ISS, The Gorilla You Should Make Nice To
from May/June 2003
by John R. Engen
A month before Hewlett-Packard shareholders were set to vote on the company’s merger with Compaq, the outcome was still in doubt. HP director Walter Hewlett, the co-founder’s son and an outspoken critic of the deal, already had 20% of the shares behind him and seemed to be gaining ground on his formidable rival, CEO Carly Fiorina.
As we all know, Fiorina won shareholder support, but by the narrowest of margins. The key in this squeaker came just two weeks before the March 2002 vote, when the big proxy advisory firm Institutional Shareholder Services backed the merger. Its recommendation, complete with saturation TV coverage and front-page newspaper stories, clinched some votes—including the 3.1% of HP shares owned by Barclays Global Investors, which had already said it would follow ISS’s guidance—and swayed many other ISS clients, large investors that held 20% of HP shares. The publicity undoubtedly also pushed other shareholders, big and small, off the fence.
Though its role in the outcome of the HP-Compaq deal was something of a public coming-out, many investors, companies, and proxy solicitors have recognized ISS’s muscle for years. The Rockville, Maryland, outfit’s 750 clients include most of the biggest names in pension and mutual funds, among them TIAA-CREF, Fidelity Investments, and the California Public Employees’ Retirement System, which together manage $3 trillion in assets.
ISS keeps careful tabs on the interests of its clients. If even one of them owns shares in a company, ISS casts its analytical gaze on any matter requiring a shareholder vote, always offering its opinion in unvarnished terms. Last year the firm issued vote recommendations for about 10,000 shareholder meetings in the U.S., and even more in other countries.
The bases for many of those recommendations, such as how ISS figures the real value of stock-based compensation for top executives, are strictly quantitative; others, such as whether to vote for incumbent directors, are founded more on principles like accountability and good governance practices. “When we see proposals that improve corporate governance, we’re likely to be for them,” says ISS chief executive Jamie Heard. “If a proposal takes rights away from shareholders, we’ll be against it.”
As the 2003 proxy season enters its final stretch, ISS’s influence on how shareholders vote is only expected to increase. Last year’s corporate governance shenanigans, heaped on top of three years of poor investor returns, have cost-conscious fund managers looking for outside advice. They don’t have many places to look. ISS, which recently merged with its biggest competitor, Proxy Monitor, has a near-monopoly in the field.
ISS vows to assess this year’s proxy issues with the view that the new Sarbanes-Oxley Act doesn’t go far enough. The firm will suggest that investors vote against the reappointment of auditors—and oppose the reelection of audit committee members—when nonaudit fees exceed the amount paid for the actual audit. It plans to back shareholder proposals demanding the regular rotation of audit firms, which goes well beyond the new law’s requirement that firms rotate senior partners assigned to corporate audits every five years. ISS will also endorse proposals calling for the expensing of stock options. “I can’t imagine any good reasons for not expensing options,” Heard says.
The firm will back proposals requiring boards to be at least two-thirds independent—a higher threshold than in rules being considered by the New York Stock Exchange and NASDAQ, which call for only a simple majority of independent directors. In some cases, demands that the jobs of CEO and chairman be separated may also get ISS support. “If a company has a strong, independent governance structure and doesn’t want a separate chairman, we might go along,” Heard says. “But if there’s a lack of independent committees or too many insiders, we’re likely to support the resolution.”
Individual directors will also come under the ISS microscope. Last year, says ISS vice president and special counsel Patrick McGurn, the firm recommended “withhold authority”—don’t vote for—in the case of at least one director at about a third of the companies whose proxies it considered. This year it is adding more stringent director-independence hurdles that will probably increase that percentage.
Investors, of course, are free to do what they wish with ISS’s opinions. Technically speaking, it would be a breach of fiduciary responsibility for fund managers to simply vote as ISS suggests, says Nell Minow, co-founder and editor of the Corporate Library (www.thecorporatelibrary.com), a shareholder watchdog. In reality, however, that’s just what some of them do.
Sometimes this adherence is meant to avoid conflicts of interest. During the HP-Compaq vote, for example, Barclays Global Investors committed itself early to voting however ISS saw fit, because CEO Patricia Dunn was an HP director. More often it’s a matter of cost and convenience. Large index-fund managers are simply too overwhelmed to pore over thousands of proxy proposals themselves. Even fund families with in-house research staffs concede that they rely on ISS’s recommendations more than they’d like.
At the least, many big investors treat the firm’s judgments as “rebuttable presumptions” that require significant persuasion to overcome, says Jack Capers Jr., a partner specializing in corporate governance at the Atlanta law firm King & Spalding.
Because many institutions are not required to disclose how they vote, it’s impossible to specify ISS’s impact. But a 2000 study by Stuart Gillan, a professor at the University of Delaware’s corporate governance center, found that recommendations from the firm typically produce vote swings of between 8% and 20%. Although that doesn’t necessarily ensure victory or defeat, “an ISS recommendation is significantly associated with the final voting outcome,” Gillan says.
This kind of clout embitters companies that wind up on the short end of ISS’s opinions. Some charge that the firm employs an “ivory tower” approach emphasizing governance standards over bottom-line results. Others say that given the volume of proposals ISS weighs each year, it’s impossible for its 81 analysts to provide the level of diligence appropriate for each one. The firm’s squeaky-clean reputation wasn’t helped last year when Ram Kumar, head of U.S. equity research, was fired after a magazine reported that he had lied on his résumé about graduating from law school.
Yet because proxy issues come up every year, few critics are willing to say anything publicly. “Everyone is afraid of ISS, because they’re so influential with investors,” says one proxy solicitor. “You don’t want to get on their bad side.”
ISS officials call that overreaction. The firm’s judgments are based mostly on empirical methods, they insist, not on personalities or theoretical notions about corporate governance. “Our clients don’t pay us to be evangelists for good governance, and we don’t lead them around by the nose,” McGurn says. “We reflect our clients’ views. They pay us to figure out what’s in the best long-term interests of shareholders. If people view ISS as anything else, they’re mistaken.”
ISS’s rise to power shows how much the investing world has changed. Back in 1985, when Robert A. G. Monks, now head of Lens Governance Advisors, started ISS, its stated mission was to spur activism among large institutions. Big investors, it turned out, weren’t interested in that. But they did want a central clearinghouse for investor research—and voting recommendations.
When Jamie Heard signed on in 1991, ISS was a one-product shop, providing research and recommendations on S&P 500 stocks. Today it has expanded into 60 countries. The fastest-growing part of the business lies in providing recordkeeping and other behind-the-scenes services to big investors. About 60% of ISS’s clients use these offerings. The outfit’s revenues reached $40 million last year; it declines to disclose earnings.
ISS’s growing clout has inevitably led to charges that the firm has become too powerful. Its biggest remaining rival, the nonprofit Investor Responsibility Research Center, does proxy research but doesn’t make recommendations. Some charge that ISS is leveraging its influence to profit in ways that should make a watchdog blush. In recent years the firm has begun rating companies numerically on their adherence to accepted good-governance principles or on how their stock-based compensation plans stack up, while simultaneously marketing consulting services to help companies improve those scores. “What bothers me is that ISS is using its position of power to make money for itself,” says one proxy solicitor. Adds Jennifer Bethel, a finance professor at Babson College in Wellesley, Massachusetts: “They’re rating companies and then selling advice to those same companies as consultants. The SEC just made accounting firms stop doing that. As a firm, they’re creating risk for themselves, because the optics are bad.”
Heard responds that ISS has a series of policies—ranging from the use of separate consulting and analyst staffs to the disclosure of any working relationship with a company it rates—that preclude conflicts of interest. The firm is also registered as an investment adviser with the Securities and Exchange Commission; registration carries with it some modest oversight. But Heard also asserts that ISS is a business that deserves to be paid fairly for its services. “If we have influence with our clients, it’s because they trust the work we do,” he says.
What’s clear is that boards and managements ignore ISS at their peril. In an era when institutions own an estimated 70% of all outstanding shares, the firm has become an influential matchmaker in the proxy-season dance. Its 2001 support of First Union over SunTrust Banks in the battle to acquire banking giant Wachovia is believed to have turned a too-close-to-call contest into a 60-40 laugher. Similarly, its support of dissidents in a 2001 boardroom scuffle at ICN Pharmaceuticals is seen as having given rivals of CEO Milan Panic the added muscle needed to win three directorships.
Many companies—and dissidents—view winning the firm’s support as a top priority in any proxy fight. “Have you ever tried to reach the manager of an index fund to solicit his vote?” asks Seymour Holtzman, an activist investor who tried, and failed, to do that in recent board-seat battles at Liquid Audio and Thistle Group Holdings. (ISS supported him on Liquid Audio but not Thistle Group Holdings.) “They won’t return your calls, but they listen to ISS.”
So do those considering proxy fights. Untold numbers of proposals never see the light of day, scrapped after their proponents find that ISS thought little of similar proposals at other companies and that investors tended to follow the thumbs-down signals. “All the proposals that never make it to the ballot show ISS’s real influence,” says Babson’s Jennifer Bethel. “It’s the dog that doesn’t bark.”
In many cases, winning ISS backing is easier than it might appear. About 40% of the firm’s recommendations address recurring proxy matters, including director elections and auditor selection. Those are based mostly on a combination of empirical research and polling of client institutions. All ISS policy changes require a year’s review by clients before they take effect, and the criteria are published, which makes them relatively simple to predict.
In reviewing most charter and bylaw proposals, such as stock authorization programs, ISS combines quantitative measures with industry comparisons. Companies that plan to use proceeds from a share offering to pursue an acquisition that has shareholder support, for example, usually receive a thumbs-up from ISS analysts, while those that offer no clear purpose for those funds are likely to be opposed.
ISS recommendations also show a pattern in contested mergers. When Harry Robinson, then CEO of Cohoes Bancorp in upstate New York, was lobbying for support of a merger with Hudson River Bancorp in 2000, proxy solicitors told him ISS “always backs the dissidents”—a prophecy that, in his case, unfortunately turned out to be true. Dissidents tend to think just the opposite. “ISS clearly has a predisposition to support management and makes a general presumption that boards do the right thing,” said Walter Hewlett after the firm came out in favor of the HP-Compaq deal. Hewlett had it right. McGurn says that ISS supports management-led mergers 90% of the time, opposing a transaction only if it’s “a bad deal on its fundamentals,” if there’s a better offer, or if it is bundled with “governance killers” such as a dual-class voting structure.
Companies that wish to win ISS backing can do things to boost their chances. The firm favors proposals that are well drafted, outline a clear vision, describe who will oversee the merged companies, and have the support of the outside board members. “They like a solid plan and quality directors,” says Holtzman, who has won ISS’s backing in several contested proxy fights. Lobbying big institutions early on to win their support, and then showing that support to ISS, also tends to score points.
As the voting date approaches, many companies request an audience with ISS analysts. These interviews sometimes take place by phone, though it’s considered more effective to meet with the firm’s officials in person. “Bring along an independent director” to show nonmanagement support for the initiative, advises one proxy solicitor.
ISS also likes such meetings. During the HP contest, McGurn says, “we demanded a significant amount of face time” with both sides to discuss integration issues. Not surprisingly, they got it.
But face time is no guarantee of success, as Harry Robinson of Cohoes Bancorp found out. ISS analysts, he says, heard his presentation, asked few questions, and opposed his plan several weeks later, having “pretty much ignored what we had to say.” The merger was rejected by 51% of the shareholders. “Absolutely, the ISS recommendation swayed the vote,” Robinson says. “Their advice was take the money [of a counteroffer] and run. They couldn’t grasp the strategy.”
This idea that ISS favors short-term payouts and rigid calculations over long-term strategy is a common complaint. “ISS assumes that the right answer for every company is to always have a ‘for sale’ sign on the door, and that directors can’t be trusted to make those decisions in the best interests of shareholders,” grouses one corporate attorney.
Similar controversy could emerge with what some proxy solicitors expect to be one of this year’s most contentious issues: repricing option plans when the stock is underwater, or issuing new options while stock prices are low. ISS will sometimes support repricing options, but only if the plan meets certain criteria, among them a complicated mathematical formula that measures the cost, reduces it to a percentage of a company’s market capitalization, and then compares that with an industry average.
The problem for many companies is that falling share prices have brought their market caps to levels where they won’t be able to meet ISS’s requirements. “There are companies screaming that they need options to attract or retain good employees,” says Thomas Long, an executive vice president with proxy solicitor D.F. King & Co. “But because of the [declining] stock market, they’re running up against huge dilution numbers that exceed ISS’s caps.”
As with other issues, McGurn says, ISS will take repricing arguments on a case-by-case basis and will sometimes look beyond the numbers and support a repricing, provided the company can show the need for it, doesn’t include senior executives in the new plan, and puts the matter up for a shareholder vote. Last year Eastman Kodak and BMC Software offered such proposals. Both won ISS backing—and shareholder support.
Playing everything the ISS way may well be the best course this proxy season.
