How to Break the Hold of Proxy Advisory Firms

The concentration of stock ownership today has given enormous power to a small group of proxy advisory firms whose research guides many institutional investors’ voting decisions. In the absence of internal research into shareholder matters by many mutual funds, negative recommendations to these investors from Institutional Shareholder Services Inc. (ISS) or Glass Lewis & Co. LLC. can have dire consequences for boards and management.

Hundreds of publicly traded companies have criticized proxy advisory firms for having too much power, operating with a lack of transparency, and creating conflicts of interests by selling consultancy services. Indeed, during the past year, proxy advisory firms have found themselves under increased scrutiny from lawmakers and regulators seeking to rein in their growing influence.

But these firms have an important role to play. Almost one-quarter of the U.S. equity market is owned by the U.S. mutual fund industry. Most of these funds do not invest the resources necessary to become informed about specific shareholder votes at companies in which they own a stake, so ISS and Glass Lewis fill the gap.

How might public companies push back and ensure greater balance? Is there a way to gain the support of a mutual fund, even if proxy advisory firms have issued negative recommendations against the board and management?

Director Connections Provide a Voice

New research out of Smith School of Business at Queen’s University and Rutgers Business School finds that one route to affect the voting decisions of funds is through boards of directors.

“We show a way for public companies to combat proxy advisory firms’ influence, to get a voice,” says Paul Calluzzo, assistant professor of finance at Smith School of Business.

Among the companies listed on the S&P 1500 index, on average 226 of them are connected to 2,910 mutual funds each year, Calluzzo says. He and Simi Kedia of Rutgers Business School have researched those connections to assess what value they may offer to the listed companies.

They found that for proposals that garnered a negative ISS recommendation or had limited shareholder backing, management received greater support from mutual funds that were “connected” to the company through a board member.

The voting patterns of these “connected funds” generally showed independence from ISS recommendations, and appeared to be both informed and value enhancing, the researchers determined. Furthermore, they found that the stronger support shown for management did not appear before the connection occurred or after it was terminated.

“The presence of the connected director may increase the likelihood of interaction between fund and firm, and might also improve the quality of information flow,” the researchers wrote.

“We show a way for public companies to combat proxy advisory firms’ influence, to get a voice”

For their study, Calluzzo and Kedia identified the five top-compensated executives at each company listed on the S&P 1500. They then pulled the names of all board members of mutual fund companies from filings with the Securities and Exchange Commission and used special software to identify the individuals in both sets of data.

“We don’t know how the information is transferred, but the effect is there. It’s a bit of a black box,” Calluzzo says.

There may be many forms of communication, from a direct conversation in the boardroom to an impression given passing in a hallway. And the subject might be the connected company itself or something else in its universe, such as a competitor, he adds.

So should a publicly traded company encourage its CEO to serve on the board of a mutual fund company, or seek to add a mutual fund director to its own board? In a vacuum, Calluzzo says, these ties “definitely have a positive influence on a company.”

But he warns they come with opportunity costs, which might include dividing an executive’s time or forgoing a relevant skillset of a potential director in favour of forming a connection with a mutual fund.

The study shows that connected directors are “a good presence” and can be advantageous for a company facing shareholder pressure, he says. “It’s another tool, but I wouldn’t say all companies should pursue these relationships.”

­—Simon Avery