Globally, the main business of proxy advisors is to advise or make recommendations to the institutional investors on the resolutions put to vote at shareholder meetings and even execute votes on institutional proxies. Research and governance ratings are only their ancillary activities. The business grew in the US and UK in the past 25 years, and its driver was the rapid institutionalisation of the securities market, consciously pushed by regulatory policies. The number of such firms increased in the two continents in the 1990s and even more in the 2000s.
Problems in the business began to surface gradually when issuers also became the consumers of the proxy advisors and started to avail of their consultancy services. The proxy advisors began to advise the issuers even on matters on which they also advised the institutional investors. The conflict of interest was apparent, but conflicts of interest often make good business - in the short run. Over the longer term, it sullies reputations.
In both the US and the UK, concerns surfaced about the proxy advisory business. The US Securities Exchange Commission put out for public comment a Concept Release on the US proxy system; the US Government Accountability Office sent a report to the Congress on issues related to proxy advisory firms and the European Securities Market Authority published a Discussion Paper on the proxy advisory industry for policy considerations. The regulators are seriously reviewing the performance of proxy advisors and considering regulating them.
The Indian securities market is far from being institutional in character, certainly not to the degree of the markets in the US and Europe are; and the necessary preconditions for the take-off and drive to maturity of this business are clearly missing. Whether early and growing media exposure, which proffers an impression of solidity and great promise for the business, will convert to a well grounded reality, or be what Daniel Kahneman would call "an illusion of validity", remains to be seen.
Let us consider the share of institutional investors in the securities markets in the two continents. In the US, for example, the share of the institutional investors grew from about 7 or 8 per cent of market capitalisation in 1950 to the current level of 66 per cent for the NYSE and around 70 per cent for the NASDAQ markets. The position has been no different in the UK and rest of Europe. Contrast this with the Indian market. A recent study conducted by Bala N Balasubramanian and Anand Ramaswamy of IIM-A, on a sample of 189 companies which have been part of the Nifty and NSE CNX 100 for some time between 2001 and 2011, concludes that "concentrated ownership and control is the predominant shareholding pattern" in India.
The conscious regulatory push towards the growth of proxy advisors in the US perhaps came from the 1988 amendment to the Employee Retirement Income Security Act of 1974, requiring "pension plan fiduciaries to consider plan beneficiaries' best interests when voting stock held by the plan". Changes proposed by the US Securities Exchange Commission in 2003 gave it a further boost, as the managers had to appoint proxy advisors to demonstrate that they were "taking their voting responsibilities seriously". Besides, over time the proxy voting process grew in complexity, necessitating the involvement of a number of third party participants and making the chain of accountability more complex, the process less transparent. Such complexities grew in the UK as well as in the European Union. The growing dependency on proxy advisors and the successes of a few firms gradually turned the business into an oligopoly on the dominant firm model.
The three major current concerns about the business are: conflict of interest; giving voting recommendations without adequate accountability and oversight for informational accuracy; and the misalignment of voting power and economic interest - as the proxy advisory firms, which control or significantly influence institutional shareholder voting, did not have any economic stake in the issuers. The evils of the first have already been discussed. The second impairs the judgment of the informed shareholders; and the third gives rise to the classical agency problem.
These problems and perils have lessons for the nascent proxy advisory business in India. First, to avoid a common pitfall - the overwhelming urge to make a mark too facilely. The second, there should be a readiness to subject themselves to the same levels of governance standards and transparency demanded from their clients and from market participants. For this the proxy advisors must be prepared to:
- publicly disclose the list of all actual clients as well as the advice given to them on shareholder matters and demonstrate that these advices are free of any conflict of interest;
- refrain from consulting for issuers on matters which are put to shareholder vote and simultaneously advising institutional clients on the same matters or providing ratings to the same issuers;
- publicly disclose the structure of their businesses, the composition of their boards and key management personnel; and
- publicly disclose their full financial results with business segmentation.
The author was formerly executive director of Sebi and is currently consultant to the World Bank.
Disclaimer: These are personal views of the writer. They do not necessarily reflect the opinion of www.business-standard.com or the Business Standard newspaper
