Proxy advisers: What is the proper role?
Proxy advisory firms (“advisers”), such as Institutional Shareholder Services and Glass Lewis, provide research and voting recommendations to help institutional investors (eg, pension and investment funds) vote their shares on issues such as executive compensation and corporate governance.
Increasingly, market participants have raised the concern that advisers have outsized influence on shareholder voting outcomes. This potentially allows advisers to exert pressure on firms to adopt the advisers’ preferred practices, which may not be in the best interests of shareholders. This influence has been recognised in the business media, such as when The Economist referred to advisers as the “éminence grise” of corporate governance, and by regulators in both the US and the UK, who are considering taking steps to restrain this influence. For example, in the US, the Securities and Exchange Commission is currently proposing rule changes governing proxy advisory firm disclosures and procedures, as well as what constitutes a proxy solicitation.
Our research, which was sponsored by CIMA’s General Charitable Trust and recently published in the Journal of Accounting Research, involved interviews with board directors, HR executives, and compensation consultants to understand how key decision-makers view advisers, in particular their role in executive compensation. We also interviewed representatives from proxy advisory firms to gain a balanced perspective and complement our findings.
Scope of influence
Our research found that key decision-makers perceive that the influence of advisers falls on a continuum from relatively indirect to more direct. For example, at the indirect end of the continuum and consistent with advisers’ own stated objectives, decision-makers view the advisers as disseminating guidelines and best practice that provide a benchmark for their vote recommendations. At the other end of the continuum, decision-makers perceive advisers, in effect, as “for-profit regulators” or “quasi-regulators”. Moreover, decision-makers describe advisers’ reports as identifying what the advisers “like” or “do not like” (or even “hate”) about a firm’s pay practices and refer to “rules” that need to be followed or even “demands”.
Through our research, we also found that many companies give in to adviser influence by making changes to their preferred executive compensation design. For example, companies change the compensation mix (eg, the proportion of stock options versus restricted shares), decrease the amount of equity issued to reduce the burn rate (ie, speed at which firms use shares available for grant in their equity compensation plans), and use certain performance measures (eg, total shareholder return) over preferred ones.
Some of these changes contradict what the board otherwise believes is optimal for the firm and its shareholders. From a corporate governance perspective, this could be a serious problem since board directors are elected to represent shareholders and leverage their expertise and firm-specific information — to which the advisers are not privy — to implement policies that help the firm achieve its strategic objectives. For example, boards are tasked with executive compensation design to hire, motivate, and retain the best talent; however, compromises to compensation also risk compromising the firm’s talent pool. Importantly, our research showed that advisers’ influence was felt not only by firms with high-risk compensation design or that had faced advisers’ scrutiny but also by firms with low-risk compensation design or that had not suffered adverse adviser scrutiny (ie, the firm receives relatively high “say on pay” vote outcomes).
At the same time, our interviewees also shared that advisers can have important positive effects on the executive compensation and governance landscape by increasing transparency and fostering accountability and communication between directors and shareholders.
It is important to understand the overt role of advisers — to provide nonbinding vote recommendations and compensation “best” practice that are not mandated for adoption — but also to recognise their perceived role (ie, those designing executive compensation often view advisers as setting “mandatory” standards).
As an alternative to succumbing to adviser influence, executive compensation plans should be designed to motivate, reward, and retain the best talent. Compromising the firm’s compensation philosophy to avoid adviser scrutiny, align with the advisers’ recommendations, or improve a proxy vote may result in short-term gains at the cost of long-term consequences. If the right directors are in place, firms may be better off staying true to their compensation philosophy while increasing shareholder outreach and improving disclosure and transparency.
There are three main takeaways for board directors and management accountants:
- Advisers can yield potential benefits, such as increasing board members’ accountability, transparency, and shareholder engagement.
- Advisers can and do exert direct influence on firms’ compensation and governance practices, even for firms that do not appear to be facing adviser scrutiny. This puts advisers in the position of being “standard-setters” on executive compensation, even though they are not accountable to any governing bodies.
- Board members and those who assist them in setting executive compensation should carefully consider whether yielding to adviser pressure will compromise their ability to achieve important strategic objectives that require retaining and properly motivating key executives.
As regulators and legislators consider whether and how to address concerns that adviser influence undermines the proxy voting system, they should balance these concerns with the benefits that advisers deliver to the executive compensation landscape and corporate governance more broadly.
Meanwhile, board directors and management accountants need to make sure they always consider the long-term health of the organisation as they evaluate the input of proxy advisory firms.
— Christie Hayne, Ph.D., is assistant professor of accountancy in the Gies College of Business at the University of Illinois (Urbana-Champaign) in Illinois, US, and Marshall Vance, Ph.D., is assistant professor in the Pamplin College of Business at Virginia Tech in Virginia, US. To comment on this article or to suggest an idea for another article, contact Oliver Rowe, an FM magazine senior editor, at Oliver.Rowe@aicpa-cima.com.