Conflicts of Interest Among Proxy Advisors

The Importance of Proxy Advisors

Proxy advisors play a critical role in corporate governance. One important way in which shareholders exert governance – ensure that executives act in shareholders’ interest, rather than their own interest – is through voting. Votes can be for particular directors (who monitor executives), for or against a say-on-pay vote, or for or against manager or shareholder proposals on issues such as corporate social responsibility, strategy, payout policy, charitable contributions, or corporate governance itself (e.g. shareholder rights).

However, many investors may be uninformed about how to vote, either due to lack of expertise in corporate governance (as may be the case for some, but not all, retail investors) or lack of incentives to become informed due to their small stakes. Even a large institutional investor may only hold a small stake in any one particular company, due to being spread thinly across thousands of companies. These concerns are particularly strong given the rapid growth of index funds who are especially diversified.

Proxy advisors, such as Institutional Shareholder Services (“ISS”) and Glass-Lewis are a potential solution to this problem. Just as credit ratings agencies guide investors on how much to charge for lending to a company, and credit and equity research reports guide investors on whether to buy or sell a company’s debt or equity, proxy advisors can guide an investor on how to vote. Even though some investors may not blindly follow a proxy advisor’s recommendation, their recommendations remain very influential. Exxon Mobil recently stated that “proxy advisors hold a position of unparalleled influence” and estimated that “between 20-25% of the votes cast at Exxon Mobil’s most recent annual meeting were voted automatically in accordance with proxy advisor recommendations.” This is backed up by large-scale causal evidence – investors are significantly more likely to vote for (against) a resolution if ISS recommends voting for (against).

Thus, it is critical that proxy advisor recommendations are unbiased. However, evidence suggests that credit rating agencies may be biased, and the Global Analyst Research Settlement was in response to concerns of equity analyst bias. A forthcoming paper in Management Science by Tao Li of Warwick Business School, based on his PhD dissertation at Columbia Business School, suggests that conflicts may also exist with proxy advisors.

Why Might Conflicts Exist?

What’s the source of such a conflict? Tao studies ISS, who sells not only proxy voting services to investors but also consulting services to firms who are considering management-sponsored proposals. Thus, there is a potential concern that ISS may recommend that investors vote for management if it is a consulting client – either as a “quid pro quo” for commissioning consulting services, or to show that its consulting has succeeded in designing management-sponsored proposals that shareholders are willing to approve. Indeed, the Ohio Public Employees Retirement System dropped ISS’s services in the mid-2000s, commenting that “the thing that tipped us was [ISS’s] actual or perceived conflicts due to the corporate consulting.”

Documenting Potential Conflicts

How did Tao study whether these conflicts actually existed? Simply showing that ISS is more likely to recommend votes for management when also provides consulting services does not suggest bias, because it could be that the consulting genuinely improved proposal quality. So, Tao looks at the entry into the proxy advisory market by Glass Lewis, a major competitor providing no consulting services. The hypothesis is that competition disciplines ISS from issuing biased recommendations, just as it does so with equity analysts.

But, simply showing that ISS recommends “against” more often when Glass Lewis enters will still not suggest that ISS was previously biased. It could be that managers are starting to make more egregious proposals, which both causes ISS to recommend “against” and also encourages Glass Lewis to enter, since investors need more voting guidance. Thus, Tao compares firms that are potential clients of ISS (proxied by large firms) – where conflicts exist – with firms that are not potential ISS clients because they are too small. This “difference-in-differences” analysis controls for time trends. Using a medical analogy, large firms are “treated” firms, where any bias is reduced by Glass Lewis’s entry, and small firms are “placebo” firms – Glass Lewis’s entry is irrelevant, since there were few conflicts to begin with.

Indeed, Tao finds that, when Glass Lewis initially covers a new firm, ISS becomes tougher towards potential clients than non-clients. Also supporting a “conflict” explanation, the effect is stronger for more complex votes where it is easier to be biased (e.g. on proposals related to governance and executive compensation) rather than “no-brainer” votes where bias might appear blatant (e.g. uncontested director elections). For contested director elections, the effect is stronger for first-time director nominations than director reappointments, again potentially because the former are more complex and thus bias was easier before Glass Lewis’s entry.

Moreover, any potential bias has real outcomes – it is important. Tao compares proposals with potentially biased recommendations from ISS that pass by a narrow margin to those that fail by a narrow margin (focusing on narrow margins zones in on proposals where any potential bias was particularly important). Firms with proposals that narrowly pass subsequently outperform those that narrowly fail. These effects are small, but Tao finds that executives at these firms have higher abnormal pay, higher growth in pay, and more cash payments. These results suggest that any potential bias allows managers to extract value at the expense of shareholders.


Tao is careful not to over-interpret his results. While suggestive of conflicts, they do not prove bias. The published paper does not use data on ISS’s actual client base, and can only proxy for it using firm size. (Tao, like any institutional client that purchases ISS’s voting recommendations, was able to check potential conflicts of interest using ISS’s actual client base, but was not allowed to write any papers based on the client list.) Moreover, even if ISS’s recommendations were biased, they may still be informative – a biased recommendation may still be better than no recommendation, and so proxy advisory firms play an important role in compensation. But the result do suggest that, just as investors use credit ratings and analyst reports to guide their investment decisions but do not blindly follow them, investors should similarly use proxy recommendations as an important input to their votes but it is critical that they also do their own analysis. If investors do not have sufficient “skin-in-the-game” to do their own analysis, policymakers should encourage them to take large stakes in firms – potentially by increasing the threshold (currently 5% in the US and EU, and 3% in the UK) at which they need to disclose their holdings. My conversations with a very large, but very diversified, institutional investor revealed that they virtually automatically follow ISS in their voting, which may not lead to the best outcomes.

Corporate Governance in China

China will soon become the largest economy in the world, but many Westerners (myself included) know very little about it. Moreover, the vast majority of research on corporate governance is on the US. We often assume that these findings will apply throughout the world, but this assumption is unwarranted – the institutional setup is very different across different countries.

I thus sought to educate myself on China, and came across an excellent article by Fuxiu Jiang and Kenneth Kim of the Renmin University of China. In addition to providing a non-technical survey into Chinese corporate governance in its own right, it also introduces a special issue of the Journal of Corporate Finance with many papers on Chinese corporate governance. I summarize the article in bullet-point format below. All of these points I learned from the original article, so please cite it (not me) if you use anything from it (Jiang, Fuxiu atnd Kenneth A. Kim (2015): “Corporate Governance in China: A Modern Perspective”. Journal of Corporate Finance 32, 190-216). I hope you find this as helpful as I did.

Institutional Background

Capital Markets

  • On December 19, 1990 and July 3, 1991 the Shanghai and Shenzhen Stock Exchanges were launched. Shanghai is analogous to NYSE and Shenzhen to Nasdaq.
  • Regular domestic shares are A-shares, denominated in RMB. A small fraction of firms have B-shares, denominated in foreign currency (US or Hong Kong dollars).
    • B shares have the same cash flow rights as A shares, but were originally restricted to foreign investors.
      • Since 2001, Chinese can own B shares
      • Since 2003, qualified foreign institutional investors (QFIIs) can own A-shares
    • B shares are less than 0.5% of the total market cap on the two exchanges
  • Regulator is China Securities Regulatory Commission (CSRC), the equivalent of SEC
  • Shares are divided into tradable shares (TS, 1/3) and nontradable shares (NTS, 2/3). Initially, controlling shareholders (often the state or legal persons) held NTS, and domestic individual investors held TS.
  • Individual investors are typically uninformed speculators, leading to stock market volatility. Government has thus promoted institutional investors
    • In April 1998, the first closed-end fund was introduced. Open-end mutual funds and index funds were subsequently introduced.
    • October 27, 1999: insurance companies were approved to own stocks indirectly through a securities investment fund. October 24, 2004: insurance funds were allowed to invest in stocks directly.
    • As above, QFIIs could hold A-shares from 2003
    • Thus, tradable shares became held also by domestic and foreign institutional investors
  • Split share structure was to ensure that the government could retain control of firms. But, government realised that non-tradability is a problem – since NTS holders don’t benefit from stock price appreciation, they had little incentive to pursue shareholder value maximisation. Thus, conflict between TS and NTS
  • April 2005: government initiated the Split Share Reform, to transform all NTS into TS. Since this would dilute the value of TS, NTS holders had to negotiate a compensation plan with TS holders (typically additional shares)
    • Pilot programs conducted in April and June 2005. Reform expanded to all listed firms in August. By end of 2007, almost all firms had established a plan and timetable to convert NTS into TS. Since 2005, NTS are called “restricted shares” to convey the fact that they will eventually become tradable
  • Turnover is high. Even though it’s fallen, it still remains high by international standards. Average holding period of 1 year (4 months) on Shanghai (Shenzhen) Stock Exchange

Corporate Governance

  • For listed firms, a shareholder meeting is required once per year
    • Interim meetings can be called by large shareholders
  • A listed firm must have 5-19 directors
    • Board must meet at least two times per year
    • Since June 30, 2003, at least 1/3 of the board must be independent (can’t be related to the manager, be one of the top 10 shareholders or own 1% of shares, or have a business relationship with the firm).
    • Since China has concentrated ownership, primary duty of independent directors is to monitor large controlling shareholders on behalf of minority shareholders. In countries with dispersed ownership, it’s to monitor management on behalf of all shareholders.
  • Board structure is two-tier: in addition to the board of directors, there is a board of supervisors. Must have at least three supervisors, include representatives of shareholders, and at least 1/3 must be employees
  • Note that it’s the board chair who’s typically in charge of a company, not the CEO or General Manager (GM is often the title given to the CEO)
    • Chairs typically work full-time and go to work every day, unlike in the UK and US

Internal Governance: Stylized Facts and Interpretation

  • Ownership concentration
    • In 2012, largest shareholder owns, on average, 1/3 of the firm; 5 largest own over half of the firm
    • Ownership concentration has declined over time, particularly from 2005 to 2006 since common compensation in the Split Share Reform was to transfer shares from NTS to TS holders
    • Firms where the large shareholder owners > 50% have higher ROE but lower Q than other firms. Thus, even ignoring causality, it’s hard to say whether large shareholders are good or bad for firm value
    • From 2007, firms with multiple large shareholders outperform firms with single large shareholders in ROE. This may be because 2007 is the first year when firms have more TS than NTS, so governance through exit is strong (one large shareholder can threaten to sell if another large shareholder doesn’t cooperate with it)
    • When the government is a large shareholder, it does not tunnel for private benefits (e.g. perks), but it may sacrifice shareholder value for political objectives such as maintaining employment or overinvesting to prop up GDP
  • Managerial ownership
    • SOEs: managers have very little stake, typically because the manager is a government official appointed by the state
    • Non-SOEs: average ownership is 16%, since most non-SOEs are family firms or founded by entrepreneurs. But, median ownership is 0% in most years and 1.1% in 2012. Managers are rarely given shares or options as compensation; managers only become significant shareholders if it’s a family firm or if they buy the shares personally
  • Managerial pay
    • Pay has rapidly increased in a short period of time, but remains modest globally. In 2012, median pay for top manager of SOEs is RMB 470k ($77k)
    • Pay is not an important incentive for SOE managers. They’re government employees, so are incentivized by being promoted to high-level government positions when their term says firm managers has finished. Also, poorly-performing SOE managers are fired. Thus, incentives still matter, but aren’t provided by pay
  • Institutional ownership
    • Has risen over time, largely driven by emergence of mutual funds
    • But, ownership remains small.
      • In 2012, total institutional (mutual fund) ownership averages 17.4% (7.6%).
      • Median ownership of a mutual fund was 0.067% in 2011
    • In 2011, average holding period for a mutual funds is less than 6 months
  • Board structure
    • CEOs are chairs 25% of the time in non-SOEs, 10% of the time in SOEs
  • Capital structure
    • Average leverage in non-financial firms is 1/3. High compared to UK and US
    • Debt is unlikely to discipline managers in China since creditor rights are weak. Thus, bankruptcies are extremely rare
    • Banks don’t appear to monitor. Qian and Yeung (2015: even when controlling shareholders are tunneling from minority shareholders, banks continue to lend, and loan terms aren’t unfavorable.
  • Dividend policy
    • Dividends are very small: around 1%. Potential reasons:
      • Minority shareholders aren’t able to pressure firms to pay out earnings as dividends, since minority shareholder rights are weak.
      • Turnover is high, and so minority shareholders are speculators going after capital gains rather than caring about dividends
    • Dividends are largely driven by regulations.
      • E.g. Number of paying firms more than doubles in 2000 because a CSRC regulation, with effect from March 2001, required a Chinese-listed firm to pay dividends for three consecutive years if it wants to sell new shares

External Governance

  • As China has transitioned from a centrally planned economy to a market-oriented one, China has issued many laws and securities regulations, but China remains internationally weak in its laws, enforcement, and punishment
  • Government recognizes this and is taking steps. 2002 is referred to as the “Year of Corporate Governance of China”
    • Released Code of Corporate Governance
    • CSRC enacted many governance reforms and regulations, e.g. Improving disclosure requirements when large shareholders change
    • CSRC undertook an unprecedented large-scale review of 1,175 listed firms. Found that 30% had significant governance problems. Many CEOs were fired, many firms were fined.
  • Unlike other countries, little governance through managerial labor market, which is nascent
    • SOEs don’t compete among themselves for the best managers, since the government is the only demand-side entity
    • Many non-SOE firms are family firms, so little external hiring historicallly. May change going forwards as firms become more complex, and China’s one-child policy limits number of family candidates
  • Unlike other countries, little governance through corporate control market, which is nascent
    • State won’t sell SOEs to a raider
    • For non-SOEs, ownership is so concentrated that it would be hard for a raider to gain control
    • But, this may change going forwards given that almost all shares are now tradable
  • Like other countries, product market competition is an effective governance mechanism
  • Many Chinese firms engage in CSR to curry favor with the government, since one of the government’s main roles is to promote social welfare (like other countries). Lin et al. (2015): firms that engage in CSR are more likely to receive government subsidies
  • Cross-listings are likely an effective way for Chinese firms to obtain good governance

China’s Corporate Governance Code

  • Like most codes, contains broad and vague language that describes guiding principles rather than explicit regulations. There are eight chapters
  1. Shareholder rights
  2. Rules for controlling shareholders, including advocating a “reasonably balanced shareholding” (multiple sizable blockholders rather than a single large blockholder)
  3. Rules for directors and board of directors
  4. Duties and responsibilities of the supervisory board. Board is accountable to all shareholders and oversees both directors and senior management
  5. Performance assessments for directors, supervisors, and management
  6. Stakeholders. Firms should be good corporate citizens and cooperate with, inform, listen to, and honor the legal rights of stakeholders
  7. Disclosure. Firms must fully and accurately disclose all information required by law
  8. Code comes into effect on the date of issuance

House of Commons Report on Corporate Governance

Today the House of Commons Select Committee on Business, Energy, and Industrial Strategy (BEIS) published its report on corporate governance, after extensive consultation of oral and written testimony from a wide range of stakeholders. I applaud the Select Committee for such an extensive, thorough job with an issue of national importance, and am personally grateful to them for publishing my initial and supplementary written testimonies as well as inviting me to testify orally in Parliament. I endorse the vast majority of the recommendations and believe that they will help “make Britain a country that works for everyone”, in Prime Minister May’s words. This post aims to summarize the 81 page report into a few simple bullet points, and link them to the evidence.

Executive Pay

  • LTIPs (bonuses based on hitting financial targets) to be scrapped from 2018; no existing LTIPs to be renewed.
  • Instead, give executives equity that they are required to hold for the long term (at least 5 years). The equity must not vest (= become saleable) all in one go
    • See here for the arguments for replacing LTIPs with equity, and here for evidence that CEOs cut investment when their equity vests
    • These ideas are also advocated by The Purposeful Company, a leading consortium of leading executives, investors, consultants, and academics (full report here, short summary here)
    • LTIPs are almost ubiquitous, but used because “we’ve always done it that way” rather than because they are effective. Given this common usage, the proposal is a radical one – but a highly desirable one – and I greatly applaud the Committee for its boldness
  • Where bonuses are used, they should be on wider performance criteria (e.g. qualitative factors) and must be stretching
  • Shareholders’ “say-on-pay” vote will remain advisory, rather than being changed to binding (as initially mooted).
    • However, if an advisory vote has < 75% support, there should be a binding vote the next year and the Remuneration Committee (RemCo) chair should be encouraged to resign
  • Firms should not be forced to put workers on RemCos, but worker representation to be on a comply-or-explain basis
  • Firms, public sector, and large third-sector organisations to publish pay ratios between the CEO and senior management, and the CEO and all UK employees. The ratio must be on a consistent basis each year
    • The actual advocacy of pay ratios was lukewarm, with little justification given. See my Harvard Business Review article for the potential unintended consequences of such disclosure (including for workers themselves).

Directors’ Duties and Reporting

  • More specific and accurate reporting on directors’ duties to other stakeholders, including long-term consequences of decisions
  • Reporting to contain fewer boiler-plate statements. Companies to be more imaginative and agile in communicating directly with stakeholders
  • The report recognises that UK corporate governance is very well regarded internationally. Thus, it strongly supports maintaining
    • The unitary board, where all directors share the same responsibilities
    • The statement of directors’ duties in Section 172 of the Companies Act (that directors “promote the success of the company for the benefit of its members” (i.e. shareholders) while having regard for other stakeholders)
    • “Comply or explain” guidelines (firms do not need to comply with certain guidelines, permitting flexibility – but if they do not, they must explain why not)
  • I particularly applaud the report’s caution against overreacting to the scandals at BHS and Sports Direct. These scandals are tragic, but do not mean that all companies should have to suffer.
    • The Report writes (paragraph 24): “Corporate governance in the UK is still strong and remains an asset to the country’s reputation for doing business. We are conscious that a small number of highly damaging examples of corporate governance failure should not lead to a hasty and disproportionate response. We do not believe that there is a case for a radical overhaul of corporate governance in the UK”

Expanded Role for the Financial Reporting Council (FRC)

  • FRC to introduce a new tiering system (Red, Yellow, Green) for corporate governance
  • FRC to engage and hold directors to account
    • If engagement unsuccessful, report failings to shareholders
    • If still no response, take legal action
  • FRC to be renamed and resourced, to match this expanded role

Private Companies

  • New governance Code for the largest private companies to be developed
    • Compliance to be examined by an expanded FRC, funded by a small levy on businesses

Shareholder Engagement

  • Paragraphs 13-16 recognise the importance of blockholders (large shareholders) and the dangers of the ownerless corporation
    • However, this point is not subsequently picked up. Encouraging large shareholders to form, and helping shareholders to engage with companies, could further help the Government’s mission. See Chapter 4 of The Purposeful Company Policy Report.
  • Investor Forum to facilitate better engagement between boards and shareholders, particularly if rated Yellow or Red by new FRC tiering system
  • Shareholders encouraged to engage more in pay

Stakeholder Representation

  • Companies to be encouraged to consider a Stakeholder Advisory panel, to consult stakeholders other than shareholders
  • Annual Report to contain a section on how firms engage with shareholders
  • Workers on boards should not be mandated, but report highlights that there is nothing in the law to prevent it. Would like it to become the norm by opening up new director positions to all.
    • Worker directors will not be a delegate of the workforce as a whole but act in their own capacity, and have the same rights and responsibilities as other directors

Board Diversity

  • 2020 target for half of new appointments to senior and executive management to be women. Companies should explain why they have failed to meet the target and the steps taken to address it
  • Every existing FRC reference to gender diversity should also add a reference to ethnic diversity


  • Firms to report on their people policy in the Annual Report, i.e. approach to investing in people and how they ensure that their pay and working conditions are reasonable
  • Investors to disclose voting records; FRC to name those who don’t vote
  • Firms to provide full information on advisors engaged in transactions

A Note on the Use of Evidence

  • The Report writes “The TUC states that “There is clear academic evidence that high wage disparities within companies harm productivity and company performance“.” This statement is actually false. The TUC (potentially inadvertently) quoted an unpublished 2010 paper by which found that high pay ratios are negatively correlated with firm performance. However, the final version of the paper was published in 2013 (i.e. 4 years ago). After going through peer review, it found the opposite result. In the authors’ own words, “We find that employees do not perceive higher pay ratios as an inequitable outcome. We do not find a negative relation between relative pay and employee productivity. We find that firm value and operating performance both increase with relative pay.”
    • This highlights the potential issue of “confirmation bias”. You can always find some academic paper to support any viewpoint (some studies support vaccination, others oppose it). So, just having “evidence” to support a viewpoint means little – what matters is the quality of evidence. One cannot just hand-pick an unpublished draft that shows what you would like it to show, particularly when the published version shows the opposite.
    • Claiming to be unaware of the published paper is not an acceptable defense. It is incumbent upon a witness, who chooses to quote an unpublished paper, to check whether it has since been published. Confirmation bias is not only misinterpreting evidence once you have received it, but the failure to search for new evidence. One cannot just stop at finding a half-finished paper because it shows what one would like it to show, and not bother to see if there is a finished version
    • I highlighted in my supplementary testimony that the result was overturned (and the US evidence was independently confirmed using UK data in a paper forthcoming in a top journal). Thus, while the bulk of the Report is balanced and well evidenced, it is surprising that it contains a statement known to be wrong. The Oxford Dictionaries word of 2016 is “post-truth”, which has led to a widespread, and very welcome, acknowledgment of the importance of correcting untruths. Thus, when such corrections are made, they should not be ignored.
    • As stated in my supplementary testimony, “The goal of the above is absolutely not to discredit the TUC, which is an organisation I respect, and whose goal of encouraging ethical treatment of workers I very much share. [Indeed, I expect that we both share strong support for the Committee’s recommendation for firms to disclose their people policy.] This is simply intended to be one example of how important it is to be critical with evidence.”
    • Moreover, that the paper finds that pay ratios are positively correlated with future performance is far from the final word. Academic evidence is only one input into a decision. My concern is only that, when evidence is quoted, it should be quoted accurately.
    • I will discuss best practices for the use of evidence in my upcoming TEDx talk, “From Post-Truth to Pro-Truth”, on 12 May in London. See here for details of the event and excellent other speakers.