Regulation of proxy advisory firms

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This article was written by Joseph Muraca and Antony Freeman.


Some of Australia's leading corporate personalities have recently expressed serious concerns about the influence, voting records and intentions of proxy advisory firms.

This followed a relatively turbulent 2016 'AGM season' for an unprecedented number of major corporates who faced significant protest votes on resolutions relating to remuneration (including short-term incentives and 'soft' versus 'hard' targets) and certain governance initiatives.

This article looks at whether these concerns are warranted and at the same time discusses potential reform proposals to address the concerns.

Our view is that it is time for a code of conduct to be developed by the industry (potentially in conjunction with ASIC) to improve transparency, accountability and disclosure of conflicts, while ensuring proxy advisors remain independent and free from greater pressures during peak periods.

Evaluating the behaviour and influence of proxy advisors

Despite claims by reform advocates that proxy firms provide 'thoughtless recommendations' and wield excessive influence over voting results, it's hard to prove that any particular voting recommendation is without merit. Established governance guidelines, such as those developed by the ASX Corporate Governance Council, do provide a framework for proxy firms to develop a standardised 'checklist' to test company performance and help frame voting recommendations. But, there is always a subjective element to voting recommendations that is not helped by the binary categorisation of recommendations into 'yes' or 'no'.

At the same time, it's not always easy to determine what is an "optimum" outcome for a company on a particular resolution. Reasonable minds can differ, for example, on when it is time for a valued long-standing director to retire.

How influential are proxy advisors?

The jury is out on whether the recommendations of proxy firms actually distort overall voting results. This uncertainty was noted by the European Securities and Markets Authority (ESMA) in its Final Report on the role of the proxy advisory industry, where it stated that it had "not been provided with clear evidence of market failure in relation to how proxy advisors interact with investors and issuers". ESMA further noted that although there is a perception of some degree of influence of proxy advisors on voting outcomes, clear evidence is rarely available.

In the US, the Council of Institutional Investors (CII) affirmed ESMA's position in an open letter to a Senate Committee opposing the tighter regulation of proxy advisors. The CII cited evidence indicating that although ISS, the US' largest proxy firm, recommended against 'say on pay' proposals at 12 per cent of Russell 3000 companies in 2016, only 1.7 per cent of those proposals failed to receive majority support from shareholders.

Why industry reform is still necessary

We think there are compelling reasons for reform of the proxy advisory industry. This is despite the lack of conclusive data relating to the influence of proxy firms, and although anecdotal evidence indicates that market forces have led to the preference of certain proxy firms over others because of the quality of their advice and analysis.

First, a prevailing perception amongst some that proxy firms lack the requisite levels of transparency, objectivity and resources is enough of a motivator to warrant reform. Without minimum standards, questions as to the integrity of proxy advice carry additional weight, providing boards with an 'out' where they can blame 'shoddy' proxy advisors for poor AGM results, deflecting scrutiny away from their own performance.

Secondly, the absence of minimum standards and a concentrated pool of market participants also results in a lack of real accountability for proxy firms. Even for proxy firms which hold an Australian Financial Services Licence, there is no requirement to go beyond certain basic measures mandated by the Corporations Act, including:

  • disclosing potential or actual conflicts of interest that may exist (for example, whether a report was sponsored by a client) and the policies in place to manage such conflicts;
  • providing the company in question with access to their proposed voting recommendations well before the AGM, to allow the company to respond to any adverse recommendations;
  • engaging company management in relation to areas of concern, to provide the company with the opportunity to rectify outstanding issues before voting recommendations are issued; and
  • maintaining appropriately resourced research teams, particularly during AGM season, to increase the reliability of proxy advice and ensure that staff are appropriately qualified.

If we are to assume that proxy firms have some level of influence over voting results, then these deficiencies may result in a range of unwanted outcomes. For example, while investors are not bound to follow voting recommendations, Australia's unique 'two strikes' rules can give disproportionate weight to unfavourable recommendations. Increasing use of a 'strike' to signal views on matters that are not related to remuneration provides further cause for concern.

Possible avenues for reform

Responses to proxy advisor related issues in comparable jurisdictions have including the following:

  • the issuance of non-binding policy guidance encouraging proxy advisory firms to establish, maintain and apply policies to identify and manage conflicts (Canada);
  • the introduction and development of an industry code of conduct, overseen by a regulator, that deals with the identification and management of conflicts, disclosure of voting methodologies and the provision of information on proxy advisor engagement with companies (EU); and
  • prescriptive legislation covering the areas of conflicts, engagement, advanced voting recommendations and resourcing, such as the Corporate Governance Reform and Transparency Act of 2016, which failed to pass Congress last year (US).

Why we support the introduction of an industry code of conduct

We think a nuanced approach is needed that balances the need for proxy advisors to remain independent and free from greater pressures during peak periods, but encourages proxy firms to improve transparency, accountability and the disclosure of conflicts of interest. We believe that the best way of achieving this balance is through an industry code of conduct, for the following reasons:

  • (Influence) there remains a lack of conclusive evidence surrounding the influence of proxy firms on voting outcomes. The 'stick' of a legislative approach is unnecessary given this lack of certainty.
  • (Disclosure of conflicts) improved disclosure and mitigation of conflicts of interest can be achieved through a code of conduct that ensures proxy advisors provide details of any conflict and the mitigation steps taken, without the need for additional red tape.
  • (Enforcement costs) requiring a regulator to constantly assess proxy firms' policies and behaviour would place a significant burden on regulatory resources. A code of conduct could still ensure firms disclose their voting policies and methodologies and provide details of their expertise and resourcing in particular markets.
  • (Independence) large companies have significant recources at their disposal to pressure proxy advisors. Providing companies with a right to view draft recommendations and argue their cause poses an unnecessary risk to the independence of proxy advice. A code should encourage proxy firms to publish details of any discussions with companies, but engagement should not be mandated.
  • (Barriers to entry) mandating certain qualification standards or staffing levels is likely to increase cost pressures, potentially reducing the number of firms in the market. A code of conduct could require proxy advisors to disclose their relevant expertise and depth of market knowledge without restricting competition and increasing the cost of proxy advice.

A role for ASIC

The process of drafting, implementing and enforcing a code of conduct would be best supervised by ASIC to ensure the proper principles are put in place and that the code's governance procedures are adequate. As ESMA has done in the EU, ASIC could also outline its expectations for the code upfront, including the principles it would like to see included, and monitor its implementation with periodic 'health checks'. If the industry fails to develop and enforce the code appropriately, ASIC could then assess the need for more prescriptive measures.

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