ESMA Says Proxy Advisor Industry Doesn't Need EU Regulation - It Needs A Code of Conduct

The European Securities and Markets Authority (ESMA) recently determined that no additional EU regulation concerning proxy advisors is warranted at this time. The ESMA found that additional regulation was not justified because it had not been provided with clear evidence of market failure in relation to how proxy advisors interact with investors and issuers. However, it did identify several concerns and recommended that the industry develop a code of conduct. In two years the ESMA may reconsider its position if no substantial progress has been made. The Final Report of the ESMA can be found here.

Background

In March 2012, ESMA published a Discussion Paper on proxy advisors, seeking input of stakeholders on several key issues relating to the proxy advisory industry, and asked whether market participants see any need for policy action in this area. ESMA viewed the Discussion Paper as an opportunity to gain evidence on the extent to which “market failures” related to the activities of proxy advisors may exist, the extent to which EU-level intervention might be appropriate, and what ESMA’s role might involve.

The Discussion Paper noted that if evidence demonstrates that there are market failures (e.g., so that advice given cannot be said to be accurate, independent and reliable) and these market failures give rise to regulatory concerns, there might be increased need for the introduction of measures to address such concerns. Such measures would ultimately aim to achieve better outcomes through the shareholder vote process (e.g., by minimizing factual errors contained in reports, mitigating or eliminating conflicts of interest that impair the independence of any advice and enhancing the level of transparency in the proxy advisor market).  Even without clear evidence of market failure, some regulatory initiatives may be considered as necessary in order to prevent potential risks.

The Discussion Paper invited contributors to provide ESMA with their input on 12 questions, which ranged from the degree of influence of proxy advisors on investors’ voting to the key issues related to the offer of their services, ending with the existence of a need for any policy action in this area. A total of 63 comment letters were received (57 were non-confidential and are available here.

Final Report

After analysis of the inputs received, ESMA concluded in the Final Report that it has not been provided with clear evidence of market failure in relation to how proxy advisors interact with investors and issuers. On this basis, ESMA currently considers that the introduction of binding measures would not be justified. However, based on its analysis and the inputs from market participants, ESMA considers that there are several areas, in particular relating to transparency and disclosure, where a coordinated effort of the proxy advisory industry would foster greater understanding and assurance among other stakeholders in terms of what these can rightfully expect from proxy advisors. Such understanding and assurance will help to keep attention focused where it belongs, namely on how investors and issuers can, from their respective roles foster effective stewardship and robust corporate governance, and ensure efficient markets. Consequently, ESMA considers that the appropriate approach to be taken at this point in time is to encourage the proxy advisory industry to develop its own Code of Conduct. 

While ESMA will facilitate the establishment of the work on a Code, ESMA states that the Code will need to be drafted and adopted by the proxy advising industry itself.  In two years the ESMA may reconsider its position if no substantial progress has been made.

Observations

So why did the ESMA not recommend additional EU regulation, and only suggest an industry code of conduct?  The Final Report states:

“The rationale for this decision mainly relies on the feedback coming from the market. ESMA asked specifically whether stakeholders consider that there is market failure in relation to how proxy advisors interact with investors and issuers. The feedback did not provide any clear examples of such market failure.” 

I had expected that feedback from issuers would reveal some “market failure” examples.  However, after reading several of the letters it became apparent that most did not provide much detail.

 The Hundred Group

 For example, the letter written by The Hundred Group:

“The Hundred Group represents the views of the finance directors of FTSE 100 and several large UK private companies. Our member companies represent almost 90% of the market capitalisation of the FTSE 100, collectively employing over 7% of the UK workforce and in 2011, paid, or generated, taxes equivalent to 13% of total UK Government receipts.”

The Hundred Group’s seven page letter was big on concerns and suggestions but weak in any actual examples of “market failure.”  I’m not sure if there was one concrete example in the letter. In any event The Hundred Group was wary of the introduction of additional regulation, either at the national or European level. In its experience, regulation risks significant unintended consequences.  It preferred the development of an industry code, along national lines, against which advisors measure their compliance and which provides a framework for institutional investors to govern their use of proxies.

On a more interesting side note, The Hundred’s Group’s letter also had recommendations concerning the conduct of institutional investors:

“Investors should be required to notify the company of any intention to vote against a resolution with at least 14 days notice, in order to give the company the opportunity to engage in a dialogue with the investor. If this were to happen in every case, the need to understand the advisor’s methodology diminishes, although we would still find it helpful if any deviations from a standard model were being employed.”

“In our view there should be an ownership threshold above which an institution should retain the responsibility for both engagement and the voting decision – we recommend that this is set at a maximum of 1% of the voting capital of the company. In the case where the ownership level is lower and an institution relies on the advice of the proxy [advisor], a mechanism should be in place which allows the investor to understand and challenge the proxy’s advice.”

EuropeanIssuers

A letter from EuropeanIssuers.  

"EuropeanIssuers is the first and only pan European organisation created to promote the interests of issuing companies. It represents the vast majority of publicly quoted companies in Europe. Its members are national associations and companies from 14 European countries counting together some 9.200 listed companies with a combined market value of some € 5.000 billion."

Its four page letter states that its members do not favor binding EU regulation.  A majority of the members prefers either an EU-wide industry code or an EU recommendation which can be implemented in national codes or regulation as appropriate.  I didn’t find concrete examples of market failures in the EuropeanIssuer’s letter either.

Manifest Information Services

Manifest Information Services is not an issuer, but I found its letter interesting. In fact, it points out what I perceive to be a flaw in the Discussion Paper, and why I believe respondents did not identify specific examples of “market failure” from which ESMA might have been educated. Although the Discussion Paper refers to “market failures,” none of the 12 specific questions requesting comment refer specifically to “market failure.”  As Manifest points out, the Discussion Paper “does not state whether the problems referred to are, or if there has already been, a market ‘failure’ or simply feels there is potential for a market ‘failure’. Indeed, ESMA does not even explain what market failures might be, such as a failure of securities markets, investment markets, markets for research, markets for access to issuers and so on.”  While I am not suggesting there is evidence of systemic market failures due to proxy advisers, I am saying that the Discussion Paper could have been clearer, which could have resulted in more examples. Alternatively, the lack of examples could also stem from issuer apathy towards responding to, or lack of awareness of, the Discussion Paper, or there just is no evidence.

In any event, Manifest’s 37 page letter is a stimulating read. To give you a flavor, it starts out with “We question the regulatory competence under which ESMA has taken it upon itself to investigate this issue,” and it ramps up after that.