The Agency Cost Case for Regulating Proxy Advisory Firms

Abstract

The current market for proxy advice arises out of an agency problem, but not the one usually assumed. Investment fund managers have relatively few economic incentives to invest effort on corporate governance and so they tend to organize around picking the best stocks and trading those stocks at the optimal time. This creates a market for third party proxy advisors, but both investment managers and proxy firms bear few of the costs of poor governance and operate under incentives to keep proxy advice as inexpensive as possible.

Empirical evidence drawn from the academic studies performed on this market, along with trends revealed by submissions to the SEC and CSA, show significant problems with the content of proxy advice (including mistakes in what produces good corporate governance and frequent errors in voting recommendations) along with problems in the process by which the advice is delivered (including insufficient information for advisors to comply with their own voting guidelines, conflicts of interest, opacity, and an apparent inability to correct errors.)

The case for regulatory intervention in the market for proxy advice can be stated quite simply: (1) there is empirical evidence of significant, repeated informational failures produced by the market for third party proxy voting advice; (2) there is evidence these failures arise systemically as a logical consequence of the conflicts of interest of the agents that make up the market; and (3) there is evidence of significant externalities in the market for proxy advice, suggesting the value of good proxy advice is not captured by the agents that participate in the market and that high-quality advice is therefore underproduced. This is precisely the type of market failure securities regulation is designed to fix. The paper concludes by recommending the modest application of traditional disclosure tools to the market for proxy advice.

Keywords: Corporate Governance, Securities, Corporate Law, Corporations, Proxy Advisors, Proxies, Shareholder Voting, Agency Costs

JEL Classification: G18, G30, G34, K22, K20