Melissa Sawyer and Frank Aquila of Sullivan & Cromwell LLP discuss the decline in ISS’ influence on shareholder votes, stemming primarily from institutional investors’ disagreement with some of ISS’ policies and institutions’ growing reliance on internal corporate governance analysis. pills arena Read our copy of the article below – or go to their published article.
ISS has long been a leader in analyzing, proposing, implementing and enforcing corporate governance reforms. In the past, ISS’s voting policies and recommendations dramatically influenced the outcome of many shareholder votes and whether ISS would recommend against a management proposal was a topic of regular discussions in board rooms. Activists used ISS recommendations as a tool in their attacks on poison pills, staggered boards, executive compensation and many other issues. ISS used the implementation of majority voting for uncontested elections, combined with its withhold vote recommendations, as a hammer to encourage companies to adopt ISS’s approach to corporate governance. Sometimes companies would even settle or compromise with an activist engaged in a proxy fight if the activist got a favorable ISS recommendation, rather than take the matter to a vote. More recently, however, several factors have started to erode ISS’s influence and raise questions about ISS’s role.
ISS’s Institutional Shareholder Clients Increasingly Do Their Own Research
In the past, proxy solicitors found that a large number of ISS’s clients would blindly follow ISS’s voting recommendations. ISS provided a service—recommending a shareholder friendly approach on how to vote—and institutions were ready consumers of that service. The institutions deferred to ISS’s expertise. Now, however, large institutional shareholders (such as Blackrock and Vanguard) are increasingly employing departments filled with their own full-time analysts and taking a more bespoke approach to shareholder votes. Some institutional investors even speculate that fully delegating voting decisions to ISS would not be consistent with their fiduciary obligations to their investors or, in the case of pension funds, their beneficiaries.
As a result of these changes, activists can no longer be certain that an ISS recommendation in favor of the activist’s proposals will guarantee victory for the activist. Whereas activists could once pitch their approach to ISS and assess with some certainty the likelihood of victory based on ISS’s response, activists must now expend more resources to meet directly with shareholders. In those meetings, the activists have to be cognizant of legal issues like the proxy solicitation, beneficial ownership reporting and insider trading rules. This development also places a greater onus on companies to communicate directly with their shareholders, fueling a growth in investor relations efforts.
ISS applies many of its voting policies across the board, without taking account of a company’s industry, the size of the company or other unique factors. For example, ISS has a policy of recommending withhold votes for directors who maintain a poison pill that is not “shareholder friendly” and compliant with ISS’s strict criteria. Some institutional investors have come to reject ISS’s application of these policies in certain circumstances. In the poison pill example, for instance, an institutional investor may favor a more robust, non-shareholder friendly poison pill if the investor agrees with the board that the company’s stock is undervalued by the market, making the company vulnerable to an unsolicited low-ball takeover attempt. In a more recent example, a non-binding proposal to split the roles of chairman and chief executive of JP Morgan was defeated, notwithstanding ISS’s recommendation in favor of the proposal. This development may reflect a gradual restoration of respect for the expertise and analysis that directors exercise in the boardroom.
Regulators have started to take a closer look at ISS’s role in shareholder meetings. For example, the House Committee on Financial Services scheduled hearings, titled “Examining the Market Power and Impact of Proxy Advisory Firms”, to consider whether proxy advisory firms are pushing political agendas on behalf of unions and pension funds rather than serving shareholder interests. In addition, the SEC recently fined ISS in connection with an ISS employee’s leaking voting information about proxy fights in exchange for perks. This appears to be the first time the SEC actually brought an action against a proxy advisor, but it may be an indication of things to come. Given ISS’s past influence over the outcome of shareholder votes, it is entirely possible that the SEC will take a closer look at whether all of ISS’s activities comply with the proxy solicitation rules, Regulation FD and the beneficial ownership reporting rules, among other things. The SEC may also start to look at the role that other advisors and service providers, like Broadridge, play in shareholder votes. A SEC review may result in more regulation and transparency in the long run. The SEC may also take a look at ISS’s voting recommendations in stock-for-stock mergers under the ‘33 Act rules that apply to communications about securities offerings.
Interestingly, the Delaware courts have not been that interested in ISS to date. Even though ISS has been criticized for conflicts of interest resulting from its sales of corporate governance consulting services for the very companies against which it makes corporate governance-related voting recommendations, the issue of whether those conflicts give rise to claims has not really been addressed by the Court of Chancery.
Increasingly, ISS is starting to share the corporate governance reform spotlight. Activists (like Bill Ackman), academics (like Lucian Bebchuk), organizations (like the Council of Institutional Investors) and even legislators have started to get into the corporate governance reform business. Particularly since the financial crisis, other countries like England and Canada have also been a source of interesting reform ideas. Blogs like the Harvard corporate governance blog provide a convenient and free forum for institutional investors to access timely information about the latest trends and ideas. As a result, ISS’s role as the arbiter of good corporate governance is waning, and being supplanted by a mere “analyst” function of applying corporate governance trends to the facts and circumstances presented by particular companies at shareholder meetings. Accordingly, institutional investors will need to decide if they think the quality of ISS’s analysis is better than what the investor can do in-house based on publicly available information. Also, ISS will increasingly compete with institutional investors and activists to hire the best researchers.
ISS is not going away any time soon, but their role in the corporate governance landscape is certainly changing. The “market” is putting pressure on ISS: Directors are increasingly willing to act against ISS’s policies and recommendations if they think it is in the best interests of the company to do so, and institutional investors are engaging more directly in discussions with companies about potential reforms and are expending more resources to perform their analysis of voting decisions in-house. Regulators and courts may also start to put pressure on the role of proxy advisors in shareholder votes. It will certainly be interesting to see if ISS revises its business model to respond to these pressures in any way.