Accounting and Control RSS

  Proxy Advisors: How Much Value Do They Add? 

Larcker D. F.; McCall, Allan L.; Ormazábal, Gaizka
Print Share

Proxy advisors provide research and recommendations on whether to vote for or against a management or shareholder proposal presented in the proxy statements of firms.

In recent years, legislators and regulators have made numerous revisions to the proxy voting process in an effort to enhance shareholders' ability to influence the corporate governance choices of public companies. These changes have substantially increased the volume of proxy issues voted on by shareholders.

They have also added a whole new layer of corporate bureaucracy, which puts even greater strain on the limited time and resources of many institutions.

To fulfill their fiduciary duty to vote on ballot items in proxy statements, many institutions subscribe to third-party proxy advisory firms such as Institutional Shareholder Services (ISS) and Glass Lewis -- two firms that control roughly 80 percent of the market.

In their paper, "Proxy Advisory Firms and Stock Option Repricing," featured in the Journal of Accounting and Economics, IESE's Gaizka Ormazabal, together with David Larcker and Allan McCall of Stanford, tries to shed light on this issue.

Using a sample of stock option repricings announced between 2004 and 2009, the authors studied the impact that following the policies advocated by proxy advisors has on a repricing firm's market position, operating performance and employee turnover.

The Rise of Proxy Advisors
The rise in influence of proxy advisors is a fairly recent development, largely as a result of regulatory changes.

In 2003, the NYSE and Nasdaq altered their listing conditions to require that any new equity compensation plan, or material modification to an equity compensation plan, receive shareholder approval.

This was followed by a decision by the U.S. Securities and Exchange Commission to require mutual funds to develop and disclose "unconflicted" policies and procedures used to determine their proxy votes, as well as to disclose their voting on all shareholder proposals.

At the same time, the SEC announced that the use of proxy voting policies developed by an independent third party, i.e., proxy advisors, was free of conflicts of interest and met mutual funds' proxy voting obligations.

The result was that many mutual funds suddenly began to rely more heavily -- and some, even exclusively -- on the recommendations of third-party proxy advisory firms in determining their proxy votes.

As proxy advisory firms grow in power and influence, doubts are being raised as to whether they have appropriate incentives and invest sufficient resources to verify whether their voting recommendations are actually correct.

Unfortunately, if their policies regarding corporate governance are incorrect and are adopted by public companies in order to gain a majority of favorable votes for management proposals, these policies have the potential to impose a real cost on individual firms and the economy as a whole.

Even the SEC has changed its tune somewhat, after raising concerns about the potential for "undisclosed conflicts of interest."

It has also cautioned that some proxy advisors "may fail to conduct adequate research, or may base recommendations on erroneous or incomplete facts."

The Impact on Stock Option Repricing
To explore this issue further, the authors examined the economic consequences of proxy advisors in the specific context of underwater stock option repricings, whereby firms replace underwater stock options with new awards of options, restricted stock and/or cash.

Critics of repricings have argued that they are used by entrenched managers to extract rents from shareholders by reducing the downside risk of their compensation contracts.

However, research has shown that allowing some exchange of underwater stock options is almost always preferable to a commitment to not adjust initial contracts after they have gone underwater, which all too often results in an exodus of key company personnel.

The authors based their analysis on a comprehensive sample of 264 repricings announced between 2004 and 2009. For each repricing, they measured the degree of conformity to ISS guidelines, and then compared that with subsequent firm performance and executive turnover.

They found that the stock market reaction to the introduction of repricing plans was positive but decreasing according to the extent to which the repricing conformed to proxy advisory firm guidelines.

They also discovered that the more firms conformed to proxy advisory firm voting recommendations, the weaker their operational performance and the higher their likelihood of executive and employee turnover.

Their results suggest that overcompliance with proxy advisor guidelines on stock option repricing limits the recontracting benefits of these transactions and is not value increasing for shareholders.

As the authors point out, however, their study examined only one management proposal that affected these particular 264 firms.

An important public policy question is the extent to which these results reflect the generalized impact of voting recommendations made by proxy advisory firms on issues that have a much larger impact on investor returns, such as equity compensation plans, executive bonus plans, say-on-pay, director elections, and mergers and acquisitions.
This article is based on:  Proxy Advisory Firms and Stock Option Repricing
Publisher:  Elsevier
Year:  2013
Language:  English