Potential Conflicts of Interest Exist among Proxy Advisory Firms That Could Affect Their Vote Recommendations, but SEC Has Not Identified Any Major Violations in Its Examinations of Registered Firms

In the proxy advisory industry, various conflicts of interest can arise that  have the potential to influence the research conducted and voting  recommendations made by proxy advisory firms. Some industry professionals also  contend that corporations could feel obligated to subscribe to ISS’s  consulting services in order to obtain favorable proxy vote  recommendations on their proposals and favorable corporate governance  ratings. For example, on its Web site, ISS explains that  it is “aware of the potential conflicts of interest that may exist between   proxy advisory service … and the business of ISS Corporate Services,  Inc. .” The Web site also notes that “ISS policy requires every ISS  proxy analysis to carry a disclosure statement advising the client of the  work of ICS and advising ISS’s institutional clients that they can get  information about an issuer’s use of ICS’s products and services.” In  addition, some institutional investors we spoke with noted that ISS has on  occasion disclosed to them, on a case-by-case basis, the existence of a  specific conflict related to a particular corporation. All of the institutional investors—both large and small—we spoke with  that subscribe to ISS’s services said that they are satisfied with the steps  that ISS has taken to mitigate its potential conflicts. According to SEC, to  date, the agency has not identified any major violations of applicable  federal securities laws in its examinations of proxy advisory firms that are  registered as investment advisers and has not initiated any enforcement  action against these firms. Analysts Cite ISS’s Long-standing Position in the Industry as a Potential Barrier to Competition, Although Firms Have Entered the Market in Recent Years

As the dominant proxy advisory firm, ISS has gained a reputation with  institutional investors for providing reliable, comprehensive proxy  research and recommendations, making it difficult for competitors to  attract clients and compete in the market. For example, while firms may need to offer comprehensive  coverage of corporate proxies in order to attract clients and although ISS  might have access to corporate information that other firms do not, much  of the information needed to conduct research and offer voting  recommendations is easily accessible. Specifically, they have attempted to differentiate themselves from  ISS by providing only proxy advisory services to institutional investor  clients. While some of these newer proxy advisory  firms have attracted clients, it is too soon to tell what the firms’ ultimate  effect on competition will be. Large Institutional Investors Reportedly Rely Less Than Small Institutional Investors on Advisory Firms, Limiting the Influence These Firms Have on Proxy Voting Results

We conducted structured interviews with 31 randomly selected  institutional investors to gain an understanding of the ways in which they  use proxy advisory firms and the influence that such firms have on proxy  voting. The following summarizes several of the reasons that large institutional  investors’ reliance on proxy advisory firms’ research and  recommendations is limited:    Most of the large institutional investors we spoke with (15 out of 20)  reported that they generally rely more on their own in-house research  and analyses to make voting decisions than on the research and  recommendations provided by their proxy advisory services providers. They explained that they use the research and  recommendations provided by proxy advisory firms to supplement  their own analysis and as one of many factors they consider when  deciding how to vote. In particular, large institutional  investors, which cast the great majority of proxy votes made by all  institutional investors with over $1 billion in assets, reportedly place  relatively less emphasis on the firms’ research and recommendations than  smaller institutional investors. Appendix I: Scope and Methodology

Our objectives were to (1) identify potential conflicts of interest that exist  with proxy advisory firms and the steps that the Securities and Exchange  Commission (SEC) has taken to oversee these firms; (2) review the factors  that might impede or promote competition in this industry; and (3) analyze  institutional investors’ use of proxy advisory services to help vote proxies  and the influence proxy advisory firms may have on proxy voting.
Why GAO Did This Study

At annual meetings, shareholders of public corporations can vote on various issues (e.g., mergers and acquisitions) through a process called proxy voting. Institutional investors (e.g., mutual funds and pension funds) cast the majority of proxy votes due to their large stock holdings. In recent years, concerns have been raised about a group of about five firms that provide research and recommendations on proxy votes to their institutional investor clients. GAO was asked to report on (1) potential conflicts of interest that may exist with proxy advisory firms and the steps that the Securities and Exchange Commission (SEC) has taken to oversee these firms; (2) the factors that may impede or promote competition within the proxy advisory industry; and (3) institutional investors' use of the firms' services and the firms' potential influence on proxy vote outcomes. GAO reviewed SEC examinations of proxy advisory firms, spoke with industry professionals, and conducted structured interviews with 31 randomly selected institutional investors. GAO is not making any recommendations.

What GAO Found

Various potential conflicts of interest can arise at proxy advisory firms that could affect vote recommendations, but SEC has not identified any major violations in its examinations of such firms. In particular, the business model of the dominant proxy advisory firm--Institutional Shareholder Services (ISS)--has been the most commonly cited potential conflict. Specifically, ISS advises institutional investors how to vote proxies and provides consulting services to corporations seeking to improve their corporate governance. Critics contend that corporations could feel obligated to retain ISS's consulting services in order to obtain favorable vote recommendations. However, ISS officials said they have disclosed and taken steps to mitigate this potential conflict. For example, ISS discloses the potential conflict on its Web site and the firm's policy is to advise clients of relevant business practices in all proxy vote analyses. ISS also maintains separate staff who are located in separate buildings for the two businesses. While all institutional investors GAO spoke with that use ISS's services said they are satisfied with its mitigation procedures, some industry analysts continue to question their effectiveness. SEC conducts examinations of advisory firms that are registered as investment advisers and has not identified any major violations. Although new firms have entered the market, ISS's long-standing position has been cited by industry analysts as a barrier to competition. ISS has gained a reputation for providing comprehensive services, and as a result, other firms may have difficulty attracting clients. Proxy advisory firms must offer comprehensive coverage to compete and need sophisticated systems to provide the services clients demand. But firms interested in entering the market do have access to much of the information needed to make recommendations, such as publicly available documents filed with SEC. Competitors have attempted to differentiate themselves from ISS by, for example, providing only proxy advisory services and not corporate consulting services. While these firms have attracted clients, it is too soon to tell what their ultimate effect on enhancing competition will be. Among the 31 institutional investors GAO spoke with, large institutions reportedly rely less than small institutions on the research and recommendations offered by proxy advisory firms. Large institutional investors said that their reliance on proxy advisory firms is limited because, for example, they have in-house staff to assess proxy vote issues and only use the research and recommendations offered by proxy advisory firms to supplement such research. In contrast, small institutional investors have limited resources to conduct their own research and tend to rely more heavily on the research and recommendations offered by proxy advisory firms. The fact that large institutional investors cast the great majority of proxy votes made by institutional investors and reportedly place relatively less emphasis on advisory firm research and recommendations could serve to limit the firms' overall influence on proxy voting results.