Questions numbers 3&4

Are Voting Guidelines Ruling Your Business?

By GAIZKA ORMAZABAL & ALLAN L. McCALL

PROXY ADVISORS

O ver the past two decades, U.S. mar- kets have seen corporate gover- nance failures blamed for a series of crises, including the dot-com

boom/bust, the accounting scandals at the be- ginning of the 21st century and the global finan- cial crisis. In response, legislators drafted new laws such as Sarbanes-Oxley and Dodd-Frank, which aimed to improve internal controls and corporate governance. Less well known, at least outside the world of institutional invest- ment, are the regulatory changes made in 2003 by the U.S. Securities and Exchange Commis- sion (SEC) to require mutual funds to develop “unconflicted” policies and procedures in rela-

tion to their proxy votes, as well as disclosing their voting on all shareholder proposals.

The reasoning was simple: If conflicts of in- terest on boards were as widespread a problem as the corporate governance crises suggested, then investors – particularly institutional in- vestors – needed to pay much closer attention to governance in the companies in which they invested.

The intentions behind this new legislation were laudable. After all, what investor would not want better disclosure, transparency and accountability?

C r i t i c s p u s h b a c k t h a t t h e s e p o t e n t i a l benefits need to be weighed against other

DEEP insight

IESEinsight 31 ISSUE 21 SECOND QUARTER 2014

IIR119

For the exclusive use of A. Sivakumar, 2015.

This document is authorized for use only by Abirami Devi Sivakumar in 2015.

Are Voting Guidelines Ruling Your Business?

Recent legislative and regulatory decisions giving shareholders more influence over the governance of U.S. listed companies

has motivated corporate boards and

management to engage with shareholders

– with unintended consequences. There

has been a dramatic rise in the number

of proxy issues that have to be voted on

by shareholders. Under SEC rules, many

institutional investors have a fi duciary

obligation to cast a vote on every item

that comes before them, leading many to

outsource their voting decisions to proxy

advisors. The two largest proxy advisory

fi rms – Institutional Shareholder Services

(ISS) and Glass, Lewis & Co. (Glass Lewis)

– control most of the proxy advisory market

and have thousands of institutional clients,

meaning that the corporate governance

policies of these two companies affect a

signifi cant proportion of shareholder votes.

The authors studied proxy voting on 264

stock option repricings for 251 individual

firms and found that those repricings that

were more aligned with proxy advisory

firm guidelines experienced lower stock

returns, weaker operational performance

and a higher likelihood of executive and

employee turnover. This negative impact

on shareholder value suggests that there

is a need to better understand the role

of proxy advisors’ recommendations on

other more important voting issues such

as executive compensation, director

elections or equity compensation plans. The

regulatory debate on the U.S. proxy advisory

industry is important worldwide, as the

SEC’s regulatory choices are a benchmark

for other national and regional regulatory

bodies.

EXECUTIVE SUMMARY

possible drawbacks of the regulation. In a 2013 speech on the dangers of reactive legis- lation, Daniel M. Gallagher, a commissioner at the SEC, argued that “the resulting regu- latory mandates are often based upon false narratives and in the end lead to the expan- sion of a universal law: the law of unintended consequences.”

In the case of the SEC’s proxy voting legisla- tion, the unintended consequences have been subtle but impactful for corporate boards and investors. One of the controversies is the in- crease in the influence of proxy advisors – firms specializing in corporate governance research to whom institutional investors frequently outsource part or all of the analysis of corpo- rate governance matters that are put to a share- holder vote.

This article draws upon research that we have conducted with David F. Larcker from

Stanford University. We highlight one unin- tended consequence of this new regulatory framework and discuss the main controver- sies around the proxy advisory industry. We also call for a more thorough investigation of the impact of proxy advisory firms on company performance.

This issue concerns firms and investors not just in the United States but worldwide, as oth- er national and regional regulatory bodies use the SEC’s regulatory choices as a benchmark.

The Rise of Proxy Advisory Firms The traditional view of corporate governance involves three main actors – shareholders, managers and boards of directors – whose in- terests are not always aligned.

Shareholders provide corporations with capital, managers make use of that capital and boards supervise the managers to make sure

This article discusses the main controversies around the proxy advisory industry. We also call for a more thorough investigation of the impact of proxy advisory firms on company performance.

IESEinsight32 SECOND QUARTER 2014 ISSUE 21

For the exclusive use of A. Sivakumar, 2015.

This document is authorized for use only by Abirami Devi Sivakumar in 2015.

Are Voting Guidelines Ruling Your Business?

they allocate the capital appropriately. Share- holders are also meant to oversee the board’s actions through periodic shareholder votes.

In the wake of the last decade’s corporate governance failures, the U.S. government, fi- nancial regulators and major stock exchanges sought to rectify the balance of power between these three actors. Shareholders, they decided, needed greater input on corporate governance matters.

In 2003, the New York Stock Exchange and the Nasdaq altered their listing conditions to require that any new equity compensation plan or material modification to an equity compensation plan had to receive shareholder approval. This was followed by the SEC’s re- quirements that many institutional investors disclose both their voting polices and actual votes in proxy voting matters, ostensibly to expose potential conflicts of interest between mutual fund management and the funds’ ulti- mate shareholders.

The result has been a dramatic increase in the number of proxy issues that have to be vot- ed on by shareholders, putting strain on insti- tutional investors’ limited time and resources available to research these issues.

To deal with this burden, the SEC allowed investment firms to use independent third par- ties to guide their proxy voting and thereby ful- fill their proxy voting obligations. Specifically, the SEC issued guidance providing that if an in- vestor’s votes followed the recommendations of an independent third party (i.e., a proxy advisor) then its voting would be considered “unconflicted.”

Consequently, many institutional inves- tors began relying more heavily – some even exclusively – on the recommendations of third- party proxy advisory firms in determining their proxy votes. This, in turn, led to a rise in influ- ence of a small number of proxy advisors on the outcomes of corporate elections. A decade later, two firms – Institutional Shareholder

Services (ISS) and Glass, Lewis & Co. (Glass Lewis) – control most of the entire sector.

For institutional investors, hiring proxy advisors provides a mechanism for sharing the cost of research on proxy issues. What’s more, having a proxy advisor’s seal of approval on your proxy votes could help shield you against accusations of conflicted voting.

Although it seems like a win-win arrange- ment, doubts are starting to be raised with re- gard to the depth and quality of the research offered by proxy firms, and whether enough is being done to understand the economic con- sequences of their voting recommendations.

Does One Size Fit All? One concern is that public companies may fol- low the corporate governance policies of proxy advisors in order to gain a majority of favorable votes for management proposals, even though the policies may not be appropriate for the firm’s specific circumstances. Such actions have the potential to impose real costs on firms and their shareholders.

As anyone with managerial or executive experience will know, few rules of corporate governance can be accurately assessed without deep knowledge of a company and its manage- ment. And herein lies the problem: The recom- mendations of proxy advisors tend to be based on best practices applied to all companies. Yet these general rules could be irrelevant and even detrimental to some companies in certain business situations.

To help shed light on this issue, we exam- ined the economic consequences of proxy ad- visor guidance on “underwater” stock option repricings, whereby fi rms seek to replace stock options whose exercise price is higher than the current share price (i.e., “underwater”) with new awards of options (with lower strike pric- es), restricted stock and/or cash.

Critics of repricings – including proxy ad- visors – have argued that such moves are used

Doubts are being raised regarding the depth and quality of the research offered by proxy firms, and whether enough is being done to understand the economic consequences of their voting recommendations.

IESEinsight 33 ISSUE 21 SECOND QUARTER 2014

For the exclusive use of A. Sivakumar, 2015.

This document is authorized for use only by Abirami Devi Sivakumar in 2015.

Are Voting Guidelines Ruling Your Business?

Gaizka Ormazabal is an as- sistant professor of Account-

ing and Control at IESE. He

received a PhD in business

from Stanford University and

a PhD in construction engi-

neering from the Polytechnic

University of Catalonia, where

he also earned a degree in civil

engineering. His research fo-

cuses on executive compensa-

tion and corporate governance

mechanisms, including mana-

gerial risk-taking incentives and

corporate risk oversight.

Allan L. McCall is a re- searcher in the Center for

Leadership and Development

at Stanford’s Graduate School

of Business in the areas of

corporate governance and

compensation. He holds a

PhD from Stanford University.

Prior to that, he was a co-

founder and principal at Com-

pensia, and vice president of

compensation and benefits

for Providian Financial. He

earned a degree in economics

from Yale University.

ABOUT THE AUTHORS

by entrenched managers to extract rents from shareholders by reducing the downside risk of their compensation contracts. In other words, repricings end up insulating managers from the financial repercussions of their own bad performance.

However, research has shown that allowing some exchange of underwater stock options could be preferable to refusing to adjust initial contracts after they have gone underwater, which risks leaving a company’s employees with little or no financial incentive to stay the course in their current role, or with incentives to take excessive risks.

In our study, we analyzed a sample of 264 stock option repricings announced between 2004 and 2009. For each repricing, we mea- sured the degree of conformity to proxy advi- sor guidelines.

We then compared the conformity with subsequent firm performance and executive turnover and found that repricing programs that did not conform to proxy advisor policies were generally more benefi cial for shareholders. Specifi cally we found that fi rms with repricing

Compliance with proxy advisor guidelines on stock option repricing limited the recontracting benefits of these transactions and had a detrimental effect on shareholder value.

programs more aligned with proxy advisors’ policies had a smaller increase in stock price, weaker operational performance and a higher likelihood of executive and employee turnover.

Put another way, compliance with proxy advisor guidelines on stock option repricing limited the recontracting benefits of these transactions and had a detrimental effect on shareholder value.

Proceed With Caution This is not to say that everything proxy advi- sors do is flawed or damaging to shareholder value. Admittedly, our study examined only one management proposal that affected 251 individual firms in our sample.

For example, in the context of mergers and acquisitions, there is evidence suggest- ing that proxy advisory firms’ recommenda- tions may be better tailored to each situa- tion. In these settings, proxy advisors must typically conduct firm-specific research into e a c h M & A t r a n s a c t i o n t o d e t e r m i n e t h e i r recommendation.

Moreover, some large investment firms seem to make up their own minds regardless of the proxy advisor’s views. Michelle Edkins, head of governance for the New York-based asset manager BlackRock, told Reuters that proxy advisors provide a valuable service by helping them cast votes in relation to thou- sands of company stocks, but added that re- search from proxy advisory firms was just one of many inputs in their voting decisions.

Advocates of the proxy advisory industry also argue that critics overstate the influence of proxy advisors because many shareholder votes are non-binding and thus can be disre- garded by corporate executives and boards of directors.

That being said, negative non-binding vot- ing outcomes could also introduce significant costs for the affected companies in the form of reputational damage and litigation.

IESEinsight34 SECOND QUARTER 2014 ISSUE 21

For the exclusive use of A. Sivakumar, 2015.

This document is authorized for use only by Abirami Devi Sivakumar in 2015.

Are Voting Guidelines Ruling Your Business?

However, critics’ main concern rather re- lates to the fact that proxy advisors’ incentives to produce high-quality voting recommenda- tions are unclear.

First, proxy advisors owe no fiduciary du- ties to the shareholders of the companies on which they are advising, nor have they any di- rect stake in corporate performance.

Second, proxy advisors are deemed inde- pendent and thus protected by the current regulatory framework.

Third, because the proxy advisory industry is highly concentrated (being controlled as it is by only two main players), it is not clear whether proxy advisors are subject to substan- tial competitive pressure.

Fourth, to the extent that proxy advisors provide services to both investors and corpo- rate issuers on the same governance issues, proxy advisors could be subject to conflicts of interest. For example, the largest proxy advi- sor, ISS, not only sells proxy voting services to institutional investors but also offers consult- ing services to corporations that are the sub- ject of ISS recommendations to institutional investors.

For these reasons, it seems vital that both policy makers and regulators scrutinize the effects of proxy advisory firms’ recommenda- tions on issues that could potentially have a very large impact on investor returns, such as equity compensation plans, executive bonus plans, director elections and say-on-pay.

Time is of the essence given that countries and regions far and wide are contemplating adopting regulatory frameworks for proxy voting similar to the SEC’s, including propos- als for self-regulation.

Before such measures are exported beyond U.S. borders, we need to establish a much broader and deeper understanding of how the recommendations of proxy advisors impact shareholder value and the economy at large. This improved understanding will help answer

the questions about the proxy advisory indus- try that are currently on the desk of regulators. Should the SEC regulate the proxy advisory industry? Would this regulation stifle a source of independent research and increase manage- rial entrenchment? Is competition rather than regulation the solution to the potential prob- lems of the proxy advisory industry?

Moreover, the debate on the role of proxy advisors cannot be decoupled from the regu- latory debate on shareholder voting. We agree that investors should vote their shares if doing so is expected to increase shareholder value. However, should institutional investors be re- quired to vote in every election?

While there is a clear case to be made for a certain amount of shareholder supervision of boards and management, especially in light of recent scandals, we believe it should be done with both caution and moderation.

Otherwise, we risk solving one problem only to create a potentially bigger one – name- ly the loss of independence of company boards and management and, by extension, their abil- ity to create value for both their institutional and retail investors.

While there is a clear case to be made for a certain amount of shareholder supervision of boards and management, we believe it should be done with both caution and moderation.

� Larcker, D.F., A.L. McCall and G. Ormazabal.

“Proxy Advisory Firms and Stock Option

Repricing.” Journal of Accounting and Economics 56 (2013): 149-69.

TO KNOW MORE

IESEinsight 35 ISSUE 21 SECOND QUARTER 2014

For the exclusive use of A. Sivakumar, 2015.

This document is authorized for use only by Abirami Devi Sivakumar in 2015.