the Securities and Exchange Commission’s Division of Corporation Finance backed off of two troublesome interpretations of the SEC’s shareholder proposal rule, Rule 14a-8.  Rule 14a-8’s “ordinary business” exclusion allows companies to omit from their proxy statements proposals dealing with day-to-day matters that are more appropriately handled by management without shareholder input.

Although the SEC has provided some guidance in its releases regarding the application of the ordinary business exclusion, it has been left to the Staff to decide whether companies can exclude the many proposals challenged each year by companies.  In doing so, the Staff formulates decision rules, such as allowing exclusion of proposals dealing with legal compliance programs, choice of suppliers and a company’s code of ethics.

One such decision rule has allowed the omission of proposals dealing with an internal “evaluation of risk” or “risk assessment.”  This reasoning was developed for highly technical proposals asking companies to do detailed cost/benefit analyses of environmental liabilities.  In the past few years, however, the Staff had expanded the application of this rationale to allow exclusion of a wide variety of proposals, including proposals addressing topics the Staff had held to be “significant social policy issues” to which the ordinary business exclusion should not apply.  Companies began to cite this reasoning even when proposals didn’t mention or suggest risk evaluation or a cost/benefit analysis.

Unsurprisingly, companies were able to frame many kinds of proposals as touching on or somehow involving risk.  For example, a proponent might support a labor rights proposal by arguing that irresponsible practices could harm the company’s reputation or endanger a valuable contract; a company seeking exclusion would describe the proposal as requiring the company to assess the risks and benefits associated with its current labor practices, as compared with the practices urged in the proposal.  Governance proposals likewise often have a nexus with risk of some kind.

Sponsors began drafting to avoid this reasoning, which was difficult given its potential boundlessness and the existence of contradictory Staff determinations on the same proposal formulation.  Rather than squarely asking companies to disclose steps they were taking to respond to rising pressure to reduce greenhouse gas emissions—a formulation that was deemed excludable—proponents began filing proposals asking companies to set greenhouse gas emissions targets, one of the few climate-related proposals to survive the no-action process.

Sensibly, the SEC Staff has realized that the “evaluation of risk” decision rule resulted in the “unwarranted exclusion of proposals that relate to the evaluation of risk but that focus on significant policy issues.”  From now on the Staff will look to the underlying subject matter of the proposal in deciding whether it can be omitted on ordinary business grounds.  Although this approach does not eliminate all need for the Staff to exercise subjective judgment—a goal that is unachievable given the open-ended nature of the exclusion--it is an important step in the right direction.

A second change made by the Staff in SLB 14E relates to proposals on succession planning.  In the wake of the high-profile botched leadership transitions at Citigroup, Merrill Lynch and other financial companies, shareholders submitted proposals asking companies to adopt policies on CEO succession planning that included certain elements.

In a breathtaking example of missing the forest for the trees, the Staff allowed companies to exclude these proposals in reliance on the ordinary business exclusion, reasoning that they dealt with the “termination, hiring or promotion of employees.”  In other words, the Staff believed there was no meaningful difference between CEO succession planning by the board and the day-to-day managerial choice about whether John Doe gets promoted from grade 1 to grade 2.  SLB 14E reversed that interpretation and stated that proposals on CEO succession planning would not be excludable as ordinary business.

Activists will likely respond to SLB 14E by retooling proposals on key corporate accountability issues to ask for the precise changes they want to see, whether in disclosure or behavior.  Proposal formulations will likely vary more according to company-specific factors such as industry and current policies and practices.  Finally, sponsors will revive the CEO succession planning issue, which was in the spotlight again recently when Bank of America CEO Ken Lewis announced that he would retire at the end of 2009 and the board admitted that no successor had been identified.

Beth Young — Senior Research Associate

SEC Rules on Board Leadership Disclosure

In the proposed rules on “Proxy Disclosure and Solicitation Enhancements” (find them here: http://www.sec.gov/rules/proposed/2009/33-9052fr.pdf) published in the Federal Register, on Friday, July 17th, the SEC is proposing that companies report details regarding the company’s current leadership structure in their proxy and information statements.  Specifically, the new disclosure rules would require companies to address the following issues:

• “whether and why they have chosen to combine or separate the principal executive officer and board chair positions”
• “whether and why the company has a lead independent director, as well as the specific role the lead independent director plays in the leadership of the company” (applies only to those companies where the “role of principal executive officer and board chairman are combined, and a lead independent director is designated”)
• “why the company believes [the current structure is] the best structure for it at the time of the filing"

If adopted, the new rules would be effective for the 2010 proxy season.  According to the SEC, the intention of the rule is to “provide investors with insights about why the company has chosen that particular leadership structure.”

Hopefully, under these new rules, companies would discuss any leadership structure they have, and not limit the discussion to whether they have separated the role of CEO and Chair.  It would be most helpful for shareholders to see an explanation of whatever leadership structure the company has in place.  At The Corporate Library, we have identified numerous leadership structures among the more than 3,200 North American companies we cover, beyond the more common structures mentioned in the SEC’s proposed rules.  For example, I have been conducting a study of over 100 US companies that have an Executive Chair of the Board (i.e., a board chair who is not CEO but who is an employee of – and paid a salary by – the company).  Ideally, companies with this structure would explain to shareholders the roles and responsibilities that person is providing the company and why they are paying large salaries – sometimes as much or more than the CEO – to an Executive Chair.  Similarly, explanations for situations where there are other unusual leadership structures, such as Vice Chairs, Co-Chairs, an “Office of the President,” etc. would be helpful.

A positive change that we would see if these rules are adopted is more meaningful information about the roles and responsibilities of the lead independent director. However, companies should also have to disclose their reasoning if they have combined the roles of CEO and Chair of the Board and NOT created the position of lead independent director (or a similar position).  Surprisingly, there are many US companies which fall into this category.

If companies comply with the spirit of the new disclosure rules, shareholders should be given insight into the process by which the board decides upon the best leadership structure.  Ideally, when making this decision, the board will take into consideration issues such as the following: the person currently filling both roles;  the presence of a lead independent director and the person currently in that role; the current composition and effectiveness of the entire board and other governance structures currently in place; the compensation practices currently being used to motivate corporate leaders; the company-wide leadership succession plan; the competitive and economic situations facing the company, etc.  We can hope that all boards already have such a process in place, and discuss the issue as a standing agenda item on their annual board calendar.

However, it is not only important to determine the best structure for the company and the board “at the time of filing,” as the SEC requests.  Boards should also acknowledge that this structure may not always be appropriate.  The board’s decision would not be complete until they also discussed and decided upon the changes that would lead to the need to reassess the leadership structure.

Along those lines, the SEC should consider requiring companies to disclose whether or not there is a succession plan in place for board and company leadership.  I understand that companies will not disclose the details of succession plans, but telling shareholders that one is in place and describing the role the board plays in creating, reviewing and updating the plan should be given consideration.

In the rule proposal, the SEC is careful to point out that they are not taking a stand on which leadership structure is preferred, stating that “… we note that different leadership structures may be suitable for different companies depending on factors such as the size of a company, the nature of a company’s business, or internal control considerations, among other things.” However, we do hope that, if approved, the requirements for more disclosure will ensure that all boards are having meaningful discussions and debates about the appropriate leadership structure for their companies, both currently and in the future.

Annalisa Barrett — Senior Research Associate

Mary Schapiro On Point

As we wind down our proxy season data collection and gear up to analyze the fruits of our labor, we would be aided by many of the proposed changes that SEC Chairman Mary Schapiro described in her testimony Tuesday (http://www.house.gov/apps/list/hearing/financialsvcs_dem/sec_testimony.pdf). Among the various improvements she described that the SEC has been working to propose and implement are proxy access (allowing alternative director candidates to be included on a proxy), expanded CD&A explanation of compensation policies (to include those regarding lower-echelons of employees beyond just the Named Executives), expanding disclosure of board information (to include qualifications of directors, among other details), requiring earlier disclosure of voting results after annual meetings, and elimination of broker votes on uncontested director elections.

All of these efforts would help shareholders, largely by improving the culture of accountability at their companies.  Needing to publish information often has an impact on the information itself – the proverbial “sunlight” on the issues at hand – and these proposals go far in this regard. Others improve the timing of information (there’s another proverb – time being money) which also aids shareholders and their efforts, giving closure to outstanding issues, and informing them of those still to be addressed. Yet others, like fighting “ballot-stuffing” and allowing for competition for a board seat, simply right past wrongs. Schapiro’s testimony was a refreshing view into an agency that is doing good in a tough time.

Michelle Lamb — Research Associate

Obama Reform for the Financial Sector

The White House has put forward one of the most comprehensive regulatory reforms of the financial sector ever (http://www.financialstability.gov/docs/regs/FinalReport_web.pdf).  Most importantly for investors and boards from a governance perspective are the strengthening of investor protection that are covered. These include increasing transparency, and Say on Pay. Details are below. In addition, the Financial Stability Board’s compensation principles, which largely deal with the integration of risk assessment into compensation practices, are recommended to the Basel Committee on Banking Supervision. Also, the proposal calls for a single set of global accounting standards. The very long list of reforms is given below:
 

• create a Financial Services Oversight Council
• implement heightened consolidated supervision and regulation of all large, interconnected financial firms
• strengthen capital and other prudential standards for all banks and bank holding companies
• close loopholes in bank regulation
• eliminate the SEC’s programs for consolidated supervision
• require hedge funds and other private pools of capital to register
• reduce the susceptibility of money market mutual funds (MMFs) to runs
• enhance oversight of the insurance sector
• determine the future role of the government sponsored enterprises (GSEs, like Fannie Mae and Freddie Mac)
• strengthen supervision and regulation of securitization markets
• create comprehensive regulation of all OTC derivatives, including credit default swaps (CDS)
• harmonize futures and securities regulation
• strengthen oversight of systemically important payment, clearing, and settlement systems and related activities
• strengthen settlement capabilities and liquidity resources of systemically important payment, clearing, and settlement systems
• create a new Consumer Financial Protection Agency
• reform consumer protection
• strengthen investor protection
• The SEC should be given expanded authority to promote transparency in investor disclosures.
• The SEC should be given new tools to increase fairness for investors by establishing a fiduciary duty for broker-dealers offering investment advice and harmonizing the regulation of investment advisers and broker-dealers.
• Financial firms and public companies should be accountable to their clients and investors by expanding protections for whistleblowers, expanding sanctions available for enforcement, and requiring non-binding shareholder votes on executive pay plans.
• Under the leadership of the financial services oversight council, we propose the establishment of a financial consumer coordinating council with a broad membership of federal and state consumer protection agencies, and a permanent role for the SEC’s investor advisory committee.
• Promote retirement security for all Americans by strengthening employment-based and private retirement plans and encouraging adequate savings.
• create a resolution regime for failing bank holding companies, including tier 1 FHCs (tier 1 FHCs are: firms whose failure could pose a threat to financial stability due to their combination of size, leverage, and interconnectedness)
• amend the Federal Reserve’s emergency lending authority
• strengthen the international capital framework
• improve the oversight of global financial markets
• enhance supervision of internationally active financial firms
• reform crisis prevention and management authorities and procedures
• strengthen the Financial  Stability Board
• strengthen prudential regulations
• expand the scope of regulation
• introduce better compensation practices
• In line with G-20 commitments, we urge each national authority to put guidelines in place to align compensation with long-term shareholder value and to promote compensation structures do not provide incentives for excessive risk taking. We recommend that the Basel Committee on Banking Supervision expediently integrate the Financial Stability Board principles (http://www.financialstabilityboard.org/publications/r_0904b.pdf) on compensation into its risk management guidance by the end of 2009.
• promote stronger standards in the prudential regulation, money laundering/terrorist financing, and tax information exchange areas
• improve accounting standards
• tighten oversight of credit rating agencies

It’s quite a list. Visit the CorporateCounsel.net's blog posts on the paper as well.

Paul Hodgson — Senior Research Associate