Proxy advisors as regulatory spawn

Larry Ribstein —  26 October 2010

John Carney comments on the rise of proxy advisory firms.  He attributes this partly to increasing complexity caused by the securities industry.  He notes the irony that “[r]eforms to securities regulations that were ostensibly intended to empower shareholders or further ‘shareholder democracy’ have instead resulted in increasing domination of proxy questions by a small clique of advisors.”  Of course this irony is to be expected, since shareholders’ rational passivity renders the whole “democracy” notion simply an artifact of regulators’ imagination.

So, as Carney says, this is really about firms’ protecting themselves from proxy regulation requiring institutional investors to vote in their clients’ interests.  The funds cover their rear ends by “outsourcing” the decisions to “a small clique of advisors” whose interests may be more aligned with certain large institutional investors than with small investors the rules were supposed to help.

Even worse, Carney notes the “frightening parallels” between proxy advisors and credit rating agencies, who also “saw the demand for their services grow largely due to demand driven by regulation. Because the demand was not driven by genuine market demand for analysis, ratings agencies were able to profit while providing poor credit analysis.”

In better world, we would get competition among many different governance models, enabled by state law.  In the world to which we are rapidly moving, we get one-size-fits-all federal regulation overseen by a rigid oligopoly.

I should note that these problems aren’t new.  Four years ago, in my review of Paul Rose’s Corporate Governance Industry, I noted that the institutional investors paying for advice from firms like ISS and Glass Lewis, were buying “criticism insurance.” They were protected not only from the regulators, but from critics like Gretchen Morgenson.

Larry Ribstein


Professor of Law, University of Illinois College of Law

4 responses to Proxy advisors as regulatory spawn



    You’re assuming that they are correct in believing (if they really believe) that there is no economic incentive for monitoring agency costs. Actually, there are two: one, more and more of their clients are demanding it; two, that poor governance is a risk factor, and correlates over the longer term with poor (often spectacularly poor) performance.

    I know, there are some studies that claim to demonstrate otherwise, but they were, I believe, poorly constructed in two respects. First, they almost always looked for positive correlations between high governance scores and outperformance; governance is not a positive performance factor for the same reason that being law-abiding is not a sufficient reason in itself to hire someone—it’s an important requirement, not a sign of growth or performance potential. Second, most of the studies were event-driven. As with most risk factors, the event does not occur when the risks are first taken, and certainly not when they are ameliorated—they will occur somewhere down the road. As a veteran portfolio manager, I can assure you that plenty of investors who were told they might be supping with the devil, but thought they would have time to get out safely, ended up losing barrelfuls of money.

    There is another issue: many institutions do not pay for an in-house governance program primarily because their directors or trustees passionately hate the idea. They hate the idea because they are also CEOs and directors of other companies which may at some point be the object of governance concerns. It’s a conflict of interest problem as much as it is a problem of demonstrating and quantifying the economic incentives.

    I know: in an ideal efficient market, higher agency costs will translate rapidly into a higher cost of capital and underperformance. The problem is that this assumes (a) that the market is monitoring those agency costs itself, and (b) that real-life capital markets are efficient. I think we have had enough practical experience with efficient-market theorists in recent years to demonstrate that markets are far from perfect, or at least that when they return to equilibrium, it is sometimes with a very long lag and often a violent over-correction. As for the market being potentially a sufficient monitor of agency costs, yes, it does have this potential at least in theory, (which does create a free-rider problem), but this is not solved by abolishing (or crippling) proxy advisors, nor by recommending that all investors vote blindly with management.

    Douglas B. Levene 26 October 2010 at 6:09 pm


    You haven’t addressed Prof. Ribstein’s point, which is that most institutional investors have no economic incentive to devote any resources to monitoring agency costs. The only reason they outsource that activity – by buying advice from proxy advisory firms – is that they are required to do so. So, there’s no reason to expect to them to care very much about the quality of the advice they are getting.



    Of course, we never had abuses of power by directors and chief executives before the regulators started empowering shareholders, did we?

    The problem of the power of the proxy advisors is analogous to that of the credit rating agencies for one reason: most institutional investors refuse to dedicate any resources to dealing with these issues, so they outsource it. If instead of regarding governance issues as a nuisance artificially created by regulators, they attempted to integrate consideration of them into their investment process, they would (a) be capable of making independent judgments rather than merely trying to cover their rear ends by relying on someone else’s opinion, and (b) they would only make a fuss about substantive governance issues—but they would really make a fuss about those.

    There is another important analogy with credit rating: as we saw in 2007 – 2008, it wasn’t that the ratings were unimportant, it was that they had been corrupted. And they were corrupted because bond investors insisted upon having a measure of risk, but refused to pay anything for it themselves. So the issuers paid instead. Similarly, one may argue that the recommendations can be important (yes, most of them are routine, but there’s no controversy here), and that they key issue is only whether the system has been corrupted or not. The analogy to the credit rating system would only hold if the companies themselves were paying for the governance advisors’ recommendations. There have been accusations that ISS has some conflicts of interest due to the fact that they also have a consulting service for issuers, but they claim to be careful to avoid those conflicts, the other proxy advisors have no such conflicts, and in any case, the complaint Mr. Carney is making is that on the contrary, the recommendations are anti-management. It would be as if one argued that the credit ratings agencies were an unnecessary nuisance because ratings on a lot of paper were too low, not that they were too high.

    I agree that it would be better if more investors did some research on these issues and thought for themselves, rather than relying entirely upon third-party recommendations. But they would have to be prepared to spend a bit more on staff dedicated to considering these issues from an investment point of view. As it is, there is an almost total lack of coordination between corporate governance and investing at most institutions in the U.S. Then, when something that has been flagged for years goes very wrong, the portfolio managers who had ignored the risk run screaming to their lawyers, and a raft of after-the-fact litigation results. Is this really the better way to run this particular railroad?

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