Public companies in the United States face unique demands. Under rules developed by the federal Securities and Exchange Commission (SEC), any of such a company’s shareholders can float an idea for all shareholders to consider by placing a “proposal” on the corporate proxy statement, a government-mandated document that makes required disclosures and lays out items to be considered at the company’s annual meeting. Such ideas need not relate to the bottom line and can involve matters of “general social concern,” such as human rights issues or the use of recycled packaging. And the sponsoring shareholder need not own many shares: under current rules, a shareholder need only have held $2,000 of stock for one year to get on the company ballot.
On Thursday, December 6, the Senate Banking Committee held a hearing considering the SEC’s rules governing these shareholder proposals. The hearing also looked at proxy advisory firms, which assist institutional investors in casting their shareholder votes, and which now play an outsized role in determining the outcome of those votes. The hearing follows on the heels of a roundtable discussion on the “proxy process” held November 15 by the Securities and Exchange Commission.
Over the last eight years, I have researched these issues exhaustively. Three central takeaways stand out, which I hope the Congress and SEC will consider.
First, a small group of shareholders dominates the shareholder-proposal process. Three allied small shareholders—John Chevedden, Kenneth Steiner, and Jim McRitchie—and their family members file between one-quarter and one-third of all shareholder proposals annually to the 250 largest public companies. (Their proposals tend to involve “governance” issues, like the rules for electing directors and for shareholders to spur corporate action outside of annual meetings.) I’ve called these investors “corporate gadflies,” but at the SEC Roundtable, McRitchie proudly dubbed his group the “Main Street Investors.” Regardless of nomenclature, there are significant risks in allowing low-stakes investors to influence corporate decisions orders of magnitude greater, in dollar value, than those investors’ stakes. The late Evelyn Davis, another corporate gadfly, received a glowing obituary in The New York Times at her passing, but her record highlights some of these risks: Davis published a 20-page annual investor newsletter that she sold to companies for $495 apiece—with a minimum order of two—parlaying her activism into a reported $600,000 annual income from the newsletter alone. One suspects that companies bought the newsletter not due to its market insights but to placate an aggressive corporate gadfly who threatened to introduce shareholder proposals costing the company far more than the newsletter tab.
Most shareholder proposals not sponsored by corporate gadflies are introduced by institutional investors with interests that depart from most other shareholders’. A majority come from special-purpose “social” investing funds that expressly consider factors other than share value, or from investment funds affiliated with religious organizations, public policy groups, or foundations that similarly hope to leverage their shares to “make a difference.” Almost all other shareholder proposals come from investment funds affiliated with organized labor—either multiemployer private pension plans, such as that for the AFL-CIO, or pension funds holding retirement assets for government employees, typically overseen by elected politicians. Whereas social-investing funds’ proposals largely seek policy goals related to environmental or human-rights concerns, labor-affiliated funds also sponsor proposals related to board governance and executive compensation. But even this activism may not relate to maximizing share value: our research shows that labor-affiliated shareholder activism has regularly correlated not to share returns but to labor-organizing campaigns or the spending patterns of targeted companies’ political action committees. Institutional investors without a social orientation or a labor affiliation have sponsored less than 1% of all shareholder proposals, each year dating back more than a decade.
Given that “special purpose” investors have sponsored most shareholder proposals, a second core observation about this process is unsurprising: it tends to be co-opted to advance policy concerns irrelevant to—or diametrically opposed to—the concerns of the average shareholder who wants to maximize his investment return. In each of the last two years, a majority of all shareholder proposals involved social or policy concerns rather than bottom-line-oriented issues like corporate governance or executive compensation. A Manhattan Institute report by Tennessee professor Tracie Woidtke shows that such shareholder-proposal activism tends to be negatively associated with share value.
A third central observation policymakers should consider is that proxy advisory firms exert enormous control over the shareholder voting process. It’s unsurprising that both the Senate and the SEC have focused on the role of proxy advisers: the proxy-advisor market is largely a duopoly, dominated by Institutional Shareholder Services (ISS), owned by a private investment vehicle, and Glass Lewis, a subsidiary of a Canadian public-pension fund. According to a Manhattan Institute study, the recommendation of ISS tips the shareholder vote by fifteen percentage points, controlling for other factors—meaning that a thinly capitalized firm with some 600 employees effectively acts like an owner of 15% of the total stock market.
In a report released in the spring, Stanford’s David Larcker, Brian Tayan, and I point out that there’s little debate that at least some institutional investors outsource their shareholder voting to a proxy adviser. Indeed, in defending his firm in the SEC roundtable last month, ISS CEO Gary Retelny insisted that 82% of the firm’s clients voted according to fund-specific custom voting policies—implicitly conceding that 18% of ISS customer funds voted wholly according to the proxy advisor’s recommendations. That’s a problem because market-dominant proxy advisory firms have opaque processes and often recommend votes negatively associated with shareholder value—in no small part because they are prone to capture by some of the same special-interest investors that introduce shareholder proposals in the first place.
Shareholder proposals can be a useful way for shareholders to communicate with corporate managers and boards, but current rules make the costs of the shareholder-process greater than its benefits. Stock-ownership thresholds should be substantially increased—or unsuccessful proposal sponsors should be required to repay companies’ direct costs in listing such proposals on corporate proxies—to prevent small-stakes agitators from imposing costs on other shareholders. And current SEC rules allow shareholders to keep reintroducing the same proposal year after year, even if overwhelming majorities of shareholders vote against them. It probably makes sense to “sunset” proposals, at least for a time, when large majorities of shareholders say “no.” Finally, it’s time to bring back the old SEC rule permitting companies to exclude shareholder proposals that are more about social or policy concerns than share value—getting politics out of the proxy process.
Diagnosing the problems with the market for proxy advisory firms is easier than developing solutions. Such firms’ failings are largely a function of their clients’ desire to comply with government-mandated fiduciary voting at the lowest possible cost. Any regulatory approach should be careful not to create more barriers to entry in an already-concentrated market and to be respectful of corporate trade secrets. Still, there’s little reason that corporate issuers and institutional investors should be subject to a host of disclosure requirements while proxy advisory firms that significantly influence both should have no fiduciary duties or disclosure requirements whatsoever. Larcker, Tayan, and I outline several steps that Congress and the SEC could take that would improve accuracy, transparency, and accountability for proxy advisory firms—such as requiring proxy advisers to publish their vote recommendations after the proxy season is over to facilitate third-party review, requiring institutional investors to report the extent to which they rely on proxy advisers in making voting decisions, and imposing fiduciary standards on proxy advisers.
Hopefully, the Senate and the SEC will give serious consideration to these issues. American stock markets have long been the envy of the world, but our policies have led to a decline in the number of initial public offerings and publicly traded companies in the United States. If our policymakers resist loopy ideas bound to exacerbate this problem and tweak our existing rules with common-sense reforms, we can point things back in the right direction.
James R. Copland is a senior fellow with and director of legal policy for the Manhattan Institute. He has been listed on multiple occasions in the National Association of Corporate Directors’ “Directorship 100” list, designating the individuals most influential over U.S. corporate governance.
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