The Deal: SEC's Gallagher Sounds Alarm on Proxy Advisory Firms

NEW YORK (The Deal) -- Dan Gallagher, a Republican member of the Securities and Exchange Commission, on Tuesday argued that best practices being implemented by proxy advisory firms globally aren't going to be enough to alleviate his concerns that the firms are too powerful because some institutional investors rely on their recommendations for key shareholder votes on proxy battles and other matters.

"We have to be skeptical," Gallagher told reporters after speaking at a governance conference at the agency Tuesday.

At issue are the two U.S. proxy advisory firms, Glass Lewis & Co. and Institutional Shareholder Services. Critics of the advisory firms argue that at times the firms have conflicts of interest that they don't disclose even as their recommendations carry a great deal of weight with some of their institutional investor clients who often automatically follow the recommendations. The corporate community has raised concerns that ISS and Glass Lewis are a duopoly that drives many institutional investors to follow their advice, which often include recommendations in favor of dissident director nominees or shareholder proposals that seek to have companies remove anti-takeover protections. His comments come as the SEC plans to hold a roundtable discussion Thursday on whether the agency should hike regulations on proxy advisory firms.

Gallagher's comments also come as the European Securities and Markets Authority has encouraged the proxy advisory industry to develop its own consistent global code of conduct. At the same time the U.S. proxy advisory industry has provided for public comment a set of draft best practice principles. However, Gallagher reiterated a comment he made in June that he would like the SEC and Department of Labor to change their guidance in a way that tells investors that they can no longer rely on proxy advisory firms to decide how to vote, a change that would give the firms less power, and pressure investors that rely on proxy advisory firms to do their own due diligence.

Academics have produced various studies arguing that anywhere from 6% to 30% of institutional investors rely blindly on recommendations on votes made by ISS and Glass Lewis. These observers agree that smaller institutional investors, such as midsized mutual funds, are the ones that rely on the proxy advisory firms while larger shareholders such as the California Public Employees' Retirement System or BlackRock (BLK), have large teams that conduct their own due diligence before deciding how to vote. These large institutional investors often vote in a way that is contrary to recommendations made by proxy advisory firms, indicating that they make their own independent judgment.

University of Pennsylvania Law professor Jill Fisch said that based on her analysis, roughly 6% to 10% of institutional investor votes rely on ISS, "after controlling for other factors."

Katherine Rabin, chief executive of Glass Lewis, told reporters that institutional investors "aren't relying on proxy advisory firms." She added that proxy advisory firms plan to apply the ESMA code globally, adding that removing the SEC guidance wouldn't have much of an impact on voting decisions.

"We provide research and data and in large part custom policy implementation. We are helping them [institutions] implement the custom policies they seek. They develop their own policy," she said.

Rabin added that if Glass Lewis recommends against a corporation's executive pay decisions, companies will use that as a trigger to conduct their own more-detailed research and analysis for that company.

However, Gallagher refuted assertions that fewer than 10% of institutional investors rely on the proxy advisory firms, arguing that "they have to tell you the truth" when responding to questions on whether they make their own independent assertions. He added that even if one fund blindly relies on the advisers "then that is too many."

Gallagher acknowledged that the smaller institutional investors typically don't have the capital or ability to hire individuals focusing on these kinds of votes and that the SEC should tailor its new guidance taking into account the size of firms and "whether the full panoply of responsibilities should apply to everybody." He stopped short of saying that smaller institutions should be exempt from conducting their own due diligence on proxy fights and other matters. Gallagher suggested to reporters that some smaller institutional investors could be pressed to conduct a due diligence on more important nonroutine votes such as proxy fight director elections and not have to worry about less important routine votes.

"You could differentiate the types of votes. There is compulsion to vote and if there were categories, routine vs. nonroutine, for votes it would make life a lot easier for sure," he said.

However, Fisch said that having these firms only vote on nonroutine matters would not make life easier for them because of the ever-increasing number of key votes that are nonroutine. "Identifying the universe of so-called routine votes is pretty hard," she said.

She acknowledged that smaller mutual funds and smaller pension funds rely on the proxy advisory firms, noting that proportionately they account for relatively few votes as a percentage of total votes cast in the U.S.

Fisch added that her studies compared institutional investor votes to the proxy advisory recommendations and showed that many votes are different from proxy advisory firm recommendations. The discrepancy, she argued, demonstrates that most midsize and larger institutional investors exercise their own independent judgment.

She added that having the SEC take away its guidance that allows institutional investors to rely on proxy advisory firms on voting matters would create a void for many smaller firms, which she said she believes would have lower returns if they have to "do the work" on deciding how to vote on governance matters.

Written by Ronald Orol

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