The politics of proxy voting and the importance of shareholder representation

As the 2024 election quickly approaches, many Americans consider how their vote will affect political races. While our focus tends to be on the voting process in political elections, most companies experience their own form of elections.

Many investors who own a certain number of shares in a company have voting privileges in corporate affairs. Since very few shareholders end up attending shareholder meetings themselves, however, they generally employ someone to vote on their behalf. This is known as proxy voting.

What is becoming increasingly problematic is that many shareholders have relinquished control over their voting privileges. This effectively outsources their votes to be managed by a pair of consulting firms that bear no fiduciary obligations to the shareholders.

While traditionally proxy voting has been a fairly uncommon aspect of the world of investing, it is becoming an increasingly salient political issue. Former and current members of Congress have voiced great concern over the lack of election integrity in the proxy review season.

The proxy review season marks the period where shareholders actively consider and propose new resolutions to change or reform the internal affairs of the company. This empowers shareholders to advise the board of directors on how the corporation should be governed.

In corporate affairs, each shareholder is permitted to cast a vote proportional to the number of shares they own. The straight-forward process, however, has eroded in recent years due to three troubling trends.

Firstly, the rapid increase in shareholder resolutions has made it difficult for regular investors to keep track of every corporate development.

Secondly, the Securities and Exchange Commission’s (SEC) troubling regulatory intervention in proxy voting has undermined the ability of corporations to reject frivolous environmental, social, governance (ESG) proposals, which comprise the bulk of new resolutions.

Thirdly, the parallel rise and narrow market for proxy advisory services, dominated by the duopoly of Glass Lewis and Institutional Shareholder Services (ISS), has opened the door for investors to take cues from hired professionals, rather than exercise their own independent judgment. Together, these firms account for more than 90 percent of the proxy advisory market.

These three trends have incentivized shareholders to outsource most, if not all, of their corporate voting power to this pair of proxy advisors. Corporations are supposed to be governed by the voting decisions of their shareholders and directors. The new reality is that unaccountable proxy advisors are driving many of the decisions being made at companies, directing institutional investors to engage in a process called “robovoting.”

Like its name suggests, robovoting is where “institutional investors mechanically follow a proxy advisor’s voting guidance without any independent review,” according to Prof. Paul Rose of Ohio State. “In effect, an institutional investor transfers its fiduciary voting authority to a third party.”

This is problematic because many institutional investors (i.e., mutual funds, retirement accounts, education savings accounts) are obligated under law to serve the best interests of their retail investors. Voting blindly for the recommendations of private proxy advisors undermines the trust that investors place in the fiduciaries overseeing their investments.

Retail investors are thus two steps removed from their votes, as institutional investors punt them over to proxy firms.

It was estimated that proxy recommendations accounted for 20 percent of proxy voting decisions in 2019. A more recent UK study estimates that 75 percent of institutional investors rely on proxy recommendations. This includes many institutional investors that forsake their benchmark policy in favor of Glass Lewis or ISS’s bespoke policies.

Robovoting is a direct consequence of the SEC’s regulatory meddling in the proxy review process. It grew from the SEC’s 2003 Proxy Voting by Investment Advisers (“best interest”) rule, which allowed financial advisers to vote in the “best interest” of their clients. However, the rule permitted that the term “best interest” encompassed the opinions of third-party proxy advisors, who have no fiduciary responsibility to their clients.

Proxy advisors have become even more dominant from recent revisions to the final Proxy Advisor Rule, adopted in July 2020. The Rule provided supplemental guidance that permitted proxy advisors to vote on behalf of their clients regarding shareholder resolutions.

Two notable benefits from the Proxy Advisor Rule were the requirement that (1) proxy firms disclose any conflicts of interests and (2) proxy advisors be transparent and actively engage with the company whose shareholders receive their advice (part of Rule 14a-9).

However, once Gary Gensler became Chair in January 2021 and cemented the Democratic control of the SEC, the Commission amended the Advisor Rule in 2022.

Among the most controversial changes was deleting portions of Rule 14a-2(b)(9), which required proxy firms to share their recommendations with companies at or prior to the moment they voted on behalf of their shareholders.

It also required proxy advisors to quickly inform their clients of any corporate response (whether support or rejection) to an advisor’s recommendation or vote.

Rescinding these requirements has removed much of the control and oversight that companies had with proxy firms. Now, proxy firms enjoy unfettered discretion in issuing their recommendations without fear of being second-guessed by the companies they are impacting. In other words, the SEC has sheltered proxy advisors from any form of corporate accountability.

The troubling reality is that many shareholders are two steps removed from the major decisions that shape the governance of the companies they own. Much of this is due to the SEC’s regulatory intervention, which has deprived corporate oversight during the proxy review process, while elevating unaccountable proxy advisors to pursue their agendas absent any say by the shareholders.

Combined with the problematic proxy advancement of ESG measures, companies are becoming hijacked by political forces beyond their control. We are seeing companies forced to consider a greater number of ESG proposals rather than economically relevant measures, while shareholders lose out on their voting rights.

The SEC needs to restore true shareholder representation by ensuring that proxy advisors are accountable to the companies and investors they service. Robovoting is no substitute for votes cast by real shareholders.