Institutional Shareholder Services Research Articles

Proxy Advice Industry and Its Growing Influence

Mutual funds rely on recommendations from proxy advisors when voting in corporate elections. Proxy advisors’ influence has been a source of controversy, but it is difficult to study because information linking funds to their advisors is not publicly available. A key innovation of this paper is to show how fund-advisor links can be inferred from previously unnoticed features of a fund’s SEC filings. Using this method to infer links, I establish several novel facts about the proxy advisory industry. During 2007-2017, the market share of the two largest proxy advisory firms has declined slightly from 96.5 percent to 91 percent, with Institutional Shareholder Services (ISS) controlling 63 percent of the market and Glass Lewis 28 percent in the most recent year. A large fraction of ISS customers appear to have robo-voted, rising from 5 percent in 2007 to 23 percent in 2017, at which time over 50 percent of small index funds robo-voted. Negative recommendations from ISS or Glass Lewis reduce their customers’ votes by over 20 percent in director elections and say-on-pay proposals. Finally, proxy advisors cater to investors’ preferences, adjusting their recommendations to align with fund preferences independent of whether those adjustments lead to recommendations that maximize firm value.

ISS’s Proxy Voting Guidelines and ROE Management

We examine the impact of the proxy voting guidelines of the Institutional Shareholder Services (ISS) on managers’ opportunistic reporting behaviors. In January 2015, the ISS introduced a new advisory guideline based on firms’ return on equity (ROE), and started to recommend that shareholders should vote against the proposed director election for firms whose ROE is lower than 5%. Focusing on this benchmark, we find that managers are more likely to achieve this threshold since the publication of the guideline and, in particular, they do so by accrual management and increased dividends. Moreover, firms with higher institutional ownership are more likely to beat the threshold. This paper thus contributes to the literature by providing new evidence that earnings management can be motivated by a unique soft law and detects managers’ discretion in the context of ROE.

PORTFOLIO FIRM RESPONSES TO INSTITUTIONAL INVESTOR ACTIVISTS AND THEIR TACTICS

ABSTRACT Purpose Institutional Investor Activism (IIA) has become a dynamic institutional force and a valuable tool for institutional investors in their attempt to influence their portfolio firms. Correspondingly, there has been a rapidly increasing body of scholarly literature devoted to understanding this phenomenon as it affects numerous disciplines within the organization science academy. Prior research in IIA has considered a number of antecedents and processes that may influence corporate outcomes (Goranova & Ryan, 2014b), yet results have been equivocal thus leaving unanswered questions critical for the scholarly discourse on IIA. An overlooked aspect of this literature is the heterogeneity that exists among institutional investor activists and the impact these differences can have on portfolio firm responses. This study examines the heterogeneity of private pension fund and mutual fund activists and answers the following research questions: 1: How do the characteristics of institutional investor activists ultimately influence the likelihood that a firm will comply with an investor's requests/demands?; 2: How is the relationship between institutional investor activists and firm responses moderated by activism tactics? Method To test the hypotheses, we built a database of activism events by institutional investors (II). For comparison purposes, we limited the database to activism events that occurred within the United States. The database included completed activism events from 2010-2017 with completed activism events defined as II demands that resolved (either positively or negatively) within four years. The sample used all activism events for private pension funds and mutual funds. The sample ended up being 238 IIA events spread across the two different types of IIs with the unit of analysis being the II-portfolio firm dyad. The sample included 122 non-proxy-based tactics and 146 proxy-based tactics used within the 238 activism events. Data and databases came from Activist Insight, Thomson Reuters, S&P Capital IQ, the Investor Responsibility Research Center (IRRC), Institutional Shareholder Services (ISS), and Lexis-Nexis. Portfolio firm-level data came from Standard & Poor's Compustat annual dataset. Drawing on 238 observations activism events in the United States, we undertake an empirical test of the effects of private pension fund and mutual fund activism on portfolio firm responses using ordered logistic regression. Results Overall, the tests of the models showed mixed support for the hypotheses. Private pension plans were found to be less likely to receive favorable responses from their portfolio firms whereas mutual funds are not less likely to receive favorable responses from their portfolio firms. In addition, the moderating effects of proxy-based tactics on both types of institutional investors were not supported which runs contrary to prior research. Future research should continue to explore the differences among institutional investors as we have limited understanding of their effects to date. Conclusion These results, and the use of ordered logistic regression with interaction terms, highlight both the success in understanding variance among institutional investors and the continued need for further research on shareholder activism. Keywords Shareholder Activism, Mutual Fund Activism, Stakeholder Salience Theory, Activism Tactics, Strategic Management

Do Corporate Governance Ratings Change Investor Expectations? Evidence from Announcements by Institutional Shareholder Services*

Abstract This paper examines empirically the announcement effect of commercial corporate governance ratings on share returns. Rating downgrades by Institutional Shareholder Services (ISS) are associated with negative returns of –1.14% over a 3-day announcement window. The returns are highly correlated with the proprietary analysis of ISS and are decreasing in agency costs, consistent with ratings providing independent information on underlying corporate governance quality. We thus show that the influence and impact of ISS extends beyond proxy recommendations and subsequent voting outcomes. Our findings contrast with the insignificant price impact of Daines, Gow, and Larcker (2010), whose analysis we replicate and successfully reconcile to ours by pooling upgrades and downgrades together.

Beyond EVA

A former partner of Stern Stewart begins by noting that the recent acquisition of EVA Dimensions by the well‐known proxy advisory firm Institutional Shareholder Services (ISS) may be signaling a resurgence of EVA as a widely followed corporate performance measure. In announcing the acquisition, ISS said that it's considering incorporating the measure into its recommendations and pay‐for‐performance model.While applauding this decision, the author also reflects on some of the shortcomings of EVA that ultimately prevented broader adoption of the measure after it was developed and popularized in the early 1990s. Chief among these obstacles to broader use is the measure's complexity, arising mainly from the array of adjustments to GAAP accounting. But even more important is EVA's potential for encouraging “short‐termism”—a potential the author attributes to EVA's front‐loading of the costs of owning assets, which causes EVA to be negative when assets are “new” and can discourage managers from investing in the business.These shortcomings led the author and his colleagues to design an improved economic profit‐based performance measure when founding Fortuna Advisors in 2009. The measure, which is called “residual cash earnings,” or RCE, is like EVA in charging managers for the use of capital; but unlike EVA, it adds back depreciation and so the capital charge is “flat” (since now based on gross, or undepreciated, assets). And according to the author's latest research, RCE does a better job than EVA of relating to changes in TSR in all of the 20 (non‐financial) industries studied during the period 1999 through 2018.The article closes by providing two other testaments to RCE's potential uses: (1) a demonstration that RCE does a far better job than EVA of explaining Amazon's remarkable share price appreciation over the last ten years; and (2) a brief case study of Varian Medical Systems that illustrates the benefits of designing and implementing a customized version of RCE as the centerpiece for business management. Perhaps the most visible change at Varian, after 18 months of using a measure the company calls “VVA” (for Varian Value Added), has been a sharp increase in the company's longer‐run investment (not to mention its share price) while holding management accountable for earning an adequate return on investors’ capital.

Are Performance Shares Shareholder Friendly?

Performance shares, or PSUs, have become the largest element of pay for top executives in corporate America. Their spread was ignited by institutional investors looking for more “shareholder‐friendly” equity awards—as opposed to restricted stock and stock options, which have been characterized as “non‐performance” equity. Although that characterization has been challenged by many directors and compensation professionals, proxy advisers like Institutional Shareholder Services have continued to insist that the majority of stock be granted based on performance, compelling public companies to conform to that standard.With over a decade of experience with PSUs, the evidence is in regarding their net effect: PSUs greatly complicate long‐term incentives. Pay disclosures are dominated by discussion of PSUs, including metrics, goals, performance and vesting, and any differences in one grant year versus the next over three overlapping periods. PSUs may be contributing to the increase in pay. Companies issuing a significant portion of their long‐term incentives in the form of PSUs have been granting about 35% more in value than companies granting only restricted stock and stock options. Shareholders don't appear to be getting anything for that added complexity and cost. S&P 500 companies using PSUs have underperformed their sector peers, and companies using solely “non‐performance” equity have significantly outperformed their sector peers, and in every single year over the last decade. Given these findings on PSUs, it is time for institutional investors and their proxy advisors to reconsider their view of these vehicles as “shareholder‐friendly,” and rethink their unqualified promotion of their use by the companies they invest in.

Mutual fund board connections and proxy voting

We study fund-firm connections that arise when firm executives and directors serve as fund directors. We find that connected funds are significantly more likely to vote with management in proposals with negative Institutional Shareholder Services (ISS) recommendations or low shareholder support. As our data show that management support does not exist either before connection formation or after its termination, this result is unlikely to be caused by omitted factors. Rather, the connected fund's voting patterns show independence from ISS recommendations and successful connected voting is associated with positive announcement returns, suggesting that connected fund support for management reflects information advantages. Lastly, we find that a fund family and firm are more likely to connect when the fund family holds a large stake in the firm and is geographically proximate as well as when it has a record of voting independently from ISS.

Third-Party Institutional Proxy Advisors: Conflicts of Interest and Roads to Reform

With the rise of institutional activist investors in recent decades—including a purported 495 activist campaigns against U.S. corporations in 2016 alone—the role that third-party institutional proxy advisors play in corporate governance has greatly increased. The United States Office of Government Accountability estimates that clients of the top five proxy advisory firms account for about $41.5 trillion in equity throughout the world. For several years, discussions have developed regarding conflicts of interest faced by proxy advisors. For example, Institutional Shareholder Services, the top proxy advisory firm in the world, frequently provides advice to institutional investors on how to vote proxies while simultaneously providing corporate clients with advice on how to improve their corporate governance. Situations like these have given rise to debate as to whether such conflicts are truly problematic. At a minimum, institutional investors must be confident in the services that are provided to them by proxy advisors. Without a showing that recommendations are given in a neutral and non-biased way, accidentally or intentionally, the system cannot work effectively to maximize shareholder fairness. This Note posits that, despite the fact that third-party proxy advisors are currently acting within the law, reforms should be made that better address and limit the amount of conflicts of interest that may arise as a result of their business. Such reform should take place through legislation, informal SEC notice and comment, or, potentially, through the voluntary action of proxy advisory firms.

The Inside Job: Share Pledges by Insiders and Earnings Management

The study creates the first comprehensive database of share pledges by insiders in the U.S. to reveal the prevalence of this practice and its role in encouraging earnings management. I find that during the fiscal years 2006 to 2014, insiders at one of every three S&P1500 firms pledged their ownership in the firm as collateral to obtain loans at least once. I exploit a 2012 market-wide advisory against share pledges by Institutional Shareholder Services, the largest proxy advisory firm, as a quasi-natural experiment. A difference-in-differences estimation reveals that, after the shock, insiders curtailed share pledge activity by approximately 40% and firms with share pledges reduced earnings manipulation by an average 15% of their reported profits. The results suggest that share pledges distort the incentives of insiders and motivate them to inflate earnings.

Corporate governance risk and the agency problem

PurposeThis study aims to investigate the relationship between corporate governance risk and agency costs across different countries.Design/methodology/approachCorporate governance risk indicators were obtained from the Institutional Shareholder Services Europe (S.A.) for 4,135 firms across 27 countries. Agency costs and other control variables were derived from companies’ annual financial reports using the DataStream database. Ordinary least squares multiple regression analysis model was used to test the study hypothesis.FindingsAgency costs have a significant negative impact on corporate governance risk across countries. The extent of corporate governance mechanisms used, however, varies across geographic regions and industry types. The relationship between corporate governance risk and agency costs is more obvious in the non-financial than financial sector. These results were robust after several statistical checks.Practical implicationsThe findings will help stakeholders, including corporate management, regulators and investors to improve corporate governance mechanisms and capital allocation decisions across countries.Originality/valueEvidence is provided on the role of agency costs in corporate governance risk across geographic regions for financial and non-financial companies. The paper also overcomes common problems in corporate governance research such as construct validity, limited data and endogeneity.

Evaluating the link between commercial governance ratings and firm performance in a cross-European setting

PurposeThe purpose of this paper is to explore the ability of commercial governance ratings (CGR) to predict firm performance.Design/methodology/approachBased on the review of the corporate governance literature, the authors pose five hypotheses on the relationship between CGR and firm performance. Then, the authors test these hypotheses for the latest version of the Institutional Shareholder Services Inc. (ISS) index (Quickscore) with a sample of firms formed by the constituents of the Standard and Poor’s Europe 350 stock market index.FindingsThe authors have not found a consistent significant relationship between Quickscore ratings and firm performance. This main result holds across a variety of checks.Research limitations/implicationsSome of the additional analyses are conducted with rather small samples. The results of these analyses have to be carefully taken. Recommendations for further research are offered.Practical implicationsThe results call into question the usefulness of CGR, marketed by influential consultant companies, and which are becoming increasingly popular among investors, as reliable predictors of firm performance.Originality/valueDespite an increasing body of research on the use of CGR as predictors of firm performance, the available research is heavily concentrated in the US market. No previous study has explored this relationship using the recently developed ISS index Quickscore in a cross-European setting. The use of a cross-country sample of companies allows the authors to address the impact of institutional factors on the CGR-firm performance relationship. Moreover, the authors do not limit the study to the overall scores of the index but examine also the partial scores (pillars) which intend to assess specific dimensions of governance. This makes the evaluation of the relationship more complex and challenging.

Empirical Evidence on the Role of Proxy Advisors in European Capital Markets

Responding to regulators’ requests and filling a void in the academic literature, this paper provides comprehensive empirical evidence on the role of proxy advisors in 14 European countries. Exploiting coverage data and using content analysis of proxy voting reports by Institutional Shareholder Services and Glass Lewis, we provide descriptive analyses of proxy advisors’ firm coverage, the variation and determinants of voting recommendations, the relation between voting recommendations and shareholder voting at annual general meetings, and market reactions to the release of voting recommendations. Overall, our findings suggest an economically important role of proxy advisors in European markets. Throughout our analyses, we document that this role varies with governance- and ownership-related firm characteristics and with country-level measures of institutional strength.

The impact of the Sarbanes-Oxley Act on corporate innovation

We study the effect of the passage of the Sarbanes-Oxley Act (SOX) on corporate innovation. SOX dramatically changed corporate governance landscape of public firms in the U.S, especially in increasing monitoring from outside independent directors, which may have an impact on corporate innovation. The passage of SOX introduced an exogenous shock to the corporate governance structure, which enables us to establish causality between SOX and corporate innovation. Using patent and citation data from the NBER patent citation database, board of directors data from Institutional Shareholder Services (ISS) and a difference-in-difference regression technique, we find that SOX increases corporate innovation, as measured by the number of patents and the number of citations per patent. Moreover, we find that the effects are stronger for firms facing more severe agency problems, i.e., firms with more entrenched CEOs as proxied by a longer tenure, and firms with low institutional ownerships. The effect is also found to be stronger for firms operating in innovative industries.

Ties That Bind: How Business Connections Affect Mutual Fund Activism

ABSTRACTWe investigate whether business ties with portfolio firms influence mutual funds' proxy voting using a comprehensive data set spanning 2003 to 2011. In contrast to prior literature, we find that business ties significantly influence promanagement voting at the level of individual pairs of fund families and firms after controlling for Institutional Shareholder Services (ISS) recommendations and holdings. The association is significant only for shareholder‐sponsored proposals and stronger for those that pass or fail by relatively narrow margins. Our findings are consistent with a demand‐driven model of biased voting in which company managers use existing business ties with funds to influence how they vote.

The Role of Proxy Advisory Firms: Evidence from a Regression-Discontinuity Design

Proxy advisory firms have become important players in corporate governance, but the extent of their influence over shareholder votes is debated. We estimate the effect of Institutional Shareholder Services (ISS) recommendations on voting outcomes by exploiting exogenous variation in ISS recommendations generated by a cutoff rule in ISS voting guidelines. Using a regression discontinuity design, we find that from 2010 to 2011, a negative ISS recommendation on a say-on-pay proposal leads to a 25 percentage point reduction in say-on-pay voting support, suggesting a strong influence over shareholder votes. We also use our setting to examine the informational role of ISS recommendations.Received April 13, 2015; editorial decision June 13, 2016 by Editor Itay Goldstein.

The Role of Mutual Funds in Corporate Governance: Evidence from Mutual Funds’ Proxy Voting and Trading Behavior

AbstractThis paper examines mutual fund families’ proxy voting records to analyze their choices between voting against management (“voice”) and voting with their feet (“exit”). Even though proxy voting is particularly conducive to governance through voice rather than exit, we provide evidence that both exit and voice are important governance mechanisms when Institutional Shareholder Services recommends voting against management. Funds with smaller ownership blocks and shorter investment horizons are more likely to exit, and funds are more likely to exit small, liquid firms with greater insider ownership.

Who Controls Corporate Charters? Shareholder Activism and Charter Amendments

Prior scholarship has characterized corporate charters as relatively static documents that, if ever amended, tend to serve the interests of managers over those of shareholders. This paper challenges the conventional accounts using newly constructed, original data on corporate charters of the 221 largest, publicly traded U.S. companies. The novel dataset shows that, starting around 2005, there was a substantial increase in charter amendment activity that tends to empower shareholders. This paper argues that a new rule from the U.S. Securities and Exchange Commission (“SEC”) in 2003 and its subsequent interpretation regarding mutual funds’ fiduciary duty in proxy voting have played an important role in this change by empowering proxy advisory firms, such as the Institutional Shareholder Services (“ISS”). The general rise of shareholder influence on charter amendments, however, has not completely shifted control from managers to shareholders. Directors’ exclusive right to dictate the final draft of charter provisions has enabled managers to make compromised implementations which impose limitations on how shareholders can exercise newly granted rights. This paper argues that the current practices of the SEC and proxy advisory firms tend to disregard such compromises and presents suggestions on how to better facilitate a more nuanced debate on charter amendments.

The Effect of Corporate Governance on Corporate Social Responsibility

Motivated by agency theory, we explore the effect of corporate governance quality on corporate social responsibility (CSR), using the governance standards provided by Institutional Shareholder Services (ISS). Our evidence reveals that firms with more effective governance make significantly less investment in CSR. It appears that managers tend to over-invest in CSR and are forced to reduce CSR investments when corporate governance is more effective. In particular, an improvement in governance quality by one standard deviation translates into a decline in CSR investments by 7.16%. Our fixed-effects analysis also shows that, within firms, when governance quality improves over time, CSR investments decline significantly. Using the passage of the Sarbanes-Oxley Act of 2002 as an exogenous shock that improves the quality of corporate governance, we demonstrate that high-quality governance is not merely associated with, but rather brings about, lower CSR investments.

The impact of political connections on the quality of corporate governance

This study examines whether the quality of governance of politically connected firms is different from the quality of governance of firms that have no political connections. Based on S&P/TSX firms from 2010 to 2014, and using the Institutional Shareholder Services Governance Index, our study shows that politically connected firms have higher risk levels associated with the overall governance index than non-connected firms. More specifically, the risk in politically connected firms is greater with respect to shareholders' rights and structure of compensation indexes. However, no significant difference between politically connected and non-connected firms was noted in terms of governance risk related to board structure or audit and risk oversight indexes. The risk associated with structure of compensation and shareholders' rights is higher than that associated with other aspects of governance (board structure, audit and risk oversight).

The impact of political connections on the quality of corporate governance

This study examines whether the quality of governance of politically connected firms is different from the quality of governance of firms that have no political connections. Based on S&P/TSX firms from 2010 to 2014, and using the Institutional Shareholder Services Governance Index, our study shows that politically connected firms have higher risk levels associated with the overall governance index than non-connected firms. More specifically, the risk in politically connected firms is greater with respect to shareholders' rights and structure of compensation indexes. However, no significant difference between politically connected and non-connected firms was noted in terms of governance risk related to board structure or audit and risk oversight indexes. The risk associated with structure of compensation and shareholders' rights is higher than that associated with other aspects of governance (board structure, audit and risk oversight).