by James Hyatt

Proxy advisory services -- the firms that handle the chore of voting shareholder proxies for institutional investors, and at the same time provide stiff appraisals of corporate conduct – may be about to start receiving their own report cards for a change.

A lot of Corporate America thinks it's about time.

The services' influence has certainly been growing in the wake of corporate scandals and ever more heated debates over ethical behavior and attention to social responsibility issues.

The proxy services play a key role because institutional holders turn to them for advice when voting billions of shares at annual meetings. The services get paid to help manage the actual proxy voting process and they also weigh in on management-vs-shareholder debates over such hot button issues as compensation, the makeup of boards of directors, and proposals on corporate disclosures and behaviors.

For almost a decade, academics, corporate officials, regulators and shareholder activists have kicked around the issues of proxy advisory service behavior and performance: do they exercise too much influence; does their advisory business influence their voting recommendations; is more formal oversight needed?

The Advisory Industry

A lot of the conversation, of course, is aimed either in a veiled way or implicitly at the 800-pound gorilla in the room, RiskMetrics Group and its influential proxy advisory unit ISS Governance – which, by some estimates, advises half the world’s common stock.  RiskMetrics had $303 million of revenues in 2009; of that, almost half or $145 million came from the ISS segment. The company last year issued proxy and vote recommendations for more than 37,000 shareholder meetings in 108 countries and voted 7.6 million ballots representing over 1.3 trillion shares.

RiskMetrics in 2009 had 3,500 clients in 53 countries, including 70 of the 100 largest investment managers, 43 of the 50 largest mutual fund companies, and 42 of the 50 largest hedge funds.

(RiskMetrics in March said it would be acquired by MSCI Inc. for about $1.55 billion in cash and stock, subject to various approvals.  MSCI calculates more than 120,000 indices daily and its Barra unit provides risk models and portfolio analytics.)

In addition to RiskMetrics, other major proxy advisors include Glass Lewis & Co.; Egan-Jones Proxy Services; Marco Consulting Group; Proxy Governance, Inc.; Governance Metrics International; and CtW Investment Group.  (RiskMetrics, Marco Consulting and Proxy Governance are also registered with the SEC as investment advisers.)

New Scrutiny

Questions about proxy advisors have been raised in the past. The Government Accountability Office, the audit arm of the U.S. Congress, took a look at proxy service providers in 2007 and an SEC Compliance Alert in mid-2008 addressed some proxy voting issues as well.

Nonetheless, questions about the performance and role of proxy advisory services continue to simmer.  SEC Chair Mary Schapiro told the Practising Law Institute last November:

“...we'll be asking about the role of proxy advisory firms in corporate voting.  Given the influence that these firms' recommendations have on corporate voting outcomes, we'll probe the need for rules to ensure that advisory firms are basing their research and recommendations on accurate and reliable information.  And, that they are providing adequate disclosure of any conflicts of interest they may have in providing voting recommendations. “

Given the pressures surrounding the new financial services legislation, the SEC may find such steps pretty far down on its agenda.   But regulators are being pressed for action by members of the "Shareholder Communications Coalition," comprised of the Business Roundtable, the National Association of Corporate Directors, the Society of Corporate Secretaries and Governance Professionals, the National Investor Relations Institute, and the Securities Transfer Association, whose members often find themselves the object of proxy service criticism.

In March 2010, the Coalition distributed a “discussion draft” on” proxy advisory services: “The Need for More Regulatory Oversight and Transparency”. Among its criticisms: institutional investors that hire third-party proxy advisory firms often find that firm guidelines “do not evaluate the facts and circumstances of each public company with respect to the matters to be voted on; instead, these guidelines encourage a “one-size-fits-all” or “check the box” methodology.”

RiskMetrics, it notes, provides corporate governance and executive compensation consulting services as well as voting recommendations on proposals at shareholder elections – which, the study suggests, “may create conflicts of interest”.  Moreover, all proxy advisory firms may face conflicts when an institutional client is backing a specific ballot proposal or has instigated a “vote no” campaign against directors.  The SEC, the draft suggests, should examine such situations for conflicts.

The draft report recommends that proxy advisory firms:

--be subject to more robust oversight by the SEC;
--be required to register as investment advisers;
--be subject to conflicts of interest disclosure; and
--have “a complete and total separation” of the proxy advisory business from all other business including consulting and research services.

It also calls for public disclosure of procedures, guidelines and assumptions for making voting recommendations and voting decisions, calls for institutional investors to exercise more due diligence concerning delegation of decisions to proxy advisory firms, and calls on the firms to maintain a public record of all their voting recommendations and voting decisions.

The report concludes: “We believe that proxy advisory services have an oversized impact on the proxy process. Despite their large role, proxy advisory firms generally remain unregulated and unsupervised and often are not transparent with regard to their standards, procedures, methodologies, and conflicts of interest.”

Dual Roles

RiskMetrics’ 2009 annual report acknowledges the “perceived conflict of interest between the services we provide to institutional clients and the services, including our Compensation Advisory Services, provided to certain corporate clients.”  It concedes that “in the event that we fail to adequately manage these perceived conflicts of interest, we could incur reputational damage.”  RiskMetrics spells out its policies regarding conflicts and disclosures here.

Asked for comment on the recent proxy advisory discussions, a RiskMetrics spokesman said the company is awaiting the substance of the SEC’s concept draft “and will refrain from making  any comment before it is available.”

One of the testier critics, Tamara C. Belinfanti, an associate professor at the New York Law School, in a legal studies research paper in 2009 argued “The Case for Increased Oversight and Control” over the proxy advisory and corporate governance industry.

She builds her argument around “agency theory,” or situations where one party uses another party to act on his behalf but where the parties’ “incentives are misaligned” – classically, in the case of corporations, the separation of ownership and control.

Ms. Belinfanti declares: “From an agency theory perspective, ISS presents a lethal combination – significant power and virtually no accountability.” And, she says, “ISS bears minimal residual risk of a poor voting decision vis-à-vis company shareholders.”

She argues for the SEC to regulate the proxy advisory industry “similar to the regulation it is currently contemplating for registered credit rating agencies,” for an oversight board for the industry similar to the Public Company Accounting Oversight Board, and for the mutual fund industry to pay more attention to proxy advisor decisions “and not simply follow the vote recommendations of these advisors.”

In March this year, Ms. Belinfanti posted a more acerbic comment about RiskMetrics on The Huffington Post, prompted by the MSCI acquisition announcement:  “ISS is incompetent and it is only a matter of time before markets and regulators realize ISS…is a ticking time bomb waiting to explode.” She noted that ISS had given high governance ratings to Lehman Brothers and AIG before their financial woes.  And she said MSCI’s governance rating was “in the bottom 2.5% of all S&P 400 companies in terms of corporate governance,” declaring the merger agreement “belies the reliability of its own corporate governance ratings system.”

"Prudent Man" Standards

A recent posting at the Harvard Law School Forum on Corporate Governance and Financial Regulation by attorneys at Latham & Watkins LLP raises other issues, commenting on “The Parallel Universes of Institutional Investing and Institutional Voting”.

SEC and Labor Department ERISA rulings, they note, require that institutional investors vote portfolio shares under “prudent man” standards, which often has resulted in outsourcing voting mechanics and recommendations to the proxy advisory firms. (The burden is huge; there are more than 10,000 public U.S. companies.)  Other investment managers have created an internal “corporate governance” staff to vote portfolio shares.

The result, the authors argue, is that voting policies are often applied in a one-size-fits-all fashion that doesn’t take into account a company’s particular circumstances. And, they declare, “economic ownership and economic decision making have been effectively decoupled from voting decisions throughout most of the investment management world.”

The separate interests of the investment community and the governance community, they argue, mean that public companies “need to engage in constructive and separate dialogues with each constituency. “Too often, corporate governance issues are seen as a distraction from a company’s goal of creating economic value for its shareowners. Although this may be true, it is also somewhat beside the point because voting decision makers at the company’s institutional shareowners demand otherwise.”

James Hyatt, a retired reporter and editor for The Wall Street Journal, has been writing about business ethics and social responsibility issues since 2005.

Corporate advisory firm RiskMetrics Group Inc. this week rolls out a scorekeeping tool that will provide a new benchmark for measuring a firm’s attention to governance issues of interest to institutional and other investors.

The new GRId, or Governance Risk Indicators, will score companies against best practices in four areas: board, compensation/remuneration, shareholder rights and audit.

Companies will be ranked with a low, medium or high “absolute level of concern” on performance in those areas, based on 60 to 80 questions.  The initial GRId assessments will cover about 8,000 companies in the U.S., Canada, U.K., France, Germany, the Netherlands and Sweden.

The indicators will replace RiskMetrics’ current CGQ, or Corporate Governance Quotient, ratings, at the end of June.  RiskMetrics said the new indicators take into account practices in local markets, as well as tie-in the proxy voting policies of its Institutional Shareholder Services proxy advisory group.

RiskMetrics stressed the ratings would reflect a company’s individual policies measured against best practices rather than “a relative score tied to peer practices.”   In a sample report, RiskMetrics graded a hypothetical Smith Co. as raising “medium” concern over its board structure, low concern over compensation and audit, but high concern over shareholder rights because directors aren’t elected annually, the board can issue blank check preferred stock, and other hot-button practices.

RiskMetrics said “high-level” ratings will be available on the Yahoo Finance!  website starting in April.  Companies don’t pay to be rated, and also have free access to a site to verify their data.  Institutional investors pay for access to underlying data factors on which the high-level ratings are based

RickMetrics on March 1, 2010, announced a $1.5 billion agreement to be acquired by MSCI Inc., a major provider of market indexes and portfolio analysis.

An explanation of the new approach is available here.

When do you know that ESG (or factoring environmental, social, and governance issues into investment and corporate decisions) has gone mainstream? One clue is this week's announcement that MSCI (Morgan Stanley Capital International) is acquiring ESG research conglomerate RiskMetrics (which gobbled up ESG pioneers KLD, Innovest, and Institutional Shareholder Services over the past three years). Another is the agenda of last week's meeting of the Securities and Exchange Commission's Investor Advisory Committee (IAC), which included items such as "ESG Disclosure Work Plan" and "Proxy Voting Transparency." So what does this mean?

The fact that an Investor Advisory Committee even exists – one of SEC Commissioner Mary Schapiro's first initiatives, to return to the "Commission's traditional role as the investor's advocate" (in the words of Committee sponsor, SEC Commissioner Luis Aguilar) – is testament to the success of the G part of the ESG equation: the SEC is governing itself more democratically. The Committee acts as the SEC's sounding board, rebounding guidance to the Commissioners on their regulatory agenda. The Committee's 18 members each represent a different constituency – with the AFL-CIO's Damon Silvers representing labor, and ProxyDemocracy Director Mark Latham representing individual investors, for example.

"Of course, the Commission doesn't have to act on anything the Committee recommends," IAC member Adam Kanzer of Domini Social Investments, who represents the ESG community of social investors, told me in an interview this week. But the very existence of the Committee establishes a mechanism for expressing the public mind – so the Commission would need a damn good reason to act against its recommendations.

The ESG equation squares the circle, reuniting the bifurcation the ol' Investor Responsibility Research Center (which got eaten up by Institutional Shareholder Services in 2005 established with its separate "social and environmental" and "governance" departments (no more having to track down either Meg Voorhes or Carol Bowie, as ESG creates a both/and.) Also, the ESG formulation has turned on its head the traditional perception of sustainability issues as time-wasting, extraneous concerns that drain on returns to potentially material risks and opportunities that investment trustees and corporate directors must factor into decision-making.

Kanzer and Stephen Davis of Yale's Millstein Center for Corporate Governance, chair of the Investor as Owner Subcommittee, outlined the workplan on ESG disclosure (according to meeting attendee Peter DeSimone of the Social Investment Forum, the socially responsible investing industry organization):

• In April, Subcommittee members will hold a meeting on the benefits of ESG disclosure to investors from a risk management perspective;
• In May, they will look at accounting standards and triggers for disclosure of contingent liabilities in the United States and other markets;
• In June, they will review reporting standards, including the Carbon Disclosure Project (CDP) and the Global Reporting Initiative (GRI), and look at information collected by the European Commission during its six meetings on ESG disclosure over the past year;
• In the summer, the Subcommittee plans to hold a public hearing on ESG disclosure to coincide with another meeting of the entire SEC.

The SEC Staff Interpretation released last month – the Commission Guidance Regarding Disclosure Related to Climate Change – set precedent on the E part of ESG disclosure. The guidance does not introduce new rules, but rather clarifies existing rules requiring companies to disclose material risks related to climate change, such as projected impacts of new legislation and international treaties capping carbon emissions.

Predictably, the move prompted opposition: House Financial Services Committee Ranking Member Spencer Bachus (R-AL) fired a letter to Chairman Schapiro voicing "very serious concerns" that the move represents the SEC trying to "promote a political agenda through regulation" and "will impose potentially significant compliance costs on issuers with little apparent benefit to investors." The preponderance of evidence and opinion debunking his concerns (think Stern Report and CDP) raises serious questions whether Bachus is promoting a political agenda through obstruction. Similarly, Senator John Barrasso (R-WY) introduced the Maintaining Agency Direction on Financial Fraud (or MADOFF) bill explicitly to "block" mandatory climate risk disclosure.

Bachus and Barrasso may be spitting into the wind. The corporate community generally understands and even encourages climate change regulation to create certainty and level the playing field through initiatives such as Business for Innovative Climate and Energy Policy (BICEP) and the US Climate Action Partnership (USCAP). Even recently-departed USCAP members BP, ConocoPhillips, and Caterpillar "have reiterated their belief that climate change is a real and serious issue, and that greenhouse gas emissions must be reduced," according to SustainAbility Vice President Jeff Erikson, who pointed to a ConocoPhillips press release re-stating support for federal climate change legislation. "The disagreement instead seems to be in the details of which industries will be most disadvantaged under legislation that USCAP supports," Erikson continued, before voicing disappointment at the three companies' decisions to leave USCAP.

Finally, the Investor Advisory Committee returned to the question of democracy in the wake of the recent Citizens United v. Federal Election Commission case, which considerably expanded corporate political contribution rights. The Investor as Owner Subcommittee voiced its intention to mirror its ESG disclosure proposal by proposing better disclosure or corporate political contribution limits.

The very existence of the Committee expands democratic mechanisms at the SEC, which allows and encourages the submission of public comments to the Committee - twenty five have come in as of this date.  Given the leverage opportunity the IAC represents, maintaining SEC momentum on ESG and corporate democratization may require more of a groundswell to demonstrate widespread public support for these measures – time to "sharpen your pencils."

Bill Baue is Executive Director of Sea Change Media, and Executive Producer/Host of Sea Change Radio, a nationally syndicated show with a global podcast audience. This article was first published on CSRWire.