Mixed views on proxy advisor regulation

The CSA’s paper, which seeks market feedback on whether there needs to be some regulatory intervention in the proxy-advice business, garnered extensive feedback – from both Canadian market players and firms in other countries, including the U. S., the Netherlands and India.

If the CSA consultation has produced any consensus, it’s that issuers and investors are sharply divided on the issues raised. Generally, institutional investors suggest that there really is no need for regulatory intervention; in contrast, issuers have many concerns with the role these firms play, and they are keen for the regulators to step in.

In many ways, the dilemma of whether or not to regulate proxy-advice firms parallels the problem presented by credit-rating agencies before the CSA decided to regulate them.

Much like the credit-rating agencies, proxy advisors play a critical role in the capital markets, but they do so outside the scope of regulation; being neither issuers nor investors, proxy-advice firms don’t have to register and are free from regulatory oversight.

Moreover, the concerns about proxy advisors are much the same as those the credit-rating agencies had faced before they were herded under regulatory supervision.

Critics of the role that proxy advisors play worry that institutional investors too often follow recommendations blindly, as many investors did with credit ratings in the run-up to the financial crisis.

The critics also fret about the lack of transparency in the formulation of voting recommendations and about possible conflicts of interest between their advisory role for investors and the other services they offer to issuers. These concerns are similar to those that had dogged the credit-rating agencies.

And so, the question that regulators face with the proxy advisors is much the same as those they had with the rating agencies: do proxy advisors need to be regulated; and, if so, how?

In the case of the credit-rating agencies, the CSA initially proposed to adopt a “comply or explain” approach, which would have required firms either to adhere to industry best practices or explain why they did not.

However, amid concerns that this approach wouldn’t be considered strict enough by regulators in other jurisdictions (which would have prevented the use of Canadian credit ratings in those markets), the CSA toughened its stance and introduced a new regulatory framework for credit-rating firms. That framework requires that firms seek regulatory approval and imposes various rules concerning conflicts of interest, governance and conduct along with reporting requirements. Now, the CSA is considering similar options for the proxy-advice firms.

Of course, the significant difference between the two situations is that the financial crisis – and the contributory role played by the credit-rating agencies – made a compelling case for regulatory intervention. So far, proxy-advice firms haven’t been part of a similar market failure; thus, the case for regulation is much less clear.

Furthermore, it’s hard to see how proxy-advice firms could pose as big an unchecked risk as the credit-rating agencies had. In the latter instance, investors were placing undue reliance on conflicted opinions, which led to a massive misallocation of capital and a large buildup of unrecognized credit risk.

If investors lean too heavily on the allegedly conflicted, opaque opinions of proxy advisors, the only real risk is that this serves as a drag on a company’s management – perhaps denying the election of its preferred directors or imposing unwanted governance obligations on the firm. Although this may be a less than ideal situation, it doesn’t appear to represent a threat to the financial markets or economic catastrophe.

Nevertheless, it certainly appears that there is a good deal of interest and strongly held opinions about whether proxy advisors need to be regulated. To their critics (mostly issuers), proxy advisors play a significant role in the markets without any check on their actions.

That line of thinking is reflected in the submission to the CSA from law firm Norton Rose Canada LLP, which reports that it put together a working group of issuers (with a combined market cap of $120 billion) to consider the issues raised by the CSA’s paper. That submission says the working group believes that the activities of proxy advisors “should be regulated or subject to oversight, as they exercise substantial influence in the capital markets without the corresponding accountability or economic exposure.”

Norton Rose’s submission also notes that the need for supervision is heightened by the fact there is minimal market competition among proxy advisors. The only two real players in the market are Institutional Shareholder Services Inc., which is owned by research and analytics firm MSCI Inc.; and Glass Lewis & Co. (GL), which is owned by the Ontario Teachers’ Pension Plan Board. The fact there are so few players also means that there is no industry association to establish standards, so that role would fall to the regulators.

Indeed, it’s this lack of competition that lies at the heart of many of the concerns about proxy firms. According to the CSA paper, there appears to be a growing demand for proxy research; and with an ever-growing slate of complex issues for investors to review and limited capacity, some critics believe proxy advisors’ opinions have become increasingly influential. And as proxy advisors become more important, issuers believe these opinions need greater scrutiny. So, without flourishing competition in this space, critics would like to see regulators set some standards for proxy advisors.

Many of the issuers’ complaints boil down to what they perceive to be mistakes in proxy-advice firms’ opinions. For example: issuers worry that proxy advisors just don’t understand the compensation plans the proxy-advice firms are telling investors to vote against; may be relying on improper benchmarks; or may be arbitrarily setting inappropriate governance parameters that lead to voting recommendations against management.

Many issuers would like more transparency regarding how proxy firms arrive at their voting recommendations and more influence over those ultimate opinions.

The Canadian Investor Relations Institute’s (CIRI’s) comment recommends that: proxy advisors be required to disclose their methodologies, sources, assumptions and voting rationale; issuers be given an opportunity to correct any errors in proxy-advice firms’ reports and voting recommendations before they are distributed to shareholders; those reports include issuer comments; and a dispute-resolution process be set up to resolve disagreements over the information included in these reports.

The CIRI comment also says proxy-advice firms should be required to disclose any conflicts and that institutional investors be required to disclose how they assess advice from proxy-advice firms.

Some comments suggest that regulators should require proxy-advice firms to register – and enforce those requirements. Other comments call for a lighter touch, such as adopting a non-binding policy to encourage compliance with a set of best practices.

Conversely, among investors, the lack of competition in the proxy-advice business is presented as a reason to avoid regulation. Investors argue that any sort of regulation could create a needless barrier to entry, which would prevent competition from emerging.

“We would not wish to see a situation in which unnecessary or premature regulation reduced competition between service providers,” states the comment from Toronto-based fund-management firm Northwest and Ethical Investments LP. “We already consider the number of players in the market to be rather limited, and would prefer to see more choice.”

Moreover, the proxy-advice firms dispute the wisdom of requiring them to engage with issuers. GL’s comment contends that what companies perceive to be mistakes are often just genuine differences of opinion, not factual matters that require correcting.

Furthermore, GL’s comment resists the suggestion that proxy firms should be required to provide their research to issuers before delivering it to shareholders, warning that “companies would undoubtedly take advantage of the report review opportunity to lobby [proxy advisors] on policy and vote recommendations, severely limiting the utility of the exercise.”

Thus, GL’s comment frames the issue as a question of free speech, and says any obligation to give proxy-advice reports to issuers before they are published “would have a deeply chilling effect on the freedom of expression… and cannot be justified merely because the views expressed in such reports might be controversial or even erroneous.”

That said, GL’s comment indicates the firm is looking at how it could provide issuers with access to the data GL uses in its analysis prior to issuing reports, which may enable companies to factcheck the underlying data. In addition, GL’s comment says, the firm is open to working with the rest of the proxy-advice industry to develop an industry code of conduct to govern policy and research development, conflict management and disclosure, and transparency.

However, GL’s comment staunchly opposes the idea that this code should be imposed by regulators, or even that proxy-advice firms be required to adhere to “comply or explain” standards set by the regulators.

© 2012 Investment Executive. All rights reserved.