Ep50 “Is Proxy Advising a Catch-22?” with Chester Spatt

Proxy Advisory Firms and Shareholder Voting

• Proxy advisory firms advise shareholders on how to vote in important shareholder meetings, acting as information aggregators that take a position on particular shareholder votes and advise large institutional investors to vote a certain way, with the two biggest firms being ISS (Institutional Shareholder Services) and Glass Lewis (38s).
• The need for proxy advisory firms is often justified by the high cost of individual shareholders investigating and making informed decisions, making it more efficient to have one firm do the investigation and share its conclusions (1m22s).
• However, this argument does not apply to other contexts, such as political candidates, where individuals are expected to make their own informed decisions (1m49s).
• The crucial difference between proxy advisory firms and other contexts is the objective, with shareholders theoretically having the same objective of maximizing share value, but often disagreeing on how to achieve it (2m7s).

Differing Shareholder Objectives and the Role of Proxy Advisory Firms

• The disagreement among shareholders suggests that either they do not have the same information or their incentives are not aligned, with shareholders having different objectives due to various interests, such as employees who are also shareholders (2m58s).
• This raises a problem for proxy advisory firms, as they can only do one investigation for all shareholders, making it difficult to advise shareholders with different goals, creating a catch-22 situation (3m47s).
• If shareholders have different goals, proxy advisory firms would need to do a different investigation or interpretation for each shareholder, but if shareholders all have the same goals, then proxy advisory firms are not needed (4m0s).
• Proxy advisory firms may not be necessary if all shareholders have the same goal, as they can simply follow the actions of other shareholders, but if there are different interests and groups of shareholders, these firms should provide tailored advice, which is not currently observed in the data (4m18s).
• The lack of tailored advice from proxy advisory firms means that they do not provide different advice to different groups of shareholders based on their individual interests, contrary to what might be expected (4m28s).

Proxy Advisory Firms as Cover for Investors

• One possible role of proxy advisory firms is to provide cover for large investors and portfolio managers, allowing them to justify their decisions by following the advice of these firms (5m22s).
• This cover can be used to shift responsibility away from the decision-makers if the decision does not work out, allowing them to claim that they simply followed the advice of the proxy advisory firms (5m50s).

Proxy Advisory Firms vs. Rating Agencies

• The relationship between proxy advisory firms and rating agencies is also relevant, with rating agencies collecting new information that might be useful to the market, whereas proxy advisory firms do not seem to be in the business of collecting additional information through analysts (6m13s).
• Despite the potential for replication of rating agency models using publicly available information, there seems to be a demand for authoritative agencies that create a consensus around certain issues, which can be seen as a coordination device (6m54s).
• The credibility of established rating agencies and proxy advisory firms allows them to provide cover for investors, which would not be possible for new entrants in the market, even if they could replicate the ratings or advice using public information (7m28s).

Incentives of Proxy Advisory Firms

• The true incentives of proxy advisory firms are a concern, with some arguing that they may have an objective to create close votes, as this would increase the perceived need for their services (8m2s).
• Proxy advisory firms may have an objective to create conflict in order to justify their services, which could lead to controversy for the sake of controversy and potentially damage their reputation as information providers (8m23s).

Alternatives to Proxy Advisory Firms: Observing Large Money Managers

• A possible alternative to using proxy advisory firms is to observe how large money managers vote, as they have the resources to conduct their own investigations and may have aligned incentives with other investors (9m6s).
• Large money managers, such as Vanguard, may have the right incentives to vote in the best interest of their shareholders, but their scale and diversification across thousands of stocks could affect their engagement and voting behavior (9m13s).
• Smaller funds, despite having fewer investments, may have stronger incentives to engage with companies and vote due to the larger fraction of their portfolio at stake (10m29s).
• Research by Felix Kner suggests that small funds with few investments are more active in engaging with companies, such as on conference calls and earnings calls, due to their larger incentives (10m38s).
• The relative importance of dollar amounts versus relative amounts in resource allocation is a key consideration, as large funds like Vanguard or BlackRock may hold a significant fraction of shares, making their vote count, while smaller funds may not (11m5s).
• There is a concern that small funds may lobby proxy advisory firms, such as ISS, to influence their decisions, which could be a plausible possibility, but this aspect has not been thoroughly explored (11m49s).

Services and Scale Economies of Proxy Advisory Firms

• Proxy advisory firms provide various services, including vote recommendations, detailed reports on issues being voted upon, and a general corporate governance philosophy, as well as customized advice and assistance with implementing voting decisions for asset management clients (13m10s).
• These services reflect scale economies, which is why proxy advisory firms have an important role in the marketplace (14m8s).

Shareholder Perspectives and Unanimity Theory

• The need for proxy advisory firms arises from the fact that shareholders may have different perspectives and incentives, such as labor unions, executives, and investors with different tax situations or philosophies, like ESG (15m30s).
• Even if the objective of management and equity holders is to maximize firm value, there can be disagreement among shareholders due to different priorities and assessments (14m31s).
• Researchers have studied "unanimity theory," which explores the conditions under which everyone agrees to maximize firm value, but in reality, unanimity is not always the case (14m40s).
• Different investors may have their own prior beliefs or assessments, which is why a voting mechanism is used to resolve different perspectives (16m10s).

Expert Opinion on the Role of Proxy Advisory Firms

• Chester Spatt, the Pamela R. and Kenneth B. Dunn Professor of Finance at the Tepper School of Business at Carnegie Mellon University, suggests that the role of proxy advisory firms is important in helping to resolve these differences (12m42s).
• Spatt also notes that some investors may view the services provided by proxy advisory firms as a way to make their votes count, even if they are small funds (12m28s).
• Proxy advisory firms may face a Catch-22 situation, as they need to cater to different investors with varying incentives and interests, making it challenging to provide advice that covers all objectives (16m25s).
• Despite this, proxy advisory firms can generate basic information relevant to investors, even those who choose to go their own way, and provide insights from diverse perspectives (16m47s).
• These firms try to put themselves in the shoes of different investors and offer somewhat customized advice, making them information aggregators that take certain investor groups' preferences into account (17m3s).

Uncontested Votes and Implementation Tools

• Many votes are uncontested, and proxy advisory firms' services include identifying such votes, which may not be important or contentious (17m41s).
• From an asset manager's perspective, proxy advisory firms provide implementation tools that make it easy to implement votes in a timely manner (17m58s).

Conflicting Objectives and Alignment with Management

• Proxy advisory firms are value-maximizing entities with objectives that may not be aligned with investors', as evidenced by differences in perspective between major proxy advisory firms and index players like Vanguard and BlackRock (18m22s).
• Major index players tend to vote in ways more aligned with management than proxy advisory firms, which may be due to the firms' incentives to make their voting advice more valuable by encouraging closer votes and promoting controversy (18m35s).
• Small mutual fund players adhere more closely to proxy advisory firm recommendations due to a lack of scale to spend on votes, whereas larger players like Vanguard and BlackRock have more resources to devote to stewardship (19m41s).
• A more suitable benchmark for evaluating mutual fund votes may be the index funds, rather than proxy advisory firm advice, as they provide a more accurate representation of investor interests (19m32s).
• Small asset managers lack the scale to spend on due diligence like large firms, resulting in less independence from proxy advisory firms, which is why indexers are more favorable to management as they perform their own due diligence (20m16s).

Case Study: HP and Compaq Merger

• Small funds heavily rely on input from proxy advisory firms, which may not always be value-maximizing, as illustrated by the example of the HP and Compaq merger (20m39s).
• In the HP and Compaq merger, ISS recommended that HP shareholders vote for the merger despite signals that the deal was not in the best interest of the shareholders, and the deal ultimately went through with less than 52% support (20m54s).
• The merger is widely regarded as a disaster, illustrating a failure of value maximization in the ISS recommendation (21m46s).

Benchmarking Against Large Mutual Funds

• The objectives of proxy advisory firms, such as ISS, may not be aligned with those of shareholders, as they may benefit from increased controversy and the value of their services (21m57s).
• In contrast, large mutual funds like BlackRock have objectives that are more narrowly focused on the value of the company and what is good for the company, making them a better benchmark (22m22s).
• While large indexers like BlackRock and Vanguard may have some conflicts of interest, their incentives are generally better aligned with those of shareholders than proxy advisory firms (22m42s).
• The votes of BlackRock and Vanguard are not always aligned, but they are closer than the recommendations of ISS (22m52s).
• Proxy advisory firms like ISS may face costs if their recommendations are consistently poor, as people may take their recommendations less seriously and reduce the value of their services (23m11s).