19 July 2016
Although investors can outsource activities, stewardship cannot be delegated away
When ICSA and the Financial Times published the latest Boardroom Bellwether survey in May, most of the attention was understandably focused on business’ views on Brexit. Yet for me, the most striking statistic in the report was the response to the question: how does your company perceive the influence of proxy advisers on shareholder engagement? Only 3% of respondents feel they have a positive impact. The others are equally divided between those who view their influence as negative or neutral.
Unless perhaps you are an opposition party in North Korea, a 3% approval rating is not encouraging, to put it mildly. It is therefore worth considering whether proxy advisers really are doing as bad a job as this survey suggests.
The European Commission appears to believe so. The revised Shareholder Rights Directive, which after much delay appears likely to be agreed in the next couple of months, is set to impose extensive new reporting requirements on proxy advisers.
If and when the directive takes effect, proxy advisers operating in the EU will be required to disclose not only their research methodology and how they manage conflicts of interest but also ‘the qualifications of the staff involved’ in producing research and advice. To decipher whether regulation of this sort will solve the problem, the job that proxy advisers do and why it has become necessary must be fully understood.
The proxy advisory industry has been created to meet the needs of investors pursuing particular investment strategies. Many institutional investors invest in thousands of companies across many markets. This is a conscious strategic decision they have taken – not an unavoidable inevitability.
What is inevitable is the impact on their ability to oversee and engage with the companies in which they invest.
Each of these thousands of companies will hold an AGM at which resolutions are tabled for shareholder agreement. The numbers vary, but for a company listed in the UK it can easily amount to 20 resolutions every year. Multiply the number of companies by the number of resolutions and then factor in the fact that the majority of AGMs take place in a concentrated period of two to three months every year, and it is obvious that investors cannot meaningfully assess each and every resolution on its merits before deciding how to vote.
Investors need a process that enables them to sift through all these resolutions and identify which are uncontentious and which require them to carry out a more detailed assessment. This is where proxy advisers come in. Institutional investors could carry out this initial sift in house, but the majority choose to use advisers in order to reduce their costs.
Many investors also contract out the process of placing their votes to proxy advisers, again primarily for cost reasons. More significantly, many even contract out the thinking that goes with it. They choose to delegate the authority for deciding how to vote to the adviser, signing up to a standard voting policy that they want to be applied to their investments – this is the source of the ‘box-ticking’ charge from companies.
If the main reason institutional investors use proxy advisers is to reduce their costs, it is not surprising that advisers have had to adopt a relatively low-cost business model in order to win orders. This, of course, will have an impact on the quality of analysis they can undertake, and the amount of time they can devote to researching individual companies. Again, bunching of AGMs around peak periods reduces this further.
Contractually, the duty of proxy advisers is to provide the services requested by their clients. By and large, it appears that investor clients of the proxy advisers do not have concerns. This may reflect satisfaction with the quality of the services and advice they receive, or it may reflect a general indifference on the part of some investors to voting and to engagement with the companies in which they invest. There is probably a bit of both.
However, the nature of the role they carry out means that the effectiveness of proxy advisers cannot be judged purely in terms of whether they meet their contractual obligations. We also need to consider the impact of their activities on the companies they analyse. There are two respects in which their influence is seen as important: voting results and the quality of engagement.
When it comes to voting results, I have yet to come across compelling evidence that proxy advisers have a negative impact on voting results to any significant extent. It is possible to find the occasional example where there appears to be a correlation between a voting outcome and the recommendation made by a particular proxy adviser, and the public profile of some advisers might lead one to conclude they have more impact than they really do.
However, in 2015 the average vote against resolutions at FTSE 350 AGMs was less than 3%. This hardly suggests there is a systemic problem, with swathes of companies suffering undeserved defeats because of pernicious proxy advisers.
There is, however, irritation generated by the activities of proxy advisers – and it is entirely understandable. Many companies make considerable efforts to communicate with their shareholders to ensure they understand the policies they have adopted and the reasons for them. If they feel that they are being judged against some sort of standard template and little or no attempt is being made to understand and take account of their particular circumstances, then of course they will be frustrated.
This frustration is even more strongly felt in countries such as France and Sweden, where companies feel they are being judged against standards set in the US or UK. Hence their support for EU regulation.
But where do you point the finger of blame? At the proxy advisers for the way in which they carry out their clients’ wishes? Or at those clients – the company’s shareholders – who have delegated this activity rather than take responsibility for it themselves, and are only willing to devote a limited amount of time and money to analysis and engagement? In my view, the proxy adviser firms are a symptom of the problem, not the root cause.
This is not to say that proxy advisers are undeserving of any criticism. There is always scope to improve the quality of any service, and individual firms and the sector as a whole have not always been responsive when concerns have been raised.
The introduction of industry Best Practice Principles in 2014 was a welcome development, leading to more transparency about how the firms operate. However, the failure to put in place any arrangements to monitor performance against those principles was a missed opportunity that made it easier for those seeking regulation to argue that it was justified.
The new requirements in the Shareholder Rights Directive may have a marginal positive effect if they lead to a better understanding of the basis on which the proxy adviser firms make their recommendations.
But will knowing the qualifications held by individual researchers at these firms lead to more constructive engagement and better-informed voting decisions? No. That will require a change of approach on behalf of many of their clients and – to quote from the UK Stewardship Code – a recognition that although they can outsource activities, ‘they cannot delegate their responsibility for stewardship’.
Read the full results of the FT–ICSA Boardroom Bellwether.