Proxy Advisors Add A Moral Hazard
Published: 11 Oct 2021
Proxy advisors are not a new problem
The Securities Exchange Commission (SEC) has been concerned about the role of proxy advisors in proxy voting for at least twenty years. A good summary of the past two decades and recent rule making can be found here. Prior research shows that a substantial portion of institutional asset managers, controlling more than $5 trillion in voted with the proxy advisors, e.g., more than 95% and frequently more than 99% of the time. This problem is further exacerbated because two proxy advisors – ISS and Glass Lewis – comprise about 90% of the market giving them significant influence over outcomes.
In July 2020, the SEC adopted a final Proxy Advisor Rule designed to ensure that institutional investors and proxy advisors act in the underlying shareholders best interest when voting. Although proxy advisors have valuable services, investment advisors/managers must ensure that their votes follow policies developed specifically to ensure voting is aligned to their clients’, the ultimate shareholders’, best interest.
Determining shareholders’ best interests is very hard
One critical question is what is in an investor’s best interest? Historically, the SEC has taken the view that voting should be aligned with maximizing shareholder value. The maximizing shareholder value goal does not have a time horizon, other than “long term,” which makes measurement somewhat ambiguous. Further, shareholder value is expressed solely in monetary returns; however, shareholders may not calculate whether their best interests have been served solely in monetary terms. Shareholders may find their best interests are served when they meet a financial goal – not necessarily a maximum return – while also achieving a more intangible goal, such as getting a company to progress on removing micro plastics from national water supplies.
A second important detail is that shareholders are not uniform and some shareholders may be more interested in influencing a company’s environmental and social impact at the expense of broader business strategy. Such interested shareholders may have the ability to lobby and / or influence proxy advisors, resulting in voting recommendations not determined by value maximization but by a subset of shareholders’ views.
Finally, proxy advisors and investment managers do not have the sufficient resources nor crystal balls to assess what is in the shareholder’s best interests or value maximizing when considering environmental, social or political issues – no one does. Shareholder preferences for how a company impacts the world may not translate into returns. Likewise, risks and resulting losses associated with specific business strategies arising out of a particular vote or series of votes may not be apparent for many years.
Concentrating influence without accountability creates a moral hazard
Given proxy advisors’ monopolistic position and because no one is publicly measuring or tracking the impact of their recommendations means that proxy advisors are generally protected from backlash associated with the potential downside risks and losses shareholders may face, creating a moral hazard. One remedy is for investment managers to more proactively manage their proxy voting policies; however, this approach means making assumptions about what constitutes shareholders’ best interests. Another approach is to at least try to understand underlying shareholders’ best interest and align voting policies.