Andrey Malenko, Nadya Malenko,
Based on: Journal of Finance, 2019, 74(5), 2441-2490 DOI: https://doi.org/10.1111/jofi.12779
Proxy advisory firms provide shareholders with research and recommendations on how to cast their votes at shareholder meetings. For diversified institutional investors, the cost of performing independent research on each proposal in each of their portfolio companies is substantial. Instead, the institution might prefer to get information from a proxy advisory firm in exchange for a fee. In recent years, demand for proxy advisory services has increased substantially for several reasons: a rise in institutional ownership, the 2003 Securities and Exchange Commission (SEC) rule requiring mutual funds to vote in their clients’ best interests, and growth in the volume and complexity of issues voted upon. The largest proxy advisor, Institutional Shareholder Services (ISS), has approximately 2,000 institutional clients and covers about 45,000 shareholder meetings around the world each year.
The growing influence of proxy advisors has attracted the attention of policy makers and led to a number of proposals to regulate the proxy advisory industry, culminating in the SEC’s 2020 amendments to its rules governing proxy voting advice. The most common focus of policy discussions has been concern about the quality of proxy advisors’ recommendations: their one-size-fits-all approach, occasional inaccuracies in their data, and potential conflicts of interest given their consulting services to corporations. However, there is another concern about proxy advisors’ growing influence that has received much less attention: the presence and easy availability of their advice crowds out institutional investors’ independent research. Independent research by shareholders is key to effective and informative voting outcomes because of the notion of the “wisdom of the crowd”: aggregate information from a large group of agents can rival and dominate that of a few experts. Intuitively, while each individual shareholder’s information and conclusions may be imprecise, the aggregate vote of a large number of shareholders eliminates idiosyncratic views of individual shareholders, resulting in efficient decisions. In contrast, if many shareholders follow the proxy advisor, they all make perfectly correlated mistakes, that is, any imprecisions and errors in the proxy advisor’s research are aggravated through the vote.
To see why the presence of proxy advisors undermines the wisdom of the crowd, consider shareholders’ information choices. Shareholders individually decide whether to purchase the proxy advisor’s information, conduct their own independent research, do both, or remain uninformed. One might think that the presence of an additional source of information—the proxy advisor’s research—wouldn’t make shareholder voting less informed. After all, shareholders make decisions to maximize the value of their holdings and can always choose to ignore information they find less valuable. Such an opinion is common among market participants, who have pointed out that “institutional investors are sophisticated market participants that are free to choose whether and how to employ proxy advisory firms” and that “what we have is the most sophisticated institutional investors in the world … making a free market decision to pay for outside, objective analysis … There could not be a better example of market efficiency.”[i]
However, the market efficiency view does not take into account the collective action problem among shareholders. Intuitively, if some shareholders follow the proxy advisor, it’s especially important that remaining shareholders do their own research and not rely on the same source of information. And yet, each shareholder takes into account only the effect of his information choice on his own value and ignores its impact on other shareholders. This collective action problem leads to excessive crowding out of independent research and an overreliance on proxy advisors’ information, creating too much conformity in shareholders’ votes. As a result, even though proxy advisors offer an additional source of valuable information that shareholders could ignore, the mere availability of their advice is often detrimental to firm value. Moreover, perhaps paradoxically, improving the quality of proxy advisors’ recommendations is not always desirable because it can exacerbate the crowding out effect even more.
Is this problem equally detrimental to all firms? The answer is no: its extent depends on the firm’s ownership structure. In firms with dispersed ownership, the crowding out effect is negligible and the presence of proxy advisors leads to more informed voting. This is because, given their small stakes, dispersed shareholders have little incentive to invest resources in independent research and, consequently, would vote uninformatively (for example, always with management) in the absence of proxy advisors. In contrast, in firms with more concentrated ownership, in which large shareholders would otherwise perform their independent governance research, the crowding out effect can be significant, leading to less informed voting outcomes. Empirical work supports this conclusion: firms with dispersed ownership are more valuable when shareholders follow ISS recommendations, but those with concentrated ownership are less valuable under the same circumstances.[ii]
The idea that proxy advisors can crowd out shareholders’ own research has implications for two actively debated issues: proxy advisors’ influence due to shareholders’ litigation concerns and the level of competition in the proxy advisory industry.
First, it’s frequently argued that some shareholders follow proxy advisors not to make more informed voting decisions, but to protect themselves from potential litigation. According to the 2003 SEC rule and two follow-up statements issued by the SEC in 2004 (referred to as “no-action letters”), an institution “could demonstrate that the vote was not a product of a conflict of interest if it voted client securities, in accordance with a predetermined policy, based upon the recommendations of an independent third party.” As a result, as former SEC commissioner Daniel M. Gallagher put it, “relying on the advice from the proxy advisory firm became a cheap litigation insurance policy.” Greater litigation pressure is likely to make voting less efficient unless proxy advisors’ recommendations are of particularly high quality because it exacerbates the crowding out effect and results in even less independent research. Consequently, the SEC’s recent decision to withdraw its 2004 no-action letters has the potential to improve shareholder voting outcomes: this decision presumably reduced institutional investors’ ability to mitigate litigation risk by following proxy advisors.[iii]
Another commonly discussed issue is the market power of the existing proxy advisors. The industry is dominated by two players, ISS and Glass Lewis, with ISS’s market share exceeding 60 percent and their combined market share exceeding 90 percent. As a result, proposals to restrict proxy advisors’ market power have been widely discussed. However, increased competition among proxy advisors is likely to both give shareholders access to a range of opinions, and reduce fees. While the former effect improves the wisdom of the crowd, the latter undercuts it because lower fees encourage even more investors to purchase proxy advisors’ research instead of acquiring their own information.
Corporate democracy in voting aims to aggregate the views of a large number of a firm’s owners, who all care about maximizing firm value. As such, harnessing the wisdom of the crowd is arguably much more important than in political elections, where incentives are likely to be less aligned. Any developments in corporate democracy, such as the rise of proxy advisors, should be evaluated from this perspective.
[i] See, respectively, the Government Accountability Office 2016 report “Proxy advisory firms’ role in voting and corporate governance practices” and the Harvard Law School Forum on Corporate Governance post “Regulating Proxy Advisors Is Anticompetitive, Counterproductive, and Possibly Unconstitutional” from March 2, 2018.
[ii] Calluzzo and Dudley (2019) “The real effects of proxy advisors on the firm”.
[iii] https://www.sec.gov/news/public-statement/statement-regarding-staff-proxy-advisory-letters.
Associate Professor of Finance
Stephen M. Ross School of Business, University of Michigan
Associate Professor of Finance
Stephen M. Ross School of Business, University of Michigan