Theoretically, the owners of publicly traded corporations decide how to govern them. At the annual meeting, shareholders submit proxy votes to select members of the board of directors. They also decide which policies the corporation will put in place. Anyone who owns stock in a corporation can submit a proxy vote, but large mutual funds and the corporation’s executives often have the most influence over decisions because they own the most shares.
Mutual funds often manage billions of dollars for clients who hope to retire some day. These clients, often full-time employees of other companies, don’t have the time or the expertise to participate in corporate governance decisions. So they contribute money to a 401k account and buy mutual fund shares with the money in that account. Beyond that point, these clients don’t actively participate in making decisions for the companies whose stock they own.
Instead, the mutual fund managers make the proxy voting decisions for each stock the fund holds. Making decisions about corporate governance is one of the fiduciary duties of the fund manager, in addition to picking stocks according to a specified investment plan. For example, a growth fund manager will buy stocks when their revenue is expected to grow faster than that of other companies. And a momentum fund manager will invest in stocks if their prices have gone up recently.
But there are a lot of growth and momentum stocks. The fund manager may hold shares in hundreds, or even thousands, of companies. An index fund may even own shares in every company listed on a major stock exchange in the United States. And that means that the fund manager is responsible for making the proxy votes for each of these stocks. That’s a lot of responsibility, and the fund manager’s clients can file a lawsuit if a bad decision causes a stock in the fund to go down.
So fund managers outsource the research. They hire proxy advisory firms to investigate the proposals that will be voted on at the annual meeting. And these firms decide what decisions are the best ones for the corporation to make. The fund manager can then accept the decision made by the proxy advisory firm, satisfying fiduciary responsibilities. The fund manager does not even have to fill out the proxy voting form and send it in to the corporation. Through a process known as robo-voting, the proxy advisory firm can fill in the form with the mutual fund manager’s credentials and send it in directly.
Two proxy advisory firms, ISS and Glass Lewis, provide this service for most of the mutual funds in the United States. These firms influence the votes for shares of stock worth trillions of dollars. And while the largest fund managers perform their own research and make the final decisions themselves, many smaller funds just allow the proxy advisory firms to make whatever decisions they want. This includes many large government pension funds.
In 2019, the Securities and Exchange Commission created a proposal that could reduce the influence of the proxy advisory firms. Corporations would receive the right to respond to the proxy advisory firm’s proposal and point out mistakes in its research before the vote took place. And proxy advisory firms would have to provide details about their conflicts of interest. For example, a firm may provide consulting advice to companies about how to improve their scores on metrics that the same firm uses to make voting decisions. But this proposal would not ban robo-voting, so the proxy advisory firms would still be able to automatically submit votes for their clients.
The proposal has not yet been implemented by the SEC. It’s still possible that the agency could ban robo-voting. The SEC could also eliminate the commentary period that would allow corporations more time to respond to the proxy advisor’s recommendations. And other changes, like adjustments to the rules about reporting conflicts of interest, could take place as well. But regardless of what the final rules look like, the SEC is expected to release new rules for proxy advisory firms within the next few months.