The new year brought new developments in the world of financial services: specifically, the role of artificial intelligence (AI). In January, JPMorgan Chase announced it would replace its proxy advisory services with artificial intelligence. Chief Executive Jamie Dimon even went as far as to say that proxy advisors are “incompetent” and “should be gone and dead, done with.”
For those who have been following issues related to environmental, social, and governance (ESG) and diversity, equity, and inclusion (DEI), this is a major event. The two major proxy advisory firms, Institutional Shareholder Services (ISS) and Glass, Lewis, & Co. (Glass Lewis), have been criticized for using their recommendations on shareholder voting to push politically motivated ESG/DEI crusades (sometimes unbeknownst to the shareholders they represent). This has made the industry the target of a recent executive order aiming to increase federal oversight in the proxy advisory industry.
Ultimately, though, the proxy advisory industry was born out of regulation. Further government intervention could invite greater cronyism. If the proxy advisory industry wants to win customers back, it needs to focus on fiduciary obligations, not politics. If federal officials want greater transparency and accountability in the proxy advisory market, they should focus on rolling back unnecessary regulations and simplifying any regulations that remain to encourage a competitive proxy market.
How Did We Get Here?
A proxy vote is a vote where a shareholder of a publicly traded company authorizes another party to vote their shares at a corporate meeting. Proxy voting involves electing company directors, approving executive compensation, voting on mergers, and considering shareholder proposals. It allows shareholders to participate even if they cannot attend the meeting in person or submit a ballot electronically.
Research on proxy advisory firms notes that institutional investors – those who manage large numbers of shares on behalf of many clients – began paying attention to shareholder voting matters after a “wave of hostile takeover actions” during the 1980s. Around the same time, private retirement funds were legally required to vote their shares based on a “prudent man” standard of care. By the early 2000s, this legal requirement was expanded to include mutual funds and other registered investment companies.
The proxy advisory industry as we know it today emerged from two main sources. Small and midsize funds sought guidance on shareholder voting practices to meet their legal obligations. Then, in 2003, the SEC introduced a regulation requiring all institutional investors — including mutual funds and index funds — to develop and disclose both their proxy voting policies and their actual votes. These policies and guidelines must be free from conflicts of interest, yet the regulation explicitly allows institutional investors to rely on third-party proxy advisors to meet this requirement. Notably, these third-party firms are not held to the same fiduciary standards as the institutional investors they advise.
Enter Glass Lewis and ISS.
Although there are technically five proxy advisory firms, the two largest (ISS and Glass Lewis) have a roughly 97 percent share of the market for proxy advisory services. These services have a major influence over corporate governance decisions, company-wide equity compensation, and a host of other issues.
Having such a large market share made them an enticing target for political activists. Before long, activists manipulated proxy guidelines to recommend voting for political crusades such as ESG and DEI. As one of the authors wrote in a recent white paper, these ideas are often incoherent, contradictory, and even run counter to successful business performance and high financial returns. Unbeknownst to many shareholders, who put their voting on autopilot based on proxy recommendations (known as robovoting), their votes pushed political objectives to the detriment of their own financial security.
Can Proxy Advisory Firms Win Back Trust?
As Dimon’s comments suggest, the two big proxy advisory firms have a PR and a business problem. Institutional investors are looking for exits or have already taken them. New advisory firms are forming. And bigger clients like JP Morgan believe they can harness AI to bring their proxy work in-house.
If ISS and Glass Lewis want to win back investor and shareholder trust, the best thing they can do is dump the political crusades. These services came about because there was a demand for providing voting guidelines that were compliant with an overbearing SEC. Proxy advisory services would do well to demonstrate that they follow a prudent man standard of care and follow the sole interest rule: that the proxy advisory services make decisions based solely on the financial well-being of their clients.
By voluntarily committing to these standards and delivering recommendations that benefit clients, they can refute claims of incompetence and prove they may be less biased than an AI program.
Markets Ensure Accountability & Transparency
Now, the White House wants to intervene again in response to the problems created by regulations and interventions. We’ve seen this pattern before: politicians see a problem, they intervene. Then the intervention leads to new, unforeseen problems, prompting a renewed urge for government intervention. Unfortunately, this approach to “fixing” problems leaves people worse off, creates unintended consequences, and gives greater power to government officials.
If policymakers are concerned about proxy advisors and political crusades, they should focus on deregulation. Instead of adding an additional layer of regulatory complexity, federal policymakers will improve accountability for proxy advisory services by promoting market competition and removing government regulations.
Currently, proxy advisory services can advertise their business as a means of helping funds comply with onerous regulations rather than increase the value of their shares. If the SEC relinquishes requirements to publish voting guidelines and shareholder votes, proxy advisory services will have to entice clients by showing the value they add to a potential client’s business. If they fail to do so, potential clients will happily pass them over for other service providers, bring shareholder voting guidelines in-house (as many public pension systems have done), or rely on emerging technology.
There is no doubt that the proxy advisory industry, once firmly planted in American finance, is now facing regulatory threats and existential crises from AI. If these businesses hope to survive, they would do well to focus on serving customers instead of political ideologies.
