In the last two decades, the proxy advice market has consolidated into two companies that some believe control as much as 97 percent of that market, leaving little diversity in available advice. The companies, ISS and Glass Lewis, are opaque about the bases for their recommendations, and critics accuse them of offering simplistic one-size-fits-all solutions that do not increase shareholder value.  Complicating matters, investors don’t always agree on what sort of advice they want, especially when it comes to social issues: Traditional funds and socially responsible investors (SRI) disagree about whether firms should sacrifice profit for social goals. All of this raises thorny questions about proxy advice: What constitutes a “good” recommendation, can advisory firms provide good advice – and why does their advice inspire so little confidence? In a new working paper, we propose a theoretical framework to address these questions, which leads to some troubling conclusions.
As for what constitutes “good” advice, it’s important to recognize that the standard normative metric in financial economics – value maximization – loses its force in the presence of investors who care about non-pecuniary consequences. It could be socially optimal to trade off corporate profits for improved human rights or greenhouse gas (GHG) abatement, as recently suggested by the Business Roundtable, in which case the best policy may not be the one that maximizes firm value. We propose instead to evaluate the quality of advice in terms of how well it represents the underlying preferences of investors who purchase the advice, if (hypothetically) they had been fully informed. What constitutes good advice, then, varies among shareholders. From this perspective, shareholder elections are best when they accurately represent the distribution of shareholder preferences.
In our framework, proxy advice is the outcome of competition between advice suppliers trying to serve a market of heterogeneous customers. An advisory firm can adopt an SRI perspective and support GHG abatement, renewable energy, and so forth; or it can adopt a strict value-maximizing perspective. As profit maximizers themselves, advisory firms will choose the type of advice they offer based on how it affects their bottom line.
Our framework also incorporates the fact that funds usually purchase advice bundled with vote-execution services. An individual fund may have to cast thousands of votes each year, a complicated and time-consuming process that for some is just a distraction from their core business strategies. For such a fund, vote execution services are more valuable than the advice itself.
We show that competition can produce two industry structures, depending on the size of the market. When the market is relatively small, a perfectly competitive population of “boutique” advisory firms emerges, collectively offering a wide array of advice so that all investors can find an adviser aligned with their preferences. Corporate voting is representative, in the sense that votes reflect investor preferences.
When the market becomes sufficiently large, though, the industry comes to be dominated by a “platform” firm that exploits economies of scale. With high enough demand, it is efficient for an advisory firm to pay the fixed cost to set up a vote execution platform that can serve the entire market at low marginal cost. The platform firm drives out its competitors, like a textbook natural monopoly. This would be fine if the platform monopolist’s recommendations represented the consensus view of shareholders, but we show that its advice tends to be aligned with the preferences of SRI funds, even though they represent a minority of shareholders. Because so many funds end up voting based on this slanted advice, corporate elections pressure the issuer into adopting policy positions that are favored by the SRI funds.
At first glance, it seems counterintuitive that the monopoly adviser would cater to the relatively smaller segment of the market. Why wouldn’t a profit-seeking adviser align its recommendations with the preferences of the majority of funds that want to maximize value? The reason is that funds focused on returns do not much care how their votes are cast, in contrast to SRI funds, whose business model is based on advancing social goals. The advisory firm can offer advice that appeals to SRI funds, knowing that it will not cost them business from value-focused funds, while the converse is not true, and therefore slants its advice toward social goals.
Our framework offers a way to understand the recent evolution of the proxy advice market. At the start of the 21st century, most funds did not vote, and the demand for proxy advice was low, so the advisory industry was comprised of numerous competitive firms.  In 2003, the SEC issued guidelines requiring mutual funds to vote, causing a huge increase in demand for proxy advice. With the surge in demand, it became feasible to invest in platform technologies, and the industry began to consolidate into a small number of firms capable of executing enormous numbers of votes at low cost (ISS says it executes 9.6 million votes each year). In this narrative, the SEC’s decision to force mutual funds to vote played an important role in consolidation of the industry.
As for the apparently low quality of advice offered by ISS and Glass Lewis, our framework suggests this is because many customers are not willing to pay for high quality advice – they are mainly purchasing low-cost vote-execution services. The platform monopolists maximize profit by aligning their recommendations with the subset of investors for whom advice is important, the SRI funds. This helps explain an otherwise puzzling recent finding: that ISS’ voting recommendations are generally “to the left” of those of most investors, closer to the preferred position of SRI investors.  If the goal of the SEC’s 2003 regulations was to make corporate elections more responsive to shareholders focused on value maximization, it may have had the opposite effect by aligning proxy advice with the preferences of SRI funds.
One potential policy solution would be to limit the market share of individual advisory firms. This would prevent consolidation into a natural monopoly, and support an industry structure with numerous boutique firms, each offering advice tailored to a particular investor segment, and voting would be representative. Simply breaking up the largest proxy advisers, in our analysis, would only work in the short run because the underlying scale economies would lead to reconsolidation over time. Another potential policy would be to prohibit proxy advisory firms from providing vote execution services. For example, ISS might be forced to divest its ProxyExchange voting platform. This would prevent the natural monopoly in vote-execution services from creating a monopoly in advice.
Our model is stark and elides some important real-world issues. We ignore the potential conflict of interest between proxy advisers’ role as advisers and their consulting businesses, and we assume a given adviser offers the same advice to every customer, when in fact some customization occurs. Yet we believe the framework isolates some key economic forces in the proxy advice market.
Effective proxy advice is crucial for shareholder governance to work. On their own, shareholders don’t have the incentive to acquire knowledge and cast informed votes because of free-rider problems. This is especially so for mutual funds, which now dominate the market and simply track an index. Observers have hoped that proxy advisers could become effective intermediaries, providing information to investors at low cost, and allowing informed voting. Our analysis suggests that basic economic forces – competition and economies of scale – might make this more difficult than it first appears.
 Larcker, David F., Allan L. McCall, and Brian Tayan, “And Then A Miracle Happens! How Do Proxy Advisory Firms Develop Their Voting Recommendations?,” Stanford Closer Look Series, February 2013; Larcker, David F., Allan L. McCall, and Gaizka Ormazabal, “Outsourcing Shareholder Voting to Proxy Advisory Firms,” Journal of Law and Economics, February 2015, Vol. 58(1), 173-204.
 For example, Proxy Voter Services (acquired by ISS in 1997), Proxy Monitor (acquired by ISS in 2001), IRRC (acquired by ISS in 2005), and Proxy Governance (acquired by Glass Lewis in 2010), in addition to ISS, Glass Lewis, and Egan-Jones. See https://online.wsj.com/public/resources/documents/ProxyAdvisoryWhitePaper02072011.pdf
 Bolton, Patrick, Tao Li, Enrichetta Ravina, and Howard Rosenthal, “Investor Ideology,” Journal of Financial Economics, forthcoming.
This post comes to us from John G. Matsusaka, who is a professor, and Chong Shu, who is a PhD student, at the University of Southern California Marshall of Business. This post is based on their new working paper, “A Theory of the Proxy Advice Market when Investors have Social Goals,” available here.