Agency Capitalism: Corrective Measures (Part 2)

This is Part 2 of a post which started out reviewing the important thesis outlined in The Agency Costs of Agency Capitalism: Activist Investors and the Revaluation of Governance Rights by Ronald J. Gilson and Jeffrey N. Gordon (January 1, 2013). See Agency Capitalism: Corrective Measures Part 1 and Part 3. Current law encourages mindless indexing of portfolios and voting like lemmings to fulfill fiduciary duties. While Gilson and Gordon stressed the need for activist hedge funds, below I explore some additional options.

Large Funds Could Become Activists 

In 1999, Anne Simpson, who now heads corporate governance efforts at CalPERS, co-authored the book Fair Shares: The Future of Shareholder Power and Responsibility in which she advised that holdings should not be too fragmented to warrant the time and resources needed for proper monitoring. Alternatively, funds could cooperate to monitor through organizations like the Council of Institutional Investors (CII) and the PIRC Pensions Investment Research Consultancy (PIRC).

CalPERS has long invested a small portion of their assets in governance oriented hedge funds such as Relational Investors. They would take a stake in a hedge fund, with its expensive management fees, and both would target some of the same companies for corporate governance reforms. At least CalPERS got some additional reward from their targeting efforts beyond what they would get while strictly indexing.

For years, I advocated CalPERS should own stocks in fewer companies so they could be more effective in their corporate governance activities. For example, see my 1996 interview with outgoing general counsel Richard Koppes. I also ran for the CalPERS Board several times advocating they double-down on “focus list” companies to benefit more from the “CalPERS Effect.” It didn’t make sense to spend a lot of effort trying to reform corporate governance at a 0.5% holding when other funds get 99.5% of the benefit.

Now, perhaps because of the influence of Anne Simpson, CalPERS is finally committed to buying additional shares of stock in companies where CalPERS engages in seeking corporate governance reforms over a sustained period, usually five years. Many of these efforts can be done totally in-house, without the expense of investing in activist funds. (CalPERS Puts Money Where Mouth Is: CalPERS backing ESG engagement with stock purchases, Pensions&Investments, 3/4/2012) CalTRS will reportedly follow suit at a later date.

This is a very positive development and might be followed by a few other large public pension funds. However, the movement is unlikely to spread to most large diversified mutual funds for the reasons outlined by Gilson and Gordon.

Governance Funds

Aside from the activists investors discussed by Gilson and Gordon there are starting to be a few funds specializing in corporate governance. For example, The Governance Fund Advisors, LLC, is a private investment management firm “that seeks to capture hidden value by differentiating well-governed companies from those which are poorly governed. The firm utilizes guiding metrics centered on effective corporate governance in seeking to realize undiscovered returns and extract greater gains from publicly traded companies.”

A second such effort is underway at the Global Index Group (GIG) to develop corporate governance indices. GIG us using GMI Ratings data to build an index that will allow institutional funds and others to incorporate governance risk factors into portfolio strategies.  “For fiduciaries truly concerned about avoiding the next Enron or Lehman, using the index to integrate governance insights more fully into the investment process is an essential step,” said CEO Kelly Haughton. These funds don’t index blindly but take into account risk, excluding or underweighting investments in companies with the riskiest corporate governance practices.

Willauer Prosky and Willauer (WPW) is another fund, which relies on its corporate governance expertise. They “use proprietary governance analytics along with classic financial analysis to identify the best and worst corporate citizens whose shares provide significant opportunities for price discovery. Good governance is an underpriced asset and a strong mitigator of risk.” They invest long in a few companies with outstanding corporate governance and short a few companies with exceptionally bad practices. “The Management Fund allocates capital away from those companies that actively seek to use it for selfish and unsustainable ends and towards companies that, through excellent governance practices, create long-term prosperity for their shareholders.”

Such funds, while unlikely to be activist themselves, are at least raising the value the market assigns to good governance and are, perhaps, lowering the cost of capital for well governed companies.

Proxy Access

Proxy access is a topic that should be familiar to regular readers. It would help shareowner activists by substantially reducing the cost of running candidates.  As Gilson and Gordon indicate, the average proxy contests costs about $11 million. Those costs are reduced substantially if candidates can appear on the corporate proxy, instead of having to solicit their own proxies.

As I have written extensively elsewhere (The Case for Proxy Access, NACD Directorship, and my 2002 rulemaking petition to the SEC), directors will never be accountable until they can be voted out of office and replaced by shareowner nominees. Even with proxy access, we still cannot expect most diversified mutual funds to nominate candidates, since they won’t even file shareowner proposals, which involve only minimal costs.

Depending on the holding period and threshold levels required (I have filed proposals requiring as little as 1 year by 50 shareowners collectively holding 1/2% of outstanding stock, similar to John Harrington’s proposal at Bank of America (BAC) modeled after language I created with other members of the now suspended US Proxy Exchange), we could easily double the number of competitive seats each year. A similar proposal will be on the proxy at Goldman Sachs (GS) and at other companies later this year. Again, the outcome of most such contests will be decided by large funds with little incentive to spend much analyzing governance issues, so choices will need to be clear and compelling if they are to result in changes.

Disclosure Regarding Nominating Committee Processes

Although not nearly as powerful as proxy access, shareowners could start recommending more nominees to corporate nominating committees under existing rules. Disclosure Regarding Nominating Committee Functions and Communications Between Security Holders and Boards of Directors, SEC rules effective January 1, 2004, requires companies to disclose the disposition of a recommended nominee, under specified circumstances, from “security holders that beneficially owned, in the aggregate, more than 5% of the company’s voting common stock… for at least one year as of the date the recommendation was made.”

Yes, cobbling together a 5% group and then deciding on suggested nominees would be a rather large task, especially given the likelihood that such recommendations would be rejected. However, if such initiatives are dismissed, that fact could certainly be used to bolster future proxy access efforts. “We tried, but out company wouldn’t listen.”

Proxy Advisor Contests

Large institutional investors generally subscribe to proxy advisory services such as those provided by Institutional Shareholder Services (ISS) and Glass Lewis. These services provide analysis of issues and advice on how to vote at thousands of companies. While there is much debate concerning just how influential such services are, researchers report anywhere from 3.5% to over 50%. Choi, Fisch and Kahan, for example, found ISS accounted for a 6%-10% vote shift (The Power of Proxy Advisors: Myth or Reality?).  See also, Voting Decisions at US Mutual Funds: How Investors Really Use Proxy Advisers by Robyn Bew and Richard Fields.

Regardless of how influential such services are, many institutional investors and most retail investors don’t benefit from their services because they don’t subscribe. According to Mark Latham (Proxy Voting Brand Competition):

The biggest obstacle to paying advisors is the shareowners’ free-rider problem. Whether you are an individual or an institution, if you pay for advice to improve the quality of your voting, that helps all other shareowners even if they do not pay for or receive the advice. For example, if you own 1% of a company’s shares then only 1% of the benefit from your voting comes back to you. So most shareowners have almost no incentive to pay for voting advice.

The solution Latham proposed eliminates the free-rider problem:

By paying as a group, we shareowners would benefit from better voting advice than any we have now. All shareowners of a company would get the advice instead of just the minority that currently subscribe to such research. Competition for advisor reputation would maintain pressure for high quality and moderate pricing.

Holding a contest for the best advice could bring in new proxy advisors specializing in specific industries or companies. In-depth analysts might comment not only on items on current proxies but might provide investors with key comparisons with competitors and could delve into issues on the horizon, many of the same issues analyzed by shareowner activists as described by Gilson and Gordon. Costco: Proxy Advisor Contest Proposed, discussed a proposal we submitted last year but which failed to win a no-action challenge because of a couple of technical issues. Revised language addressed these issues and was submitted to Amazon (AMZN), reading as follows:


WHEREAS some shareowners hire proxy advisors to help them vote in the best interest of their clients, but most do not;

WHEREAS many shareowners lack the time and expertise to make the best voting decisions, yet prefer not to always follow directors’ recommendations;

WHEREAS shareowners could benefit from greater competition in the market for professional proxy voting advice;

THEREFORE BE IT RESOLVED that, Inc. shareowners request the Board of Directors, consistent with their fiduciary duties and state law, to hold a competition for giving public advice on the voting items in the proxy filing for the Amazon 2014 annual shareowners meeting, with the following features:

  • The competition would be announced and open for entries no later than six months after the Amazon 2013 annual shareowners meeting. To insulate advisor selection from influence by Amazon’s management, any person or organization could enter by paying an entry fee of $2,000, and providing their name and website address. Each entry would be announced publicly, promptly after it is received. Entries’ names and website addresses (linked) would be shown promptly on a publicly accessible Amazon website page, in chronological order of entry. Entry deadline would be a reasonably brief time before Amazon begins to print and send its 2014 proxy materials.
  • The competition would offer a first prize of $20,000, a second prize of $15,000, a third prize of $10,000, and a fourth prize of $5,000.
  • Winners would be determined by shareowner vote on the Amazon 2014 proxy. The Amazon Board would include this voting item in that proxy: “Which of the following proxy advisors do you think deserve cash awards for the usefulness of information they have provided to Amazon shareowners? (You may vote for as many advisors as you like. See each advisor’s website for their information for Amazon shareowners. Prizes, of $20,000, $15,000, $10,000 and $5,000 will be awarded to advisors based on the number of shares voted to approve the usefulness of their advice.)” Then the name and website address of each advisor entered would be listed in chronological order of entry, followed by check-boxes for approval, disapproval and abstention for each entry. The advisor receiving the most approval votes would get first prize, and so on.
  • It would be expected that each proxy advisor would publish advice on its website regarding the Amazon 2014 proxy, but there would be no formal requirement to do so. The incentive to win shareowner voting support and to maintain the advisor’s reputation would be considered sufficient motivation for giving quality advice.
  • The Amazon filing that reports the final 2014 proxy voting results would show the total number of shares voted for each proxy advisor.
  • The decision of whether to hold such a competition in subsequent years would be left open.

(Further information on proxy advisor competitions: “Proxy Voting Brand Competition,” Journal of Investment Management, First Quarter 2007; free download at

If ISS and Glass Lewis do use something of a check-box approach, who can blame them, considering the amount they are paid for their research?  The answer is not to exclude shareowners from influencing corporate governance. The answer to provide shareowners easy access to better analysis, tailored to the needs of each specific company. We might even attract hedge funds like ValueAct Capital and Relational Investors, with years of experience serving on boards, to perform the analysis. Of course, ISS, Glass Lewis and other proxy analysts would also be able to join the competition but would have to provide their analysis to all shareowners, not just their subscribers. Proxy advisor contests could become the first step toward activism if problems are found. If no problems are found, they provide greater assurance that existing governance is working.

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