Institutional Shareholder Services, the dominant player in the business of telling big shareholders how to vote their proxies, is facing increased scrutiny of potential conflicts of interest.

For years, ISS has accepted payments both from large shareholders -- who buy access to its reports on proxy matters and corporate governance rankings -- and from the very companies whose business it scrutinizes and ranks. But a recent opinion letter from the

Securities and Exchange Commission

has encouraged institutional investors, who often follow ISS advice on company referendums, to take a closer look at ISS' relationship with its corporate clients. Such clients pay for services that can help them improve their ISS ratings.

While the SEC didn't forbid such relationships, it did warn that they could lead to conflicts of interest. Proxy advisers have a duty to disclose to their investor clients "relevant facts" about their relationships with the companies they cover, such as the amount of fees the advisers have received from those companies, the SEC stated.

At the same time, institutional investors have a responsibility to determine whether the proxy advice given by research companies such as ISS is in the best interest of clients -- mutual fund investors, for example -- or whether it was motivated by the research companies' determination to serve their own corporate customers, the SEC said in its letter, sent May 27.

"An investment adviser could breach its fiduciary duty of care to its clients by voting its clients' proxies based upon the proxy voting firm's recommendations because the proxy voting firm could recommend that the adviser vote the proxies in the firm's own interests, to further its relationship with the issuer and its business of providing corporate governance advice, rather than in the interests of the adviser's clients," wrote Douglas Scheidt, the associate director and general counsel in the SEC's investment management division, in a letter to ISS rival Egan-Jones.

The SEC letter didn't specifically refer to ISS, but the company is the leading proxy adviser, influencing an estimated 20% of shareholder votes at a typical public company. Competitors such as Glass Lewis and Egan-Jones don't provide services to the companies whose proxies they analyze -- and have tried to use that fact to differentiate their research from that of ISS.

"Lots of people have been concerned about this lack of disclosure and potential conflicts of interest," said Greg Taxin, CEO of Glass Lewis. "What ISS is doing is holding steadfast in a business model that has inherent conflicts."

The letter represents an extension of an SEC rule enacted last year that requires institutional investors to avoid potential conflicts of interest in their proxy votes. The rule arose following the proxy battle over Hewlett-Packard's merger with Compaq.

The SEC charged that a unit of Deutsche Bank voted on the merger without disclosing to clients that its investment bank was working for HP on the deal. Deutsche Bank

paid a $750,000 fine to settle the charges, but didn't admit to any wrongdoing.

ISS has responded to the SEC letter with a statement on its Web site and a Webcast with clients earlier this week. The firm tried to reassure clients that it is mindful of the potential conflicts of interest and has taken steps to address them.

The portion of ISS' staff that serves public companies works on a different floor of the ISS office building than the proxy adviser's research staff that analyzes proxies, said Cheryl Gustitus, a spokeswoman for ISS. The two staffs' database systems are separate as well, she said.

Moreover, investor clients can find out about ISS' relationship with customers by simply sending an email to ISS, Gustitus said. "We have been as transparent as anyone could be to make sure perceived conflicts of interest don't turn into real conflicts of interest," she said.

According to Gustitus, about 15% of ISS' revenue comes from its 400 corporate clients, with the remaining 85% coming from institutional investors. Considering that the firm analyzes some 8,600 proxies, reflecting virtually all U.S. public companies, during the regular proxy season, ISS likely issues investor reports on the proxies of nearly all its corporate clients, she said.

Despite the steps ISS takes to avoid conflicts, its recommendations involving its corporate clients has sparked some skepticism. The ISS' recent proxy report on

eBay

(EBAY) - Get Report

is a case in point.

At its annual meeting this year, eBay is

asking shareholders to approve a plan that would increase its pool of stock options for company employees by some 24%. ISS rival Glass Lewis has recommended that shareholders vote against the plan, calling eBay's options plan "egregious."

In contrast, ISS is

advising shareholders to vote in favor of eBay's plan. ISS noted that the cost of eBay's plan came in below ISS' predetermined limit. What ISS did not disclose in its report is that eBay is a customer.

eBay paid ISS $15,600 this year for access to the firm's Corporate Governance Quotient service, which grades the structure and policies of companies' boards of directors, according to Gustitus. Meanwhile, in March, prior to issuing its proxy statement, eBay paid $8,600 for access to ISS' ISSue Compass product, Gustitus said.

ISSue Compass is a proprietary formula developed by ISS to evaluate stock option plans. By using ISSue Compass, companies such as eBay can determine how much a particular stock plan would cost shareholders, according to ISS' reckoning, and how much dilution it would cause, said Gustitus. The service also allows companies to see how those values would change if they adjusted their plan assumptions, such as the number of shares issued.

Officials at eBay did not return calls seeking comment on the company's relationship with ISS.

When determining what to recommend on a particular stock plan, ISS researchers use essentially the same formula.

The formula that ISS uses is "demonstrably unsound," charged Gary Lutin, an investment banker and shareholder rights advocate. "Even if it could be relied upon, they sell a service

that allows companies to game the thing. Under these conditions, how can someone with a fiduciary duty be relying on their advice?"

Gustitus denied that companies with access to ISS' governance and options models can "game the system." The company's research department considers each proxy independent of any business dealings that ISS may have with a corporation, she said. Just because a company buys access to ISS' formulas doesn't mean that the proxy adviser will automatically give its stock plan or governance the thumbs up, she said.

"That's where everyone makes same leap," she said, adding, "that's just dead wrong."

Meanwhile, Gustitus quickly responded to a series of email messages requesting information on ISS' relationship with eBay. But the fact remains that investors wouldn't otherwise know about that relationship from reading ISS' report.

That lack of disclosure stands in contrast to statements that ISS Special Counsel Pat McGurn made last year to the

Wall Street Journal

. McGurn said that it was ISS' policy to disclose its relationship with corporate clients in its reports on those clients' proxies. When that disclosure was not present -- as it wasn't with a number of reports last year -- it was due to "operational missteps," he told the

Journal

.

ISS changed its policy last July, after the

Journal's

report, Gustitus said. Instead of routinely disclosing its relationships with corporate clients, the company now places a disclosure on its reports warning investors that it may have done business with the corporation it is reviewing and directing further questions about its possible relationship to an email address.

"They are asking their clients to undertake a new obligation so that ISS can remain with a foot in each business," said Taxin. "That seems like an extraordinary thing to ask a client to do."

But Gustitus said ISS moved to the email model for disclosing potential conflicts because each of its investor clients seemed to have different questions about its corporate relationships. Since the SEC issued its letter, about 12 of ISS' investor clients have contacted the firm to inquire about those relationships, she said. ISS has some 1,000 investor clients globally, of which about 300 are affected by the SEC's recent guidance, Gustitus said.

"This seems to work for the clients," she said. "They can literally ask us what they need to ask us, and we can give whatever information they need."