Proxy Advisory Services Regulation: What’s Good For the Goose…

As a commentator, one of the best things you can find to write about is when you come across someone being totally disingenuous; it’s almost as good as when companies do something really stupid (for which see “How Not to Run a Conference Call” December, 2007 and “What Was He Thinking, Whole Foods Version”, August 2007).

Which brings me to this week’s subject, the possibility of the Securities and Exchange Commission imposing regulations upon proxy advisory firms. Proxy advisory firms have grown in size and influence over the last twenty years. Their positions on corporate governance, compensation and proposed mergers and acquisitions have become important to both investors and corporations, creating in effect, de facto standards. Yet the manner in which the proxy advisory firms reach their recommendations and ratings, the formulas they use when looking at compensation and equity plans, and the process by which they make recommendations regarding merger and acquisition activity are considerably less than transparent. Further, the amount of research available to support their positions on corporate governance is less than overwhelming and far from conclusive. Finally, some firms, such as ISS, have actively worked both sides of the street, advising institutions how to vote and selling their consulting services to corporations to tell them how to structure things in order to get approval and high ratings from ISS.

So when the Securities and Exchange Commission asked for comments on the proxy process earlier this year it is not surprising that a number of comments came back suggesting that proxy advisory firms be subject to some regulation from the SEC, namely that proxy advisory firms should be subject to proxy rules and regulated as investment advisers, including mandated disclosure of specific conflicts of interest, transparency on how they develop their ratings and recommendations, and that they adopt procedures ensuring the accuracy of their reports and voting recommendations.

It seems as though the proxy advisory firms, which like more regulation for corporations, are not so happy when the shoe is on the other foot. Here’s Nell Minow, Chair of The Corporate Library and former general counsel and CEO of ISS in a comment letter to the SEC: “I would like to object in the strongest possible terms to the possible regulation of proxy advisory services.” Later in her comment letter, she goes on to explain how market forces will keep the proxy advisory services honest.

In other words, if we just let competition work without government getting in the way, everything should be fine. Of course this is exactly what they say doesn’t work for corporations when they want more regulation on say on pay, proxy access, compensation disclosure and a whole host of other corporate governance issues.

It does seem to make sense that these firms, which have a great deal of influence in how investment firms vote should at least be required to disclose the methodology by which they come to their ratings and recommendations, disclose any potential conflicts of interest (or better yet, be prohibited from conflicts of interest) and show they have stringent procedures in place to prevent inaccurate reports and recommendations.

After all, if increased disclosure and regulation is good for the goose (corporations), then it is certainly also good for the gander (proxy advisory firms).

Corporate Governance Ratings – What Are They Good For?

Way back in 1970, there was a Motown record that had as its catch phrase, “War, what is it good for? Absolutely nothin’!” Today, there is research that suggests that the same can be said about corporate governance ratings.

For the past ten years or so, investor relations practitioners have been drawn into the debate on corporate governance. It’s not that IR practitioners have a special expertise in corporate governance, or that many of them really want to become experts. It’s just that Boards of Directors have been under increasing scrutiny to comply with a list of “best practices” compiled by groups such as Institutional Shareholder Services (“ISS”), Governance Metrics International (“GMI”) and The Corporate Library. Directors do not like it when shareholders withhold their proxy votes for failure to meet minimum corporate governance scores. And it’s investor relations that talks to the shareholders, so IR people find themselves working with the Corporate Secretary and the General Counsel to find out how they can achieve the highest possible corporate governance scores to present to shareholders while actually changing corporate practices as little as possible.

The underlying premise of the governance rating services is simple, yet compelling on its surface: companies that focus on corporate governance as indicated by high ratings will, over time, generate superior returns and economic performance and lower their cost of capital. Conversely, companies weak in corporate governance as shown by low governance scores represent increased investment risks that should be penalized by a higher cost of capital.

But did you ever take a step back and wonder whether the corporate governance ratings have any value in actually predicting poor corporate governance or performance? I certainly have. And so too, it seems, have Professors Robert Daines of Stanford, Ian Gow of Kellogg and David Larker of Stanford. In a recent scholarly article, “Rating the Ratings: How Good Are Commercial Governance Ratings?” which is to be published in a forthcoming issue of the Journal of Financial Economics they look at how effective corporate governance ratings are in helping shareholders figure out if companies with high corporate governance scores are actually better governed. The findings are so startling and unequivocal that I am going to quote the article abstract in its entirety:

Proxy advisory and corporate governance rating firms (such as RiskMetrics/Institutional Shareholder Services, GovernanceMetrics International, and The Corporate Library) play an increasingly important role in U.S. public markets. They rank the quality of firm corporate governance, advise shareholders how to vote, and sometimes press for governance changes. We examine whether commercially available corporate governance rankings provide useful information for shareholders. Our results suggest that they do not. Commercial ratings do not predict governance-related outcomes with the precision or strength necessary to support the bold claims made by most of these firms. Moreover, we find little or no relation between the governance ratings provided by RiskMetrics with either their voting recommendations or the actual votes by shareholders on proxy proposals.

Inside the article the language is even stronger. Here’s my favorite quote: “One especially interesting result is that CGQ (perhaps the most visible governance rating) [Corporate Governance Quotient, a measure devised by RiskMetrics/ISS] exhibits virtually no predictive ability, and when CGQ is significant, more often than not it has an unexpected sign (e.g., higher CGQ seems to be associated with lower Tobin’s Q, and in some models more class-action lawsuits).” In other words, high governance scores have virtually no value, and companies that put in all of the so called best practices are actually more likely to be worth less and get sued more often.

What all of this suggests to me is that good oversight by the Board of Directors and good management of the shareholders’ assets is not a function of a formula or a list of practices. Rather, the way Boards and managements function needs to be examined by investors on a case-by-case basis in relation to their cultures and their track records. How Boards function does need more transparency so that investors can judge for themselves if they are practicing good stewardship. But those that think that good governance can be boiled down to a single number score are just kidding themselves. And if you are paying to get advice on how to increase your governance scores, you’re wasting corporate assets.

The Shifting Sands of Activist Investing

For about the past 6 – 7 years there has been a quiet revolution occurring in corporate governance. It has been an interesting process to watch as shareholders, usually led by union pension funds, have pushed for reforms in anti-takeover provisions, executive pay and director elections.  

The fact that it is the unions pushing for reform strikes me as ironic.  Regardless of how you feel about the need for collective bargaining, unions are not known as reforming forces.  Many union pension plans, in particular, have been grossly mismanaged, so for them to lead the charge for reform in corporate governance seems to be rich indeed.  When I gave this some thought, my conclusion was that a governance system has to be pretty broken for a group of union people to see an opportunity for reform.  So I took a hard look at the issues they chose to contest. 

Start with anti-takeover measures.  Companies usually experience a takeover bid in the form of an offer to purchase the company’s stock that is higher than the current stock price.  So anti-takeover measures, when all is said and done, are designed to allow management to turn down an offer that is higher than the current market price, but less than the managers think the company might be worth sometime in the future.  Presumably this is because the company managers know more about the company than the market and are in a better position to assess the true value of the company.  But wait, aren’t markets supposed to be efficient and incorporate all available information about a company into the stock price?  And aren’t managements supposed to disclose all material information about the firm to investors?  So anti-takeover measures really boil down to company management saying we want the ability to say no, because we believe that our two birds in the bush (the future value of the company) are worth more than the bird you have in hand (the takeover bid), because of information which we haven’t bothered to disclose, but which could make us real valuable in the future.  Sounds like a losing issue to me. 

Executive pay is an issue where corporations ceded the moral high ground a long time ago.  The pay packages you see for most CEOs of major corporations today are obscene.  The irony here is that the unions have persuaded Wall Street money managers, who often make almost as much as CEOs, to vote for reforms aimed at lower pay.  Maybe there’s a touch of envy involved. 

Finally, think about director elections.  I lived in Chicago for many years, so I’m not shocked by elections that are lopsided in favor of incumbents.  But under the current system for electing directors, you only need a single vote in favor of the director to get him elected.  You can’t vote against him, you can only withhold your vote.  This bears a strong resemblance to the old Soviet era politburo elections. 

If this were just about the obscure ways in which companies conduct their internal workings you could file this piece under important, but boring.  However, it seems that by allowing activists to learn how to win votes on easy issues, corporations are now starting to encounter a more sinister foe. 

According to a speech given by John Siemann of Laurel Hill Advisory Group at the NIRI 2008 Southwest Conference, hedge funds have become much more involved in the proxy activist arena.  ISS, the proxy advisory firm, now counts almost as many hedge funds as clients as it does union pension funds. For the hedge funds, the preferred method of attack is the “Short Slate” proxy fight, where an activist hedge fund nominates one or two directors for the board.  Once on the board, the new directors use their positions to agitate for items that may boost the near term stock price, such as special dividends, share repurchases and the sale or spin-off of non-core assets, at the expense of longer range initiatives.  According to Laurel Hill statistics, in 2006 – 2007, there were almost 200 short slate fights and in more than 66% of these situations, hedge funds won at least one seat on the board. Moreover, in almost 80% of the contests, ISS recommended in favor of at least one member of the dissident slate.  

So it would appear that having allowed the camel’s nose under the tent on issues that were hard to defend, corporations now find that they have provided a road map to investors to actively challenge the manner in which a corporation is being run.  I guess you really do reap what you sow.