Corporate Shareholder Meetings: Proxy Advisory Firms' Role in Voting and Corporate Governance Practices
Released: 2016-11-15T00:00:00


Highlights: section_title: Why GAO Did This Study
paragraphs: As institutional investment has grown over the last 30 years, institutional investors increasingly have relied on proxy advisory firms. The proxy advisory industry in the United States consists of five firms—two of which are the largest and most dominant proxy advisory firms. Some members of Congress, industry associations, and academics have raised issues about proxy advisory firms' influence on voting and corporate governance, the level of transparency in their methods, and the level of regulatory oversight.

GAO was asked to review the current state of the proxy advisory industry. This report discusses (1) the influence proxy advisory firms may have on voting and corporate governance, (2) how firms develop and apply policies to make vote recommendations, and (3) SEC's oversight activities. GAO reviewed literature; analyzed the proxy advisory firms' policies and SEC policies and examinations; and interviewed the 5 proxy advisory firms, 13 institutional investors, 11 corporate issuers, SEC officials, and industry stakeholders. GAO randomly selected corporate issuers from Standard and Poor's indexes and judgmentally selected institutional investors (based on size and type of investor) from industry associations' information.

GAO makes no recommendations in this report. GAO provided a draft to SEC for its review and received technical comments, which were incorporated as appropriate.

section_title: What GAO Found
paragraphs: Institutional investors, such as pension plans and mutual funds, hire proxy advisory firms to obtain research and vote recommendations on issues, such as executive compensation and proposed mergers that are addressed at shareholder meetings of public corporations (corporate issuers). Market participants and other stakeholders with whom GAO spoke agreed that with the increased demand for their services, proxy advisory firms' influence on shareholder voting and corporate governance practices has increased. But recent studies, market participants, and stakeholders had mixed views about the extent of the influence. For example, some said influence can vary based on institutional investor size (there is less influence on large institutional investors that often perform research in-house and have their own voting policies).

Proxy advisory firms, specifically Institutional Shareholder Services and Glass Lewis & Company—the two largest firms—develop and update their general voting policies through an iterative process, involving analysis of regulatory requirements, industry practices, and discussions with market participants. Corporate issuers and institutional investors told GAO that unlike in the past, the firms have made more of an effort to engage market participants in the development and updating of voting policies, such as criteria for assessing the independence of board directors and executive compensation packages. According to the firms, they apply these general voting policies to publicly available company information to develop vote recommendations, which also are based on institutional investor voting instructions and criteria that firm analysts determine are applicable to the issue being voted on. Firms have taken steps to communicate with corporate issuers and allow review of data used to make vote recommendations before they are finalized. However, some corporate issuers told GAO that firms continue to apply policies in a one-size-fits-all manner, which can lead to recommendations not in the best interest of shareholders. Corporate issuers also stated that they often do not understand the rationale for some vote recommendations and would like to discuss them before they are finalized. Proxy advisory firms told GAO that to maintain objectivity and satisfy research reporting timelines for clients, they limit the breadth of such discussions.

Securities and Exchange Commission (SEC) oversight of proxy advisory firms and the services they provide has included gathering information, issuing guidance, and examining proxy advisory firms and use of the firms by investment companies, such as mutual funds. In 2010, SEC summarized concerns that market participants raised about conflicts of interest, accuracy, and transparency of proxy advisory firms and requested comments on potential regulatory solutions. In December 2013, SEC held a roundtable to discuss issues facing the proxy advisory industry, and issued guidance in June 2014 on disclosure of conflicts of interest, among other things. According to SEC, it also has continued to address concerns surrounding proxy advisory firms through its examinations of investment advisers and investment companies that retain their services. SEC made these examinations a priority in 2015 and an area of focus in its ongoing initiative for registered investment companies that had not been examined by SEC.

section_title: Letter
paragraphs: Each year at tens of thousands of meetings, shareholders of publicly  traded companies (corporate issuers) vote on issues that could affect the  companies’ value, such as the election of directors, executive  compensation packages, and proposed mergers and acquisitions. The  shareholders receive advance notice of the votes through a written proxy  statement—information about the issues subject to vote—and may vote in  person or choose a third party (proxy) to cast their vote. Most proxy  votes are cast by or on behalf of institutional investors, such as mutual  funds and pension funds, because of the level of stocks they manage  relative to other types of investors. Institutional investors frequently hire  proxy advisory firms to provide research on the issues being voted on and  also make recommendations on whether to vote for or against these  issues.

As demand for the services of proxy advisory firms has grown, concerns  about the industry in the United States also have increased. For example,  some former Securities and Exchange Commission (SEC)  commissioners, industry associations, and academics have raised  concerns about the firms and their influence on shareholder votes and  corporate governance, and whether increased oversight and  transparency was needed. More recently, some members of Congress  expressed similar concerns and introduced legislation aimed at improving  the accountability and transparency of proxy advisory firms. Critics  contend the firms have a disproportionate influence on shareholder votes  and have no obligation to make voting recommendations in the best  interests of shareholders, and the proxy advisory industry suffers from  conflicts of interest and a lack of competition. Others counter that proxy  advisory firms provide a valuable service for institutional investors,  including identifying and aggregating information, and note that  institutional investors are sophisticated market participants that are free to  choose whether and how to employ proxy advisory firms. Moreover, they  note that without the services of a proxy advisory firm, institutional  investors would need significant resources to adequately manage a  complex and variable set of voting decisions on myriad corporate issues.  In June 2007, we reported on issues related to the proxy advisory firm  industry, including how potential conflicts of interest could affect proxy  advisory firms’ recommendations, a lack of competition within the  industry, and the extent to which institutional investors rely on advisory  firms. For example, we found larger institutional investors were less likely  to rely on proxy advisory firms because they could research voting issues  in-house, in contrast to smaller institutional investors that did not have  such research capabilities.

You asked us to review several additional aspects of the proxy advisory  firms industry. This report discusses (1) the demand for proxy advisory  services and the extent to which firms may influence proxy voting and  corporate governance practices, (2) how proxy advisory firms develop  and apply voting policies to make vote recommendations and efforts to  increase transparency, and (3) SEC’s oversight since 2007 related to  proxy advisory firms and the services they provide.

To address these objectives, we conducted a literature review and  examined studies, reports, congressional testimony, documentation from  SEC, which regulates the proxy solicitation process for publicly traded  equity securities, and documentation from proxy advisory firms. We also  identified and conducted interviews with officials and representatives with  knowledge of the industry (SEC, 5 proxy advisory firms, 13 institutional  investors, 11 corporate issuers, 4 proxy solicitors, 2 international  regulatory organizations, and 8 industry and advocacy groups). We  conducted the interviews to obtain an understanding of issues affecting  the proxy advisory industry and a variety of perspectives, as well as to  corroborate the information obtained in our literature review. Additionally,  for the first objective, we reviewed and summarized literature, and  analyzed available information on users of proxy advisory firms and the  demand for proxy advisory services, factors that may have contributed to  demand, and the possible influence of firms on proxy voting and  corporate governance practices.

For the second objective, we compared proxy advisory firms’ policies and  procedures for selected voting issues with corporate governance  standards developed by other entities, such as stock exchanges that  have corporate governance requirements that corporate issuers must  meet to be listed on the exchange and one large institutional investor that  has developed its own voting policies on corporate governance issues.  We analyzed criteria and tools proxy advisory firms use in developing  vote recommendations, and identified several examples of different proxy  voting issues to illustrate the process. We also reviewed proxy advisory  firms’ policies and views on the transparency of their processes, including  methodologies used to develop vote recommendations.

For the third objective, we reviewed and summarized SEC oversight  activities since our 2007 report, including SEC’s efforts to solicit  comments about proxy advisory services and updated guidance and  examination procedures. We also reviewed several examinations that  covered issues related to proxy advisory services. Throughout this report,  we use certain qualifiers when describing responses from interview  participants, such as “few,” “some,” and “most.” We define few as a small  number such as two or three; some as at least four or more but less than  most; and most as at least seven or more relative to the total number  possible. See appendix I for more information on our scope and  methodology.

We conducted this performance audit from August 2015 to November  2016 in accordance with generally accepted government auditing  standards. Those standards require that we plan and perform the audit to  obtain sufficient, appropriate evidence to provide a reasonable basis for  our findings and conclusions based on our audit objectives. We believe  that the evidence obtained provides a reasonable basis for our findings  and conclusions based on our audit objectives.
subsections: section_title: Background
paragraphs: Publicly traded companies are generally required by state law to hold  annual meetings to conduct business that requires shareholder approval.  U.S. public companies hold their annual meetings to consider key  management and shareholder proposals that may have an effect on a  company’s operations and value, such as executive compensation and  director elections, or other more routine issues that may not affect value,  such as changing a corporate name or approving an auditor. They also  occasionally hold special meetings during the year to consider key issues  such as proposed mergers and acquisitions.

Shareholders are provided advance notice of annual and special  shareholder meetings through a written proxy statement, which typically  includes a proxy ballot (also called a proxy card) that allows shareholders  to appoint a proxy to vote on the shareholder’s behalf if the shareholder  decides not to attend the meeting. Proxy voting can be conducted online,  by mail, or by telephone. Shareholders may instruct the proxy how to  vote the shares or grant the proxy discretion to make the voting decision.  Because of their large stockholdings, institutional investors (such as  investment advisers, insurance companies, mutual funds, and pension  plans) cast the majority of proxy votes.

In general, proxy voting in shareholder meetings involves several key  participants such as shareholders (including institutional investors),  corporate issuers, proxy agents, and proxy advisory firms (see table 1).  Institutional investors frequently hire proxy advisory firms to provide  analysis and proxy voting recommendations and facilitate voting, record  keeping, reporting, and disclosure requirements. For instance, the  mechanics of tracking proxy cut-off times, managing and analyzing proxy  materials, and casting votes can require significant resources. Many  institutional investors use a proxy advisory firm to help perform some or  all of these services. While proxy advisory firms perform services year- round, most of the services center on the proxy season. Some publicly- traded companies also may use a proxy solicitor to identify, locate, and  communicate with shareholders to secure votes on certain issues.
subsections: section_title: Proxy Advisory Firms
paragraphs: Currently, the proxy advisory industry in the United States consists of five  firms: Institutional Shareholder Services (ISS), Glass Lewis & Co. (Glass  Lewis), Egan-Jones Proxy Services (Egan-Jones), Marco Consulting  Group (Marco Consulting), and ProxyVote Plus.

ISS, founded in 1985, provides research and analysis of proxy issues,  custom policy implementation, vote recommendations, vote execution,  governance data, and related products and services. ISS also  provides advisory/consulting services, analytical tools, and other  products and services to corporate issuers through ISS Corporate  Solutions, Inc. (a wholly owned subsidiary). ISS is owned by Vestar  Capital Partners, a private equity firm, and company management. As  of September 2016, ISS had more than 900 employees in 18 offices  in 12 countries, and covered approximately 39,000 meetings in 115  countries. ISS had about 1,600 institutional investor clients and  executed more than 8.5 million ballots annually on behalf of those  clients.

Glass Lewis, established in 2003, provides proxy research and  analysis, custom policy implementation, vote recommendation, vote  execution, and reporting and regulatory disclosure services to  institutional investors. Glass Lewis is an independent portfolio  company of the Ontario Teachers’ Pension Plan Board and Alberta  Investment Management Corporation. As of September 2016, Glass  Lewis had more than 350 employees and offices in San Francisco,  New York, Ireland, Australia, and Germany that provide services to  more than 1,200 institutional investors that collectively manage more  than $20 trillion.

Egan-Jones Proxy Services was established in 2002 as a division of  Egan-Jones Ratings Company. Egan-Jones provides proxy services,  such as notification of meetings, research and recommendations on  selected voting issues, voting guidelines, execution of votes, and vote  disclosure. As of September 2016, Egan-Jones Ratings Company had  approximately 450 clients of all types firm-wide including funds,  institutions, corporate issuers, and public entities. Of these, Egan- Jones’ proxy research or voting clients mostly consisted of mid- to  large-sized mutual funds. Egan-Jones covers approximately 40,000  companies. Many of its largest institutional clients use Egan-Jones  research to augment their own research. Egan-Jones is based in  Haverford, Pennsylvania.

Marco Consulting Group, an Illinois-based firm, was established in  1988 to provide investment analysis and advice, and proxy voting  services to a large number of Taft-Hartley and public benefit plans.  As of September 2016, Marco Consulting served 300 clients with  assets of $145 billion. Marco Consulting uses ISS as the provider for  its proxy voting platform and reporting. Marco Consulting also  subscribes to research services from ISS. It has offices in Chicago,  Boston, and Denver.

ProxyVote Plus, also based in Illinois, is an employee-owned firm  established in 2002 to provide proxy voting services to Taft-Hartley  fund clients. ProxyVote Plus conducts internal research and analysis  of voting issues and executes votes based on its guidelines.  ProxyVote Plus reviews and analyzes proxy statements and other  corporate filings, and reports annually to its clients on proxy votes cast  on their behalf. As of September 2016, ProxyVote Plus had more than  200 clients throughout the United States and Canada.

Of the five firms, ISS and Glass Lewis are the largest and most often  used by institutional investors. To compete, proxy advisory firms must  offer comprehensive coverage of corporate proxies and use sophisticated  systems to provide research and proxy vote execution services. As we  reported in 2007, ISS’s long-standing history—since 1985—of working  with institutional investors, as well as its reputation for providing  comprehensive proxy voting research and recommendations, makes it  the most dominant proxy advisory firm. We found that ISS’s dominance  makes it difficult for competitors to attract clients and compete in the  market. We also reported that institutional investors may be reluctant to  subscribe to a potentially inexperienced or less-established proxy  advisory firm that may not provide thorough coverage of all of their  institutional holdings. According to market participants and other  stakeholders with whom we spoke, these conditions continue to exist,  and, among other things, the initial investment required to develop and  implement the necessary technology is a significant expense for firms.

section_title: U.S. Regulatory Framework
paragraphs: Under the Securities Exchange Act of 1934 (Exchange Act), SEC  regulates the proxy solicitation process for publicly traded equity  securities. SEC also regulates the activities of proxy advisory firms that  are registered with SEC as investment advisers under the Investment  Advisers Act of 1940 (Advisers Act). Under SEC rules, when soliciting  proxies, certain information must be disclosed in writing to shareholders  in a document referred to as a proxy statement. These proxy statements  must include important facts about the issues on which shareholders are asked to vote. A party soliciting proxies must file such proxy statement  with SEC unless it is exempt under the proxy rules. Under the Advisers  Act and related SEC rules, registered investment advisers are subject to  a number of regulatory requirements that provide important protections to  the firm’s clients. For example, an investment adviser must disclose  information about its business practices and potential conflicts of interest  to clients and prospective clients. Additionally, registered investment  advisers are required to adopt and implement written policies and  procedures reasonably designed to prevent violation of the Advisers  Act. Finally, regardless of whether a proxy advisory firm is registered as  an investment adviser, all firms that meet the statutory definition of  investment adviser, and are unable to rely on an exclusion from the  definition, are subject to the antifraud provisions of the Advisers Act. This  act prohibits investment advisers from engaging in any act, practice, or  course of business that is fraudulent, deceptive, or manipulative.

Table 2 describes whether and how proxy advisory firms are registered  with SEC. ISS, Marco Consulting, and ProxyVote Plus are registered as  investment advisers and, according to their SEC registration filings,  identified their work as pension consultants as the basis for registering as  advisers. Egan-Jones Ratings Company (Egan-Jones’s parent  company) is registered as a Nationally Recognized Statistical Rating  Organization and must meet certain regulatory requirements related to its  credit ratings activity, but these requirements do not apply to its proxy  advisory services. Glass Lewis is not registered with SEC.

SEC also has issued several rules and policy documents that provide  guidance on proxy voting by investment advisers and investment  companies. For example, SEC issued a final rule in February 2003 that  addresses an investment adviser’s fiduciary responsibilities to clients  when the adviser has the authority to vote their proxies, including  adopting policies and procedures to ensure proxies are voted in the best  interest of clients. The rule also requires that an adviser must (i)  disclose to clients how they can obtain information from the adviser on  how their securities were voted and (ii) describe the adviser’s proxy voting  policies and procedures to clients, and upon request, provide clients with  a copy of those policies and procedures. SEC issued another final rule in  February 2003 that requires investment companies such as mutual funds  to disclose how they vote proxies relating to portfolio securities they hold,  and file with SEC and make available to shareholders information about  specific proxy votes cast. In May 2004 and September 2004, SEC staff  issued guidance that, among other things, clarified how an investment  adviser could resolve conflicts of interest in voting clients’ proxies and  ensure that proxy advisory firms could adequately analyze proxy issues  and make recommendations in the best interests of the adviser’s clients.  We focus on SEC oversight since 2007 later in this report.

SEC monitors compliance with the federal securities laws and regulations  through risk-based examinations of registered investment advisers.  Based on examination findings, SEC may send letters to investment  advisers, including proxy advisory firms registered as investment  advisers, requesting that they correct identified deficiencies. SEC may  take enforcement actions for more serious violations. Proxy voting issues  and proxy advisory firms may not be examined on a regularly scheduled  basis because SEC uses a risk-based approach to identify examination  priorities each year. Among other things, SEC may consider the risk of an  entity based on prior examination findings; significant changes in a  registrant’s business activities or disclosures regarding regulatory or other  action brought against them; and tips, complaints, or other referrals.  SEC uses this approach to help allocate its limited resources to focus on  those registrants that examination staff believe place the investing public  or market integrity most at risk.

section_title: International Regulatory Actions Related to Proxy Advisory Firms
paragraphs: International regulatory organizations, including the European Securities  and Markets Authority and Canadian Securities Administrators, have  taken actions to promote increased engagement among market  participants and transparency into proxy advisory firms’ processes. In  recent years, these organizations conducted reviews of the proxy  advisory firm industry and concluded that regulatory intervention was not  needed. Specifically, the European Securities and Markets Authority  concluded that regulation was not justified because there was no  evidence of a market failure in relation to how proxy advisory firms  interact with institutional investors and corporate issuers. However, both  entities proposed guidance and recommendations for the firms to  enhance transparency, among other issues.

In a 2013 report, European Securities and Markets Authority officials  recommended the creation of an industry code of conduct. Subsequently,  a group of proxy advisory firms, including ISS and Glass Lewis, published  a set of best practice principles that included disclosing their (1) research  methodology and, if applicable, general voting policies; and (2) policies  for communication with corporate issuers, shareholder proponents, other  stakeholders, media, and the public. In December 2015, European  Securities and Markets Authority released a follow-up to its 2013 report  responding to the establishment of best practice principles. This report  concluded that the best practice principles had a positive impact on the  market, mainly in terms of enhanced clarity for different stakeholders on  how proxy advisory firms operate. The report also stated that while the  majority of the industry is signatory to the principles, including ISS and  Glass Lewis, broader sign-up to the principles would contribute to  establishing the principles as the prevailing standard in the industry. ISS  and Glass Lewis have posted statements of compliance on their websites  that describe how they apply the principles in their work.

In April 2015, the Canadian Securities Administrators adopted the  National Policy 25-201 Guidance for Proxy Advisory Firms. The policy is  intended to promote transparency in the process leading to vote  recommendations and the development of proxy voting guidelines, and  foster understanding among market participants about the activities of  proxy advisory firms. The guidance is not intended to be prescriptive but  rather encourage proxy advisory firms to consider the guidance in  developing and implementing practices that are tailored to their structure  and activities.

section_title: Several Factors Have Led to Increased Demand for and Influence of Proxy Advisory Firms, but Mixed Views Exist on the Extent of Influence
paragraphs: The market for proxy advisory firms has grown, with higher demand  stemming from factors including the rise of institutional investing and the  effect of some new policies and requirements. Recent studies and the  market participants and other stakeholders with whom we spoke agreed  that proxy advisory firms influenced shareholder voting and corporate  governance practices. But market participants and stakeholders had  mixed views about the extent of this influence and some said that  influence can vary based on the size of the institutional investor or the  voting policies used. Studies we reviewed also did not agree on the  extent of the influence or whether it was helpful or harmful.
subsections: section_title: Increased Demand for Proxy Advisory Firms’ Services Stems from Rise of Institutional Investing and Requirements for Shareholder Voting
paragraphs: The market for proxy advisory firms has grown over the last 30 years as  institutional investors have relied more on firms to provide research,  analysis, and vote recommendations. According to academic and industry  studies, the increased demand for proxy advisory services stems from  several factors, including the growth in the proportion of shares owned by  institutional investors, the number and complexity of voting issues, and  shareholder activism and the effect of some new policies and  requirements. Some of these issues are consistent with themes we  identified in 2007.

Institutional Ownership. The increased ownership share that  institutional investors hold and the high volume of proxy votes they are  responsible for casting has increased demand for proxy advisory firms.  According to a recent Broadridge and PwC report, in 2016 institutional  investors owned 70 percent of shares outstanding in U.S. public  companies compared with retail investors (or individual investors) who  owned 30 percent of shares outstanding. Institutional investors also  have voted at much higher rates; for example, as of June 2016, 91  percent of institutional investors voted their shares compared with 28  percent of retail investors. Because many institutional investors use the  services of proxy advisory firms, increased institutional ownership has  resulted in a greater demand for these firms.

Number and Complexity of Voting Issues. Some institutional investors  may lack the resources to consider the many complex proxy issues that  come before them for a vote and instead may opt to use the services of a  proxy advisory firm, which adds to the demand for the firms. For example,  the Dodd-Frank Wall Street Reform and Consumer Protection Act  requires a shareholder advisory vote on executive compensation (“say- on-pay”). The act allows shareholders to vote their opinion on executive  compensation plans every 1–3 years, thereby increasing the volume of  shareholder votes on this issue. Institutional investors also have become  more involved in a range of corporate governance and other issues such  as board composition and diversity, executive severance agreements  (including “golden parachutes”), strategy and growth, and sustainability  and climate change that can require extensive analysis. Thus, the  growing number and complexity of proxy voting issues has also  contributed to the increased demand for proxy advisory firms.

Shareholder Activism and Regulation. Proxy advisory firms also have  become more prominent because of continued shareholder activism and  the impacts of some regulations. For example, many institutional  investors seek the services of proxy advisory firms to assist in their  assessments of corporate governance practices and carry out the  mechanics of proxy voting. As discussed earlier, in 2003, SEC adopted a  final rule that required registered investment advisers, among other  things, to adopt policies and procedures reasonably designed to ensure  that they vote proxies in the best interests of clients. According to some  industry stakeholders, based on certain interpretations of the rule and  subsequent SEC staff guidance, some investment advisers determined  that they could discharge their duty to vote their proxies and demonstrate  that their vote was not a product of a conflict of interest if they voted  based on the recommendations of a proxy advisory firm. As a result,  institutional investors tended to outsource their research and voting  decisions, which helped to increase the demand for proxy advisory  services. However, in 2014, SEC staff issued a Staff Legal Bulletin that,  among other things, included guidance on investment advisers’  responsibilities in voting client proxies and retaining proxy advisory firms,  including notice that investment advisers are not required to vote every  proxy, depending on the proxy voting arrangements between advisers  and their clients. We discuss other aspects of this guidance later in the  report.

section_title: Studies and Market Participants Agreed That Proxy Advisory Firms Influence Voting and Corporate Governance, but Had Mixed Views about Extent of Influence
paragraphs: Recent studies, market participants, and other stakeholders agree that  proxy advisory firms have influence on shareholder voting and corporate  governance practices, but had mixed views about the extent of their  influence. Our review of four recent studies that analyzed the extent to  which proxy advisory firms’ recommendations influenced voting decisions  and shifted some fraction of the votes shows that proxy advisory firms  have influence on shareholder voting. For instance, using a sample of  director elections, a 2009 study found that ISS recommendations have an  impact on shareholder votes, and directors receiving a negative ISS  recommendation receive 19 percent fewer votes. However, a 2010  study concluded that while both ISS and Glass Lewis appear to have a  meaningful impact on shareholder voting, media reports often overstate  the extent of ISS’s influence on voting. The study found that the impact  of an ISS recommendation is reduced once director- and company- specific factors that are important to investors—failure to attend board  meetings, financial performance, corporate misconduct, and a lack of  responsiveness to shareholders—are taken into consideration. Unlike  higher estimates, the analysis showed that an ISS recommendation  shifted 6–10 percent of shareholder votes.

Additionally, a 2013 study concluded that proxy advisory firm  recommendations are the key determinant of voting outcomes in the  context of mandatory “say-on-pay” votes. The study found that negative  ISS and Glass Lewis recommendations are associated with 25 percent  and 13 percent more votes against the compensation plan, respectively.  The study also found that the relationship between proxy advisory firm  recommendations and shareholder votes varies based on the rationale  behind the recommendation and the institutional investor’s ownership  structure. For example, the relationship between negative  recommendations and shareholder votes is weaker for shareholders with  larger holdings and, thus, presumably greater incentives to perform their  own internal research. The study concluded that this suggests that at  least some shareholders are not directly influenced by the  recommendations and take into account the underlying basis for the  recommendation and other relevant factors. A 2015 study also found that  proxy advisory firms have an effect on voting outcomes related to say-on- pay proposals. Specifically, the study concluded that negative ISS  recommendations reduce the percentage of votes in favor of say-on-pay  proposals by about 25 percentage points.

Similarly, our interviews with market participants and other stakeholders  showed mixed views on the extent of influence proxy advisory firms have  on voting. Most of the 13 institutional investors,11 corporate issuers, 4  proxy solicitors, and 8 industry association representatives with whom we  spoke stated that proxy advisory firms (more specifically, ISS and Glass  Lewis—the two firms with the largest number of institutional investor  clients) have influence on shareholder voting. However, some investors,  solicitors, and investor association representatives said that proxy  advisory firms had little influence and that such influence varied based on  the size of the institutional investor or whether the institutional investor  uses its own or the proxy advisory firm’s research and voting policies.  Specifically, they told us that the level of influence that ISS and Glass  Lewis have on voting and corporate governance is minimal because large  institutional investors cast the majority of proxy votes and do not  exclusively rely on the research and vote recommendations offered by  proxy advisory firms to help decide how to vote proxies.

We previously found in 2007 that large institutional investors, which cast  the great majority of proxy votes made by all institutional investors, placed  less emphasis on proxy advisory firms’ research and recommendations  than smaller institutional investors, and tended to have their own in-house  research staffs to conduct research that drove their proxy voting  decisions. Some institutional investors and investor association  representatives with whom we spoke also said that the firms’ influence  has significantly declined in recent years, as some institutional  investors—in particular, asset managers (such as investment advisers to  mutual funds) and pension funds—have taken a greater interest in proxy  voting and developed in-house expertise to address proxy vote-related  issues.

The institutional investors and investor association representatives also  pointed to the growing trend among institutional investors of using their  own voting policies as a basis for voting decisions instead of relying on  the proxy advisory firms’ policies and vote recommendations. For  example, officials from the four large institutional investors told us that  they conduct their own research and analyses to make voting decisions  and use the research of proxy advisory firms only to supplement their  internal research and analyses. Officials from one proxy advisory firm  also told us that while firms provide vote recommendations, it is the  institutional investor that makes the actual vote decision, which is most  often based on the institutional investor’s own voting policies. Moreover,  they noted that as clients of the proxy advisory firm, institutional investors  always retain the ability to change the vote that the proxy advisory firm  casts on their behalf.

According to large institutional investors and a few investor association  representatives that we spoke to, some smaller institutional investors who  do not have their own in-house research staffs to analyze the many proxy  voting issues and companies in their portfolio will obtain such services  from proxy advisory firms and rely more on the research and  recommendations proposed by the firms. In these cases, the resulting  vote recommendation could have more of an influence on the voting,  because some of these smaller institutional investors have a tendency to  adopt the firms’ recommendations and vote accordingly. One small  institutional investor told us that it relies on the research and the vote  recommendations of ISS and will consider the firm’s recommendations on  certain actions before making voting decisions.

Other studies that we reviewed showed that proxy advisory firms also  have an influence on corporate governance practices. For example, a  2015 study found that to avoid a negative vote recommendation,  companies changed their compensation programs before the formal  shareholder vote in a manner consistent with the features known to be  favored by proxy advisory firms. A 2013 study also found that more than  half of companies involved in the study responded to a shareholder vote  triggered by a negative recommendation from the proxy advisory firms by  making changes to their compensation plan. In addition, a 2012 study  found that more than two-thirds of U.S. companies say their executive  compensation program is influenced by the policies and voting  recommendations of the two largest proxy advisory firms—ISS and Glass  Lewis. In particular, a majority of companies say they are likely to make  changes to their compensation program to gain a favorable “say-on-pay”  recommendation from these firms. Two corporate issuers also told us  that proxy advisory firms have some influence on the development of their  governance practices and they would generally accept the firms’ advice  on corporate governance requirements.

Officials from one proxy advisory firm with whom we spoke stated that  they agree that proxy advisory firms have influence on corporate  governance practices. The proxy advisory firm further indicated that its  policy frameworks reflect its institutional investor clients’ preferences for  better disclosure, strong shareholders’ rights, and adoption of best  practices governance standards. They noted that such influence is good  and ultimately they want to have a positive influence on their clients  because they view that as part of their responsibility—to promote good  governance. Similar to the views expressed by the officials of the proxy  advisory firm, investor association representatives also suggested that  consideration be given to the context in which influence is often viewed.

They noted that most often, influence is viewed negatively. However, the  representatives said that proxy advisory firms’ influence can be positive.  That is, if the recommendations proxy advisory firms make help to  promote good governance, then the firms’ influence on voting is beneficial  to shareholders. Additionally, a 2009 study found that proxy advisory firm  recommendations—at least for uncontested director elections—appeared  to be based on factors that should matter to institutional investors, such  as good governance, director attention, and performance.

section_title: Proxy Advisory Firms Have Increased Engagement with Market Participants and Stakeholders in the Vote Recommendation Process
paragraphs: Proxy advisory firms develop their general voting policies and update  them through an iterative process involving analysis of institutional  investor and corporate issuer input, industry practices, and discussions  with other stakeholders. These policies are similar to or in some cases  stricter than other standards such as those from the New York Stock  Exchange (NYSE) and the NASDAQ Stock Market (NASDAQ). Proxy  advisory firms have taken steps to communicate with corporate issuers  when developing voting recommendations and have allowed some to  review proxy reports for accuracy before they are final. While some  corporate issuers said they still do not understand the bases for some  vote recommendations and would like to have a dialogue about the proxy  reports, proxy advisory firms said that to maintain objectivity and satisfy  research reporting timelines for clients they have to limit the breadth of  such discussions.
subsections: section_title: Proxy Advisory Firms Have Increased Engagement with Stakeholders in Development of Their Voting Policies to Address Concerns
paragraphs: Proxy advisory firms’ voting policies outline their approaches for  evaluating positions on, and rationales for, recommendations on  corporate governance issues. For example, ISS and Glass Lewis officials  said they develop three types of policies: general, specialized, and client- customized.

General policies reflect the firm’s own positions and rationales on  various corporate governance issues and are generally used in  developing their vote recommendations. The policies may take into  account national and international corporate governance codes and  practices, as well as the views of institutional investors, corporate  issuers, and other stakeholders.

Specialized policies reflect the institutional investor clients’  perspective on specific governance issues such as sustainability,  socially responsible investing, public funds, labor unions, or mission  and faith-based investing. Since these policies reflect specific  institutional investor perspectives or needs of different institutional  investors, voting recommendations developed under these policies  may in some cases differ from recommendations formed under  general policies.

Client customized policies are based on institutional investor clients’  unique corporate governance guidelines, and reflect each investor’s  specific philosophies and approaches. For these clients, the proxy  advisory firm prepares voting recommendations based on these  policies. As a result, the vote recommendations issues under these  policies may differ from those issued under general policies.

Since specialized and client customized policies reflect different  perspectives of different institutional investors, voting recommendations  developed under these policies in some cases may differ from  recommendations formed under general polices. The following discussion  focuses on general policies, which represent the general guidelines the  firms use for their analyses in developing vote recommendations.

According to the two largest proxy advisory firms—ISS and Glass  Lewis—they develop their general voting policies and update them  through an iterative process, which recently has included increased  engagement with institutional investors, corporate issuers, and other  stakeholders. ISS and Glass Lewis have taken steps to obtain input  from and communicate with market participants about voting policies.  Some corporate issuers we interviewed said that both ISS and Glass  Lewis recently have made more of an effort to engage market participants  in the general policy development process unlike in the past when their  outreach was less frequent or formal. When we spoke to both proxy  advisory firms, they also said that they made their processes more  transparent than they were in the past. For example, they have begun to  conduct engagement meetings, hold roundtables, and post guidelines to  their websites. Specifically, Glass Lewis officials said they have created a  corporate issuer resource website that offers links to its guidance  documents, forms to request engagement meetings, and responses to  frequently asked questions. ISS officials said they invite institutional  investors, corporate issuers’ management and board directors, and other  industry stakeholders to participate in its annual proxy voting policy  survey. According to ISS, the survey is designed to provide input on key  issues that are factored into the development of ISS’s general policy  guidelines, including proposed policy updates as well as new policies.  See figure 3 for examples of the types of communication mechanisms  used.

A few corporate issuers told us that although input is obtained from both  corporate issuers and institutional investors, it does not necessarily make  its way into the final general policy guidelines. One corporate issuer we  interviewed said there has been a noticeable increase in outreach (a lack  of outreach was evident in the past). But the corporate issuer also said  there is a difference between proxy advisory firms soliciting input and  using input to modify policies. Another corporate issuer, who said it was  not solicited for feedback, said it seemed like policies were sometimes  developed in a vacuum. However, Glass Lewis officials said that they  have responded to issuer feedback, for example, Glass Lewis changed its  approach for selectin issuer peer groups used in its pay for performance  analysis. Also, Glass Lewis officials said that they work with an  independent advisory council that provides guidance in the development  and updating of its voting policies.

Further, some have raised concerns about ISS’s policy survey and  published results. For example, one market participant we interviewed  said that a relatively small number of institutional investors drive ISS’s  policy formation process in part because a small number of ISS investor  clients participated in the survey. In a February 2013 working paper, the  authors also noted that ISS’s policy survey relied on a small number of  participants and provided little detail about the composition of the  respondent pool. ISS officials said there has been consistency in the  relative mix of institutional investors and corporate issuers responding to  the survey, with more corporate issuers than institutional investors  answering the survey questions.

section_title: Proxy Advisory Firms’ Voting Policies for Selected Governance Issues Generally Were Similar to or Stricter Than Those of Other Selected Market Participants
paragraphs: Based on our review of selected general voting policies of proxy advisory  firms and other market standards on corporate governance, the firms’  policies were similar to or in some cases stricter than the other standards  and covered a broader range of issues. We reviewed selected policies  from the five proxy advisory firms, NYSE, NASDAQ, and a large  institutional investor, and looked specifically at the issues of director  independence, overboarding (number of public company boards for which  a director can serve before being considered overextended), independent  chairman/chief executive officer (CEO), and proxy access, as illustrated  in the following examples:

Board independence. Proxy advisory firms and the exchanges  (NYSE and NASDAQ) require some level of independence on  corporate boards. Specifically, both exchange listing requirements  and firm voting policies call for a majority of independent board  directors on corporate boards. However, these bodies vary on the  “look-back” period required for directors to be deemed independent  from the company. The five proxy advisory firms and one institutional  investor policy that we reviewed require a 5-year look back, while the  exchanges require 3 years. One proxy advisory firm’s rationale for this  difference was that 5 years allows enough time for management and  board members to settle any conflicts of interest. This firm also notes  that it does not automatically apply the 5-year threshold and will  consider the type of relationship the nominee has with the company.

Overboarding. Proxy advisory firms and some institutional investors  have policies on overboarding, but the exchanges do not. In 2016,  both ISS and Glass Lewis updated their director overboarding policies  to reflect concerns about directors overcommitting themselves.  Specifically, a few institutional investors expressed the position that if  directors served on too many boards, they would not have sufficient  time to focus on the issues related to any one company. The  institutional investor policy we reviewed—which had a lower threshold  than that of the proxy advisory firms—explained that generally it is  unlikely that a director will be able to commit sufficient focus to a  particular company when a director commits himself or herself to a  large number of boards. Both ISS and Glass Lewis’s policies outline a  phased transition to a lower board membership threshold for directors.  ISS policy states, for example, that it will recommend that  shareholders vote against directors who sit on more than six boards,  but beginning in 2017, ISS policy states that it plans to make negative  recommendations for directors sitting on more than five. Glass Lewis  policy also states that it plans to note a concern for these directors in  its report, thus providing a transition period before putting the full  policy into effect. The current policy cites six boards, but in 2017  Glass Lewis’ policy also recommends voting against a director who  serves on more than five boards. Further, a couple of the firms have  changed their policy on the number of boards that a CEO should  serve on. For example, in 2016, Egan-Jones changed its  overboarding policy limiting the number of outside boards a CEO may  serve on to one. Glass Lewis plans to make a similar adjustment in  2017. Glass Lewis policy states that during the 2016 proxy season, it  plans to note as a concern CEOs serving on more than one outside  boards, and then beginning in 2017 it will base its recommendation on  this lower threshold. ISS policy recommends a vote against CEOs  who sit on more than two outside boards.

Independent chairman/CEO. The issue of an independent  chairman/CEO is another example of an issue area covered by the  proxy advisory firms’ and large institutional investor’s policy, but not  addressed by the exchange listing requirements. Specifically, all five  proxy advisory firms have independent chairman/CEO policies. One  firm said the development of this policy was guided by feedback from  institutional investor clients. Similar to the five proxy advisory firms,  the large institutional investor policy we reviewed generally supports  the separation of chairman and CEO when a company does not have  a lead independent director. The institutional investor policy states  that support for independent leadership is important given the roles  that the chairman plays, such as contributing to oversight of CEO  succession planning and serving as an advisor to the CEO.

Proxy access. The issue of proxy access is another area not covered  by the exchange listing standards, but addressed by the proxy  advisory firm and institutional investor policies. Specifically, the five  proxy advisory firms have a proxy access policy. According to market  participants, the increased rise of shareholder activism also saw  increased attention on the issue of proxy access. One market  participant we interviewed said that proxy advisory firm policies have  become more complex and nuanced, and the firms have enhanced  policies on proxy access as the issues have received more attention.  Similarly, the institutional investor policy we reviewed supports proxy  access, stating that long-term shareholders should have the  opportunity to nominate directors.

Market participants with whom we spoke generally viewed proxy advisory  firms’ policies on corporate governance as stricter than other industry  standards but reflective of institutional investors’ interests. Specifically, for  select corporate governance issues, proxy advisory firm policies may call  for higher standards of compliance than other industry standards, such as  exchange listing requirements. Some market participants said that these  stricter standards are a reflection of the higher standards for which some  investors look and that in their view help promote better governance  practices. They stated that exchange listing standards tend to only serve  as a baseline for publicly traded companies. A few institutional investors  pointed out that their policies require even higher standards of  compliance than the proxy advisory firms have developed. For example,  representatives of one institutional investor told us that their company’s  overboarding policy is stricter than both ISS’s and Glass Lewis’s policies.  The officials added that the issue of overboarding is a case in which  institutional investors were ahead of the marketplace and proxy advisory  firms were just now “catching up.”

section_title: Proxy Advisory Firms Considered Company- Specific Information in Vote Recommendations and Allowed Some Corporate Issuers Opportunities to Correct Data
paragraphs: Proxy advisory firms’ approaches for developing vote recommendations  can be case-by-case or rules based. Policy application may depend on  factors such as the type of vote cast or the voting instructions provided by  institutional investor clients. A more rules-based approach might be  applied with some board of director issues such as board independence,  which uses a time period threshold to ensure that directors with previous  work history with a company have been separated long enough to be  independent. However, such issues may still be subject to a case-by-case  review. For example when applying the look-back period for director  independence, Glass Lewis’s proxy policy states that it will not  automatically recommend voting against former executives of a company  who have consulting agreements with the company during the look-back  period.

In contrast, vote recommendations on mergers and acquisitions would  always be applied on a case-by-case approach that considered the facts  and circumstances of the companies involved. The proxy advisory firms  state in their respective general policies that they consider the benefit that  implementation of a proposal would have on shareholders of the  company being evaluated. For example, in proxy reports we reviewed of  a merger, both ISS and Glass Lewis evaluated the potential benefits of  the merger to investors on both sides of the proposed transaction. Both  ISS and Glass Lewis found that investors for one company would benefit  and thus recommended in favor of the merger for investors of that  company, but recommended against the merger for investors of the other  company because it would not be to their benefit.

In conducting evaluations such as these, ISS and Glass Lewis officials as  well as some corporate issuers we interviewed also said that the firms  consider new and company-specific information. For example, in 2015  reports on this merger, ISS made adjustments to its original reports to  account for company-specific information that clarified two data points,  adjusting the estimated fair value of one of the companies. The updates  were included in the reports and clients were notified through an alert or  note—a process the proxy advisory firms use when they have updated or  revised information in their reports. Proxy advisory firm officials also  pointed out that while analysts have the discretion to engage with clients  as well as with some corporate issuers during each proxy season, the  firms only consider new or company-specific information that is publicly  available to help ensure their reports and recommendations are based on  the same information available to clients and the broader investing public.

Both Glass Lewis and ISS officials acknowledged that corporate issuers  expressed an interest in reviewing proxy reports for accuracy in advance  of proxy meetings. In addition, international regulatory organizations, such  as European Securities and Markets Authority and Canadian Securities  Administrators, have promoted increased engagement and transparency  between corporate issuers and proxy advisory firms. Therefore, the proxy  advisory firms have developed specific procedures that corporate issuers  or their representatives may use to review or report errors related to the  proxy reports prepared by the firms (see fig. 4).

Specifically, Glass Lewis developed a new process in 2015 by which  companies can receive a draft data-only version of a report for review  before the firm completes its analysis. These data-only versions do not  contain the firm’s recommendations. Companies interested in receiving a  report must submit a request. Corporate issuers are given a 48-hour  window to review the draft and provide corrections. ISS offers a similar  opportunity to Standard and Poor’s 500 companies and to companies in  comparable large capitalization indices in some countries outside the  United States. However, unlike the data-only versions of the reports  provided by Glass Lewis, these reports contain ISS’s analyses and vote  recommendations. Other corporate issuers have the option of requesting  a copy of the published report in advance of the company’s annual  meeting. Standard and Poor’s 500 companies have the opportunity to  review ISS’s draft reports and provide feedback within 1-2 business days.  One stakeholder we interviewed said that this time window did not always  allow corporate issuers enough time to review. However, Glass Lewis and  ISS officials indicated that these time windows allow them to meet their  report publishing deadlines. In addition to the draft review process, ISS  officials said ISS has a Feedback Review Board that provides a  mechanism for stakeholders to communicate with ISS throughout the  year regarding the accuracy of data, research, and general fairness of  policies.

ISS and Glass Lewis documents state that the opportunity to review  advance copies of each company’s specific report is only an opportunity  to check data for factual errors and not a mechanism for conveying  disagreement with ISS’s or Glass Lewis’s methodologies or analyses.  Some corporate issuers stated that there are differences of opinion,  conflicting points of view, and misinterpretations of the data. However,  ISS documentation indicated that although the review process allows for  a verification of data, it has to limit the breadth of the review because it  adds operational complexity and significant time to the research  production process. Glass Lewis policy states that during proxy season it  has to limit discussions on its policies or recommendations to help it  remain objective. However, Glass Lewis officials said that it engages with  issuers extensively outside of proxy season on issuer-specific issues  including specific recommendation as well as general policies. Both  corporate issuers and institutional investors we interviewed said that the  data errors they found in the proxy reports were mostly minor, but as we  discuss below, some errors can lead to negative recommendations.

Some issuers raised other concerns regarding how policies were applied  during recommendation development and that the approaches used did  not always account for differences across corporate issuers. For example,  ISS’s and Glass Lewis’s general compensation policies lay out a set of  criteria they use in evaluating an executive compensation package.  Corporate issuers we interviewed expressed concern that firms applied  these policies in a one-size-fits-all or rules-based manner. A few  corporate issuers said they had to initiate outreach to the firms to explain  the corporate issuers’ unique circumstances before the recommendations  were reversed. Corporate issuers with whom we spoke pointed to another  example of one-size-fits-all application involving overboarding policies. As  mentioned earlier, ISS and Glass Lewis general policies provide a  threshold (number) for public company boards on which a director can  serve before being considered overextended. One small corporate issuer  we interviewed said it was unsuccessful in trying to make a case for  keeping a highly qualified director who contributed needed expertise but  was deemed overboarded. Given the company’s small size,  representatives found it very important to have this individual on its board.  Although a few corporate issuers with whom we spoke were frustrated  that consideration has not been given for special circumstances or the  effect the decision would have on the company, one proxy advisory firm’s  policy refers to institutional investor concerns about directors being  overextended. As previously discussed, a 2013 study found limited  evidence of a one-size-fits-all approach in the context of mandatory say- on-pay. The study found that proxy advisory firms take into consideration  mitigating company-specific circumstances, severity of the issue, the  firm’s rationale, and the overall quality of the compensation plan when  policies were applied during recommendation development.

Furthermore, some corporate issuers and stakeholders would like further  insight into how the proxy advisory firms arrived at their vote  recommendations. A few stakeholders also told us they hire consultants  with expertise on executive compensation and have developed models  similar to those used by proxy advisory firms to help them better  understand how firms produce their results and recommendations.

To further increase transparency into the proxy advisory firm vote  recommendation process, stakeholders have proposed making the  reports available to the public at some time after the annual meeting.  Market participants and other stakeholders told us there are advantages  and disadvantages to making proxy advisory firm reports public at an  appropriate time. For example, some market participants said a possible  advantage to making the reports public is that it would allow for greater  scrutiny and the ability to further evaluate the validity of proxy firm  recommendations and whether the recommendations have a positive  effect on shareholder value. But several stakeholders agreed that making  them public would negatively affect proxy advisory firms’ ability to be  profitable. Proxy advisory firms did not support the idea of making their  reports publicly available at no cost after the relevant shareholder  meeting because it would undermine their business model. They noted  that their clients use these reports throughout the year and not just as a  basis for voting proxies.

section_title: SEC Oversight Activities of Proxy Advisory Services Have Included Information Gathering, Guidance, and Examinations
paragraphs: Since 2007, SEC oversight of proxy advisory firms and the services they  provide has included information gathering on issues relating to the firms,  issuance of guidance, and examinations of firms registered as investment  advisors and of registered investment companies or investment advisers  using proxy advisory services (see fig. 5).

Concept release. Since our last report in 2007, SEC sought public  comment on concerns that had been raised by stakeholders in the proxy  advisory industry in its 2010 Concept Release on the U.S. Proxy  System. According to SEC staff, the agency occasionally publishes  concept releases to raise awareness and collect the public’s view on  certain securities issues so the agency can better evaluate the need for  future rulemaking. The 2010 concept release discusses, among other  things, concerns that had been raised by corporate issuers and industry  participants about the level of accuracy and transparency in how proxy  advisory firms formulate voting recommendations and potential conflicts  of interest. Concerns related to accuracy and transparency include that  firms’ voting recommendations may be based on inaccurate or incomplete  data. Additionally, the 2010 concept release reiterated what we reported  on in 2007, that a conflict of interest for a proxy advisory firm could arise if  it provided both proxy voting recommendations to institutional investors  and consulting services to companies on the same matter. And as we  reported in 2007, the most commonly cited potential for conflict of interest  involved ISS; specifically, that ISS advises institutional investors on how  to vote proxies and provides consulting services through its subsidiary,  ISS Corporate Solutions, Inc., to companies seeking to improve their  corporate governance. The concept release also discussed other types of  potential conflicts of interest on which we reported in 2007, such as when  owners or executives of the proxy advisory firm have significant  ownership interest in, or serve on the board of directors of companies  (corporate issuers) with matters being put to shareholder vote and on  which the proxy advisory firm is offering vote recommendations.

The concept release also requested public comments on a list of potential  regulatory solutions for addressing conflicts of interest and accuracy and  transparency issues. For example, SEC asked for comments about  revising interpretive guidance or regulations to require more specific  disclosure of the presence of a potential conflict and the extent of controls  and procedures ensuring the accuracy of proxy research reports provided  to institutional investor clients.

SEC received about 300 comment letters on these and other issues  discussed in the release. SEC staff stated these comment letters helped  to inform subsequent work on proxy advisory firms (as discussed below).  Furthermore, SEC staff stated that they continue to routinely review  issues raised in the concept release, and have met with several  stakeholders and associations representing corporate issuers, investors,  and proxy advisory firms to see if the issues are still prevalent and plan to  continue these discussions with various stakeholders.

Roundtable. In December 2013, SEC held a roundtable to discuss  issues facing the proxy advisory industry. Participants included the SEC  Chair as well as four SEC Commissioners and various officials and  representatives from institutional investors, investment advisers,  corporate issuers, academia, law firms, and proxy advisory firms.  According to statements by the Chair, the roundtable continued the  review of the use of proxy advisory services and related issues that were  discussed in the 2010 concept release.

The roundtable discussed the use of proxy advisory firms in general and  also reviewed key topics of interest, including potential conflicts of interest  for proxy advisory firms and users of their services, the transparency and  accuracy of the recommendations the firms make, and what the nature  and extent of institutional investor reliance on proxy advisor  recommendations is and should be. The Chair stated she was particularly  interested in the discussion of potential conflicts of interest. One  Commissioner also drew attention to these issues in a number of  speeches in 2013 and 2014.

Guidance. SEC staff addressed some of the issues discussed above  through guidance. After the concept release and the roundtable, SEC  staff took steps to address issues in the proxy system in a 2014 Staff  Legal Bulletin. SEC staff stated the bulletin summarized the staff’s views  on laws and SEC regulations related to proxy advisory firms. For  example, SEC staff provided guidance that spelled out various  responsibilities for disclosure of conflicts of interest. The guidance made it  clear that proxy advisory firms must provide notice of the presence of a  significant relationship or a material interest. In addition, according to the  Staff Legal Bulletin, such disclosure should enable the recipient to  understand the nature and scope of the relationship or interest, including  the steps taken, if any, to mitigate the conflict. The disclosure should also  provide sufficient information to allow the recipient to make an  assessment about the reliability or objectivity of the recommendation.

Additionally, the bulletin clarified and restated responsibilities of  investment advisers to demonstrate that proxy votes are cast in  accordance with clients’ best interests and the adviser’s proxy voting  procedures. Among other things, the guidance states that investment  advisers who use proxy advisory firms should ascertain whether the proxy  advisory firm has the capacity and competency to adequately analyze  proxy issues. In doing so, the guidance states that investment advisers  could consider, among other things, the robustness of the proxy advisory  firm’s policies and procedures regarding its ability to ensure that proxy  voting recommendations are based on current and accurate information  and to identify and address any conflicts of interest. The Staff Legal  Bulletin further states that investment advisers who use the services of  proxy advisory firms could also consider the adequacy and quality of the  firm’s staffing and personnel.

Institutional investors with whom we spoke told us they perform due  diligence on proxy advisory firms in various ways. A few institutional  investors reported conducting various types of compliance reviews of  firms, including site visits and analyst interviews. For example, one  institutional investor has analysts dedicated to conducting ongoing due  diligence on the data quality of the proxy advisory firm’s reports. This  institutional investor validates the firm’s data and communicates any  errors it identifies to the firm. The institutional investor said that the errors  found in proxy reports generally were minor and that firms typically were  able to update and correct their reports.

Examinations. SEC staff also considered some of the issues discussed  previously through examinations of proxy advisory firms registered as  investment advisers and registered investment companies using proxy  advisory firms. As discussed, proxy advisory firms that are registered  investment advisers under the Advisers Act are subject to examination by  SEC. According to SEC staff, proxy voting issues and proxy advisory  firms may not be examined on a regularly scheduled basis because SEC  uses a risk-based approach to identifying examination priorities each  year. As noted previously, all entities, including proxy advisory firms, that  meet the statutory definition of an investment adviser (where no exclusion  from the definition is available), regardless of whether they are registered  with SEC, are subject to the Advisers Act’s antifraud provisions.  Legislation that has been proposed would require all proxy advisory firms  to register as such, creating a new regulatory framework for the  registration of proxy advisory firms.

In January 2015, SEC staff announced examination priorities for 2015,  which included select proxy advisory firms and how they make recommendations on proxy voting and how they disclose and mitigate  potential conflicts of interest. The examination priorities for 2015 also  included reviewing investment advisers’ compliance with their fiduciary  duty in voting proxies on behalf of investors. SEC staff efforts on this  priority were incorporated into an ongoing Never-Before-Examined  Investment Company Initiative that launched in April 2015. This initiative  involves focused, risk-based examinations in a number of higher-risk  areas, including compliance programs. SEC staff announced that as one  of the areas to be reviewed within the compliance program, it would  review investment companies’ portfolio proxy voting policies and  procedures. The examination focus would include the oversight of a proxy  advisory firm retained by the investment company’s investment adviser, if  applicable.

In determining examination priorities through a risk-based approach, SEC  staff told us that the decision to examine this issue for this initiative was  based on several factors, including the higher risk that these investment  companies may have weaker internal controls, including procedures for  overseeing proxy advisory services. As of August 2016, the initiative is  ongoing. We reviewed 41 percent of the examinations completed as of  August 2016 on SEC’s 2015 priorities addressing proxy advisory firm  issues and confirmed that SEC examined risk areas related to conflict of  interest, proxy voting policies and procedures, and oversight of proxy  advisory services, among other issues. None of the examinations we  reviewed resulted in serious violations leading to an enforcement action.

SEC staff stated they may refer to the scope, process, or relevant legal  resources used in the initiative for examinations that review portfolio  securities proxy voting in the future, although as of August 2016 none  were planned. As clarified in the Staff Legal Bulletin, due diligence  obligations over proxy advisory firms on a regular basis falls  predominately on the investment adviser using their services. Therefore,  regardless of persisting perceptions of issues with proxy advisory firms as  discussed above, it is the investment adviser’s responsibility to vote the  proxy in its clients’ best interest.

section_title: Agency Comments
paragraphs: We provided a draft of this report to the Securities and Exchange  Commission for review and comment. We also provided excerpts of the  report to proxy advisory firms for technical comment. SEC staff as well as  officials from each proxy advisory firm provided technical comments,  which we have included, as appropriate.

We are sending copies of this report to the appropriate congressional  committees, the Chair of SEC, and other interested parties. In addition,  the report will be available at no charge on the GAO website at  http://www.gao.gov.

If you or your staff have any questions regarding this report, please  contact me at (202) 512-8678 or clementsm@gao.gov. Contact points for  our Offices of Congressional Relations and Public Affairs can be found on  the last page of this report. Key contributors are listed in appendix II.

section_title: Appendix I: Objectives, Scope, and Methodology
paragraphs: This report discusses (1) the demand for proxy advisory services and the  extent to which firms may influence proxy voting and corporate  governance practices, (2) how proxy advisory firms develop and apply  voting policies to make vote recommendations and efforts to increase  transparency, and (3) Securities and Exchange Commission’s (SEC)  oversight since 2007 related to proxy advisory firms and the services they  provide.

To address all objectives, we conducted a literature review to obtain  background information and identify issues related to proxy advisory  firms. We used Internet search techniques and keyword search terms to  identify publicly available information about proxy advisory firms, from  2008 – 2016, including the history, number of firms in the United States,  types of proxy advisory services, and past or current issues facing the  industry. From research databases such as ProQuest and LexisNexis, we  obtained information from publicly available documents, such as journals,  trade publications, periodicals, studies, white papers, and congressional  testimony.

We also identified and conducted interviews with various officials and  representatives with knowledge of the industry (SEC staff, 5 proxy  advisory firms, 13 institutional investors, 11 corporate issuers, 4 proxy  solicitation firms, 2 international agencies—European Securities Markets  Authority and Canadian Securities Administrators—and 8 industry and  advocacy groups). The industry and advocacy groups were the Business  Roundtable, Chamber of Commerce’s Center for Capital Markets  Competitiveness, Council of Institutional Investors, Investment Company  Institute, Mutual Fund Director’s Forum, National Association of  Corporate Directors, National Investor Relations Institute, and the Society  of Corporate Secretaries and Governance Professionals. We also  interviewed other stakeholders from the Stanford Rock Center for  Corporate Governance, and the NASDAQ Stock Market and New York  Stock Exchange.

We conducted the interviews to gain an understanding of issues affecting  the proxy advisory industry and to obtain a variety of perspectives, as well  as to corroborate the information obtained in our other sources. The  views of those interviewed are not representative of all institutional  investors, corporate issuers, proxy solicitors, or industry and advocacy  groups. Our criteria for selecting the interviewees consisted of several  factors such as participation in prior SEC events, including roundtables;  recommendations from market participants and other stakeholders;  participation in prior congressional hearings; appearance in our literature  reviews and Internet searches; and mentions in bibliographies of relevant  papers and studies. In selecting corporate issuers (public companies that  develop, register, and sell securities to the investing public to finance their  operations), we used information from the Standard and Poor’s Smallcap  600, Midcap 400, and Large 500 indexes to randomly select a mix of  small, midsize, and large corporate issuers. In selecting institutional  investors for our interviews, we obtained information from the Council for  Institutional Investors and the Investment Company Institute to  judgmentally select a mix of 13 institutional investors (based on asset  size) and type (mutual fund companies and pension funds). We based the  asset size of institutional investors on the total assets under management  (AUM), or the total market value of all financial assets the institution  manages for its clients or on its own behalf. To ensure a mix of large and  small institutional investors, we ranked institutional investors by the total  reported AUM and selected seven institutions with the highest total AUM  and six institutions with the lowest total AUM. For purposes of this report,  we defined “large” institutional investors as those with an AUM of $600  billion or more and “small” institutional investors as those with an AUM of  $200 billion or less.

Throughout this report, we use certain qualifiers when describing results  from interview participants, such as “few,” “some,” and “most.” We define  few as a small number but less than some (two or three); some as more  than a few relative to the total number possible (at least four or more);  and most as nearly all or almost everyone relative to the total number  possible (at least seven or more).

To address the first objective, we reviewed and summarized literature and  analyzed available information on users of proxy advisory firms and the  demand for proxy advisory services, factors that may have contributed to  demand, and the possible influence of firms on proxy voting and  corporate governance practices. Specifically, to describe the demand for  services, we identified the services provided by proxy advisory firms,  users of such services, and the rationale, if any, for institutional investors,  in particular, to acquire proxy advisory services. To the extent that  relevant data or literature were available, we summarized information on  any trends, linkages, or relationships identified in the literature.

Additionally, to address the first objective, we conducted a literature  search to identify relevant academic studies and working papers on the  influence of proxy advisory firms. Our criteria for selection consisted of  factors such as whether the studies and papers were based on original  data analysis (including data that may have been gathered by others);  published in a refereed medium; written or published in 2009–2016; and  contained no serious methodological or other errors (as determined by  our quality assessment and based on guidance for using external work in  our engagements).We focused our analysis on published academic  studies and academic working papers not yet published that involved  quantitative analyses of proxy advisory firms’ influence. We analyzed the  content of these studies and papers for data or other information on the  extent of the firms’ influence. We reviewed whether the author concluded  that the proxy advisory firms’ research and recommendations moved at  least some fraction of the votes or affected a company’s governance  decisions or practices. We also reviewed whether the author concluded  that the firms’ influence was positive or negative in the sense that it was  potentially helpful or harmful to shareholders or investors.

For the second objective, we identified and analyzed available information  on how proxy advisory firms develop and apply voting policies to make  vote recommendations. We analyzed information on the firms’ voting  policies and guidelines, such as their general, custom, and specialty  policies. In some instances, we focused our review on Institutional  Shareholder Services (ISS) and Glass Lewis and Co. (Glass Lewis)  because they have the largest number of clients in the proxy advisory firm  market in the United States. We reviewed documentation issued by the  SEC and its staff and international regulators such as the European  Securities and Markets Authority and Canadian Securities Administrators  proposing principles and guidelines related to proxy advisory firm  transparency. In addition, we reviewed proxy advisory firm policies,  mechanisms, and the transparency of their voting policies, procedures,  and processes, including reviewing the firms’ websites and whether they  disclosed information about their policies and processes. We also  analyzed the views of market participants and other stakeholders on  these transparency efforts.

We also compared proxy advisory firms’ policies for selected voting  issues with related corporate governance standards developed by other  entities, such as stock exchanges and institutional investors. Specifically,  we reviewed four different voting policies from the five proxy advisory  firms and compared them with corporate governance standards  developed by the New York Stock Exchange (NYSE), NASDAQ Stock  Market, and one large institutional investor. We selected NYSE and  NASDAQ because they have corporate governance requirements that  corporate issuers must meet to be listed on the exchange and some of  these requirements are also addressed by proxy advisory firms. We also  selected a large institutional investor that has developed its own voting  policies on corporate governance issues to provide an example of how  proxy advisory firm policies compare to voting policies of institutional  investors. We reviewed voting policies and corporate governance  requirements for director independence, overboarding, independent  chairman/chief executive officer, and proxy access issues. We selected  these four topics based on what we learned from interviews with market  participants and other stakeholders and our literature review. Although  some of the proxy advisory firms have voting policies for different  countries, we focused on the proxy voting policies for the United States.

Lastly, for the second objective, we analyzed the policies firms use in  developing vote recommendations and identified different proxy voting  issues to illustrate the process. To select voting issues, we made a  judgmental selection of voting events occurring after the issuance of the  June 2014 SEC Staff Legal Bulletin on proxy voting and during the 2015  proxy season. We selected events that were either discussed in our  interviews with market participants or other stakeholders or publicly in the  news media. The example events covered the areas of (1) board of  directors’ issues, (2) mergers and acquisitions, and (3) executive  compensation. We also reviewed available information on the steps  conducted to ensure that data used for developing vote recommendations  are accurate and looked at the degree of communication between proxy  advisory firms and corporate issuers before vote recommendations are  finalized. Specifically, we reviewed ISS’s and Glass Lewis’s draft review  processes and analyzed the views of market participants who have been  involved with the processes.

For the third objective, we reviewed and summarized SEC oversight  activities since our last report in 2007 regarding proxy advisory firms and  their clients. We reviewed the SEC 2010 Concept Release on the U.S.  Proxy System related to proxy advisory firms and comment letters  industry stakeholders submitted to SEC on the concept release. We  reviewed the transcript and comments on a roundtable SEC held about  the proxy advisory industry in 2013. We also reviewed the guidance and  clarification provided in the 2014 Staff Legal Bulletin of the obligations of  proxy advisory firms and their clients who are registered as investment  advisers. To determine whether SEC addressed 2015 examination  priorities related to proxy advisory firms registered as investment advisers  and the services they provide to registered investment companies, we  reviewed 41 percent of the examinations related to SEC’s 2015 priorities  addressing proxy advisory firm and proxy voting issues completed as of  August 2016.

We conducted this performance audit from August 2015 to November  2016, in accordance with generally accepted government auditing  standards. Those standards require that we plan and perform the audit to  obtain sufficient, appropriate evidence to provide a reasonable basis for  our findings and conclusions based on our audit objectives. We believe  that the evidence obtained provides a reasonable basis for our findings  and conclusions based on our audit objectives.

section_title: Appendix II: GAO Contact and Staff Acknowledgments
subsections: section_title: GAO Contact

section_title: Staff Acknowledgments
paragraphs: In addition to the above contact, Kay Kuhlman (Assistant Director),  Michelle Bowsky (Analyst-in-Charge), Ria Bailey-Galvis, William Chatlos,  Risto Laboski, Patricia Moye, Aku Pappoe, Barbara Roesmann, Jena  Sinkfield and Anne Stevens made key contributions to this report.


Question-summary annotations: questions: question: What is the role of proxy advisory firms?
answer: Institutional investors, such as pension plans and mutual funds, hire proxy advisory firms to obtain research and vote recommendations on issues, such as executive compensation and proposed mergers that are addressed at shareholder meetings of public corporations (corporate issuers).
child_questions: question: How has their influence changed?
answer: Market participants and other stakeholders with whom GAO spoke agreed that with the increased demand for their services, proxy advisory firms' influence on shareholder voting and corporate governance practices has increased.
child_questions: question: To what extent is there a consensus regarding the scale of this influence?
answer: But recent studies, market participants, and stakeholders had mixed views about the extent of the influence. For example, some said influence can vary based on institutional investor size (there is less influence on large institutional investors that often perform research in-house and have their own voting policies).

questions: question: How do proxy advisory firms update their voting policies?
answer: Proxy advisory firms, specifically Institutional Shareholder Services and Glass Lewis & Company—the two largest firms—develop and update their general voting policies through an iterative process, involving analysis of regulatory requirements, industry practices, and discussions with market participants. According to the firms, they apply these general voting policies to publicly available company information to develop vote recommendations, which also are based on institutional investor voting instructions and criteria that firm analysts determine are applicable to the issue being voted on.
child_questions: question: How has this process changed?
answer: Corporate issuers and institutional investors told GAO that unlike in the past, the firms have made more of an effort to engage market participants in the development and updating of voting policies, such as criteria for assessing the independence of board directors and executive compensation packages. Firms have taken steps to communicate with corporate issuers and allow review of data used to make vote recommendations before they are finalized.

question: What are the issues with this process?
answer: However, some corporate issuers told GAO that firms continue to apply policies in a one-size-fits-all manner, which can lead to recommendations not in the best interest of shareholders. Corporate issuers also stated that they often do not understand the rationale for some vote recommendations and would like to discuss them before they are finalized.
child_questions: question: How did the firms justify these practices?
answer: Proxy advisory firms told GAO that to maintain objectivity and satisfy research reporting timelines for clients, they limit the breadth of such discussions.

questions: question: How has SEC overseen proxy advisory firms?
answer: Securities and Exchange Commission (SEC) oversight of proxy advisory firms and the services they provide has included gathering information, issuing guidance, and examining proxy advisory firms and use of the firms by investment companies, such as mutual funds.
child_questions: question: How has SEC advocated for market participants?
answer: In 2010, SEC summarized concerns that market participants raised about conflicts of interest, accuracy, and transparency of proxy advisory firms and requested comments on potential regulatory solutions.

question: In what ways has SEC addressed disclosure of conflcit of interest?
answer: In December 2013, SEC held a roundtable to discuss issues facing the proxy advisory industry, and issued guidance in June 2014 on disclosure of conflicts of interest, among other things.

question: What other actions has SEC taken?
answer: According to SEC, it also has continued to address concerns surrounding proxy advisory firms through its examinations of investment advisers and investment companies that retain their services. SEC made these examinations a priority in 2015 and an area of focus in its ongoing initiative for registered investment companies that had not been examined by SEC.

questions: question: Why has the importance of proxy firms grown?
answer: As institutional investment has grown over the last 30 years, institutional investors increasingly have relied on proxy advisory firms.
child_questions: question: Of what does the proxy firm industry consist?
answer: The proxy advisory industry in the United States consists of five firms—two of which are the largest and most dominant proxy advisory firms.

question: Why have some members of Congress raised issues about proxy advisory firms?
answer: Some members of Congress, industry associations, and academics have raised issues about proxy advisory firms' influence on voting and corporate governance, the level of transparency in their methods, and the level of regulatory oversight.

questions: question: What was GAO asked to review?
answer: GAO was asked to review the current state of the proxy advisory industry.
child_questions: question: What does GAO's report discuss?
answer: This report discusses (1) the influence proxy advisory firms may have on voting and corporate governance, (2) how firms develop and apply policies to make vote recommendations, and (3) SEC's oversight activities.
child_questions: question: How did GAO conduct its research?
answer: GAO reviewed literature; analyzed the proxy advisory firms' policies and SEC policies and examinations; and interviewed the 5 proxy advisory firms, 13 institutional investors, 11 corporate issuers, SEC officials, and industry stakeholders.

question: How did GAO select its samples?
answer: GAO randomly selected corporate issuers from Standard and Poor's indexes and judgmentally selected institutional investors (based on size and type of investor) from industry associations' information.