In the boardrooms of America’s largest corporations, a company with scarcely over $100 million in annual revenue and $10 million in profits commands directors’ full attention: the proxy advisory firm Institutional Shareholder Services. ISS advises pension funds, mutual funds and hedge funds on how to vote on corporate ballot items.
The company is the dominant proxy adviser, reporting 1,700 clients that manage an estimated $26 trillion in assets. But its role in corporate governance is largely a creation of federal regulations—and its positions on countless ballot items follow the lead of special-interest investors like labor-union pension funds and “socially responsible” investing vehicles, not those of the average diversified investor.
In 2011 and 2012, for example, every public company in the Fortune 200 held an advisory vote on executive pay as mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act. According to an analysis by the Manhattan Institute, ISS recommended that shareholders vote against 44 compensation packages in 338 “say on pay” votes (13%), but a majority of shareholders opposed executive pay at only six companies (1.5%).
The deviation of ISS views from those of most investors is also pronounced in voting on shareholder proposals. Under federal rules, shareholder proposals can be introduced on the proxy ballots of publicly held corporations by anyone who has owned $2,000 of a company’s stock for at least a year. Among the 200 largest public companies by revenues, each of which held annual meetings from 2006 through 2012, ISS was significantly more likely than the average shareholder to support shareholder proposals of every type. Overall, ISS has supported 1,266 shareholder proposals at these companies (63%), while a majority of shareholders supported only 212 of these same proposals (10%).
For example, from 2006 to 2012, ISS supported 35% of shareholder proposals related to environmental issues such as global warming or natural-gas hydraulic fracturing, and 70% of proposals seeking to increase disclosure of or to limit corporate political spending. Only one such proposal has received the support of a majority of shareholders.
Another example: cumulative voting. This is a common proposal to enable minority shareholders to elect a director in large companies by allowing shareholders to aggregate all of their director votes behind a single preferred candidate. Ordinarily, corporations permit investors to cast only one vote per share for any single nominee—so if a company has four open board seats, an investor with 500 shares can cast 2,000 total votes, but only vote 500 shares for any one director.
Cumulative voting would empower labor-union pension funds and other investors with a special-interest agenda to gain board representation by concentrating all their director votes behind one or two individuals to champion their interests, not those of all shareholders. ISS has backed 96% of such cumulative-voting proposals. But of the 107 proposals submitted to Fortune 200 companies since 2006, only one (in 2006 at the Bank of New York Mellon) has received majority shareholder support. (As the vote on the resolution was nonbinding, BNY did not adopt cumulative voting. The issue has been put on the ballot in each subsequent year, getting below 40% of the vote each year—most recently 26% in 2012.)
ISS support for cumulative voting is ironic, since its parent company, MSCI, has no such policy. MSCI’s position, displayed on its website, “strongly supports the one share/one vote concept and opposes cumulative voting.”
ISS receives a substantial amount of income from labor-union pension funds and “socially responsible” investing funds, which gives the company an incentive to favor proposals that are backed by these clients. About 20% of its revenues also come from consulting contracts with companies about corporate governance issues and executive compensation, according to MSCI’s 2011 annual report. Shareholder proposals that increase corporate sensitivity to ISS preferences would have the effect of increasing the incentive for public companies to enter into such consulting contracts with ISS.
While ISS recommendations on shareholder ballots do not have a good track record of being passed, they do have influence. An ISS recommendation in favor of a proposal, controlling for other factors such as company size, proposal type and proposal sponsor, bumps up the shareholder vote for that proposal by 15 percentage points. When ISS recommends against executive pay, shareholder votes in support of it drop by 17 percentage points. In close votes, ISS recommendations can tip the scale.
What accounts for this influence? It is probably attributable to smaller institutional investors effectively “outsourcing” their government-mandated fiduciary voting obligations. Larger institutional investors such as Fidelity and Vanguard conduct their own proxy analyses, but smaller mutual funds and hedge funds find performing such analyses prohibitively costly.
These smaller investors hire ISS in the first place largely thanks to government diktat. Before the 1980s, institutional investors paid little attention to shareholder proposals on corporate proxy ballots. Today, many institutional investors hire ISS because they are now forced to vote as “informed” fiduciaries by the federal government—the Department of Labor in the case of pension funds and the Securities and Exchange Commission in the case of other institutional investors.
ISS seems unlikely to face much competition in the future. Currently, the only significant alternative proxy advisory firm serving investors in American companies is Glass Lewis, which is owned by the Ontario (Canada) teachers-union pension fund.
The significant influence of ISS on corporate proxy voting—along with the large, systemic gap between its preferences and those observed in shareholders’ actual votes—raises questions about whether shareholder voting is working effectively to improve share value. Rather than pass legislation like Dodd-Frank—which amplifies ISS influence by mandating “say on pay” shareholder votes on executive compensation—Congress should instead be re-examining how much good these proxy ballots do for shareholders and capital formation.