By Wayne Winegarden - Contributor

The House Committee on Financial Services convened on April 29th for a crucial hearing titled Exposing the Proxy Advisory Cartel: How ISS & Glass Lewis Influence Markets. This session focused on examining the significant role and influence that proxy advisory firms have in shaping corporate governance and influencing shareholder voting outcomes, an issue long overdue for scrutiny.

Proxy advisory firms, particularly Institutional Shareholder Services (ISS) and Glass Lewis, play a pivotal role in the world of corporate finance. These firms emerged in response to the Securities and Exchange Commission (SEC) mandate requiring institutional investors to cast votes on all matters presented in proxy statements, which are the documents that outline the issues to be voted on during shareholder meetings. Given the overwhelming volume of decisions that institutional investors must navigate, many turn to these advisory firms for assistance. They provide valuable services by analyzing shareholder resolutions and advising on how to vote on the myriad of proposals presented each year.

Currently, ISS and Glass Lewis dominate the proxy advisory market, controlling an astounding 97% of the industry. This concentration of power grants them immense influence over corporate governance, raising concerns among stakeholders regarding the potential consequences for companies and their investors. While these firms offer a necessary service, the efficiency of their operations has come into question, especially regarding Environmental, Social, and Governance (ESG) issues. As demonstrated by the fluctuating pressure on companies to adopt ESG programs, these inefficiencies may undermine effective corporate governance, ultimately harming the companies they purportedly serve.

Despite a recent easing of pressure to implement ESG initiatives, many proposals continue to surface during shareholder meetings, demanding transparency, especially concerning corporate greenhouse gas emissions. However, the recommendations provided by ISS and Glass Lewis regarding ESG proposals often lack transparency and employ a one-size-fits-all methodology, disregarding the unique circumstances of different companies. This can lead to harmful consequences for businesses that may not be able to comply with rigid ESG requirements.

A notable analysis conducted by the American Council for Capital Formation highlighted that the ESG recommendations from these proxy advisory firms tend to disproportionately disadvantage small and mid-sized companies, favoring larger corporations that have the resources to meet these evolving demands. Adding to the complexity is the inherent conflict of interest present within the proxy advisory duopoly, as both ISS and Glass Lewis maintain their own ESG programs. For instance, ISS operates a program called ISS ESG, which offers ESG screening, ratings, and analytics to help investors incorporate responsible investing into their strategies. Meanwhile, Glass Lewis has partnered with Sustainalytics, integrating ESG principles into its voting recommendations.

This alignment raises concerns, as the same firms that hold significant sway over proxy voting also advocate for pro-ESG positions, potentially skewing the recommendations they provide. Research has indicated that initiatives related to ESG often lead to negative financial outcomes for companies. A study published in the Journal of Financial Economics examined how activist public pension funds influence the market values of Fortune 500 companies, revealing that increased activism correlates with lower stock returns. Furthermore, companies that receive proposals from activist pension funds promoting social agendas were found to be valued 14% lower than their peers not engaged in such initiatives.

Another report by the Manhattan Institute corroborated these findings, noting that public pension shareholder activism driven by proxy advisory firms adversely impacts share value. The argument that shareholders are merely exercising their rights by voting on proxy measures becomes less convincing when considering that the majority of these shareholders are institutional investors adopting ISS and Glass Lewis recommendations with minimal scrutinya practice known as robo-voting. The evidence suggests that ESG programs often fail to enhance corporate performance and rarely meet their ambitious objectives.

The insistence by proxy advisory firms on supporting ESG initiatives illustrates a significant disconnect between the advice they provide and the financial interests of individual companies. This situation exemplifies the pressing need for comprehensive reforms within the proxy market. The primary goal of such reforms should be to better align the interests of proxy advisory firms with those of fund shareholders. Specific reforms could involve ensuring that proxy advisory firms uphold their fiduciary responsibilities to shareholders, enhancing transparency concerning their biases and conflicts of interest, and clarifying the methodologies used to develop their recommendations.

While proxy advisory firms currently face challenges stemming from misaligned incentives, they undeniably serve an essential function in the financial markets. Therefore, it is imperative that the market is structured to address these flaws. The 119th Congress has a significant opportunity to enact changes that could transform how proxy advisory firms operate, ultimately improving outcomes for shareholders and corporate governance as a whole.