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).

Say on Pay and Proxy Access – Start Thinking Now About Talking to Investors

The history of legislative and regulatory reform relating to Wall Street is one of egregious excess, followed by financial distress, resulting in laws and regulations being enacted. It first played out with the boom and bust of the Great Stock Market Crash of 1929, which gave us the Securities Act of 1933 and the Securities and Exchange Act of 1934. We saw a replay following the Enron/Adelphia/Worldcom/Tyco frauds in 2000, which resulted in the Sarbanes/Oxley Act. And now we are seeing the same scenario following the financial crisis of 2008 – 2009 as Congress is feverishly putting together a financial reform package.

I generally try not to pay too much attention to the legislative process, as things change frequently and the process is not pretty to watch. However, there are a couple of things that will likely be included in the current bill relating to corporate governance – proxy access and say on pay - that investor relations officers should be thinking about.

Corporate governance issues have traditionally been an area that falls within the purview of the Corporate Secretary or General Counsel with investor relations only becoming involved if the vote doesn’t look good or if some form of a contest is looming. As activist investors have increasingly turned to proxy proposals to agitate for corporate change, investor relations has gradually become more involved in the process because they are the ones that know the investors. If proxy access and say on pay are going to open up corporate governance to more public scrutiny, it behooves investor relations practitioners to start to get more engaged with the people who vote the proxies.

Of course, when you take a hard look at who does the voting, you realize that IR people have their work cut out for them. You can generally break down investor voting blocs into three categories: active long-term investors, passive investors and active short-term investors.

Active long-term investors usually don’t want to be bothered by this stuff. Portfolio managers and analysts want to analysis stocks, not get involved in corporate governance. Their compensation is benchmarked against their performance relative to an index, not against good corporate governance and they spend their time accordingly. The result is that these decisions are handled by either subscribing to one of the services such as ISS/Riskmetrics, handing it off to an internal committee if the firm is large enough, or by voting with their feet and selling the shares if they don’t like what management is doing. As a result, the typical investor relations officer usually doesn’t talk to the person casting the proxy vote.

Passive index investors can’t vote with their feet by selling the stock as long as a company is in an index, so they all have committees and policies regarding how to vote on governance items. From an investor relations perspective however, you never talk to these passive shareholders, so you don’t know anything about their committees.

Active short term investors are here today and gone tomorrow, so by the time they appear on a 13 D report, they may have well sold the shares and moved on.

I would suggest that investor relations departments need to be proactive in discussing potential vote issues with the people who actually vote the shares. I’ve written about this before (see my post of February 10, 2010), but here are a couple of suggestions to bridge this gap: First, well in advance of proxy season, investor relations officers, together with their securities law counsel, should schedule a number of calls to key investors (both active and passive long-term investors) to discuss current disclosure issues in areas such as compensation and governance. The calls should be designed as a dialogue to discover how these investors view the topics, not as advocacy. as you can’t solicit votes without a proxy statement. What investors are interested in can then be incorporated into your compensation and governance disclosures. Secondly, when you’re out on non-deal road shows, ask to spend five minutes at the end of a visit discussing the firm’s views on disclosure issues, whether they be compensation, governance or social responsibility. This actually makes for a nice break in the road show meeting rat race as it introduces a new topic into the discussion. In the larger firms this will mean that they will have to bring in someone at the end of the meeting, as there is usually a separate person that deals with proxy voting, but it is well worth the effort as it gives upper management an opportunity to hear investors’ concerns and thinking.

This doesn’t solve all issues, as sometimes the interests of investors about compensation and governance structures are different from management’s, but at least you’ll know prior to the vote being cast and can do more accurate predictions at proxy time.

Talking to Investors Before They Vote Their Proxy

I recently had the pleasure of being interviewed for a podcast by Broc Romanek who writes the blog The Corporate Counsel (www.thecorporatecounsel.net/blog). Broc’s blog is one of the best around for digging into the technical requirements surrounding dealing with the SEC. Sometimes the stuff is way too technical for me (and I used to practice securities law), but other times the information is really useful. Just to take and example, with Washington buried under two successive snowstorms that have shut down federal government offices, you might wonder how that affects your SEC filings that may be due or that you might wish to file. Broc knows and you can find out on his blog.

Broc’s interview was on one of my favorite topics, trying to place a value on investor relations. For those of you who want a quick overview (the whole podcast is only 8 ½ minutes long) on what the research says about the value of IR, you can find it here: http://www.thecorporatecounsel.net/nonMember/InsideTrack/2010/02_10_Palizza.htm

If you want fuller treatments about the research, see my blog post of July 7, 2008. Broc was even kind enough to put in a plug for my upcoming seminar, “Fundamentals of Investor Relations”, February 24^th at The Houstonian Hotel, Club and Spa in Houston.

For more information go to http://www.palizzapartners.com/Palizza_Partners/Seminars.html

During the interview, something that Broc said struck me as interesting and I thought it was worthy of commentary. Specifically, Broc mentioned that with all of the changes to proxy rules, disclosures and the way issues are voted, there needs to be more communication between IR and the legal team. I think that Broc is right. Too often, specific, mandated disclosures such as proxy compensation discussions get compartmentalized. Lawyers read the rules, write disclosures to conform to the rules and present them in draft form to IR and management. Anybody that’s not a lawyer hates to read this stuff – it’s technical, dry and reads like a lawyer wrote it. So there are usually minimal revisions and the dense, dusty verbiage gets plunked down into the proxy statement. It’s the great irony of this type of disclosure – the more you have of it, the less likely it is to get read.

Now if you think about this process, there is a crucial link missing. Nobody talks to the investors who actually vote the shares. This is somewhat akin to politicians running for office without doing any polling. So when corporate proxy votes come in and there are large withholds on certain issues, companies have only themselves to blame. Actually, that’s not quite true, because portfolio managers in general hate spending time on corporate governance issues. It distracts from what they see as their main mission – making money on stocks.

Here’s a couple of suggestions to bridge this gap: First, well in advance of proxy season, investor relations officers, together with their securities law counsel, should schedule a number of calls to key investors to discuss current disclosure issues in areas such as compensation and governance. The calls should be designed as a dialogue to discover how investors view the topics and not as advocacy. Remember, you can’t solicit votes without a proxy statement. What investors want to hear can then be incorporated into your disclosures. Similarly, when you’re out on non-deal road shows, ask to spend five minutes at the end of a visit discussing the firm’s views on disclosure issues, whether they be compensation, governance or social responsibility. In the larger firms this will mean that they will have to bring in someone at the end of the meeting, as there is usually a separate person that deals with proxy voting, but it is well worth the effort as it gives upper management an opportunity to hear investors’ concerns and thinking.

This is not a cure-all, as sometimes investors want to hear things that management doesn’t want to disclose or they want governance structures that management is unwilling to implement, but at least you’ll know prior to the vote being cast.