Proxy advisers have inherent incentive to create controversy, study shows

When an institutional investor uses recommendations from a proxy advisor to cast a vote on shareholder issues, they may want to proceed with caution.

According to a new study by Nadya Malenko and Andrey Malenko, associate professors of finance at the University of Michigan’s Ross School of Business, professional proxy consultancies have an incentive to publicly recommend a vote contrary to what corporate management proposes.

That doesn’t necessarily mean the advisors are making misleading recommendations, but it does suggest that investors should be aware of the situation, they say.

Proxy advisors are companies that analyze proposals that a company’s shareholders should vote for, and then sell their analysis to the shareholders. Although they have been around since the 1980s, they have recently become more prominent with the emergence of institutional investors, who have large portfolios and require the services of the proxy advisors.

At the same time, the proposals to be voted on have become more complex, says Nadya Malenko.

The detailed investigative reports that proxy advisors provide to their clients are private, but their final recommendations on how to vote are often widely known through the media.

In previous research, Nadya Malenko found that proxy advisors are directly responsible for moving an average of 25% of the vote on proposals related to executive pay. Whether this strong influence should be a concern depends on the quality of advice from proxy advisors, she says.

“If they do informational research and recommendations, that’s great because they make voters more informed. But if the quality of the advice is poor, then this influence is worrying,” she said.

Malenkos’ paper focuses on a fundamental conflict: Investigative reports from advisors are more valuable to shareholders if the outcome of the vote is uncertain. Therefore, proxy advisors have an incentive to make recommendations that are “controversial” and go against what the company is proposing, says Nadya Malenko.

“If we think about their business model, they’re information sellers. They get their profits from selling their research to shareholders,” she said. “By aligning their recommendations with the more likely alternative, proxy advisors give shareholders more incentives to invest in information.”

She says the new findings don’t necessarily mean that consulting firms are also making poor recommendations in practice.

“This is a theory paper; it highlights that this problem, this fundamental conflict of interest, exists,” she said. What we can’t say is whether these are really recommendations. We hope the next step for empirical research will be to investigate that.”

In the meantime, however, the investigation could lead to reforms to address the conflict of interest.

“We hope our paper will provide a useful conversation,” said Nadya Malenko. “A possible policy implication is to disallow these public recommendations. The proxy advisors’ report could provide all of the analysis, but would not end up with a prescribed recommendation to vote yes or no. It is not necessarily an optimal solution, but under Certain circumstances it might help.”

The study is available online as a working document in the SSRN Electronic Journal